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 (email@example.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
Think about what you want the valuation approach to do
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.
Valuations should be organized by strategic assumptions
DCFs eliminate a lot of important and useful information such as information on the balance sheet
Start with the assets to determine what needs to be replaced and the cost associated with reproducing those assets
Look at current earnings, assume no growth, and see if there is any value there
If earnings power value is greater than asset value, then sustainability of that depends upon the franchise value (FV)
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?
Unless there is something to stop the process of entry, the earnings to support that are not going to materialize
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
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.
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.
Start with the earnings power value with no growth – value growth separately as that is where the uncertainty resides
EPV x 1/WACC
Estimating earnings – start with accounting operating earnings (EBIT or EBT), and make adjustments to get to the earnings power
Estimate a cost of capital
Subtract debt, add cash to get to the enterprise value (?)
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
Look at the average tax rate
Review of critical issues
Strategy for managing risks
Purchase price – margin of safety
What am I buying?
What discount am I getting?
How sure am I of these things?
Have a good default strategy in place for when you don’t have any good active ideas
Buy the index
the biggest generator of risk is people who are bored buying things that seemed like a good idea at the time
Calculating operating margins
Look back enough years to see the down part of the cycle – what were margins?
Average those margins and apply it to current year sales – that should help account for cyclical fluctuations
Adjust sales upward if they are particularly depressed
Multiply that by the current or forecasted level of sales – average level of operating earnings
Understand whether there is a positive or negative trend in operating earnings and whether that is likely to continue
Start with actual capex
Subtract an estimate of the last couple of years that has gone to growth
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
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
Then subtract that zero growth maintenance capex from depreciation and add the difference back (to maintenance capex?)
Estimating Cost of Capital
Cost of equity will always be higher than the cost of debt
VC funds pay for the most expensive type of equity – have to show 15% return projections to raise money
Cost of equity is between 7-15% (without doing any beta estimates)
Usually for a low risk firm, with not a lot of debt, the cost of capital will be about 7-8%
Medium risk firm – 9-10%
High risk firm with debt – 11-13%
What is the return required to get international and domestic investors to invest in the business? That is the cost of capital
AV > EPV – management is the problem, and growth will add negative value
AV = EPV – no barriers to entry, good measure of value
AV < EPV – like Coke where you are buying earnings power value – there better be a competitive advantage to protect these excess earnings
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
Examples of incumbent competitive advantage
Lowest cost structure
Proprietary technology – patents
Cheaper resources – labor, raw materials – although it’s a very rare quality that cheapness of labor is a competitive advantage
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.
Habit formation – customer captivity – Coke, tobacco,
High value add and high complexity lead to less searching around for alternatives – searching around could be very costly
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
What prevents the competitor or new entrant from matching the scale? Has to be something there
The market can’t be too big relative to the necessary fixed costs to scale?
For example, the scale to compete against IBM would be 40% market share – a high barrier to entry
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
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
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
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
Look at the history of the industry and see if competitive advantages exist
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
Start with a manageable list of segments – 5 is good to get started
For example: the industry that Apple is in could be broken down into:
Write down the firms in each segment
Get a feel for the nature of the industry
The point of the map is to identify different segments you have to analyze
Ask the question – have there been competitive advantages historically in these markets?
Two symptoms of competitive advantage
Above average ROIC, especially for the dominant competitor
Look at core business earnings against capital invested in that segment
Microsoft earned $17 billion in software and invested $10B
Look at market share stability – has the dominant competitor changed?
Have new competitors entered the business recently? In the last decade?
High share stability and high profitability suggests you have high barriers to entry
Is there customer captivity and proprietary technology?
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
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.