＂Value investing is a big tent that accommodates many different people. At one end of the tent, there is Ben Graham, and at the other end of the tent there is Warren Buffett, who worked with Graham and then went out on his own and made adjustments to the teachings of Ben Graham.＂
The quote above is from my favorite value investor Jean Marie Eveillard. Indeed, everyone has a different understanding of value investing. I also believe that value investing is not the only viable investment method in the capital markets. But As a believer and truth seeker of value investing, I will only talk about my own understanding of value investing. I wrote down my investment principles, mainly because I want to warn myself not to obey my principles at any time, (only about equity investing.)
Contain Six major parts few major points highlighted.
1: Value investment concept (Two major points)
A: buying stocks is part of buying a company, think like an owner
B: only purchase when there is a margin of safety.
2: Value definition and importance of free cash flow (Two major points)
A: Value is the discounted free cash flow generated during the life of the enterprise.
B: free cash flow is the most important thing. Be compared with Risk-free bonds.
3: Read the financial report (important items)
A: Balance sheet, income statement, and cash flow statements.
4: Investment process (quantitative + qualitative)
A: 4 major quantitative factors (EV/EBIT OR EBITDA, FCF yield, cash conversion ratio, ROIC or Return on fixed tangible assets)
B: 4 major qualitative factors (cyclicity or CYC, Capital intensity, customer purchase cycle, own product life cycle )
C: 4 types of companies. Class A/B/C/D
5 two supplements (accounting rules and business logic)
A: accounting rules for global investing (3 big differences IFRS vs US CAAP accounting rules )
B: Business logic (3 items revenue/ cost/ tangible assets)
6: Investment principles
A: 6 general rules
B: 5 Buy first buys
C: 3 careful buys.
D: Five “don’t or never buys
1: Value investment concept
Every stock represents a company, you should only buy it when it is below its intrinsic value. The value of this company is determined by the discounted free cash flow generated during the life of the company.
I think the core of value investing contains two major points.
A: firmly believe that buying stocks is part of buying a company.
Buying a company from the perspective of the operator, during the life cycle of a company will encounter various problems. The company operator will not easily give up its own business because of the short-term problems of the company. Investors as part-owners of businesses should think the same way.
B: It should only be purchased when the market price is lower than the intrinsic value, which is the margin of safety.
The margin of safety Ben Graham vs Warren Buffett
Ben Graham’s margin of safety is mainly about price, which is cheap and does not care about the quality of the enterprise, such as buying an asset worth a dollar for 50 cents. Among the most famous investors using the classical Ben Graham approach include Peter Cundill, Walter Schloss, and Michael price just to name a few.
One of the most famous methods is the” net-net “method, which is to use current assets (such as cash/accounts receivable / inventory)-all liabilities VS your market value.
(it should be noted here that, investors need to make their own adjustments, for example, for retail companies, jewelry / automotive, and apparel companies, jewelry / automotive inventory can be valuable, and the value of outdated apparel may be worth 0. Investors need to vary from company to company)
However,
Business becomes much more asset-light. Buffett’s emphasis on safety margins is mainly about good business models / high return on capital / future growth, that is, good companies (good), for example, the growth of the enterprise will drive the growth of intrinsic value, So you will have a margin of safety.
Buffett introduced human judgment to the future of the enterprise. This increases the probability of human errors. paying excessive prices, overly optimistic about business prospects, etc. when you buy good companies.
For example:
In the late 1990s, Buffett did not sell Coca-Cola with a price-to-earnings ratio of 40 times, and Kraft, a Kraft Heinz Company. Buffett publicly said he had overpaid the kraft recently. Both companies are world-class companies with stable repeatable revenue with well-known brands, Returns on tangible fixed asset is outstanding or even the best in a similar industry. But excessive valuation will lead to stagnation of returns for a long period of time. Once again proves the importance of the margin of safety when buying securities.
2: Value definition and importance of free cash flow
Value is the discounted free cash flow generated during the life of the enterprise.
Everyone has a different definition of value. Some people like to use low P / B, P / E, P / S data. This is just my point of view. In fact, everyone who has run a business knows that free cash flow is the most important thing.
Assume the same soft drink company and steel company with 10 times P / E. Due to its industry characteristics, soft drinks companies basically do not need a lot of investment, so its profits are converted into real cash, which can be used to M&A / dividend/repurchase stocks. For steel companies, a lot of profits need to repurchase/maintain their own equipment, so that all profits are converted into new fixed assets/inventory. The shareholders have nothing left.
in fact, stock investment is like bond / real estate investment, assuming that the bond does not default, the bond interest rate / and real estate rent will tell you the annual return,
The difficulty of stocks, although we buy the long-term free cash flow of the company, the annual cash flow during the life of the company is constantly changing. Corporate cash flow can grow or decline. In cyclical industries, there is also a big difference in the cash flow of cyclical peaks and troughs. Investors focus on the short term, and can easily excessive optimism and pessimism.
The discount rate is an abstract concept, which means that every time people say that stocks are cheap or expensive, they can of course compare historical data.
But it should be compared with risk-free bonds at that time, commonly known as government bonds ( Assuming that the interest rate of the 10 years government debt is 6%, then you buy consumer staple stocks with a free cash flow rate of 4%. You must expect this company to grow in the long run, otherwise, you will pay a higher purchase price than risk-free bonds)
3: Read the financial report (important items)
All Value investments must start from the financial statements. Below some important information investors can highlight.
Balance sheet
Assets
- Enterprise value (EV) = market value-cash or equivalent + debts. The more cash the company has, the less debt it has, indicating a more stable financial position.
- Accounts receivable / inventory: the largest part of current assets, a part of working capital, those assets will reduce cash flow, the less the better.
- fixed assets/plant & Equipment (before and after depreciation): the largest part of tangible assets, such as land/plant/office equipment/computer equipment, etc., the less tangible assets needs, the better.
- Intangible assets: software / trademarks / customer relationships / contract costs (franchise chain operations) / franchise (generally one-time such as casinos, highway licenses, etc.) Some software is treated as intangible assets and can be treated as “tangible assets”. If there is Capex need for software. It affects free cash flow.
- Goodwill: Generated during general acquisitions and does not occupy future cash flow. A lot of goodwill combined with the little fixed asset may, means the industry itself is asset-light.
- Long-term investment: This may be an equity investment or a joint venture, or it may be a financial asset. Too much long-term investment increases the difficulty of understanding business, like What is the operating status of the joint venture company, and the cash flow that the joint venture company passes to the parent of the company.
Liabilities side
- Accounts payable, the largest portion of current liabilities, owe money to suppliers, It can be regarded as short-term interest-free bonds.
- Deferred revenue: Cash paid by customers in advance. Increase operating cash flow. For example, casino chips, software subscription fees, tuition fees, and aircraft booking fees are paid in advance.
- Non-control interest: This is an equity that is not held but in the consolidated balance sheet, which means, you are not 100% controlling all subsidiaries. Increased the company’s difficulty in understanding.
Income statement & cash flow statement
- Revenue recognition (but how to make this revenue)
- Gross margin: Gross profit/revenue, more useful as goods companies than service companies,
- Operating income (operating income / ebit): operating profit before tax and before financial expense. EBITDA, Operating profit + depreciation and amortization.
- Free cash flow: free cash flow (FCF) = operating cash flow-capital expenditure (CAPEX). Cash profit.
4: Investment process (quantitative + qualitative)
Buffett and Munger are the most successful value investors in the past few decades. Buffett once attributed his huge investment success. “How the sound of his approach” is his iron investment discipline/method. I think he is too humble. Not everyone can have Buffett’s vision and insight into the industry/company.
I think the method that is more suitable for most people, including me, is the legendary American fund manager Joel Greenblatt’s “insurance method”, which means the portfolio approach. With your own investment system, you hold 20-30 stocks. If 60-70% performs well, you can also perform well. You also need to avoid concentrating on just one industry.
This method is especially suitable for fund managers, because the money managed by the fund manager is not their own, fund managers should not only considers investment, but also considers liquidity, and even if you are right in the end, the time may be too long, and your customers are not Be patient and share your gains.
All investors would like to buy cheap (quantitative) and good(qualitative) companies, so how do measure them.
A: four financial ratio factors (quantitative cheap)
- EV / EBIT EV / EBITDA: (cheap)
Enterprise Value / Operating Profit OR EBITDA. ratio smaller, the better.
- free cash flow yield, Fcf yield (normalized): (cheap)
free cash flow / (market value or enterprise value). Ratio bigger, the better. It is emphasized here that especially for cyclical industries, cash flow fluctuates greatly, and the cash flow under normal operating/normal margins conditions needs to be used.
- Cash conversion ratio: (good)
How much profit is converted into cash, basically the less working capital required (less inventory/accounts receivable, etc.), the higher the cash conversion, the better?
- Return on capital / Return on fixed assets (ROIC ): (good)
Historical return on capital = Ebitda / (historical fixed assets + intangible assets (software) +l), or EBIT / (net fixed assets + intangible assets (software) The higher the ratio, the higher the return on capital, and the less tangible assets needed. The better.
B: four qualitative points to measure (qualitative=good)
Jean Marie Eveillard once said that he would take any company, add some useful data, and then figure out its advantages and disadvantages of this company. These characteristics generally do not exceed 4-5.
Each industry has its inherent advantages and disadvantages. The following four points are determined by the characteristics of different industries. It is not determined by its location/region / even its competitive advantage.
Each of these industries is based on the characteristics of its own industry. They can be classified. (Picture from Yackman asset management)
- Industry cyclicality (cyc)(cyclically smaller, the better)
- Capital intensity (capital intensity) ( the less Capex need, the better)
- customer Purchase cycle (Purchase cycle) (one-time purchase/repeat purchase, the more repeated purchases, the better).
- 4: The product life cycle (the replacement of the product or service, the longer the cycle of the product or service itself, the better).
C: Four types of companies. Class A/B/C/D
Based on this first two factors, all companies can be classified into 4 types.
Class A: Low CYC / low CAPEX industry
Examples: software / disposable medical supplies/consumer staple (consumer goods)
Class B: High CYC / low CAPEX industry
Services companies example: Financial services: Stock exchange/asset management company /media (TV station), online advertising, and so on.
Goods companies example: cyclical consumer goods, such as luxury goods/sports products, technology products, some industrial products(capital goods), such as commercial kitchen equipment, elevators, etc., wholesale of industrial products, and on so.
Class C: Low CYC / high CAPEX industry
Services companies example: Telecom / Infrastructure / Pipeline / Hospital.
Goods companies example: food & staple retail. Utilities.
Class d: High CYC / high CAPEx
Goods companies example: raw materials/oil drilling / automotive manufacturing / most capital goods
Services companies example: transportation, (air/water transportation, etc.) and the majority of consumer services like hotels.
People can build a Portfolio around four types,
A: Should be included in any Portfolio, it reduced the downside, and can be a source of liquidity during drawdown.
B big up as well as a downside. Even have an operating downside, will not have a large cash outflow since needs less Capex.
C: bonds like equity, stable dividend as a source of cash flow.
D: Biggest up and down.
5: two supplement materials (accounting rules and business logic)
A: Accounting rules
US-GAAP compares vs IFRS accounting rules on global investing.
Accounting is the most direct/simple business language. The foundation of value investing is also accounting. The two major accounting rules in the world are American GAAP and the other is the internationally accepted IFRS. (Other countries)
Many investments like to compare the stock markets of two countries, especially the U.S. stock market and foreign stock markets. Many people like to use P / B and P / E to compare, but I feel that before comparing, it is better to understand the different accounting rules in different regions.
The most significant differences are considered to be the following three points.
- In the balance sheet Treatment of fixed assets (especially commercial real estate),
US-GAAP uses historical cost depreciation, while IFRS is using a revaluation method. This proves that using P / B to compare the US vs. international companies is misleading.
- Handling of intangible assets (development cost/software)
US-GAAP software is generally in tangible fixed assets, and development costs are included in the current income statement as operating costs.
The IFRS software is generally in intangible assets, and the development cost can be included in the cash flow expenditure but not necessarily in the cost.
This proves that the pure use of P / E is misleading, comparison such as a US and a British technology company, the development costs of US companies may reduce their earnings.
- In the cash flow statement, interest income/cost and dividend income.
US-GAAP these incomes/expenses are all included in operating cash flow while IFRS interest costs are generally included in financial cash flow, while interest income/dividend income is included in investment cash flow.
the US GAAP is direct, and the IFRS cash flow needs to be recalculated, especially if this enterprise has a lot of debt.
B: business logic
The market is full of competition. Industry competition has also led to some inherent laws of business operations, where each industry has
general rules. In fact, to understand the business logic of an enterprise, I think it mainly depends on three points.
1: Revenue recognition: that is, the business model. How business makes its money.
2: Among the cost items: the largest cost of 2 items.
For goods companies, the largest cost is the cost of goods sold,
like for tech/health care goods, R&D is large items, and for consumer goods( marketing takes up a larger cost. Both gross and operating margin are key to watch.
For service companies, the largest cost of the service industry is people, so cost is more adjustment to business conditions. Operating margin is key to watch.
Other examples, the biggest cost of an airport is depreciation,
the biggest cost of mobile games is channel expenses / R & D,
and the biggest cost of platform companies (Tripping, etc.) is generally advertising.
3: The 3-4 largest tangible assets excluding cash in the balance sheet.
In other words, the largest capital expenditure in cash flow. The following items are generally the largest assets.
Working capital: inventory/receivables
Fixed assets(PP&E)
For asset-heavy industry: plant/land / machine
For light asset service industry: machinery/telecommunication equipment/office furniture, etc.
Once you figure out both the business models, (how they make money), and largest 2 costs, and the largest 3-4 tangible assets, you can figure out business logic, what is CYC like, and what is Capex intensity like and so on.
Just a few more examples of business logic
(Only the general situation is mentioned here, and it does not mean that there are special enterprises that can exceed this range. It also excludes the temporary impact of the economic recession on companies.)
For Goods company examples
household appliance company. Its gross profit margin should be 30% -40%, and its operating margin should be 5-15%. (Small appliances/kitchenware is higher).
For a tobacco company / soft drinks/cosmetics, the gross profit margin is >50%, while the operating profit margin > 20%.
The gross profit margin of capital goods companies is 30-40%, and the operating profit margin is 10-15%.
The gross profit margin of a food retailer is <30%, and the operating profit margin is<5%.
The gross profit of cyclical retail companies is about 30-40%, and the operating profit margin is 5-10%.
For Service company’s examples
An advertising agency or IT service, under normal circumstances, its operating margin is 10-15%. The largest asset is generally accounts receivable.
Labor-intensive outsourcing companies have an operating margin of 10-15%, and the largest assets are generally accounted receivable/ fixed assets.
For cable TV networks, the operating margin is 15-20%, and the biggest asset is the production/introduction of TV series/copyright (which can be regarded as inventory).
The asset management company, operating margin> 25%, and the largest asset financial investment (own funds) largest fixed asset is telecommunications equipment/office furniture.
Restaurant operating profit margin is generally <10%. The cost of raw materials for meals is generally 30%. The largest asset is building improvement.
6: Investment principles
(Notice here is just my own investment principles, everyone should have their own suitable investment method)
Three investment strategies (copy from Terry smith with own twist)
A: Investing in good companies.
High return companies can Generate consistent free cash flow without using leverage.
B: Don’t overpaid
You can only sell cheap while you buy cheap. —- Sam Walton.
Valuation matters. Dividend matters. Leverage matters. Companies valued depend on free cash flow yield.
C: Try to do nothing.
More Transaction reduced return overtime.
A: 6 general rules
- No leverage, no shorting, no prediction of market/economy.
- Free cash flow is key, and the current/future company generates free cash flow》 Asset value. Do not buy companies with negative free cash flow.
- contrarian investment
- Do not make long-term predictions of corporate profits, if companies exceed expectations in low expectations, they can also perform well.
- Big and beautiful: Big companies are better to withstand industry problem / and have better liquidity.
- Global investing.
B: Five Buy first
- Companies with strong balance sheets (preferably net cash).
- Asset-light company / high capital return / high cash flow conversion rate company.
- Cheap company
- Companies with higher stability / repeated revenue
- The business model is simple, and one minute can describe the advantages and disadvantages of companies in the industry.
C: Three careful buys
- Cyclical + asset-heavy industry: There is no way to hold this kind of industry for a long time. To a certain extent, it should be accompanied by a price-to-book ratio. Because the loss is severe at the cycle low. There is no price-earnings ratio. A price-to-book ratio of 0.5 times is generally better.
- Companies with poor balance sheets (large amounts of net debt). Such companies can give priority to “junk bonds” than stocks.
- Non-cyclical decline, a company showing a long-term decline because product life
D: Five “don’t or never buy”
- Do not buy companies with a low cash flow conversion rate / long-term negative net cash flow.
- Overestimate companies, are companies that overreact to future expectations, no matter how good the company’s quality factor is.
- financial Leverage industry companies (such as banking/insurance).
- Companies need to finance their own customers/consumers / to buy their own products. (such as many large automobile companies, etc., and some real estate companies). Those companies have a low cash conversion ratio anyway.
- Emerging industries / non-revenue industries/concept industries (such as experimental biopharmaceuticals, etc.)
Finally, I hope that all real value investment seekers will continue to grow. Find the truth that belongs to you.