The Value Investors – Lessons from the World’s Top Fund Managers by Ronald W Chan

This is a very good book on value investing. The below is a summary of what I like to apply to my own investment philosophy and processes.

From Chapter 1 – Free to Choose in Value Land – Walter Schloss

“I also learned that life is short, so you need to be confident in yourself and stick with what you like to do rather than do something you don’t like but that will make you money”

Schloss’ duty was to find stocks that were selling below their working capital – net net. The idea behind net net is to value a company based on its current net assets by taking cash and cash equivalent at full value then giving a discount to accounts receivable and inventory, and finally deducting all of the company’s liabilities. The net net value is then derived by dividing the resulting sum by the total shares outstanding.

Schloss always like to find companies with no to low debt because debt complicates things. He also like to see whether management owns enough of company’s stock to serve its best interest. You have to often have to keep track of management’s actions, digging into the footnotes of financial statements to see if they are honest people.

“When it comes to investing,” Schloss advised,”my suggestion is to first understand your strength and weakness and then devise a simple strategy so that you can sleep at night! Remember that a share of stock represent part of a business, and so you need to understand its financial before making a judgment. When you have made a sound decision, make sure you have the courage to stay true to your conviction and not let the market affect your emotions. After all, investing should be fun and challenging, not stressful and worrying.”

Chapter 2 – Once upon a time on wall street – Irving Kahn

His motto:” There is alway something to do. You just need to look harder, be creative and be a little flexible!”

“I understand that that net-net stocks are not too common anymore, but today’s investors should not complain too much because they were only a handful of industries in which to look for stocks in the old days. Now there are so many different types of businesses in so many different countries that investors can easily find something. Besides the Internet has made more information available. If you complain that you cannot find opportunities, then that means you either haven’t looked hard enough or you haven’t read broadly enough!”

A voracious reader, Kahn devours everything except fiction, which adds little value to his search for investment ideas. In addition to reading several newspapers a day, he also read scientific journals and technology magazines regularly. A close follower of the latest news and trends, he has read thousands of non fiction books – most of which are heavily marked with his apt comments.

When hot ideas fall into his value territory during economic recessions and market corrections, Khan buys. “Real investors should never feel bearish because the time to buy value is when markets go down!”

Kahn believes that successful investing requires patience, discipline, and skepticism. An undervalued investments are not usually recognized by the broader market in the beginning, patience is required to see how they play out over time. Discipline is crucial because allowing others to suggest what stocks are worth breeds lazy thinking. The wise investor must be disciplined enough to do the hard work necessary and to look into the numbers before making any investment decisions. In this respect, discipline breeds independent thinking.

  1. Don’t depend on recent or current figures to forecast future prices, remember that many others knew them before you did.
  2. Prices are continuously molded by fears, hopes and unreliable estimates, capital is always at risk unless you buy better than average values.
  3. Remember that many complex factors – such as accounting choices and the human problems within management and with large shareholders – lie behind accounting earnings
  4. Disregard the competition at your peril – they are always attacking your company’s trade position and earnings.
  5. Don’t trust quarterly earnings. Verify reports through the source and application statement. Figures can lie and liars can figure.
Chapter 3 – Thomas Kahn

It’s important to have capital working for you instead of you working for it!

Kahn’s father taught him that if he wanted to control his own destiny, he would have to delay immediate pleasures and save and invest wisely for the future!

Investment is more of an art that involves having the right temperament and an understanding of companies.

He focuses less on current earnings and more on what earnings could be in a healthier environment in the future. He elaborated,” Corporate health provides a much better margin of safety than good current earnings! We would rather invest in a company with a solid balance sheet, strong working capital, and little leverage than in a company with a lot of debt but strong earnings at present. In fact, we often favor companies that have near-term weak earnings or even no earnings but still have good corporate health because these types of companies offer better value.

Value investing is essential contrarian approach. It involves buying something that is currently unpopular and waiting for it to become popular again.  

Chapter 4 – William Browne 

Investing is a social science, investing is driven by people and people are not rational most of the time. You need to do is to find businesses that have high probabilities of surviving in the market. Then you implement a methodology to buy them at the right price so you can be more often right than wrong. Browne is about building an investment process. The ideals of the process are that it can be passed on, and it can be applied at any point in time and in different places because logic is timeless and universal.

In value investing, there is the danger of what is known as the “value trap” which occurs when a beat down stock is mistaken for a value stock.

Chapter 5 – Jean-Marie Eveillard

Every stock represents a business which has its own intrinsic value. To determine that value, you have to estimate what is a knowledgeable buyer would be willing to pay for the business in cash. It is important to understand that the intrinsic value is not an exact figure but a range that is based on your assumptions. Because you have to review your assumptions from time to time to reflect business and market conditions, intrinsic value fluctuates over time and it can go up or down.

“I always start off my research by reading companies’ annual reports and then the footnotes to their numbers. I need to be satisfied about the integrity of the numbers and the honesty of the accounting before I look further. If there is any number that is incomprehensible, I throw the report in the wastebasket and move on.

The meaning of value – we prefer to use EV/EBIT because it introduces the balance sheet to the multiples. The main goal of the analysis is to find out approximately how much the business is worth in a reasonable range, if a knowledgeable buy were to take over the company. By using EV, we include both cash and debt in the calculation, which is better than just looking at market capitalization. Then with EBIT, we see how much interest the company is paying. Since we prefer companies with little to no debt, we expect minimal interest expenses. Then tax is also a concern because if a company pays a lower tax rate, then either the company is cheating the authorities or it is overstating its profits.

After the business is valued, the next step is qualitative analysis. This exercise focuses on the strengths and weakness of the business not from the standpoint of whether the company can increase sales or earnings over the next quarter or two, but from whether it has any sustainable competitive advantage over the next five to ten years. List three to four strengths and weakness of the business.

Permanent capital impairment is a pure mistake. It occurs when the value investor misjudges the strengths and weaknesses of a business and comes up with a deteriorating intrinsic value . Then the loss is not temporary but permanent. Hence, the value investor should cut loss, learn from mistake and move on.

Eveillard argued that gold has no intrinsic value , just as paper currencies, gold is a substitute currency because there is too much paper money and too little gold out there, gold can fluctuate, investors need to be careful even if their aim is to seek protection.

As a value investor, you can be bottom up all you want but you need to remember to pay some attention to the top down because government policies are having a severe impact on the health of the world’s financial markets.

Chapter 6 – Francisco Garcia Parames

Parames read a lot, and never use investment screens to generate ideas. Our ideas come from reading newspapers, books, magazines, analysts’ reports and even our competitors’ investment holdings.

IT is not how sophisticated you are in your valuation model but how well you know the business and how well you assess its competitive advantage. This cannot be modeled mathematically but has more to do with the investor’s own experience.

To determine competitive advantage, Parames determines whether a business will still be around in ten years’ time and whether its business model undergoes frequent change. If it fulfills these two prerequisites then his evaluation process revolves around what makes the business special. For example, does it enjoy strong pricing power? Or does its industry have a high entry barrier to new threats? Although it is always ideal to speak to a business’ management team, talking to its competitors, customers, former employees, and business suppliers is just as crucial.

Reducing risk is not about adding assumptions and complicating your investing model but about simplifying by investing in what you know best.  If you believe that a business is sustainable, then you should think like an entrepreneur and try to calculate how much the business is worth, as if you were taking it over. If it is selling at a discount, then you have found value.

Parames employs simple valuation multiples to evaluate his investments. He likes to use price to free cash flow ratio, which is a company’s market capitalization divided by its free cash flow (FCF) that is the cash flow available for distribution to stakeholders.

We like to buy good quality business with FCF mutliples of less than 11 to 12 times. Our target price is usually set at 15 times. This means FCF yield of about 6.67%. Of course, we always play around with the sensitivity of our assumptions to come up with a comfortable multiple. For example, if a business is good, then we use 17 times, if it is cyclical then maybe 13 times.

Although this type of analysis sounds too simple to be true, it requires a prudent investor to come up with a reasonable estimate of the long term FCF figure before assigning a fair multiple to it. Thus applying such a method takes considerable skill and judgment.

The FCF method focuses on the valuation of a business. To determine its quality, Parames employ return on capital employed (RoCE) which measures the efficiency and profitability of its investments. He looks for consistent RoCE of 20%. It is a moving number and no ideal figure.

We quite frequently buy and sell our portfolio stocks but the names of our stocks don’t change! We may move a stock from a 2 percent weighting to a 5 percent and then move another from 7 to 4 percent. When a stock has gone up 20 percent, it is 20 percent less attractive and so we mix and match our stock weighting to create a comfortable balance for the portfolio.

The greatest joy in investment is finding an investment that is undervalued!

Chapter 7 – Anthony Nut

You cannot compare dividend yields across companies and make a simple investment case out of it. You have to analyse the prospects of a business and see if they can grow their dividends over time. With growing dividends, you get growing income, which effectively allows you to reinvest your capital so that you can have compounding effects for your investments.

When attempting to identify investments, he looks for undervalued businesses with strong and sustainable cash flow. At the same time, he make sure that the businesses have a standing commitment to distribute income in the form of dividends, special dividends or share buybacks.

He applies Porter’s five forces to his analyses. He will not overpay for growth. He like to see efficient balance sheets rather than worry if a company has no debt. He has seen business with high debt yet their balance sheets are efficient. It is acceptable to have modest debt at a reasonable cost.

Chapter 8 – Mark Mobius

By being humble, you are more open to new ideas and can be more objective in your investment research. With an open mind, you can accept that the world changes and that you must constantly lean new things to keep pace with it.

What keeps me going today is my passion for investment research. It allows me to research the world, which leads me to understanding the meaning of life. To be a good investor, you need to open your mind and be ready to accept whatever the world has to offer.

Chapter 9 – Teng Ngiek Lian

When it comes to valuation, we must first distinguish which growth phase a company is in, and then play with its upside and downside sensitivities. If it is in a high growth stage, then value comes from the company’s prospects but if it is no-growth company, then value may comes from its share price discount.

Value is relative. When I do quantitative analysis, I do not have strict criteria regarding the numbers, such as the P/E ratio has to be less than 10 times, return on equity to be over 15 percent or debt to equity ratio has to be such and such. I think a sensible investor has to take into account the characteristics of a business, the economic conditions, the investment environment, and valuations among different potential investments. Flexibility is the key and it requires experience. No objection of buying businesses at the forefront of the new economy as long a they show proof of generating real cash flow. Without real cash flow, good businesses are nothing but good concepts. We do invest in business with high PE if it is just a passing phase or short term mishap. We like to buy fallen angels or companies going through growing pains before their earning potential is developed.

If a stock in a portfolio drops, what concerns me most is whether it has fallen along with the broader market or whether it has fallen against its sector. It is natural to fall with the broader market, but if it falls against its peers, then this means the market has concerns about this individual company. I would drill right into the reasons and find out why. Sometimes , a stock gets sick for different reasons. If it has only caught a cold then it may be an opportunity to buy more and average out but if has terminal cancer then I have no hesitation in cutting the stock right away. Because my strength lies in evaluating businesses, I am not affected by the noise in the market. What I care about most is whether the drop is due to normal business issues or business structural changes.

Chapter 10 Shuhei Abe

In addition to focus, an investor also requires vision. You need to be visionary in times of opportunity or crisis because you cannot analyse the world in a linear fashion. While you have facts, which are based on the past, you need to visualise the consequences, which will take place in the future. The scientific or quantitative aspect of investing is a skill set that you can nurture.

When an idea comes to you, you need to brainstorm, to be creative, think about the past and future and test your thesis. Then you need a systematize way to analyze the potential worth of the investment and how much return you can generate from it. I will try to find out how much it will worth two or three years’ time. We will test assumptions, play with sensitivities of our assumptions, and set a target for the investment.

Chapter 11 V-Nee Yeh

In many situations, economists have proposed good ideas for how things can be done but political constraints as well as different political motives have always ruined these good ideas. Although the world has become more uncertain and global markets have become more interconnected than ever before, market volatility is really just a change in degree rather than ever before, market volatility is really just a change in degree rather than a fundamental change. in this respect, I think the value investing methodology is just as pertinent and relevant to day as it was when I started my career.

The essence of value investing, to me, is the development of a sense of fairness and integrity because, ultimately, you are looking for a margin of safety by starting off from a point of conservatism. If you do not start off conservatively, you can have a high margin of error which deviates from being a true value investor. If you look for the downside first, you tend to be more prudent, and this quality helps you form your own opinion rather than following the crowd. Then, when you are not easily swayed by others, you gradually gain a sense of fairness, not just as an investor, but also as a person. This school of thought really helps to develop the right temperament, which indirectly cultivates your investment process and strategy.

Chapter 12 Cheah Cheng Hye

The two partners quickly settled into well-defined roles. Cheah focused on investment analysis and stock picking whereas Yeh concentrated on fund raising. “There is a big difference between being a good analyst, a good fund manager and a good chief executive. Just because you have the skill to analyze investments does not mean you have the killer instincts or decisiveness needed to pull the trigger as a fund manager. Even if you are good at both that still does not mean you can raise capital and run an investment fund properly.

We have proven that we can beat the market as a team so maybe our process is repeateable and transferable.

In formulating investment ideas, Cheah and his team look for the three Rs: the right business operated by the right people and selling at the right price. In the process, they think as contrarians and divide the Asian stock universe into three categories:

1) Undervalued and out-of-favour stocks

2) Fairly valued and highly recommended stocks

3) Overvalued concept stocks

Our main job is to invest in stocks in the first category and perhaps in those that  fall between the first and second. Sell side analysts tend to recommend a lot of Category 2 stocks, which we are always skeptical about. As for Category 3, they are always recommended by the media and taxi drivers. We aim to buy Category 1 stocks consistently and wait for them to become Category 2 stocks. When they begin to approach Category 3, we sell.

Cheah elaborated,” We are increasingly focused on qualitative research rather than quantitative analysis because in Asia, stocks that are selling cheap are likely to be in a lousy business, that is, they are nothing but cigar butts stocks. Even if bought at a good discount, these businesses can still go under because they lack sustainability and competitive advantage. They are now focus on business strength and core competence.

To outperform the market, we must minimize our losses on mistakes by constantly monitoring our portfolio and distinguishing the good and bad stocks within it.

As the leader of the company, I must constantly learn new strategies and ideas to take the company to the next level. Not only do I have to consider the structure of the company, but also how we can evolve as a whole in line with the broader macro environment.

As a diehard bottom up value investor, we focus on businesses. But at my level, I must also pay attention to top down factors, such as the state and outlook of the economy so that I can guide my team in asset and portfolio allocation. For example, if you know the economy is softening, you need to increase your cash holdings or at least allocate your positions to more defensive sectors. You cannot simply focus on a company and ignore the surrounding environment!

Cheah is a ferocious reader who never stops learning.

Conclusion

All in all, investing should be fun and challenging, not stressful and worrying. In an uncertain world, the practice of value investing is a way to maintain a peaceful mindset. By focusing a margin of safety, thinking for the long term, and having patience, the goal is to achieve investment stability over time. In the process, investors may well achieve happiness and satisfaction in life.

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