Value Investing Forum

tleonowicz said:

Did you set goals when you first started? I just set a goal to research 20 companies by the end of the month so I become more effieicent with time and have the conviction to pull the trigger if need be.

Meh. Not really. My goals are mainly psychological: keep it simple, trust the basics and the past 60 years of history that are heavily in favor of equities, hate debt, love money in your pocket now/dividends and be patient. Other than that I don't have any goals. Except beating the market. 

 

How do you go about the time spent with reports vs leg work in stores or talks with people around the products. Peter Lynch says he spends little time with the balance sheet and is more likely to stay in the hotel hes researching or try the sandwich of the shop that interests him. I have spent a lot of time with reports and feels endless (the hurdle of knowing the numbers), wondering if theres certain areas I should look at more than others. For example, after reading the Financial Shenanigansd book, I picked up an annual report of a random company and read it from last page to first page, to see if I could spot flaws. I'm assuming that based on the time i spent, I'd never sleep if I had to reasearch more than one company.

This question comes back to knowing what you are good at, staying with it and staying away from stuff you suck at. I know based on who I am and the way I interact with someone that if I started phoning companies or really putting emphasis on my own subjective experience of a product/company I'd only invest in the companies where people were nice to me on the phone or where I had a good experience of a product. In other words, I'm not critical enough of those types of experiences; at least not enough to know that I would make a good valuation decision. It would be bad. 

I know, for me, that I make better decisions about a company based on the numbers I can understand, my own thoughts and beliefs about their business, their industry etc. I'm very research and academic by nature in that way. I found out early on that I'm a horrible reporter or someone who goes out and finds the truth of a matter by talking to people. I find the truth of a matter by reading, analyzing figures and boiling it down to very simple questions and probabilities. "If it does this, this will happen. If it does that, that will happen. Am I comfortable with either situation?" That kind of thing. 

Find out what you are good at and enjoy and then build an investing model around that. Don't romanticize the experiences of someone else if it wont work for you. You'll get burned. Socrates was right about the self-examined life. 

tleonowicz said:

I have a few questions for you Graeme.

Uh oh…

I like how you posted about FCF/share, I have been starting to look at this more than EPS after I read a book called "Financial Shenanigans" and saw how easily manipulated the numbers could be for EPS. With that being said, what value do you place on the free cash? I have read that cash to a fast grower is more beneficial than to a slow grower, but to what degree? How would you account for a proper multiple of cash (like p/e for EPS)?

I place a pretty high value on Free Cash. As a shareholder of a business, the only chance I have at seeing any sort of return on my investment is broken down into two categories: what I've started calling my 'hard returns'–actual money in my pocket. This mainly comes from dividends. And 'soft returns'–which comes from stock price gain which is achieved by figuring out an intrinsic value price and then buying well below it. For me, a good portfolio has a balance between these two (and, obviously, the perfect business is an dividend paying, currently undervalued one.) Free Cash is the way that those two things are realized in a real way. And if you're used to working with P/E, you can just substitute the E with FCF/share. I still use P/E and below book value screens to look for possible companies. As for questions about cash being more beneficial to a fast grower vs a slow grower, it's probably true. Sounds about right. But as far as I'm concerned, a high FCF company means I have a greater probability of realizing that "soft return" of share increase. Besides, bigger slower growing companies better be paying a good dividend, or be super undervalued or I wont touch them.  

With discount rates, how do you come about them? From what I understand, its a rate of return that is suitable to the investor, not a set number. I have yet to read about CROIC but I do know about ROE so I can kind of understand what you're getting at there.

Yeah, the discount rate is the big question all the time. My brother-in-law is an investment banker and they go crazy trying to figure out discount rates by calculating a WACC (weight average cost of capital) and other things that are basically alchemy. For me, I use the discount rate as policing my margin of safety. Every company I value always gets a 15% DR and I see what valuation that gives me. If I'm reasonably assured that they are a 'safer bet' due to a bunch of other factors (size, what industry they're in, what I feel about management, past performance, dividend history, debt levels, CROIC and ROIC/overall money management abilities) I will ascribe a lower DR to them. I never go below 9%. But more recently I've been keeping it at 15% for everything and if I feel the company is safe, I will look for a lower margin of safety–like a 30%-40% over a 50%–especially if I have a reasonable dividend return that I can reinvest.  

Last, how do you sum it all together? You say from the valuation models you get $x, is there anything that can sway x in either direction that would be in the qualitative form?

You'll have to do some reading on the DCF and on the Graham formula to get to the heart of it. The main thing that can sway x is…uh….well…everything. That's why the best valuations are a range. It's also a reason why I'm experimenting more with keeping my discount rate constant for my valuations. I also try to give myself three scenarios and find a valuation range for each scenario: an everything-is-awesome scenario, an everything-is-not-growing/just maintaining what you have scenario and an everything-is-shrinking scenario. You can run reverse valuations to see which one the market feels the company is doing. Then you can decide what scenario is the most probable and look for your desired margin of safety. Obviously if you think it is in scenario 2 with a $15-$17 range valuation, but the market is pricing it as if it is going to shrink by 10% every year (which would be a scenario 3) then that could be a good buy opportunity. But be prepared to wait a while because my guess is that the market takes a long time to go from "OMG they are dying" to a "hey..they're just…existing alright." So be prepared to hold on to something for a while. This is harder than it sounds. 

You goal is to find a fair value range and then buy when it is well, well below that range. Only swing at pitches that the pitcher wishes he actually didn't throw at you. 

I have a few questions for you Graeme.

I like how you posted about FCF/share, I have been starting to look at this more than EPS after I read a book called "Financial Shenanigans" and saw how easily manipulated the numbers could be for EPS. With that being said, what value do you place on the free cash? I have read that cash to a fast grower is more beneficial than to a slow grower, but to what degree? How would you account for a proper multiple of cash (like p/e for EPS)?

With discount rates, how do you come about them? From what I understand, its a rate of return that is suitable to the investor, not a set number. I have yet to read about CROIC but I do know about ROE so I can kind of understand what you're getting at there.

Last, how do you sum it all together? You say from the valuation models you get $x, is there anything that can sway x in either direction that would be in the qualitative form?

This was a terrific example in my opinion. I really do appreciate you taking the time to go through it. 

Cool. That's a good start. But we're going to have to work with some numbers. What company is it?

Welcome to the fun and crazy world of value investing! The best thing you can do in my opinion is:

1. Figure out what it means to value a company. Don't think about share prince, but think about company value and what you would pay outright for it. The first few chapters of Greenblatt's The Little Book that Beats the Market is a good place to start. Then go around to easy-to-analyze companies a practice. It'll take time. When I was starting out I made my own DCF model in a spreadsheet and tried to analyze KO. I think I got an intrinsic value of $14. Which, obviously, was crazy. Valuing is an art. You'll get the hang of it. 

2. Actually put your ideas into practice. There is no substitute for learning as you go. You will be more motivated to learn when you have money in the market

(but money in the market means…)

3. Learn to control your emotions. This is huge. Be ruthless in learning your weaknesses and how you make bad decisions. Go read Charlie Munger's speech called The Psychology of Human Mismanagement. Go through each of his examples and see how they pertain to you and your own biases. Keep notes on all your market buy and sell decisions and the exact reasons for doing it. If you sell something and make money, write a little report for yourself on what happened and how it worked. If you lose money, write a more detailed report as to why this happened. The way I do it is "how would I explain why I lost money to my wife." If the answer she responds with is "so basically you're an idiot" then take steps to not make that mistake again. Investing isn't about making one decision that pays off for a lifetime; it's about limiting mistakes. 

4. Stay active in these forums! Ask a ton of questions. Post hypotheticals and see what others think about it.