Value, Growth & Risk - Intelligent Investing in Great Businesses

We all want to earn a high return on our investment. That’s the entire purpose of investing. To commit cash today for the opportunity to receive more cash in the future. Our purpose for investing is not that different than the goals of a business; to generate profits for its owners. As investors, we can align our philosophy with that of the businesses we seek to invest in.

Not only do businesses generate profits, but they can reinvest those profits in the business to fuel future growth. This future growth leads to more profits, and the cycle repeats. You might think I’m defining a growth company, but in essence, I’m describing a great business. You see, value and growth are often described as the Yankees and the Red Sox. I don’t believe that to be the case.

If one can identify a great business and buy it at a good/great price, then they have made an intelligent investment.

Businesses only have a few ways to return value to owners (shareholders). Through dividends, share repurchase, acquisitions, and reinvestment into the business. Ideally, the business is able to reinvest its profits into itself and generate a high return on investment. This internal reinvestment rewards shareholders through increasing the total value of the business they invested in and often increasing the share price.

Of course, growth cannot continue forever. Companies will eventually enter into a lifecycle stage where they find it difficult to continue to earn high returns on investment. It’s at this point where they may seek to reward shareholders with a dividend, share repurchase, etc. It’s at this point where CNBC would describe the company as a “value company” when in reality it’s an income company. Its stable market price and dividend offer a low-risk investment for recurring income.

I believe the best time to invest in a company is during its growth phase and buying that company at a discount to its intrinsic value. I believe this form of value investing can lead to above-average returns while mitigating downside risk as I will attempt to explain. I believe it to be self-evident and for that reason, I will cover the concepts and allow you to come to your own conclusions as I did.

Over the past 10 years, I have studied this topic to the fullest extent that I am capable of. Aside from having one of the great value investors as a mentor or attending the Columbia Business School of Value Investing, I have spent an outsized amount of time on this subject.

These are the people who have been most influential in my journey:

  • Benjamin Graham

  • Warren Buffett

  • Peter Lynch

  • Peter Thiel

  • Bill Ackman

  • Chuck Akre

  • Joel Greenblatt

  • Bill Miller

  • Mohnish Pabrai

  • Li Lu

  • Chris Davis

  • Phil Town

Interestingly enough, almost everyone on that list has done a “Talks at Google” talk where they deep dive into different aspects of value investing. These videos don’t get many views, but they are a gold mine of information.

I recently started an investing challenge where I am tracking my gain/loss over time for you to follow along.

Value Stocks vs Value Investments

A value stock is typically defined as a stock with a price that appears low relative to the company's financial performance, as measured by such fundamentals as the company's revenue, dividends, yield, earnings, and profit margins. The reason it’s valued in this manner is that it’s perceived to be done growing in scale and market share.

It’s at this point in the business lifecycle where it makes more sense to pay out directly to shareholders via a dividend than it does to aggressively reinvest in the business. Because the business is paying out to shareholders, it may not be retaining earnings to reinvest with, thus the business doesn’t continue to grow. With limited upside potential, the share price retains its downside potential. Should anything negative befall the company, it’s likely the stock will fall in price.

To me, value investing is understanding the intrinsic value of the company, the potential for future growth through its ability to generate high returns on its capital (reinvestment) and to buy it with a margin of safety (MOS).

Price is what you pay. Value is what you get. - Warren Buffett

Impactful Value Investing Books:

Intrinsic Value vs Market Value

The intrinsic value of a company is determining the value of the business by objective calculation or financial modeling, rather than relying on the current market share price. For one reason or another, the market price may be dislocated from the fair value of the stock.

For example, Apple may be trading at $123 per share, but you may run the numbers and find that its intrinsic value is actually $150 per share. As a business-minded investor, you then have to decide if an investment in Apple today can provide the returns you expect to achieve in the future.

All companies on the stock market are priced to the second. Each day, you are quoted a price for all the companies currently available for investment. Contrary to efficient market believers, the market is not always perfectly efficient.

Sometimes, the price quoted by the market is not reflective of the actual value of the company and that is where you can find value investors shopping. For example, company ABC may be quoted at $20 per share, but after analysis, you may discover that the company has $20 per share in cash on hand. The company isn’t simply worth its value in cash on hand, but rather many other fundamental aspects. If all else checks out, this might be a great opportunity for a value investment.

“The trick in investing is just to sit there and watch pitch after pitch go by and wait for the one right in your sweet spot. And if people are yelling, ‘Swing, you bum!,’ ignore them.” - Warren Buffett

The best part, we don’t have to invest in any of these companies on any given day. We can simply wait for something that aligns with our investing philosophy within our circle of competence.

Calculating Intrinsic Value

There are numerous ways to calculate the intrinsic value of a business and there’s no way for me to pass that information on to you. You will not be able to determine the 100% accurate value of a company. It’s just not possible. I expect it’s even difficult for the business itself to determine that.

When valuing a company, you’ll come up with a range of what the business could be worth based on its financial statements, assumptions you have about the business, future growth prospects, and many other factors. There are many strategies to accomplish this, but it also includes some intangibles like your perception of the world, your life experience, etc.

Determining the intrinsic value of any asset is a complex endeavor and is at best a ballpark estimate. Because we want to invest for the long-term (3, 5, 10+ years), we need to understand what the business will be worth in the future. Then apply it to today’s dollars to get an understanding if we are over or underpaying for the business.

Intrinsic value is the discounted value of the cash that can be taken out of a business during its remaining life. - Warren Buffett

I utilize a form of discounted cash flow (DCF) as one of many tools and insights to get insight into the intrinsic value of a business.

Additionally, I look at:

  • Return on Equity (ROE)

  • Return on Invested Capital (ROIC)

  • Return on Assets (ROA)

  • Price to Book Value

  • Debt

  • Profit Margins

  • Cash Flows

  • Price to Earnings (historical, industry, peer group)

  • Price to Earnings Growth Ratio

  • EPS growth (past and future estimates)

  • History of being a shareholder partner (buybacks, dividends, M&A, etc.)

  • Historical price per share

  • and more

Consider all of the above as ingredients that go into a mixing bowl. Some recipes take just a few ingredients and others take a lot more.

Margin of Safety

The Margin of Safety (MOS) can be understood as the amount of room between what you paid for shares of the business and the intrinsic value of the business. Because valuing a company is an imprecise practice, sticking to our MOS protects our potential downside as a result of miscalculating the intrinsic value.

Think of the MOS as a safety net. It’s likely there is an error within your intrinsic value calculations, assumptions about the business, or some other unforeseen aspect of the business. The MOS is assuming that you have made some error in your valuation of the business and protects you from it.

In addition to protecting your downside risk, it also can lead to outsized gains. Buying a company at a 50% discount allows you to participate in any future price correction AND the future profits of the company. A double rainbow!

We venture the motto, MARGIN OF SAFETY. - Benjamin Graham

Once I feel that I have a good understanding as to what the business is truly worth, I can then compare it to its current market price per share to see if it’s currently over, under, or fairly valued. Essentially, you’re taking the total price of the company if you were to buy the whole thing today and comparing that price to what the market is selling it for.

The successful value investor rarely gets an opportunity to purchase shares in companies they are fond of as a consumer. Oftentimes, it takes a large event like a recession to temporarily depress the stock price of really great companies. The largest gains are often found in obscure places before they become household names.

“A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes. It is adherence to the concept of a margin of safety that best distinguishes value investors from all others, who are not as concerned about loss.” - Seth Klarman

The companies in which I have invested were unknown to me prior to finding them on a stock screener, but I became fond of them after doing my due diligence and ultimately seeing them appreciate in value. While I might really love my Apple iPhone, Apple may not always be a great investment.

With a proper margin of safety, you can mitigate much of the risk associated with investing in individual stocks. Even if you end up buying a mediocre business, you can still end up making good returns and if you buy a great company at a bad price, you may not experience great returns.

Economic Moats

An economic moat is a feature of a business that has separated itself from its competition. There are many ways for a company to build a moat and these companies have proven to have staying power in the market. Just like a castle moat makes a great deterrent for potential invasion, they don’t mean the business is immune to competition over time.

A recent study by McKinsey found that the average life-span of companies listed in Standard & Poor's 500 was 61 years in 1958. Today, it is less than 18 years. McKinsey believes that, in 2027, 75% of the companies currently quoted on the S&P 500 will have disappeared.

Think of that for a moment, according to Buffett, we’re supposed to buy companies that we want to hold forever. The odds of you picking the 25% of companies that will still be around in 7 years is unlikely. Times may have changed, but his quote still holds weight. I propose that we should be buying companies that we want to own until they’re not worth owning any longer.

"Moats have been breached time after time. Imagine the Eastman Chemical Company going broke. Imagine all these great department stores being on the edge of extinction. Imagine all those monopoly newspapers going down. Look at the strength of the American auto industry compared to what it was, say in 1950. I think the moats are disappearing rapidly. I mean the old classical moats. I think it's probably a natural part of the modern economic system, as in old moats stop working." - Charlie Munger

The reason why these companies are disappearing so fast is that they’re moat or lack thereof is being eroded away at a faster clip. Often due to innovation, technology, advancement, politics, etc.

When we think of moats, we think of old businesses with products that everyone knows and prefers. Those companies were great investments decades ago, but it’s unlikely that they’re a great investment today. The problem is, too many people follow how Buffett and other value investors invest TODAY with hundreds of billions of dollars, and not like they did YEARS AGO when building their wealth.

Moats come in many forms, here are a few:

  • Customer Switching Costs: Products and services that are perceived as too high of a cost to switch to a competing product/service.

  • Cost Advantages and Pricing Power: Economies of scale that allow pricing at a discount to competitors (Amazon)

  • Intangible Assets: Brand recognition, household names, loyal fanbase (Apple)

  • Network Effects: Networks that become more useful as more people use them (Facebook)

Monopolies vs Perfect Markets

Perfectly competitive markets may be ideal for the consumer, but they are not ideal for the owners of a business looking to earn profits.

Since no firm has any market power, they must all sell at whatever price the market determines. If there is money to be made, new firms will enter the market, increase supply, drive prices down and thereby eliminate the profits that attracted them in the first place. If too many firms enter the market, they'll suffer losses, some will fold, and prices will rise back to sustainable levels. Under perfect competition, in the long run no company makes an economic profit. - Peter Thiel

Monopolies are often perceived as negative. In reality, business owners should want to own a monopoly. The purpose of a business is to generate profits for its owner and shareholders are owners in the business. The purpose of a shareholder should be to invest in a business that will generate profits. The most profitable businesses are the ones with the least competition.

The opposite of perfect competition is monopoly. Whereas a competitive firm must sell at the market price, a monopoly owns its market, so it can set its own prices. Since it has no competition, it produces at the quantity and price combination that maximizes its profits. - Peter Thiel

While very few true monopolies exist, the idea of a moat is to find companies that have separated themselves from the pack and deter competition for one reason or another. This is a key driver of profits, potential growth, and staying power.

Value VS Growth Stocks

It should be evident to you by now that my definition of a value stock can be applied to any stock in the market. There is a price point for most stocks with which I would consider them a value stock regardless of any other category they may fall into. Value is simply the delta between what you paid and what the business is truly worth.

Benjamin Graham often participated in “cigar butt” investing. Basically, buying a company below its liquidation value. For example, he would pay $5 per share for a company sitting on $20 of assets. Upon liquidation, the assets were sold and the value unlocked and returned to the shareholders. This is also how Buffett invested early on prior to meeting Charlie Munger.

Back then, businesses were far more simple than they are today. Textile factories, steel manufacturers, etc. Today, businesses leverage technology to earn profits without as much need for physical assets, overhead, etc. This is likely one reason why Buffett is notorious for avoiding technology-based investments.

There is no such thing as a value company and a growth company when it comes to value investing. They are two sides of the same coin. Ideally, I would invest in a growth company at a deep value relative to its intrinsic value. As Buffett would put it, “Investing in a great company at a good price.”

Investing in Compounding Machines

My ideal scenario is paying below market value for businesses that can reinvest their profits, earn a high return on investment, and compound that investment internally over time. That hopefully falls to the bottom line and increases earnings which I believe the share price is typically tied to over the long run. Increased earnings should equal an increased share price. At some point, the company may decide to buy back shares, acquire other businesses, or pay back a dividend. At this point, the investment has likely been a successful one and the position can be maintained or exited for a hefty profit.

“We think hard about the ingredients required for a business to compound in value over the course of many years. We believe these include: 1) an ability to generate above average returns on shareholders’ capital, 2) opportunities to deploy additional capital at above average returns, and 3) a management team with the skill and judgment to sustain the process of compounding over a long period of time in the face of competition. You’ll recognize this is just another way of describing our “three-legged stool” approach: Business, Management, Reinvestment.” - Chuck Akre

If you can merge Chuck Akre’s philosophy with that of the traditional Buffett - Graham philosophy, you have a match made in heaven. A compounding machine by nature is a “growth” company. Being able to identify a compounding machine AND buy it with a nice MOS is a near-perfect situation in my opinion.

Growth Reduces Risk

This might seem counter-intuitive, but I believe that growth has the ability to reduce risk in the investment. If you buy a stock with a 50% MOS AND the business has shown the potential to continue to grow at 10%, 15%, 20%, or more, then I consider that to be a very strong position. Each year that the company is able to achieve its growth targets is further increasing the delta between your cost basis (how much you paid for your position) and the intrinsic value of the company. Reducing the risk that you’ll lose money in the investment.

The share price is of little significance to me other than to determine the MOS and for my potential exit. To understand growth, you have to look at profit margins, ROIC, ROE, FCF, etc. to get an idea of how the business earns money, spends money, invests money, and ultimately returns value to its shareholders.

Patience is Key

Scenarios like the one with John and Jane don’t appear on a daily basis. Often times, you must wait for a sector-specific event or a broader economic event to take place. For example, COVID-19 reduced the stock prices of nearly all companies in the stock market. Did great companies like Visa deserve to have their share price cut by 30% or more? No. Nothing inherently changed with the company, just the fact that there was global fear in the market.

On February 19th, 2020, Visa was priced at $213 per share. On March 23rd, 2020, it bottomed at $135 per share. Did Visa deserve to lose 100B+ in market value in one month? Probably not. In fact, it fully recovered just six months later.

Had you been watching, it’s likely you could have purchased Visa at a steep discount. Of course, you would want to fully value the company and not make your decisions based solely on price action, but almost all stocks in the market experienced a significant drop.

Sometimes, a sector goes out of favor (energy, financials, healthcare, etc.) depending on the economic cycle, the political forces, and many other environmental factors, you may be able to find really great companies at a really great price.

Creating Shareholder Value

Believe it or not, many people think that somehow through purchasing a stock, the company is receiving some form of compensation. This is simply untrue. In reality, you’re becoming a shareholder with a vested interest in the long-term success of the company.

Imagine a professional sports team. There’s typically the owner and the coach. Both share a vested interest in the long-term success of the team. One is in the background and the other in the limelight. Now imagine that YOU are a co-owner of a business (team), and the CEO is your coach.

A CEO and executive team should not only run the business efficiently and effectively, but they should be able to allocate capital in ways that benefit the owners of the business (shareholders). This is why people care that the executive team of a business owns shares of the company. Both parties have aligned interests in delivering shareholder value.

Reinvesting in the Business

The company can take their profits and reinvest them into the business. This is often overlooked by average investors because it isn’t as easy to see and understand as dividend payments are.

When a business reinvests in itself buy purchasing assets, hiring new people, etc. It may be able to further increase its revenues. This, in turn, will increase the value of the business and should drive the share price higher over time. This is typically found in “growth companies.”

Acquiring Other Businesses

When a company acquires another company, this is called inorganic growth. It’s growth that the company could not have generated itself and thus went out and bought it. If done well, acquisitions can quickly increase the value of a business, but it’s not always that simple.

The company I work for was acquired 3 years ago, since then, our parent company has acquired one business a quarter. In the beginning, merging our products, processes, and people was rocky, time-consuming, capital intensive, and likely, not accretive to our bottom line. Recent acquisitions have gone much smoother as our executives, middle managers, and employees have gotten accustomed to the process.

Here are some questions to consider when investing in companies that are involved in mergers and acquisitions ( M&A):

  • How experienced is management in M&A?

  • Have they acquired companies in the past?

  • How long has it taken for that to reflect in the earnings?

  • Are they acquiring companies within their industry or a different industry?

  • Do they understand that industry?

  • Why aren’t they able to grow organically?

  • Are their processes going to bring down the newly acquired companies?

Direct Dividend Payments to Shareholders

The company may determine that they are unable or unwilling to scale up their operation and instead pay a dividend out to shareholders. This comes directly out of the companies net profits.

Dividends tell me that the company cannot find a better use of capital than to return it directly to its shareholders. This is typically due to the company entering a mature phase of its life. Seeking share price stability and possibly signaling a slowdown in growth.

Dividends are beneficial in that they can be seen, planned for, consistent, and when paired with buying shares in the company at a strong MOS, you can enjoy price appreciation back to fair value as well as collecting dividends along the way.

Share Buybacks

Share buybacks are another way of delivering shareholder value. Basically, the company determines that their own stock is undervalued in the market place and it’s a great opportunity to reduce the number of outstanding shares.

When the number of shares outstanding is reduced, each individual share becomes more valuable. A stock is simply a piece of the company pie. Although there are sometimes millions or billions of pieces to that pie. If your pie is worth $1 Billion and there are 1 Million slices of the pie, then each slice of pie is worth $1,000. Now, if the number of slices was reduced from 1 Million to 500,000 slices, each slice of the pie is now worth $2,000.

Share buybacks may be a sign that the company believes its stock to be undervalued. Some might even say that in their conference calls. Often, this can be indicative of what the intrinsic value of the company is. If management thinks it’s undervalued, your calculations say it’s undervalued, then it might actually be undervalued.

The Circle of Competence

Warren Buffett is the most famous investor to tout the idea of the circle of competence. Peter Lynch and many others also held similar philosophies though many weren’t so great at getting their idea across. It’s not as simple as investing in what you know.

Many of the things we use on a daily basis are not worth investing in and we shouldn’t invest in a company simply because we like its product to the exclusion of all other fundamentals. For example, you may really enjoy your PlayStation and believe that it is a superior product to Microsoft Xbox, but upon further analysis, Sony may or may not be a great investment.

For me, the circle of competence is more about understanding a specific sector of the market and realizing that understanding may give you an edge in identifying undervalued companies. For example, I work in the Software as a Service (SaaS) industry. This may give me critical insight into the industry that could help me identify companies that have superior products and services. Then, waiting until the market price is dislocated from the share price to make an investment.

Early on, Buffett learned the insurance business inside and out. This provided him great insight into the industry and led to his investment in GEICO. He made something north of 40 Billion in that investment.

Your circle of competence may be in how you value companies, companies that you look for, industries that you’re attracted to, etc. You wouldn’t expect to be able to understand Calculus if you don’t yet understand basic algebra. Some companies/industries are much easier to understand than others.

Never Lose Money

Losing money is the antithesis of investing. The reason so many people lose money in the market is that they don’t have a fundamental understanding of what they’re doing. Successful day traders are successful because they have a well-defined process for identifying trades, entering trades, and exiting trades. Value investing is no different, it simply uses different metrics for valuing the potential investment and the time horizon is longer.

Identifying Value Investments

I have very specific criteria that I use to identify a potential value investment. I also have a few different categories of companies that I purchase that serve a different purpose within my portfolio.

I utilize a simple stock screener looking for companies at or below book value, shareholder focused management, the potential for future growth, etc. Basically, looking for good performing companies at a discount to their intrinsic value.

There’s no single formula, screener, or calculator that one can use to find these companies. It’s a combination of past performance, future analysis, and an abstract understanding of the company.

Maybe you notice that you really enjoy a certain movie theatre chain over another. What makes that theatre so much better? Do other people feel that way? Maybe it’s worth checking their stock and looking deeper into the companies fundamentals.

Maybe you read an article about a company that is aggressively and successfully buying other companies at a rate of one per quarter and showing they can quickly increase their earnings as a result. If the market hasn’t caught on to this yet, the company may be worth taking a hard look at. Sometimes, inorganic growth can be a significant driver of growth compared to organic growth if the execution is there.

When to Buy

It’s often said that the profit is earned when you purchase a stock. Not when you sell. Depending on your entry into the investment, you can make or break your returns.

Investing in a great company at too high of a valuation can lead to great losses. Investing in a crappy company at a distressed valuation can lead to great profits. While we want to invest in great companies, we need to ensure we’re doing so at a greatly distressed valuation.

This allows us several ways to earn profits:

  1. Price returning to fair market value

  2. The continued growth of the intrinsic value of the business

  3. Potential future dividends

When you make an investment, you are hoping to earn a profit as a result of your ownership at some point in the future. The more avenues you give yourself to earn a profit, the more money you can ultimately make on an investment.

For example, company XYZ is a strong growth company. In July, John invests at $100 per share. John believes that XYZ will continue to grow into the future, growing his investment. In December, the market sells off and Jane is able to buy shares of XYZ for $50 knowing that the fair value of the company is $100 AND that it will continue to grow into the future. Who stands to make the most money in this situation?

Jane purchased what we would call a $0.50 dollar. Her $50 shares are instantly worth $100, she just has to wait for the fear to subside and the price to return to its fair value. She can make a DOUBLE and enjoy the future growth prospects of company XYZ because of her MOS in the investment.

In fact, I prefer to invest in companies that have the potential and maybe a recent history of growing the business. If the business properly allocates its capital and grows significantly over time, the earnings typically grow as well and the share price typically correlates to earnings. It stands to reason that a growing business will have a growing share price which quickly mitigates our risk in the investment. The trick is to buy the growth company at a discount to its intrinsic value.

Challenge: How great of a company can you find that is currently priced at a 50% or greater discount to its fair value?

Sometimes, we’re willing to invest with a lower MOS in return for a company with stronger fundamentals, sometimes, we need more than a 50% MOS in order to justify buying a company with not so great fundamentals.

When to Sell

Once a position is entered, it’s difficult to pinpoint the exact point at which one should sell. Everyone is going to have a different opinion on this based on experience and risk tolerance.

Some will wait to sell until the price of the stock has reached 90% of their interpretation of the companies fair value. Some will hold the investment until the underlying story of their thesis changes. Sometimes, management changes or industry changes will spur investors to sell. Ultimately, it is up to you to decide when to sell an investment.

More often than not, a novice investor will sell at the first sign of the stock price going down, or after months of a depressed stock price. This is not how you make money in the stock market. These people are effectively buying high and selling low.

You don't make money when you buy stocks. And you don't make money when you sell stocks. You make money by waiting. - Mohnish Pabrai

If I properly value a company and the price goes down, it is likely that I will purchase more shares at a significantly lower price. As long as the reason for my initial investment remains intact, I can purchase more shares with confidence. From a position of strength. In these cases, a temporary reduction in share price is welcomed.

Sometimes, the share price does not recover back to what you determined to be a fair value for months, years, or ever. In these cases, we must go back to our original valuation and determine why the market hasn’t agreed with us. There is some disconnect somewhere and we must determine what that is.

Warren Buffett once said that the market will typically catch up with the intrinsic value in about 18 months. Sometimes sooner sometimes later. Needless to say, we should be investing in companies we want to own forever if given the opportunity to purchase them at a price below their intrinsic value.

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    Disclaimer: I am not a Certified Financial Planner nor should anything I write be taken as investment advice. FIRE The Family is for educational purposes only and you should always perform your own due diligence in conjunction with consulting with a professional prior to making any investment decisions.

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