Value Investing and Risk Management

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Adib Motiwala

Motiwala Capital LLC

www.motiwalacapital.com

Disclaimer
Any material here is for education purposes only. I may have a position in some of the securities mentioned as examples. Please do your own research or consult your financial advisor. Do not take it as investment advice. This is not an offer to buy or sell securities or investment advice.

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Outline
Introduction What is value investing? Why does value investing work? An approach to Risk Management

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About me
Education MBA in Finance @UTD - 2010 MS in Comp Sc. @Texas A&M 2001 Motiwala Capital LLC (www.motiwalacapital.com) Registered Investment Advisor (RIA) in Texas Founded in 2010 Managing clients capital since April 2011. AUM : ~ $800k (as of 10/25/2011) Contact : adib@motiwalacapital.com

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Motiwala Capital Investment Philosophy

Value oriented, bottom up investing style Long Only (except in Arbitrage) Investing = Business Analysis + Financial Analysis + Behavioral aspects Buy good business at a bargain price Prefer companies with strong balance sheets, generating high ROIC and consistent FCF Dont use leverage Focus on Absolute returns Always insist on a margin of safety Practice discipline and patience.

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Motiwala Capital 3 Strategies

Typical long equity investments ( Good quality business at cheap valuation)

Special Situations Merger Arbitrage Closed end fund tender offers Dual Share Class arbitrage Spin offs
Option enhancement via Covered Calls and Cash Covered Puts

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Investment v/s Speculation

An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative - Graham and Dodd in Security Analysis (1934)

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What is Value Investing?

Hunting for bargains. Buying a dollar for 50 cents. Buying debt at 20c on the dollar Buying security at prices WELL below their intrinsic value. Companies that are neglected, unloved, obscure are typically cheap [ and not necessarily low quality ] Contrarian / Go against the crowd. Reversion to the Mean Ben Graham Father of Security analysis The Intelligent Investor Security Analysis.

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Central Concepts
Investing in a stock is part ownership in a business

Mr. Market and Intrinsic Value

Margin of Safety Circle of Competence

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Mr. Market
Manic-depressive

Metaphor that explains how stocks can become mispriced.

He Buys High and Sells Low!!!

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Intrinsic Value
The underlying value of the business. Not an absolute number but a range. Various methods Asset based approach Earnings / Cash flow based approach Private market value / Prior transactions Relative valuation It is better to be roughly right than precisely wrong

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Circle of Competence
Buy what you know. Do your own research.

Dont feel compelled to invest in an area just because every one is investing there.
Over time increase your circle of competence. Investors get better as they age ( unlike sports or some other professions)

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Margin of Safety
What is Margin of Safety ? A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck or extreme volatility Seth Klarman Why is having a margin of safety important? Valuation is an imprecise art The future is inherently unpredictable Having a margin of safety provides protection against bad luck, bad timing, or error in judgment.

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2 Rules of Investing

Rule #1: DONT LOSE MONEY

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2 Rules of Investing

Rule#2: Dont forget Rule#1 Warren E. Buffett

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Importance of downside protection

Initial Percentage Loss Required gain to break even

10%

11%

20%

25%

33%

50%

50%

100%

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Magic of Compounding
Years of Investment 20 40 60 7% return 4 times 15 times 58 times 12% return 10 times 93 times 898 times 18% return 27 times 750 times 20,555 times

Example : $100,000 investment made today will be $1 million in 20 years if investments compound annually at 12% and $9.3 million if invested for 40 years. A meager rate of 7% turns $100,000 into $1.5 million in 40 years. Keys: Invest for the long term. Stay healthy and Live Longer!!! Start EARLY! Invest in your 20s and 30s regularly. Save money!!! 10$ could turn into $930 in 40 years!!! (@12%)

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Areas of Value Investing

Net Nets Special situation stocks (Spin-offs, Mergers, Bankruptcy) Out of favor blue chips Distressed industries Turnarounds Overlooked small caps. Fallen Growth Angels GARP Sum of the parts Discounts to cash Activist Opportunities Post bankruptcy Source: Value Investor Insight

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Why do stocks become cheap?

Missing quarterly guidance/analyst expectations. Neglect from investors. (eg: Microsoft has been dead money for decade) Prior history of losses/ fraud/ accounting issues. Management issues (resignation, poor execution. eg: HPQ) Complicated business or unloved business (eg: Waste Management) Unrelated business in large conglomerate (eg: Loews) Hated company (eg: British Petroleum) Operates in an out of favor industry (Housing, Defense, For Profit Education) Painted by a common brush (eg: Ensco during BP spill.) Small cap with no analyst coverage Cyclical at the bottom of the cycle. (eg: Valero) Forced, non-economic selling ( Removal from an index )

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Advantages of Value stocks

Bad news usually dont hurt as much (did not work in 2008 and recently)

Value stocks tend to do well on slightly good news.

Value to private owners. Downside protection. Think dividend yield

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What has worked in investing?

Low price in relation to asset value Low price in relation to earnings/cash flows High dividend yield. Significant pattern of purchase by one or more insiders. Significant decline in the stocks price Small market capitalization Taken from Tweedy Browne classic research paper.

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Investment Process
Idea generation

Fundamental research
Portfolio construction and position sizing Portfolio maintenance Risk management

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Idea generation
52 week low list Low P/E, P/B, P/FCF, P/S, high dividend yield Screeners (Magic Formula, FinViz) Fund manager 13F filings Magazines/newspapers/ ValueLine Blogs / Investment Clubs (SumZero, VIC) http://motiwalacapital.com/blog/search-strategy/

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Valuation
Price is what you pay, Value is what you get Buffett.

Arrive at normalized earnings for the business operating in normal conditions (normalized margins etc)
Check what Mr. Market is offering the business to you for ? ( Market Cap and Enterprise Value)

P/FCF, P/E, EV/FCF, EV/Sales, EV/EBIT are some of the measures used.
What is the business worth? Other businesses, past valuations, Private market value. Depends on the nature of the business. Inverse DCF

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Management Evaluation
This is more qualitative than quantitative. Past Capital allocation Skills to run the business and grow it Compensation levels. Duration of management Past decision making and results Past mistakes. Past promises. Dividend policy and record. Share buyback. Insider holding level. Insider buyback Cluster selling

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Why does Value Investing work?

Focus on short term results Traders / Momentum / High frequency trading Funds that need to report performance monthly/quarterly Liquidity concerns (daily/weekly) Mandates to be fully invested at all times Closet Indexers , Managing to an index Participants view volatility as risk Greed, Fear and lack of discipline Value Investing does not always work People give up!

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Types of Risk
Business risk Risk that investment does not work from a business perspective Valuation / Investment risk Buying at a high price in relation to value Financial leverage risk Risk of default, bankruptcy, share holder dilution Portfolio risk Market Risk

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Cisco in 2000 example of Valuation risk

Since 2000 Earnings up 4x Sales up ROE in mid 20s Bought back stock But stock is 75% lower from peak WHY ?? Stock was over valued in 2000 and has never been really cheap.

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Financial Leverage Risk

Enough examples from 2008-2009 such as Lehman, AIG, Bear Stearns and so on.

Combination of operating and financial leverage can work wonders. It can also be an absolute disaster. We avoid this combination.
We look at LT Debt / Equity, Interest Coverage. The ability to service debt via cash flows.

Graham recommended Equity > Liabilities.

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How to mitigate these risks?

Know the business intimately

Buy with a margin of safety. Use conservative estimates

Avoid highly levered business especially one that is capital intensive Sector and position limits, avoid extreme concentration Sector limit: 25% max, Position limit 10% max, 15-25 long positions Beta is not risk.

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Final thoughts
Do your own homework. There are no shortcuts in investing. Ignore the noise. Understand the business. If its too difficult, move to the next company. Financials understand them and know how to value the firm. Evaluate management capital allocation, shareholder friendly decisions Know the thesis on the opposite side. Always invest with a margin of Safety. Consider Risks before Returns. Invest for the longer term. Compounding works very well over many, many years. Patience is the toughest part of Value Investing. Learn from your mistakes and of others. Stick to your style. No style works day in and day out.

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Resources
Books for value investors Intelligent Investor by Ben Graham Security Analysis by Graham and Dodd. Margin of Safety by Seth Klarman You can be a stock market genius by Joel GreenBlatt. Beat the street by Peter Lynch One up on Wall Street by Peter Lynch Common stocks and uncommon profits by Philip Fisher The little book on Value Investing The little book that beats the street. Resources for learning Letters by Buffett and Munger, Berkshire letters. Letters by great hedge fund and mutual fund managers. Value investors club, SumZero, GuruFocus http://motiwalacapital.com/blog/favorite-blogswebsites/

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