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  • Writer's pictureGreystone Capital

Introduction to the Value Investing Process: A Lecture by Bruce Greenwald

I just finished reading and taking notes on this lecture/presentation by Columbia value investing professor Bruce Greenwald. Thank you to John Chew (aldridge56@aol.com) for compiling these class notes and sharing via csinvesting.org.

Here’s a PDF link to the lecture, with some of my notes below. I hope readers gain as much from this as I did.

Greenwald Investing Lecture Notes

Valuation

  1. Think about what you want the valuation approach to do

  2. It’s a rule. It’s a machine for translating assumptions that you can make RELIABLY about the future and present day value of the security. The input you want for that machine are assumptions that you can RELIABLY make. If you can’t, move on.

  3. Valuations should be organized by strategic assumptions

  4. DCFs eliminate a lot of important and useful information such as information on the balance sheet

  5. Start with the assets to determine what needs to be replaced and the cost associated with reproducing those assets

  6. Current earnings

  7. Look at current earnings, assume no growth, and see if there is any value there

  8. If earnings power value is greater than asset value, then sustainability of that depends upon the franchise value (FV)

  9. What stops competition or the process of entry? Barriers to entry are important to pay attention to – who can earn above their cost of capital?

  10. Unless there is something to stop the process of entry, the earnings to support that are not going to materialize

  11. Valuation is calculated by a company’s long run sustainable earnings multiplied by 1/cost of capital – adjust earnings for cyclicality, tax situations, excess depreciation over the cost of maintenance capex and anything else that is causing earnings to deviate from normalized earnings

  12. Look at growth not in terms of sales, but in terms of investment required to achieve growth. If the investment is zero, we are almost always profitable (Moody’s, Duff and Phelps). At a minimum you have accounts receivable and other elements of working capital to support growth.

  13. Investments for growth is $100 million, and I have to pay 10% annually to investors who supplied that $100 million. Where am I investing that money to earn greater than that 10%? Have to have a competitive advantage there.

  14. Start with the earnings power value with no growth – value growth separately as that is where the uncertainty resides

  15. EPV x 1/WACC

  16. Estimating earnings – start with accounting operating earnings (EBIT or EBT), and make adjustments to get to the earnings power

  17. Estimate a cost of capital

  18. Subtract debt, add cash to get to the enterprise value (?)

  19. Adjust for the business cycle – look at the current year and if that is an extreme, you want the average over the cycle for the firm

  20. Look at the average tax rate

Investment Process

  1. Search strategy

  2. Valuation technology

  3. Review of critical issues

  4. Strategy for managing risks

  5. Purchase price – margin of safety

  6. What am I buying?

  7. What discount am I getting?

  8. How sure am I of these things?

  9. Have a good default strategy in place for when you don’t have any good active ideas

  10. Cash

  11. Buy the index

  12. the biggest generator of risk is people who are bored buying things that seemed like a good idea at the time

Miscellaneous

  1. Calculating operating margins

  2. Look back enough years to see the down part of the cycle – what were margins?

  3. Average those margins and apply it to current year sales – that should help account for cyclical fluctuations

  4. Adjust sales upward if they are particularly depressed

  5. Multiply that by the current or forecasted level of sales – average level of operating earnings

  6. Understand whether there is a positive or negative trend in operating earnings and whether that is likely to continue

  7. Maintenance Capex

  8. Start with actual capex

  9. Subtract an estimate of the last couple of years that has gone to growth

  10. To do that, look at the capital intensity of the business – PPE to sales – say you have $.20 of PPE for every $1.00 of sales – multiply that by the dollar increase in sales

  11. Once you have that actual growth capex, you can subtract it from the actual capex and it should give you an estimate of maintenance capex

  12. Then subtract that zero growth maintenance capex from depreciation and add the difference back (to maintenance capex?)

  13. Estimating Cost of Capital

  14. Cost of equity will always be higher than the cost of debt

  15. VC funds pay for the most expensive type of equity – have to show 15% return projections to raise money

  16. Cost of equity is between 7-15% (without doing any beta estimates)

  17. Usually for a low risk firm, with not a lot of debt, the cost of capital will be about 7-8%

  18. Medium risk firm – 9-10%

  19. High risk firm with debt – 11-13%

  20. What is the return required to get international and domestic investors to invest in the business? That is the cost of capital

Critical Issues

  1. AV > EPV – management is the problem, and growth will add negative value

  2. AV = EPV – no barriers to entry, good measure of value

  3. AV < EPV – like Coke where you are buying earnings power value – there better be a competitive advantage to protect these excess earnings

Competitive Analysis

  1. Product differentiation

  2. The distinction between commodity and differentiated products is not the critical distinction. The critical distinction of a good business is not that there are good products, but that there is nothing to interfere with this process of entry. What that something has to be is a competitive advantage

  3. Examples of incumbent competitive advantage

  4. Lowest cost structure

  5. Proprietary technology – patents

  6. Cheaper resources – labor, raw materials – although it’s a very rare quality that cheapness of labor is a competitive advantage

  7. Companies are made up of individuals. Smart people can be hired away. You have to pay them what they are worth or you will lose them.

  8. Habit formation – customer captivity – Coke, tobacco,

  9. Search costs

  10. High value add and high complexity lead to less searching around for alternatives – searching around could be very costly

  11. Economies of scale/network effects – demand benefit as more people participate – Ebay – the greater the value of the product, the lower the effective cost per unit of value delivered. Have to have some sort of customer captivity or inertia though, otherwise when a new competitor comes in with similar offering, demand can be split evenly

  12. What prevents the competitor or new entrant from matching the scale? Has to be something there

  13. The market can’t be too big relative to the necessary fixed costs to scale?

  14. For example, the scale to compete against IBM would be 40% market share – a high barrier to entry

  15. If the market is so big, that you can essentially amortize the fixed costs with only two percent of the market – you can go down to the flat part of the cost curve with small market share, because the market is global, and economies of scale advantages will disappear

  16. Problem with internet companies – low fixed costs relative to scale in humongous markets – so you have tons of small competitors with tiny share – customer captivity can fix this

  17. Global franchises tend to be narrow in product scope – what often determines economies of scale can be a particular product market when R&D is a big problem

  18. What constitutes a good business is one with captive customers that leads to high prices and high margins, and proprietary technology that’s combined with economies of scale in the relevant market. Big markets are difficult to dominate. Sustainable competitive advantages focus on narrow segments on geographical or product space and dominate those particular segments

Industry Maps

  1. Look at the history of the industry and see if competitive advantages exist

  2. Try to identify the nature of the competitive advantages, and you’ll see what that says about management’s strategy, the sustainability of those advantages and future profitability

  3. Start with a manageable list of segments – 5 is good to get started

  4. For example: the industry that Apple is in could be broken down into:

  5. Chips

  6. Hardware

  7. Software makers

  8. Network providers

  9. Component suppliers

  10. Write down the firms in each segment

  11. Get a feel for the nature of the industry

  12. The point of the map is to identify different segments you have to analyze

  13. Ask the question – have there been competitive advantages historically in these markets?

  14. Two symptoms of competitive advantage

  15. Above average ROIC, especially for the dominant competitor

  16. Look at core business earnings against capital invested in that segment

  17. Microsoft earned $17 billion in software and invested $10B

  18. Look at market share stability – has the dominant competitor changed?

  19. Have new competitors entered the business recently? In the last decade?

  20. High share stability and high profitability suggests you have high barriers to entry

  21. Is there customer captivity and proprietary technology?

  22. If you have a competitive advantage, you want a management team that understands the source of the company’s competitive advantage and will protect it and not tie it to a competitive disadvantage or negative synergies in other segments the way Apple did

  23. When you buy franchise value, which is the situation where growth has value, the most important characteristic in growth oriented investors is a good understanding of competitive advantage not a gut feel for technology

I’d highly recommend spending some time on csinvesting.org, as well as reading as much as you can about Professor Greenwald.

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