We are value investors. Ben Graham provided the original definition and many have provided their modified versions since but the core principles remain the same. Below, I will provide it in my own words. There are four key parts:
- Stocks represent an ownership stake in a business. They are not pieces of paper that happen to have prices. If you buy an investment property with four friends as equal partners, you own one share out of five. You are entitled to twenty percent of the profits from rent after expenses like painting, cleaning, advertising, and taxes. Similarly, if you own twenty shares out of a hundred shares in a company, you own twenty percent of that company. You are entitled to twenty percent of the profits from sales after expenses. So, if you buy stock in a company, no matter how little, you are an owner of that company.
- With work and experience, a range of values can be determined for a business. This range may be wide or narrow depending on the characteristics of the business and your knowledge of it. To go back to our investment property, you may have a very good idea of what a three-bedroom house would cost in your hometown, maybe even down to a 5% range. On the other hand, you probably don’t know within 30% what a million square feet of warehouse space sells for in Northern Virginia. This value is often referred to as intrinsic value.
- The stock market price of our business may vary wildly from its intrinsic value. You are given a price quote every day for your stock and it may be very volatile. Imagine someone offered to buy your home for twice what you think it’s worth or your neighbor offered to sell you their home for half your estimate. This happens regularly in the stock market when investors are feeling frightened or greedy.
- Margin of Safety – We are looking to make investments that reduce the chance of a permanent loss of capital. We do this by buying companies at a market price that is substantially below our estimate of intrinsic value. If we can buy our property at a significant discount to what we think it is really worth, we have mitigated most of the risk in the investment from the outset.
In an ideal investment, we’re trying to find the best quality business and pay the cheapest price. It’s a two-part test that breaks down into a quantitative and qualitative assessment. So, what do we mean by quality? And, what is cheap?
Let’s start with cheap because it’s intuitively easier to understand. Your friend owns and rents out a house that has reliably earned him $10,000 profit per year. Suppose your friend offers to sell you this house. Knowing nothing else, what would you pay for it? Clearly, $10,000 would be cheap (100% yield on cost) and $1,000,000 (1% yield on cost) would be expensive. And, you’d have some range of prices that you think might be a fair estimate of value. Investments are no different – it’s just that your profits may be less reliable and harder to predict. In fact, if you had perfect clarity into the future, an investment’s intrinsic value should be equal to the value of the future cash flows you receive discounted at an appropriate rate. Buying things at a large discount to your estimate of intrinsic value (cheap) is a good start. It’s not enough, though.
It’s important to know what is happening to the intrinsic value over time. Oftentimes, investors will buy a company at an apparent cheap price only to find that its intrinsic value is declining and thus converging with the price they paid, and not in a good way. These are often referred to as value traps because they seduce investors into making an investment while the stock will remain optically “cheap” all the way into bankruptcy (e.g. Blockbuster, Borders, Circuit City). On the other hand, a purchase of a business whose intrinsic value appreciates over time is likely to achieve a much better result. Even if you overpay for a business, you may end up with a decent return if its intrinsic value is increasing quickly.
Anyway, there are quick shortcuts for determining how cheap something is like free cash flow yield, enterprise value (EV) to operating earnings (EBIT), replacement cost, EV to sales, etc. These are analogous to the metrics an appraiser would use to value your home – What’s the rental yield? What are comparable homes selling for? How much would it cost to build a new house? The numbers are pretty easy to calculate once you’ve done it a few times but deciding which one to use is more art than science. Next you have to figure out if what you’ve got is Maui beachfront or a Superfund site. That’s where quality comes in.
The best way I’ve found to measure the quality of a business has been to calculate its returns on invested capital (ROIC).
NOPAT is a way to measure the earnings of a business while stripping out the effects of how it’s financed. For instance, a proper comparison of the returns on two separate rental properties would need to adjust for how much of the investment was financed with a mortgage versus equity. Invested capital can be thought of as the net assets required to run the business or, alternatively, as the amount of equity and debt financing required to fund those assets. In layman’s terms, let’s say you buy a gas station for $100,000 (net assets) with an $80,000 loan and a $20,000 down payment (financing required to fund the net assets). Your gas station generates $10,000 of NOPAT (remember, we don’t include the interest costs from the loan). In this fictional example, your gas station generates an ROIC of 10%.
The nature of capitalism is such that if a business is generating a high return on capital, it will invite competitors looking for a piece of the action. Companies that continue to generate high returns despite competition have something special – some have called it a sustainable or durable competitive advantage, others might call it a moat. Sources of advantage come from things like patents, brand names, trade secrets, network effects, switching costs, scale, and even, corporate culture. A consumer advantage arises from things that allow a company to charge a higher price or earn a higher margin than their competitors. So, Ferrari can earn significantly higher profits because of their brand name and scarcity. On the other hand, a producer advantage springs from traits that let a company be more efficient with their capital than their competitors. Costco falls into this camp with their scale and corporate culture. We can break up the ROIC equation from above to give us some hints on the source of a company’s advantage.
Truly great businesses generate consistent high returns on invested capital. In fact, in Berkshire Hathaway’s Annual Report from 2000, Buffett lists his criteria for businesses that he would be willing to acquire. The third bullet point states that they are interested in buying “businesses earning good returns on equity while employing little or no debt.” It should not surprise you that ROIC equals return on equity when a business has no debt.
All of the above can be summarized by saying that we spend our days trying to pay less for things than what they are worth. Another famous Warren Buffett proclamation says “price is not equal to value. Price is what you pay, value is what you get.” This relationship between price and value is critical because, in the long run, your returns will be represented by the convergence of the price you pay with the value you receive. If you pay a low price (cheap), great. If the value of what you bought is growing quickly (quality), even better.