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ValueWalk

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Value Investing: A Snapshot
Value investing is often called the holy grail of investing success. It is highly regarded as an
investment philosophy, having been used by investment gurus such as Benjamin Graham,
Warren Buffet, Seth Klarman and Christopher Browne. The philosophy has enabled these
investors to outperform the market by a wide margin over long periods of time.
If you were to explain value investing to a fifteen year old, this is probably how you would do it:
Finding companies where what the market thinks they're worth is substantially different from
what they are really worth, and then investing in them in order to make a profit.

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To put it very simply, those 29words areat the heart of the value investment philosophy. It is the
difference between value and price that drives the rewards from implementing the principles of
value investing.
Think of value and price in terms of the solar system.

The value of company is the sun, and the prices that the market gives the company at various
points in time are like the planets which revolve around the sun. Sometimes, the planets are in
front of the sun, and sometimes they are behind the sun. This is akin to the price being above
value at times, andbelow value at other times. The trick is to invest in the company when price
and value are farthest from each other.
Value investing is more an art than a science. Which means that with diligence and daily
practice, anyone can get better at it. A major aspect of value investing is that it is a philosophy, a
way of thinking about how the investment world works. Therefore, in order to be able to
implement it to make investments, the first step is to believe in this philosophy. The following
beliefsare at the core of this philosophy:
Markets are NOT efficient: The efficient market hypothesis might have won the Nobel Prize,
but if it held true all the time, then the asset management industry wouldn't be worth trillions of
dollars. Markets go crazy, and they go crazy as often as you and me. This happens because
investors and other market participants, as a whole, are irrational. Sometimes markets overreact
to news, events and situations, and at other times they hardly react at all. I don't have intentions
of rewriting economic theory. But avenues to profit from investments arise primarily because
markets are inefficient a lot of the time.
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Contrarian is good: Value investing often requires you to challenge conventional wisdom, go
against the wind and stand apart from the crowd. This means that very often you will be moving
in the opposite direction of everybody else. Which can be terrifying at times. It requires that you
make decisions which others will mock you for. And to stick by those decisions during good
times and bad requires discipline. You can often expect to get caught up in competing thoughts
such as the one below. But with the results that value investing can bring, you will never want to
abandon the philosophy.
"I can't afford to miss a rally, but I sure can't afford to get killed if things go in the other
direction because none of this is real"
Mindset is everything: This philosophy is as much about mindset as it is about anything else.
The mindset required by the philosophy is that investing is serious business, not a game that you
play for a few hours a day. Success in anything requires discipline, dedication and hard work.
Value investing is no different. To become a successful value investor, you have to adopt the
mindset of a successful investor, not a speculator or a day trader. Value investing requires
emotional discipline, and value investors require a sound intellectual framework to be able to
apply its principles.
Every company has a value and a price: Value investing requires that you invest based on
price AND value, not just price. In other words, every company has a market price, which differs
markedly from underlying value at various points in the business cycle. Investments should be
made using price AND value as analytical foci. A low price alone does not justify a sound
investment. If value is low, and this is reflected in price, but you don't make an effort to estimate
value, then putting your money into a stock at a low price will only result in your money being
invested in a stock that is going nowhere. So the investment process always consists of
comparing price and value in order to make investment decisions.

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Assessing Value: A 7Step Process
The worth of an equity holding in acompany is determined by its share price. So in the value
investing equation, one variable is readily available at any point in time.
The tricky bit of the equation is to estimate value. Value estimation involvesnot only the number
crunching of figures in the financial statements, but making a detailed inquiry into the non-
quantitative aspects of a business.
In this section, I providea basic overview of the 7 steps every value investor needs to adhere to
in coming up with an estimation of valuefor any company.
1. Quality of Business
The quality of a business can be assessed in lots of different ways. In value investing terms
however, we're talking about the historical patterns that have emerged in the last few years that
the company has been in existence.
There are a few key financial metrics that you need to look at when assessing the quality of a
company's business:
Free Cash Flow: As any valuation text book will tell you, this is the amount of cash that a
company generates every year from its operations. 'Cash is king'. But how that cash flows is
crucial to judging the success of a company. As an investor, your primary concern is the amount
of cash that a business generates. To get an idea of how a business is performing, analyze FCF
for the last 5 to 7 years to get a feel for the average growth rate in FCF. A company that has a
FCF average growth rate of 20% or more is performing very well indeed.
EBIT: Earnings before interest and tax are a good indicator of the value being produced from
operations. Although this figure does not provide a very good indicator of performance for
highly leveraged companies, it is a key performance metric that must be analyzed. Growth rate in
EBIT will provide clues about the sustainability of earnings. EBIT growth and FCF growth tend
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to move in tandem, and when they don't you know you need to delve deeper to understand the
cause for this. EBIT margins for the years under analysis should be fairly steady. A volatile
EBIT margin indicates that the company does not have control over either its revenue streams or
its cost base.
Crown jewels and diversification: One needs to ascertain if the company relies on a 'crown
jewel' to produce most of its revenues or profits. If a company is over-reliant on a crown jewel(s)
for revenues or profits, then the question that needs to be asked is 'How long is this sustainable?'
Most companies that are over-reliant on a single division for revenue or profits will be seen to be
diversifying their revenue streams. Is EBIT fairly evenly spread across business segments?
Beware of companies that are not making an attempt to diversify.
Dividend Yield: The annual dividend is one of the most important signaling tools in the hands of
management. Fluctuations in dividend yield that come about as a result of changes in the
numerator should warn you of changes in the quality of the business. Very often managers aim to
keep a stable dividend yield even in years of poor performance. Take the recent case of Tesco,
the UK's largest supermarket chain. EPS dropped to just about 1.5 pence per share, but the
Management chose to maintain the dividend at the preceding three year average of 13 pence per
share. This calls for closer scrutiny of Tesco's dividend announcements in the upcoming quarters.
Other financial metrics: Return on Capital Employed (ROIC), FCF Yield and leverage are
other key metrics that need to be monitored closely. Trends in these ratios provide useful
information about changes in financing structure, and very often about the performance of
management. Volatile changes in any of these metrics needs to be investigated, as the cause of
volatility can often be the deciding factor in an investment.
2. Valuation
Valuation is imprecise. Valuation is complex. Very often, analysts and investors allow
themselves to spend too much time on trying to give a business an accurate valuation. The fact is
that a valuation can only be as accurate as the accounting numbers that it is based on. There are
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plenty of ways that a company can depict its position under the current accounting standards,
especially those that report under IFRS. The depiction that one sees in the annual reports is one
scenario out of potentially many.
As David Dodd eloquently put it in Security Analysis:
"The essential point is that security analysis does not seek to determine exactly what is the
intrinsic value of a given security. It needs only to establish that the value is adequate - e.g., to
protect a bond or to justify a stock purchase - or else that the value is considerably higher or
lower than the market price. For such purposes an indefinite and approximate measure of the
intrinsic value may be sufficient."
The valuation of a company has to be carried out on 3 levels to give you a good picture of where
the company stands in the value vs. price equation.
Standalone valuation: A standalone valuation is an estimate of the value of the company based
on best estimates of growth rates and margins in the future. A Discounted Cash Flow (DCF)
model is usually constructed so as to project the financials of the company indefinitely into the
future. Since projections are always based on assumptions, such models are highly sensitive to
the assumptionson which they are based. In any case, the point here is to get an idea of how the
assumptions in the model (including the discount rate) need to be adjustedto get to the price that
the company has in the stock market. If obtaining a value close to the market price involves
unreasonable assumptions about growth rates, margins or discount rates, then you know you
potentially have a value opportunity on your hands(or not!).
Relative valuation: A relative valuation is carried out to see where the company stands in
relation to competitors and other companies with similar business models. The comparison is not
done in terms of a specific value, but more so in terms of the following ratios:
- Net Debt/ EBITDA
- Price to Earnings
- FCF Yield
- Enterprise value/(Equity - Cash)
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- EBIT Margin
- EBIT Growth yoy
Such a relative valuation gives the investor a good snapshot of where the company stands on a
number of metrics. Be careful not to compare too many metrics as this will just confuse you.
Pick appropriate metrics based on the company that you are analyzing. The aim is to aid the
decision-making process, not complicate it. Industry averages for most of the above ratios are
available. If you have access to a Bloomberg terminal, you should have no problem in getting
this information. If you don't, seek out sell side analyst reports, as these invariably have all
industry related information.
Historical valuation: The last bit of work you will need to do on valuation is to analyze two key
ratios on a historical basis. These are the price to earnings ratio and the EBIT margin (or any
other operating profit margin applicable to the company that you are studying). Analyzing the
historical trend of these two ratios should give you a good picture of how the P/E has trended in
relation to the performance of the business over time. If the P/E is on the lower end of the long
term average, while margins are trending upwards, there isa good chance you have found a stock
that is not on the radar of the market and a possible value investment opportunity.
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Putting it all together - Now that you have a good idea of the value of the company, you need to
make estimates of a range of possible values that the share price can take over your investing
horizon. An example calculation that you might conduct for your stock might look something
like this:

Where,
The implied share price is
??? ??? ????
??? ????? ????? ?????
, and the FCF (Down, Base and Up) areestimates
of what you have obtained from company and market sources,
P/L % is the profit or loss % from investing at the current price. It is calculated based on the
current share price and the total net price under the three scenarios,
The probability weightings needn't be from a probability formula, they need to be your best-
guess probabilities for each scenario.
The base case scenario to down case scenario shows you how much you would gain if the base
case scenario played out vis--vis what you would lose if thedown scenario played out. So in the
analysis above, you would make 3x the amount of money in the base case than you would lose in
the down case. Thinking in these terms can identify the attractiveness of multiple opportunities.
Central to the value investing philosophy is the concept of margin of safety. The margin of safety
principle means that investments must be purchased at a discount from their underlying value.
Current Share Price $15.00
Down Base Up
2012 FCF Per Share 1.33 1.5 1.84
FCF Yield Assumption 10.00% 7.50% 7.50%
Implied Share Price 13.30 20.00 24.53
Annual Dividend 0.15 0.15 0.15
Total Net Price 13.45 20.15 24.68
P/L% -10.3% 34.3% 64.6%
Probablity Weightings 25% 50% 25%
Probability Weighted Expected Return
Base Case : Down Case Ratio
2012 Implied EV/(E-C) 5.5 8.2 10.0
2012 Implied P/E* 10.0 13.3 13.3
*Assuming FCF/share equal to EPS
30.7%
3.32:1
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The thinking behind having this margin of safety is that when purchased at a discount to value,
investments have a higher probability of turning a profit than of making a loss. This means that
you are always making investments where even if your investment thesis is proved wrong, the
fall in price that you will suffer will be much less than if you purchased an investment without
this margin of safety.

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3. Catalysts
Catalysts are those events that eliminate the dependence on market forces to cause changes in the
share priceof companies. When an investor puts money into a stock, there is always a chance
that a certain future event or decision will narrow the gap between value and price. Such
catalysts provide investors with a cushion, above and beyond that provided by the margin of
safety.
Catalysts can be internal as well as external. Internal catalysts are those that are at the discretion
of company management. Divestitures, liquidations, share buybacks and recapitalizations are all
internal catalysts that might cause the share price to move towards its true value. External
catalysts are those that arise due to forces outside the control of the company. Regulatory
changes in favor of the company, increased holdings of voting shares and competitors going out
of business are examples of external catalysts.
Not all investments will have catalysts associated with them. However, those investments that do
have catalysts associated with them are lower risk investments, as the successful realization of a
catalyst will serve to quicken the closure of the gap between value and price.
A word of caution: Although in most cases internal catalysts are expected to lead to positive
outcomes for share prices, one must tread carefully in assessing the impact of such catalysts on
total shareholder return. A replacement of dividends by share buybacks might lead to short term
increasesin EPS and therefore return, but the long term implication of lowering dividends might
be to reduce total shareholder return. This is what happened in the case of International Business
Machines (IBM) between 1980 and 2003. So always be weary of companies that undertake share
buybacks on a frequent basis under the guise of increasing returns to shareholders.
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4. Management and smart holders
This refers to the quality of management, and to the holdings of management and other
institutional investors in the shares of a company.
The quality of management is often directly related to the success of a business. Changes in
management do not always lead to better results. With the vast amount of information available
on the internet, it is possible to get detailed information about managers and their past successes.
Despite changes in management, the fraction of the company held by management should not
fluctuate with every change in top personnel. Attitudes of new managers towards shareholders
can be judged from their actions in previous roles.
The holdings of management need to be monitored. Are the managers in charge of the business
increasing or decreasing their holdings? The ratio of cash and stock compensation is particularly
valuable. Companies which reward their managers with a greater share in the form of stock and
stock options are better aligning the interests of management and the shareholders.
As Seth Klarman put it in Margin of Safety, there are many reasons why an insider might sell
stock, but there is only one reason for buying. Keeping an eye on the stakes of managers and
owners is a good way to get into the minds of insiders on the future prospects of a company.
Smart holders and hedge funds, asset managers and other professional money managers who
make large investments in companies. Very often, these smart holders know about developments
in greater detail than can be garnered from public statements and reports.
It is possible to get details of institutional share ownership from a number of sources. Sell side
firms frequently report such data in their analyst reports. An increase in the number of smart
holders with a value bent might indicate that there is value in a particular opportunity. Two
examples are that of Newscorp Inc and Tesla Motors. In May 2011, it was reported that the share
of value investor share ownership in Newscorp Inc went up from 17% in 2010 to 44% in2011.
Similarly, in October 2013, a BoFA report indicated that institutional share ownership of Tesla
Motors fell from 85% in J anuary to under 60% in October, signifying that a lot of the increase in
share price in the intervening period could be attributed to retail investors rushing in. It must be
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kept in mind that such changes in ownership should not be given too much weight when sizing
up an investment opportunity.
5. Assessing the critical path
The critical path refers to the futuredirection of company strategy, and how this strategy is likely
to create or destroy value for shareholders. Management's discussions in quarterly and annual
reportsand on calls with analysts will provide an insight into the key acquisitions, developments
in strategy and changes in direction that the company is likely to undergo in the future. Albeit
boring and cumbersome, insightful knowledge is often gained from reading the Form 10-K filed
by the company. As an investor, it is crucial to have an understanding of the future strategy of
the company. Attention must be paid to any regulatory and/or legal changes that are likely to
affect the company adversely. The strategy of the company with respect to acquisitions can often
signal the management's confidence in deploying cash effectively.
Management often provides a description of the evolution of company strategy. One of the best
ways to judge whether a company is on track is to read past annual reports and see if the
strategies that have been made public in the past have been implemented.
6. Develop a monitoring plan
After you have conducted the analysis above, the next step is to decide on a plan of action to
monitor developments at the company. As an investor, it is inevitable that you will have a
number of companies on your watch list. From the management's discussion in the annual report,
you will be able to list out a plan to monitor future developments that have the ability to impact
the share price. These developments relate to future acquisitions and divestments, changes in
legal and regulatory regimes, and impending changes in management. You need to keep abreast
of developments with respect to your company, as these changes often can cause large swings in
price and diminish or amplify the attractiveness of an investment.
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7. Upcoming events
When a company is on your shortlist, you cannot afford to miss out on important announcements
and investor calls. Quarterly earnings reports, chairman's addresses to shareholders and other
announcements by the company have to be on your radar. Make a list of all such calls, meetings
and reports due in the next three to six months, and be sure to look out for subtle changes in the
stance that management takes with respect to strategic direction.
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Wrapping it Up
The central theme of this ebook is to give you a brief insight into the philosophy and method to
be followed to become a value investor. It draws from the wisdom and teachings of some of the
greatest value investors, past and present.
As you have probably gathered, value investing requires a lot of diligence, analysis and a
willingness to constantly refine one's investment knowledge. Having been present at talks,
meetings and conference calls with a number of successful investors in my short career to date,
one recurrent theme I have observed is that all successful investors have a repeatable process that
they bring to the table when analyzing potential investments. They never sit down to discuss
which way the market is headed; it is always about how they can improve the process of
searching for and assessing potential opportunities. They are deliberate and consistent in what
they do. Having a repeatable process ensures that they are always learning - it is possible to make
money on a bad investment and lose money on a good investment.
While markets seem to have a mind and mood of their own, value investing necessitates a deep
desire to understand the fundamentals, and act accordingly. Quick money is not the goal, long
term investment success is.

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In any case, with the way the world is progressing, you are more likely to make quick money
starting, working for or investing in a tech start-up than you are investing in the financial
markets.

"One great irony of investing is that when fears subside and financial markets rise substantially,
investors should actually become more skeptical. Risks grow when prices rise ahead of
fundamentals. It is precisely at such times - when risk premia are shrinking - that investors cease
to be rewarded adequately for the incurrence of risk."
- Seth Klarman (Letter to LPs)
By: Ryan Chadha, @RyanChadhafor ValueWalk
Also see his site: http://www.finbox.co