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Is Value Investing the “Holy Grail” of financial investing ?

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Few slides to explain because the value investing is working well vs fundamental analysis and technical analysis

Some simple flowcharts to describe the Value Investing process on stocks and Bond-Stock allocation, bond and Etf, because we are focusing only on process of value investment. What is the competitive advantage and how I can measure it


Because value investing works
Value investing process on stocks
Bond-Stock allocation in value investing
Value investing process on government and corporate bonds
Value investing process on ETFs - Exchange Traded Funds
Value Disinvesting on stocks and ETFs
Measuring competitive advantage via ROIC
Conclusion

Published in: Economy & Finance
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Is Value Investing the “Holy Grail” of financial investing ?

  1. 1. 1 Value Investor Is Value Investing the “Holy Grail” of finance investing ? Few slides to explain because the value investing is working well vs fundamental analysis and technical analysis Some simple flowcharts to describe the Value Investing process on stocks and Bond-Stock allocation, bond and Etf, because we are focusing only on process of value investment Update June 2017, included new section on ROIC competitive advantage
  2. 2. Value Investor  Because value investing works  Value investing process on stocks  Bond-Stock allocation in value investing  Value investing process on bonds  Value investing process on ETFs  Value Disinvesting on stocks and ETF stocks  Conclusion  Comment 2
  3. 3. 3 Value Investor The idea is inside four books and …: • Security Analysis, Graham & Dodd • Intelligent Investor, Graham & Dodd • Value Investing, Greenwald & … • Stocks for the long run, Siegel • Some my idea to make easier process Introduction, always every investor is going to buy low and sell high, in addition all of them admit to buy securities at low price than the underlying real value
  4. 4. 4 Value Investor quote “To invest successfully over a lifetime does require a stratospheric IQ, unusual business insights, or inside information, it is enough. What's needed is a sound intellectual framework for making decision and the ability to keep emotion from corroding that framework.” Warren Buffet In few words to be a Value Investor. “Simplicity is the ultimate sophistication“. Leonardo Da Vinci
  5. 5. 5 Because fundamental analysis and technical analysis do not work 1. Technical analysis: based on analysis of particular chart shape on price and volume, to forecast the next price movement • Do you buy an house only because its price or trade volume is rising ? • Do you buy a particular car model only because its price chart has a “special shape” Any Intelligent Investor answers NO, so there isn’t any reason because technical analysis works well
  6. 6. 6 Because fundamental analysis and technical analysis do not work 2 a. Fundamental macro analysis: many economic factors unemployment rate, GDP, inflation and interest rate to forecast economic trend and so to decide what group of securities to buy or sell 2 b. Fundamental micro analysis: analyzes the economic fundamentals of the company and predict the future price of securities estimating the cash flow or earning for next 10 years (not much easy)
  7. 7. 7 Because fundamental analysis and technical analysis do not work • Do you think is possible to do a reliable revenue forecast or profit forecast in next ten years ? • Do you remember IMF forecast on emerging market (Brazil, Russia, …) in 2010 ? They was very brilliant but now in 2016 are in recession Economic forecast in micro or macro area for long period (10 year) is extremely difficult, even in 3/5 years, in fact it is impossible Intelligent Investor answers NO, so there isn’t any reason because fundamental analysis works well However in each of these areas there are famous successful investor
  8. 8. 8 Because Value Investing works 1. Markets are not efficient and it is moody, swings between depression and euphoria 2. Figure out balance sheet without extrapolation 3. Earning and revenue no forecast 4. Earnings Power value & Moat 5. There are not good or bad stocks, but there are good stocks where there is good price Afterwards, the value investing process is simple
  9. 9. 9 Value Investing on stocks “Simplicity is the ultimate sophistication” in the Value Investing is to identify stocks whose value as a business is reliably calculable by you HOW Low price book Low P/E Significant dividend yield and paid in last ten years Upward trend in profit in last ten years Earnings Stability + Growth Low value of debt Strong financial condition Durable competitive advantage (moat)
  10. 10. 10 Value Investing process on stocks • Stock market in depression mood, least down 10% • Cheap p/e market index compare 10y bond rate > 2% / 3% (1/p/e) *100 - 10y A rate bond yield > 2% / 3% or great two third than bond rate. Least a 30% of safety margin Stocks • Normally Ignored • Unfashionable Next step “Valuation Criteria” Environment criteria No extrapolation No forecast
  11. 11. 11 Value Investing process on stocks • price book < 2 • How: use book value  easy to get it • p/e < 15 • How: use earning average five past years • however price book * p/e < 25 • Significant dividend yield and always paid in last ten years great than 1% • Upward trend in profit and revenue in last ten years at least grown 10% • However earning stability over the time Valuation criteria No extrapolation No forecast Revenue > 500m Public utility, asset > 1B
  12. 12. 12 Value Investing process on stocks • Strong financial condition • Debt / Equity < 1 • Current ratio > 2 • in public utility Debt < 2 * book value Next step “Competitive Advantage” Valuation criteria No extrapolation No forecast
  13. 13. 13 Value Investing process on stocks Earning Power Value • Epv:= earning x 1/cost of capital How: earning avg five past years -cost of capital > A 10y bond + 3% Compare Asset Value and Earning Power How: Asset Value  book value Epv < Book value Value Lost to Poor Management and/or Industry Decline Epv = Book value Free Entry, Industry Balance Epv > Book value Consequence of Comp. Advantage and/or Superior Management Epv > book value * 1.5 Competitive Advantage Extrapolation cost of capital := in simple way is the return that a an investor requires to decide if an investment meets invested capital return requirements. So could be A rating 10y bond + 3% margin
  14. 14. 14 Competitive beyond EPS to ROIC Sometimes, earning is distorted by many factor like stock-option, special situation, accounting rule or accounting adjustments, extraordinary and unsustainable operation or a one-time source of income unrelated to its core business So an other way to determine whether or not a company has a moat is to measure its return on invested capital (ROIC) ROIC = (Net Operating Profit After Taxes) / (Invested Capital) Net Operating Profit After Taxes = (Operating Profit) x (1 - Tax Rate) There are a number of ways to calculate this value one is: Invested Capital = the book value equity + the book value its debt - non-operating assets ROIC is always calculated as a percentage and It should be compared to a company's cost of capital (WACC) to determine whether the company is creating value. 14 Compare Asset Value and Earning Power ROIC < WACC Value Lost Poor Management and/or Industry Decline ROIC = WACC Free Entry, Industry Balance ROIC > WACC Competitive advantage
  15. 15. 15 Competitive beyond EPS to ROIC Some rules of thumb WACC = Ep * CoE + Dp * CoD (1 – T)  0.6*12 + 0.5*4*(1-0.35) ~ 9% Ep is the percentage of financing that is equity CoE is the cost of equity Dp is the percentage of financing that is debt CoD is the cost of debt T is the tax rate If ROIC is greater than the weighted average cost of capital (WACC), the most common cost of capital metric, value is being created. If it is not, value is being destroyed if a company has an ROIC in excess of 15% for a number of years, it most likely has a moat. That said, whether a company is creating value depends on whether its ROIC exceeds its cost of capital 15 ROIC > WACC * 1.5 How roic use average last 5 years wacc based on rules of thumb Competitive advantage ROIC in Morningstar
  16. 16. 16 Value Investing process on stocks “Sustainability” over the time depends on continuing protection Barriers-to-Entry that create value Meaningful Management Performance Product Differentiation Customer Captive Cheap Cost Negative Evidence Company evaluation products, quality, news, we understand the business … Competitive Advantage Forecast
  17. 17. 17 Value Investing on stocks Where is the margin of safety ? if selected stock meets all the criteria, then you have chosen a cheap stock, hence you are in a real safety margin Don’t forget diversification, about 30 stocks and patience Only long (you have advantage of secular GDP growth), never short importance
  18. 18. Bond-Stock allocation There are a huge number of securities type, but we identify only some securities where the value is reliable and easily calculable by you.  Stocks  Bonds In addition we use also ETF on stocks and bonds Investment Fund Cfd Certificate Stock Currency Commodity Etc Etf Convertible bond Bond Securities 18
  19. 19. Bond-Stock allocation • Investor should never have less than 25% or more than 75% in common stocks • so inverse range between 75% and 25% of bond • reduce stocks below 50% to 25% if the market is too high or too expensive • increase stocks upper 50% to 75% if the market is cheap or there are many special bargains 19
  20. 20. Bond-Stock allocation Bond-Stock allocation Stocks: 25% to 75% Bond: (100 – stocks range )% Reduce stocks range Increase stocks range dividend yield below two-third of bond yield Cheap p/e market index compare 10y bond rate < 2% (1/p/e) *100 - 10y A rate bond yield < 2% or 2/3 Mean reversion on a diversified portfolio of stock is nearly 7% annual real return the United States Compare a expecting the stock market growth with historical growth No one criteria matches with “reduce stocks range” Huge number of IPO Few stocks meet value investing criteria Market mood in euphoria 20
  21. 21. Bond-Stock allocation There are two ways to compute anticipated long-term returns (LTR) LTR:= Nominal World GDP + dividend yield or LTR:= E/P + inflation based on Graham formula where g is the growth expected in next seven to ten years and V is value V= EPS * (8.5 + 2g) we can make the converse of it and to determinate the growth rate anticipate by current market price g=(p/e)/2 - 4.25 So we compare g, LTR and mean reversion of historical stocks yield 21
  22. 22. Bond-Stock allocation Work out: measuring the US stock market (May 2017) world GDP 4.0 S&P Value 2402 P/E 23.8 Dividend Y% 1.97 Inflation 2.2 A Bond Y% 2.73 Avg return 5Y 10.45 Avg return 10Y 5.33 trailing P/E 23.8 forward P/E 18.45 LTR (gdp) 5,97 5.97 LTR (e/p) 6.40 7.62 g Graham 7.65 4.97 Stock Y% 4.20 5.42  Using trailing or forward P/E Few changes compared to last year You may be taking on a little risk in stocks today. Probably slightly less than 50% in stocks is better allocation If you are used to using forward P/E, then increase the value of 20%, because it is always historically overvalued 22
  23. 23. Value Investing process on bonds Also here there are a huge number of bond type, but we identify only some bonds where the value is reliable and easily calculable by you. So we accept only plain vanilla bonds  Government Bonds  Corporate Bonds Since the main emphasis must be placed on avoidance of loss, bond selection is primarily a negative art. It is a process of exclusion and rejection, rather than of search and acceptance. In first we get only investment grade bond (minimum BBB rate), only in exceptional situation we could invest also into speculative grade bonds. 23
  24. 24. Bond allocation • Investor should never have less than 50% or more than 95% in government bonds in relation with previous bond-stock allocation • so inverse range between 50% and 5% of corporate bond • reduce corporate bond below 50% to 5%, if exist very few corporate bonds that match with criteria • increase corporate bond upper 5% to 50%, if exist many corporate bonds that match with criteria So some criteria of value investing process on corporate bond is most import task of bond allocation. 24
  25. 25. Value Investing process on corporate bond There four principles for the selection of corporate bonds I. Safety is measured not by specific lien or other contractual rights, but by the ability of the issuer to meet all of its obligations. Senior Liens Are to Be Favored, Unless Junior Obligations Offer a Substantial Advantage II. This ability should be measured under conditions of depression rather than prosperity. III. Deficient safety cannot be compensated for by an abnormally high coupon rate. Risks of losing principal should not be offset merely by a high coupon rate IV. The selection of all bonds for investment should be subject to rules of exclusion and to specific quantitative tests corresponding to those prescribed by statute or sound rules. Typically investment grade bond 25
  26. 26. 26 Value Investing process on corporate bond • Bond market in depression mood, least down 10% • Yield to maturity compare AA government bond > 1.5% or great two third than AA government bond. Least a 30% of safety margin Next step “Valuation Criteria” Environment criteria No extrapolation No forecast 26
  27. 27. 27 Value Investing process on corporate bond Valuation criteria No extrapolation No forecast Size of Enterprise and rating •Revenue > 500m •Public utility, asset > 1B •Investment grade bond great than BBB rate Utility Industrial Interest coverage > 2 Interest coverage > 3 Stock value ratio > 0.5 Stock value ratio > 1 Interest coverage = EBIT / Interest Expense Stock value ratio = Market Cap / Bond long term debt Unavailability of sound bonds is NOT EXCUSE for buying poor ones 27
  28. 28. 28 Value Investing on stocks ETF ETF is really a disruptive instrument in the financial sector ETFs are a true democratization of investment management and capabilities. Now there is availability of once-exclusive investing techniques to a wider range of investors. ETFs today represent a vibrant and diverse array of investment strategies. We can apply the same previous process of value investing on stocks 28
  29. 29. 29 Value Investing on stocks ETF Since we would like to use the same process, we need independent and trusted data on the same parameters (p/e, book value, dividend, …) So far, only Morningstar into free area provides trusted and accurate data on ETF. The Value Investing process on stocks ETF is to identify ETF whose value as a business is reliably calculable by you. So we choose only between country ETF and sector ETF with simple strategy, the new generation like smart, beta, high/super strategy, leveraged are not eligible because they are too complex. Price/Prospective Earnings* Price/Book* Dividend Yield %* Long-Term Earnings %* Historical Earnings % Book-Value Growth %* * Forward-looking based on historical data. Since the economist’s address is always highly optimistic. They predict that corporate profits, one of the major factors driving stock prices, will increase at double-digit annual rates for at least the next three years. So we should increase p/e, dividend yield and price/book at least 20% and decrease at least 20% the other ones 29
  30. 30. 30 Value Investing process on stocks ETF Environment criteria No extrapolation No forecast Environment criteria remain the same of value investing on stock, like stock market in depression mood, cheap p/e market, ….. In EFT sector we have also the criteria normally ignored and unfashionable Valuation criteria No extrapolation No forecast • price book < 2 • p/e < 15 • however price book * p/e < 25 • Dividend yield great than 1% Long-Term Earnings % > 0 Historical Earnings % > 5% However earning stability over the time 30
  31. 31. 31 Value Investing process on stocks ETF • Strong financial condition for all selected stocks • Debt / Equity < 1 • Current ratio > 2 • in public utility Debt < 2 * book value Next step “Competitive Advantage” Valuation criteria No extrapolation No forecast We do not have direct financial parameters, so we have to compute them. We get the first ten stocks ranked by weight inside the Etf and figure out debt/equity and current ratio for each of them. 31
  32. 32. 32 Value Investing process on stocks ETF Earning Power Value • Epv:= earning x 1/cost of capital Compare Asset Value and Earning Power Epv < Book value Value Lost to Poor Epv = Book value Free Entry Epv > Book value Consequence of Comp. Advantage Country Etf Epv > book value * 1 Sector Etf Epv > book value * 1,5 Competitive Advantage Extrapolation We divide Etf in two groups, country Etf and sector Etf. The competitive advantage is more meaningful in etf sector. 32
  33. 33. 33 Value Disinvesting on stocks and ETF stocks When you have to say farewell to someone of your securities in your portfolio (selling time) In previous slide we have explained the criteria to get a good value securities However over the time, they can lack the label of value. Right now we identify the criteria to exclude them from your portfolio. When & Why Every six month you have to check your securities portfolio 33
  34. 34. 34 Value Disinvesting on stocks and ETF stocksValuation criteria No extrapolation No forecast There are two different situation, however is enough that at least one criteria is true to trigger the selling action 34 Stock too expensive Price book > 3 p/e > 25 pb * p/e > 50 Stock Quality is reducing Debt / Equity > 1.5 Current ratio < 1 Utilities sector Debt > 3 * book value Dividend cancelled for two years Reduced competitive advantage Epv < book value There is not a trigger criteria on environment
  35. 35. Value Investor  Because value investing works  Value investing process on stocks  Bond-Stock allocation in value investing  Value investing process on corporate and government bond  Value investing process on stocks Etf  Value investing process on bond Etf  Workout on real stocks, bonds and Etfs  Conclusion  Comment Next future slides 35
  36. 36. 36 Value Investing on stocks But if Value Investing is so simple, why isn’t everyone a value investor ? It is simple but not easy Value stocks don’t tend to have big payoffs. Their success is incremental; they are not a lottery tickets, so they do not promise a immediate wealth. Sometimes the price stays low also for long time and to wait for long time up to fair value Stocks that are cheap are ugly stocks, with boring stories. People sell them and buy expensive success story People are over-confident, we think a growth stock will continue to grow and a value ugly stock will only continue to go down.
  37. 37. 37 Comment on competitive advantage There is a competitive advantage if a company has some aspects like meaningful management performance, product differentiation, customer captive, cheap cost, patent, … However the “Sustainability” of it over the time depends on continuing protection barriers-to- entry that create value. Can I calculate if there is a real competitive advantage ? There are many different ways, we choose the two of them easier 1. Based on Earning and Book value Book Value (definition) is in theory, what would be left over for shareholders if a company shut down its operations, paid off all its creditors, collected from all its debtors, and liquidated itself. It refers to the amount of net assets belonging to the owners of a business based on the balance sheet values. Yield% of book value [YBV] = (earning / book value) * 100 37
  38. 38. 38 Comment on competitive advantage If YBV is great than A 10y bond + 3% (cost of capital) then there is a real competitive advantage, otherwise should be better to precede to shut down the company and to invest the liquidated cash in bond market (less risk). A “great YBV” should be over the time at least 5/7 years. Here cost of capital is the return that a an investor requires to decide if an investment meets invested capital return requirements. So could be A rating 10y bond + 3% margin 2. Based on ROIC and WACC ROIC (definition) Return on invested capital (ROIC) is a percentage that ROIC = (Net Operating Profit After Taxes) / (Invested Capital) If ROIC is great than WACC (cost of capital) then there is a real competitive advantage, otherwise should be better to precede to shut down the company and to invest the Invested capital in bond market (less risk). A “great ROIC” should be over the time at least 5/7 years. Here cost of capital is the return that a an investor requires to decide if an investment meets invested capital return requirements. So could be A rating 10y bond + 3% margin 38
  39. 39. 39 Comment on competitive advantage If the competitive advantage is verified over the time then we should wonder  is there a strategic position ?  what and where is the moat ?  where are the competitors if YBV is more then 3 times of cost of capital ?  why do customer pay more my products 39
  40. 40. 40 Value Investing Is Value Investing the “Holy Grail” of finance investing ? Yes it is. Share idea Share comment Fabio Michetti michetti.fabio@gmail.com

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