Cherry picking Value Stocks

Hello Dear Reader!

Welcome to this blog on Value Investing. In this first post, I would like to discuss 3 things: First, the objective of this blog, second an introduction to Value Investing and third, a detailed discussion of my approach of analysis of any company (which would constitute the bulk of the discussion in this post).

The objective of this blog is to present an analysis of various companies through the ‘Value Investing’ approach. Through the analysis I intend to enlighten the reader about my judgement of the company’s likely intrinsic value based on all the information available about the company in the public domain. The companies I would analyze would be listed on a recognized stock exchange and could be from any country in the world. However, being an Indian, majority of the companies I intend to analyze would be Indian and would be listed either on the National Stock Exchange or Bombay Stock Exchange or both. My method of analysis would be based on the approach taught in the ‘Value Investing’ course at Columbia Business School.

So what is Value Investing? Well, any process of investing where one buys securities at a substantial discount to their carefully calculated intrinsic values, is called Value Investing. The process of picking ‘Value Stocks’ is a painstaking one. It requires one to conduct detailed investigations about the underlying business to get a fairly clear idea of the value of the business. It therefore becomes imperative for the analyst to obtain a clear picture of the industry in which the business operates and get a good handle on the economics of the business. The more he/she understands, the better off he/she is likely to be in making assumptions about the future or even otherwise in his/her valuation. Benjamin Graham and David Dodd are often credited for bringing the value approach to looking at stocks. The seminal books: ‘The Security Analysis’ by Graham and Dodd and ‘The Intelligent Investor’ by Graham are often considered the holy grail of Value Investing.

With that brief explanation, I’ll begin the detailed discussion of my approach of analysis of any company. First of all the business of the company and the industry in which the company operates must be understood in detail.

We, first look at the business model of the company and for that I make use of Alexander Osterwalder’s ‘Business Model Canvas’ which he had famously discussed in his bestseller book ‘Business Model Generation’. The canvas was designed to help fledgling entrepreneurs planning to start a business to capture their elementary business model and gradually evolve it into a robust and workable business model through repeated deliberations, conducting interviews of customers, simulating a sale and other techniques. I have, however, found an alternative use for the canvas, of capturing the business models of the various companies I wish to analyze for an investment decision. This provides a good insight into the workings of the business. The Business Model Canvas is made up of 9 building blocks:

  1. The Value Proposition of the business
  2. The Customer Segments of the business
  3. The Revenue Streams of the Business
  4. The Channels through which the customer is approached/reached
  5. The efforts made towards Customer Retention
  6. The Key Resources are the most important assets owned by the business that will enable it to make money
  7. The Key Activities performed by the company in carrying out the business operations successfully
  8. The Key Partners/Partnerships that will have to be entered into for smooth running of the business
  9. The Cost Structure of the business

A very good illustration of using the above canvas can be seen for a low cost airline on:

After cracking the business model to the extent we can based on all the information available, we begin our industry analysis by asking questions like:

  • Why is the industry important to the economy? – What is the need/demand that the industry caters to, how strong and indispensable is the need/demand and whether the industry will remain viable over the very long term
  • How has the industry, in which the company operates, evolved to its present size and structure from its inception? – This may seem like a very broad based question, but what I will focus on are the factors and forces that have shaped and affect the industry over extended periods of time. By ‘shaped and affect the industry’ what I mean is there may be certain forces operating within certain periods which may have caused companies to change their business models in some structural manner or modify their operations in a structural way. Evaluating a company within the context of those forces can help paint a realistic picture of the future.
  • What is the competitive landscape of the industry? Is the industry fragmented or dominated by a few players?  Whether there are barriers to entry in the industry? If there are, whether they are weak or strong? How often have the dominant players changed hands over the history of the industry? – This will be a rundown on the nature of competition present in the industry that will help make assumptions about whether growth for the company will be profitable or not
  • What have been the historical margins (gross margins, operating margins and net margins) enjoyed by the industry, assets turnover ratios, historical returns on invested capital in the industry and so on. – This will help us to get a handle on the average margins enjoyed and predict what will be the likely margins for the industry over the very long term
  • Historically, how fast has the industry been growing and is it a slow grower or fast grower today? What is the industry size? Has the market for the industry’s proucts saturated or is it still un-penetrated?- This will help decide the growth potential for the company in the future
  • What are the key risk factors affecting the industry and how severely can they impact profitability? – Again, this may seem like a generic question, but I will focus only on the most important and direct risks that have the most damaging impact on the earnings of the business

Next we look at the history of the company, how the company has evolved from its inception till the present day, key events in the history of the company and its promoters and management

So… so much for understanding the business and the industry. This understanding should help provide a clear idea of the strategic assumptions necessary to ascertain the value of the business. Besides, the research that will have to be done in figuring out the above 9 building blocks will assist a great deal in specific calculations of value of the business. For example after the ‘Key Resources’  have been identified it becomes very simple to calculate the Assets Value since all that needs to be done is finding a value for each of the ‘Key Resources’ identified.

With that, let’s proceed to the mechanics of Valuation. According to the Graham & Dodd framework of Value Investing, there are 3 measures of value:

  1. The Assets Value
  2. The Current Earnings Power Value excluding any growth in earnings
  3. The Earnings Power Value taking into account growth in earnings

Note that these values are arranged in increasing order of reliability. The Assets Value is the most reliable measure of value being tangible in nature. The Current Earnings Power Value is the second most reliable measure of value primarily because it excludes the value of ‘growth in earnings’ which is a futuristic component of value subject to wide range of errors. Finally, the Earnings Power Value taking into account growth in earnings is the most uncertain/unreliable measure of value primarily because it requires one to make lot of assumptions about many variables for the future, for instance the future cost of capital, future growth rate, etc. Let’s discuss each of the measures in some detail:

The Assets Value for a viable business is the reproduction cost of the assets of the business, that is to say, what it would cost for a new entrant to create a business similar to the one we are looking at. For a business that is not viable in the foreseeable future, the assets value would be a liquidation value of the assets, that is to say, how much the assets would fetch if they were to be realized in cash.

The Current Earnings Power Value would involve calculation of a sustainable operating margin for the business which has been averaged out for the good and bad times that arise due to economic cycles and a level of sustainable sales in the future. This would give us a sustainable operating profit. From this based on the future tax rate we calculate the Net Operating Profit After Tax that can be likely to be achieved by the company on average over the long run year after year. This current earnings power without taking into account would be divided by an appropriate cost of capital. This should give us a current earnings based value for the company. To this one should add any excess cash and investments the company may be owning that is not necessary for the business and subtract any debt that the company owes to its lenders.

The next measure is the Earnings Power Value of the company taking into account value created by growth in earnings. What’s important to realize here is that growth creates value only when the rate of return on the investment needed to fund the growth exceeds the cost of capital. For an average company, growth may, at best, just be a break-even proposition. This is because the average company may not be enjoying any sustainable competitive advantages and the barriers to entry may be very weak or limited, thereby allowing it to earn only a modest return on capital. The value of growth for such companies, would, for all practical purposes be zero!

Thus, for all those companies where the incremental return on capital employed is just slightly more or equal to the cost of capital, we will not be concerned about value added by growth. Here keeping in mind the traditional Dividend Discount Model, it is pertinent to note that it is only for very high growth rates and very high ratios of growth rates to the cost of capital will a substantial value for growth be created. Another aspect about valuing growth is that one should be wary about using the traditional Dividend Discounting Model formula, primarily because bulk of the value through this formula is embedded in the terminal value given by CF/(r-g) and a small error in the variable ‘r’, the cost of capital and/or ‘g’, the growth rate, can immensely distort the value. Thus it becomes necessary to come up with a creative way of valuing growth.

To sum up the discussion on the value of growth, what we can say with certainty is that growth in a business is worth valuing only if there are substantial barriers to entry and the business is enjoying sustainable competitive advantages (‘moats’ as the legendary investor, Warren Buffett would call them) that protect its profits.

So with that I would end this post and from the next post onward I would be directly picking companies and presenting my analysis on them.