Global Value Investing

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A multifaceted approach to value investing with stock valuation based on intrinsic value estimated from cash returns, appraised value of assets, and other facets of value.

 

 

Four-Step Selection   |   Safety First   |   Calculation   |   Simulation


The Four-Step Common Stock Selection Process is the practical counterpart of the theory-based Four-Step Common Stock Investment Program (see invest). Whereas Four-Step Investment explains the "why" of intrinsic value investing with stock valuation, Four-Step Selection demonstrates the "how" of intrinsic value investing.

Four-Step Selection

Each step in the practical selection process is designed with the goal of safety foremost in mind. The number of steps is arbitrarily defined to focus clearly on the most critical components. The four steps in the process are summarized in the following table and then elaborated below.

Four-Step Common Stock Selection Process

Step 1

Search for investment ideas within circle of competence.

Step 2

Evaluate the company using discounted cash flow model.

Step 3

Study the company and its competitors exhaustively.

Step 4

Decide whether to buy with margin of safety, sell or hold.

STEP ONE : SEARCH. Search the universe of investment opportunities in marketable securities to identify acceptable investment candidates for further analysis. Although intrinsic value investing applies to companies, stocks, bonds, and cash (usually in a no-load money market fund), the valuation model is used most often for minority interests in individual common stocks.

Either the choice of a universe of stocks or at least one stock-search criterion should reflect each investor's "circle of competence." The specific circle of competence is initially based on an area of interest in which competence increases with experience in the area. The other stock-search criteria should be based on the investor's interpretation of economic fundamentals, financial statements and narrative disclosure. Interpretation requires translation from what the numbers are to what the numbers mean.

The primary search methods are (a) mechanical filtering and rank ordering of databases, either print or digital, with or without software for screening and sorting, (b) reading business and financial news media, (c) performing scientific research, and (d) receiving ideas from other investors.

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TEP TWO : EVALUATE. Evaluate the candidate company and its common stock by estimating its investment value both as a going concern and as a resource converter, and then determine its margin of safety. This will involve a calculation using one of several model types based on discounted cash flow. It is important to not take the numbers at face value, but rather to go behind the numbers to determine what they mean. An estimate of the breakup value of the company can serve as a check on its current stock market price. This involves an appraisal of individual assets that comprise the going concern. Companies present arbitrage opportunities whenever they are worth more dead than alive. The breakup value of selling the assets, paying off the debts and distributing the remainder to stock owners can serve as a floor or lower value, and the replacement cost of the assets less liabilities can serve as a ceiling or upper value of the common stock. Ideally, the book value of property, plant and equipment approximates the replacement cost of its productive capacity.

Beware of hybrid approaches that incorporate both valuation and pricing. Pricing models include the use of technical analysis charts for trend and momentum. All too often, the market-analysis tail ends up wagging the security-analysis dog. Refer to Step One of the Investment Program.

Also beware of hybrid models that incorporate both valuation and pricing such as the use of beta coefficients or so-called volatilities. This includes market-specific, industry-specific, and company-specific betas. Such models are self-contradictory and confound the concept of investment risk with a statistical entity equal to the ratio of two correlation coefficients in a capital asset pricing model that assumes the markets are perfectly efficient, i.e. that price always equals value. Refer to Step Four of the Investment Program.

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TEP THREE : STUDY. Study the company, its competitors, and its industry exhaustively if the margin of safety is sufficiently compelling to justify further interest. The objective is to determine whether the market price is in error or the intrinsic value calculation is in error for this stock.

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TEP FOUR : DECIDE. Decide whether there is sufficient safety margin to execute a market order to open a long position to buy the stock. Transaction costs are of secondary importance, but check to see if the stock can be purchased directly from the company without going through a broker. Also, check to insure that share price is high enough and trading in the stock is active enough to avoid speculative situations. For example, a minimum price of $5.00 per share and 10,000 shares or higher average daily volume for the past several months will help to avoid squeezes and manipulative situations.

A Note on Universes. Hubert M. Blalock, Jr. in Social Statistics, Revised Second Edition, 1979, McGraw-Hill, Chapter 8 Introduction to Inductive Statistics, page 8, writes: "The purpose of statistical generalizations is to say something about various characteristics of the population studied on the basis of known facts about a sample drawn from that population or universe. We shall refer to the characteristics of the population as parameters as contrasted with characteristics of a sample, which are called statistics. Footnote 2: The terms population and universe are generally used interchangeably in the statistical literature."

Although selection of individual common stocks for investment begins with a choice of universe, however implicit that choice may be, stock selection is not a statistical process. Thus the so-called measure of "risk" in the Capital Asset Pricing Model, the beta coefficient relative to some proxy of the market as a whole, is not utilized. Beta may have a place in the analysis of pricing in the capital markets as a whole (regression to the mean marginal mania) or of other "portfolios" for policy purposes but not in the valuation of individual common stocks for investment purposes.

Universes of common stocks can be conveniently defined in terms of (1) stock exchanges and stock markets; (2) continuous pre-selected groups such as averages, indexes, and lists; or (3) data sources. Examples of explicit stock universes include those common stocks traded in developed country stock exchanges, U.S. stock markets, exchange-listed stocks (not over-the-counter), or the New York Stock Exchange. Alternative stock universes include the Dow Jones Industrial Average, the S&P 500 Common Stock Price Index, and the Fortune 500 lists of the largest companies with publicly-traded stock. Further stock universes include the Value Line Investment Survey, Standard & Poor's Earnings Guide, and Internet on-line databases.

A Note on Circle of Competence. The Four-Step Investment Program applies equally to all intrinsic value investors because it is based on unchanging principles. In contrast, the companion Four-Step Selection Process differs for each intrinsic value investor because it reflects the circle of competence, or circle of interest which becomes a circle of increasing competence with the accumulation of experience by the individual investor.

The circle of competence is a specific application of the general principle of differential knowledge. Friedrich A. Hayek noted that "practically every individual has some advantage over all others because he possesses unique information of which beneficial use might be made."

The circle of competence of each investor reflects his or her personal qualities including risk tolerance, temperament, interests, knowledge, intelligence, and judgmental ability. Therefore, each step in the selection process will uniquely conform to the particular individual investor.

In addition, the circle of competence of each investor represents an arena where he or she has no competition from other market participants. This arena is a confidential monopoly created by the investor. This secret monopoly position is a proprietary interest in intellectual property. With confidentiality, there is no second guessing of an investor's judgments by others. Unless the investor purchases a significant proportion of a company's total shares outstanding, there are no legal disclosure requirements that compel him to reveal his purchase transactions to the public.

The investor uses the tools and techniques of security analysis, but the investor's job is not the same as the security analyst's job. Where a security analyst must be prepared to appraise the value of every common stock or other security traded in the market, the investor only needs to appraise those stocks in his circle of competence. Textbooks and professional reference books are written from the perspective of the security analyst. Therefore, these books cover the valuation and pricing of all securities, even if it means presenting models that are not appropriate for true, pure, intrinsic value investing.

A Note on Screening. Screening or filtering is not evaluation. Formal screening of the universe of stocks is optional. It is one way to produce a short list of investment candidates for evaluation and study within a circle of interest or competence. Screens can be either financial such as price-related or non-financial such as socially responsible investments or economically responsible investments. Screening also can be either positive screening that selects in, negative screening that selects out (deselects or rejects), or a combination of both. In addition, screens can range from few and simple to numerous and complex. Each investor can experiment to find out what works best for him or her.

A Note on Dividends versus Free Cash Flow to Equity. Each share of an ordinary issue of common stock of a company entitles the owner of the share to a pro rata portion or share of the company's assets, earnings, cash distributions, and voting power. In the process of creating value for company owners, capital investments are made by the company in promising projects with expected rates of return higher than the cost of capital, the depreciating assets of these projects generate earnings, part of these earnings are retained or plowed back in the company for reinvestment in new projects, and the other part of the earnings are paid out in cash dividends periodically, usually quarterly. Newer and relatively fast-growing companies are less likely to pay a regular cash dividend than older and relatively slow-growing companies. Even though the assets are working for the stockholders and the retained earnings are reinvested for the stockholders, the investment value of the company is based exclusively on the cash dividends paid to the stockholders and any selling price received by the owners.

To estimate the investment value of a company, the best approach is to estimate total annual dividends for a number of years. If a company does not yet pay a regular dividend, then the second best approach is to estimate total annual free cash flow to equity. This will approximate what the cash dividends could have been if management did not choose to retain all the earnings instead of borrowing money from a bank or issuing more stock in the market to raise financial capital in order to finance new company projects. Under the proper assumptions for dividends and for free cash flow to equity, the two approaches produce comparable results. The total investment value of the company is either discounted dividends or discounted free cash flow to equity, but not the sum of the two. Likewise, the dominant valuation in a particular situation may be based on either book value or breakup value of the assets in a resource conversion rather than discounted value in a continuing going concern, but these independently calculated values would not be added together because this would be double counting.
The seemingly different discounted dividend, capitalized earnings, and free cash flow estimates of investment value are shown to be equivalent. The reconciliation of these equivalent models in presented in the textbook.


Safety First

Practice safe investing. The margin of safety, you may recall, is the difference between intrinsic value and market price. Take the pulse of the stock market with the Bull & Bear Profile of the Price-to-Value graph to prepare you for practical valuation and intrinsic value investing. Whereas intrinsic values are relatively stable, market prices are highly volatile. The margin of safety is not a measure of risk but rather a prophylaxis against impulsive choices and emotion-driven actions in the stock market. As such, the safety margin is an antidote for fashionable yet foolish financial fads.

Intrinsic value refers to the true economic value of an investment asset and represents the standard to which market price quotations can be compared. Value investors look for stocks that are underpriced (not undervalued) by a margin sufficiently compelling to justify long-term investments in long positions. Short-selling of overpriced stocks is theoretically possible, but usually this is a technique utilized by short-term traders acting on rumors or noise.

For the absolute valuation of common stocks, discounted cash flow analysis is used and referred to here as the DCF model. Other approaches are available such as comparative valuation and contingent-claim valuation, but they are less desirable. A general version of the DCF model requires year-specific inputs of all variables. Specific versions of the DCF model are designed to shortcut the data input process by invoking simplifying assumptions and thereby holding one or more variables constant or setting them equal to zero.

For any given investment opportunity, an investor can choose an appropriate model, an appropriate version of the chosen model, and appropriate modifications to the chosen version for each particular case. The modifications follow from the principles and concepts of the intrinsic value investing philosophy in order to avoid over-reliance on formulaic approaches which can lead to error when conditions change.


Deterministic Calculation

An estimation of intrinsic economic value is shown as an example to illustrate the basic elements involved. The example is an appraisal of a hypothetical company in an unspecified circle of competence for an anonymous investor. The example uses MS Excel spreadsheet analysis, statistical analysis, and charting capabilities to display the parameters of the estimate, the input data requirements, and the graphical presentation of results for the general version of the DCF model.

The spreadsheet table of the most general version of the DCF model is the broadest case that can be encountered.
Every other variant of the DCF model is a narrower version of this general model. Simplified DCF models are useful because they lessen the need for input data and reduce the number of intermediate calculations. But the greater the simplification, the narrower the application and the rougher the approximation of the estimate.

The most simplified version of the DCF model assumes that each item of variable input data is either constant or zero, as follows.

Reducing the most-general DCF model to the most-simplified DCF model

Number

Assume

Description

1

Constant

deterministic, single-point estimate of value rather than stochastic (probabilistic) estimate of a range of values for every period in perpetuity

2

Constant

if converting to US Dollars from another currency, then constant currency exchange rate between USD and the other currency for every period in perpetuity

3

Zero

no margin loans for every period in perpetuity

4

Zero

no income taxes for every period in perpetuity

5

Zero

no transactions costs for every period in perpetuity

6

Constant

constant discount rate (investor-specific opportunity cost for the relevant investment time horizon) for every period in perpetuity

7

Constant

no price-level inflation for every period in perpetuity

8

Constant

constant cash dividend payment or free cash flow to equity account (not constant growth rate) for every period in perpetuity

Thus, the general DCF model for estimating investment value reduces from the full spreadsheet table to a single fraction. The formula for the value of a constant perpetual payment or a perpetuity is V = P/R. The numerator (P) is the annual nominal dividend payment per share, the denominator (R) is the annual nominal discount rate, and this is equal to the investment value per share (V). For example, an annual dividend of $2.00 per share and a discount rate of 10 percent results in an investment value of $20.00 ($2.00 divided by 0.10).

This calculation is referred to as the so-called capitalization of a stream of dividends (or cash flows). Such simplifying calculations can be used as a quick approximation to determine whether to proceed to a more detailed analysis.

The ambiguous term capitalization is often used very loosely. It has a different technical meaning when applied to earnings with a multiplier or so-called capitalization factor than when applied to dividend flows with a discount rate or so-called capitalization rate.

In economic theory, there are two basic concepts known as stocks and flows. In general, to capitalize is to convert a flow of value into a stock of value, or more specifically, a stream of future dividend payments per share into a current price per share.


Stochastic Simulation

Much information for decision making is lost when a probability distribution of estimated values is replaced by the mean of the distribution, the best single-point estimate of value. Using probability distributions and statistical simulation, investment value can be estimated for a range of values instead of only a single deterministic point value. The right side of the probability distribution between the mean and the upper tail is the speculative portion of the estimated value range. The left side between the mean and the lower tail is the investment portion. The margin of safety is the zone between the current market price and the mean estimate of value. A current market price in the investment portion results in a positive margin of safety and in the speculative portion, a negative margin of safety.

An extreme case of difficulty of valuation is a new, fast-growing, high-tech, Internet-only company. Even such a company under its most optimistic scenario of highest sales volumes and highest profit margins for many years into the future may find its common stock price within the realm of possible values at the far right side of the distribution near the upper tail. But rarely, if ever, will its stock price be in the realm of probable values anywhere left of the mean. Such a company often has little operating history, and its pricing ratios may have no meaningful figures for optional preliminary screening. To evaluate the reasonableness of a seemingly wildly overpriced stock, market price can be used as an input variable to the DCF modelto determine whether a reasonable scenario of sales volumes, profit margins and number of years of future growth would result in a value equivalent to the current price.

The measure of investment risk in the DCF model is the full probability distribution of the estimated range of investment value. Two probability distributions of estimated investment value produced by simulation of the DCF model can be compared directly if they have the same scale on the vertical axis for probability, f(x), and on the horizontal axis for investment value, x, measured in monetary units per share (US dollars or other currency) both for values and for current price. The area under each curve is the same, say, 100 probability units. Many probability distribution types are unimodal (one mode or peak) like the familiar bell-shaped curve. Often combinations of probability distributions for the input variables in the DCF model result in unimodal probability distributions of the output variable, investment value. Graphed distributions that are unimodal are the easiest to compare visually. The unimodal probability distribution of investment value that is taller and narrower is safer and more certain than the probability distribution that is wider and shorter which is riskier and less certain.

To illustrate the use of the DCF model for equity valuation, we can estimate the intrinsic value of individual companies and their common stocks using the investment models, dubbed the DCF Valuator. In Step 1 of the selection process, we will choose example stocks out of the universe of all common stocks solely on the basis of their usefulness as illustrations of the appraisal made in Step 2 of the selection process. The DCF Valuator is designed to handle the tedious calculations and help keep the focus on the valuation process. It easily performs graphed sensitivity analysis of input variables and simulations of a large number of possible future economic states of the world or business conditions. For more information about the online interactive investment models, go to the
DCF Valuator.


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