Ask the expert: Value investing
Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
Whitney Tilson, a columnist for FTWealth, is also one of the keepers of the flame of value investing - the tradition that stretches back through Warren Buffett to Benjamin Graham.
Next week sees the second Value Investing Congress, an event he founded, at the Time Warner Center in New York. His Tilson Focus fund, was the top performer among 833 funds in its Multicap Core category over the 12 months ending September 30, according to Lipper.
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Merlin Beake, London: When do you sell? All value investors have to sell at some point, if they are to realise the capital gains they have made by spotting an undervalued stock. A good value investor should presumably sell at the point where they think the company is now overvalued, but do you have any rules about the length of time you should have held the stock? Would you sell a stock if it went up 20 per cent the day after you bought it?
Whitney Tilson: We sell for four general reasons (in order of how common they are):
1) A stock rises to our estimate of intrinsic value. Let’s say we buy a stock at $10, thinking it’s worth $18-$22, with a midpoint of $20 - your proverbial 50-cent dollar. Assuming no change in intrinsic value, we would likely start trimming the position at $18 and be out by $22. Keep in mind, however, that great, unexpectedly good news might be why the stock rose 80 per cent from $10 to $18, so it’s critical not to anchor on the original estimate of intrinsic value. By the time it gets to $18, for example, our estimate might have risen to $24-$28, in which case we certainly won’t be selling. This is a major reason why we still own a ton of McDonald’s, which we bought years ago from $16 down to $12.
2) We make a mistake. Sometimes new information blows a hole in our investment thesis, in which case it’s critical not to try to recreate a new investment thesis. Just sell and move on. You don’t have to make it back the same way you lost it.
3) We find a better investment. Sometimes we sell 80-cent dollars to buy 50-cent dollars.
4) We sell to balance our portfolio. If we have a very large position that rises a lot, usually the margin of safety has gone down - instead of being 50 per cent undervalued, maybe it’s only 20 per cent undervalued - yet it’s now a much larger percentage of our fund, so we’ll trim it. We also do this if one particular sector does well - for example, we made a fortune in fast food stocks like McDonald’s, CKE Restaurants, Jack In The Box and Yum Brands in 2003 - but didn’t want half of our fund in burger stocks, all of which are exposed to mad cow risk, for example.
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Jeff Meuler, US: As a follow-up to Mr. Loh’s question…in situations where you do utilize DCF or other valuation methods that require a discount rate, how do you determine the discount rate and what gives you confidence that it is reasonable (given that slight variations in discount rates can dramatically impact the output)?
Whitney Tilson: We don’t spend a lot of time worrying about discount rates - if it’s not obviously cheap, we don’t invest. Buffett was once asked this question and replied along these lines, and then Munger piped up, “I don’t think I’ve ever seen you do a spreadsheet.” Buffett agreed.
Similarly, my partner and I can both make Excel spreadsheets sing, but through hard experience have learned that it’s “garbage in, garbage out.” Usually, the success of an investment is highly dependent on only a few key variables - in the case of Microsoft, for example, will Vista, the new Windows Office and the new server software be highly successful or fizzle? - and I can’t think of a single case in which one of those variables was the discount rate we used - whether 8, 9 or 10 per cent.
Mathematically, if small changes in discount rates are dramatically affecting valuation, then the majority of the value lies in the terminal value of the business or its high growth prospects. We tend not to invest in businesses in which the bulk of the value is dependent on great things happening far into the future - we like businesses that are generating lots of cash NOW!
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Thomas Walde, Scotland: Would you be able to recommend a relatively simple rule-of-thumb for valuation using the numbers that are available relatively easily for a private investor? I note that on most websites I only get at most a 5-year history.
Whitney Tilson: To me, this question would be like asking a pilot, “Are there any simple rules of thumb for landing a plane?” or asking a doctor, “Are there any simple rules of thumb for setting a broken leg?” I’m not criticizing your question - it’s an excellent and widely asked one - but my answer is not a popular one. Investing is very easy - anyone can do it within minutes, which is the real danger (it’s much harder to get behind the wheel of an airplane or grab a scalpel and start doing surgery) - but investing SUCCESSFULLY is very hard.
There are indeed rules of thumb that I and other seasoned investors use, but knowing when to use them - and, critically, when NOT to use them - can only come from many years of experience. So with that caveat, here are some valuation rules of thumb: I have NEVER in my life paid more than 20x current year normalized earnings for ANY company. Sure, I miss the occasional Google, but I avoid all sorts of trouble. This advice I’d freely give to any individual investor. In general, I like to pay less than 15x current year normalized earnings (e.g., P/E ratio) for great businesses like Microsoft and McDonald’s; less than 12x earnings for decent businesses and well under 10x earnings for low-quality businesses and illiquid stocks (where if I’m wrong, I’ll have trouble getting out). The exception to this rule is in the rare cases when I’m buying a balance sheet - in other words, a company that might be losing money, but where I’m buying at a very substantial discount to net cash or liquidation value.
For more on this topic, see my earlier answer in which I included links to my articles, Traits of Successful Money Managers and The Arrogance of Stock Picking.
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JN: What two books would you recommend as most influential in developing your value investing philosophy. Are there any newsletters out there that in your view are valuable for value investing?
Whitney Tilson: 1) Warren Buffett’s annual letters (available for free at www.berkshirehathaway.com and nicely organized and compiled in Lawrence Cunningham’s book, The Collected Essays of Warren Buffett);
2) The Intelligent Investor by Ben Graham. A third must-read (though it was published long after I had developed my philosophy) is Poor Charlie’s Almanack (available at www.poorcharliesalmanack.com) (full disclosure: I wrote chapter 3 and edited the entire book, so I’m biased!).
I’d recommend three newsletters: 1) Value Investor Insight (sign up for a free trial at www.valueinvestorinsight.com/freetrial). I’m biased here as well, of course, as I’m the co-founder and co-Editor in Chief, but check out the latest SmartMoney, which says: “If there’s one must-read for value mavens, it’s Value Investor Insight…rumor has it that even Buffett reads it. So does another acclaimed Omaha money manager: “I read every issue,” says Wally Weitz.”;
2) Our competition, Outstanding Investor Digest. While is doesn’t come out as often as it used to, it’s still excellent; and
3) I subscribe to Fred Hickey’s newsletter, The High-Tech Strategist, which always has good insights into what’s going on in the tech world. There’s no web site; to subscribe, send $120 ($150 if overseas) to The High-Tech Strategist, PO Box 3133, Nashua, NH 03061-3133 (add $30 – $75 if overseas - if you want it faxed).
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Clement Loh, Toronto, Canada: A critical component of value investing is the ability to estimate a firm’s future cash flow to arrive at an intrinsic value. How do you go about doing this with firms such as Google or even Apple where there can be such huge variability?
Whitney Tilson: There are two answers:
A) We don’t. We simply put the file into the “Too Hard” basket - a big basket for us! That’s the beauty of investing: we don’t have to swing at every pitch. In fact, we don’t have to swing at ANY pitches!
B) Obviously some companies have more predictable cash flows than others. The key with less predictable businesses is to have a great deal of humility when it comes to making forecasts (it’s easy to fall into the false precision trap) and then to make sure you pay a substantial discount to your most conservative estimates.
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Jeff Meuler, US: How do you view the trade off between the three main factors impacting an investment’s expected value – i.e. 1) margin of safety; 2) whether a security’s intrinsic value is appreciating/depreciating; and, 3) a potential catalyst to drive the market price towards (or above) the underlying intrinsic value? (Also, please discuss any other factors that you consider).While I agree that an adequate margin of safety is essential to intelligent investing, many investors seem to underestimate the impact from how intrinsic values change before the market price approaches the intrinsic value, and/or the opportunity cost due to the lack of a catalyst. Through such additional considerations, investors such as Buffett/Fischer/Greenblatt, et. al. seem to have dramatically improved upon Mr. Grahams original concept. Thank you.
Whitney Tilson: This is a complex question with no easy answers, but allow me to share some thoughts:
A) The calculation of intrinsic value already, to some extent, factors in whether we project the value of the business to grow or shrink over time.
B) That being said, in some cases, time is your friend and in other cases, time is working against you. In the latter case - say, a declining business like USA Mobility (USMO; pagers), Deluxe (DLX; check printing) or certain newspapers - a catalyst is more important to be sure.
C) Our observation, however, is that other investors are overly fixated on catalysts. Some of our most profitable investments have been cases in which there is no known catalyst (take USG today, for example), which scares other investors away and we can buy a stock at an extremely cheap price. Eventually, we find, cheapness is a catalyst.
D) There are no simple rules, but generally speaking, we will buy high-quality businesses like Berkshire Hathaway, McDonald’s and Microsoft if they are “only” 30 per cent undervalued, whereas a mediocre business must be at least 40 per cent undervalued and a horrible, declining business must be more than 50 per cent undervalued.
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Alex Paylan, Canada: Dear Mr Tilson, Thank you for taking the time for answering my question about how to start an investment fund. As for your suggestion that I should first look for a job in the field, I believe with the exception of Mr. Buffett there is not a single manager I think worthwhile to work for.
Whitney Tilson: Do you say that because you don’t think there are any good value investors other than Mr. Buffett, or because you believe you have sufficient training and experience such that you have nothing to learn from anyone else?
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SK Tan, Hong Kong: How important is NTA cover? Will you invest in a company trading at 25 per cent of its NTA, but generate low return (almost breaking even or a small loss) as the assets’ (e.g. prime land) potential has not been fully realised yet.
Whitney Tilson: There’s no quick answer here – it depends on the replacement value of the net tangible assets and the return that those assets will generate.
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Joseph Andelin, Utah: How does the shareholder makeup (i.e., institutional, insiders, hedge funds, et al.) affect your estimate of a firm’s intrinsic value and consequently, your margin of safety?
Whitney Tilson: It has little bearing on our calculation of intrinsic value, but sometimes it comes into play when we think about potential catalysts. We’ve found “piggybacking on activism” to be very profitable in certain cases such as Wendy’s and McDonald’s over the past year or two – but be careful which activists and which situations you piggyback on! Blockbuster, BKF Capital and James River Coal are certainly cautionary tales…
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Matthew Greenfield, New York: Often I find it hard to distinguish between value investing and growth investing, and I wonder whether it is productive to do so. To illustrate why I am confused, let me describe one of my current top picks, a biotechnology company called Aeterna Zentaris that also owns 36 per cent of a specialty chemicals business – a stake which it is about to spin out to its own shareholders in a few months, thus returning over a third of the already modest cost of a share of Aeterna Zentaris. That will leave shareholders with a biotech business with many promising drugs, including one that has already been approved for one indication and is generating over $15m a year in cash. So AEZS is a value investment of a sort, based on my break-up value analysis. But I am buying it because of the significant growth potential of their drugs–they are in late-stage trials for three significant new indications for a drug that has already been approved. And on the horizon they have some promising cancer medications and an obesity treatment. I can’t help feeling that Benjamin Graham would have liked this stock, even if it didn’t fit his criteria neatly.
Whitney Tilson: I don’t think Ben Graham would have liked it, as he focused on net-nets, meaning companies trading at two thirds or less of current assets minus all liabilities – which is a significantly negative number for Aeterna Zentaris. But this could still be a great value investment. The distinction between growth and value is largely meaningless to true value investors – as Charlie Munger once said, “All sensible investing is value investing. Growth is merely one component of value.”
I’m not familiar with the company (which trades on the Toronto stock exchange), but I took a quick look at its 2005 annual report and was pleasantly surprised because usually when I’m asked about biotech businesses, they’re profitless (even revenueless) and an investment in them is nothing but speculation on some overhyped new blockbuster drug. In this case, however, the company has a range of products, both on the market and under development, and has positive and growing earnings and cash flow.
That being said, I quickly saw some warning flags: 1) There’s quite a bit more debt ($137m) than cash ($53m); for more on this, see my column Don’t Forget Debt; 2) While there is $110m in equity, there’s $228m in intangible assets and goodwill, meaning tangible equity is NEGATIVE $118m; 3) The company has been quite acquisitive, spending larger and larger amounts each year ($93m in 2005) buying other companies. I wrote about this in one of my columns, Be Wary of Acquisitions).
In summary, this looks more like a typical growth investment: a highly acquisitive, rapidly growing company with all sorts of exciting things in the pipeline, resulting in it trading at a high multiple of trailing earnings. A value investor would be looking to pay less than 12x earnings (or free cash flow) no more than one year into the future (which, depending on your assumptions, might be the case here), but would also want to see a strong balance sheet, which is certainly not the case here.
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Jon Grabenstatter, Ohio: Is successful value investing a result of an investor’s skills or simply the doctrine he follows?
Whitney Tilson: Both. As I argued in Traits of Successful Money Managers, to be a successful value investor, one much have two things: the right approach AND the right skills. In my article, I outlined eight characteristics in each of these two categories. To summarize, the right approach means analyzing businesses and trying to buy into them at a substantial discount to a conservative estimate of their intrinsic value. The right skills means having the training and experience to value at least some businesses AND having the temperament to avoid getting into trouble.
My experience is that very few people have what it takes to be a successful investor, as I discussed in The Arrogance of Stock Picking. Analyzing companies and investing in individual stocks is really, really hard – I’ll show you the scars on my back if you want proof! – and few people have the time, training and temperament to do so successfully over time (if you want to build these skills, you might want to consider attending the Value Investing Congress, a biannual conference I organize; our next conference starts next week in NYC). You wouldn’t try to pilot a plane or perform surgery without years of experience – and I can assure you that investing is just as difficult (not to mention dangerous, if you don’t know what you’re doing).
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Robert Goodyear: Value investing uses book value as one of its critical valuation metrics. Is book value really a relevant metric in a post industrial world?
Whitney Tilson: Old-style Ben Graham value investing did indeed focus heavily on book value – to be precise, buying companies at a discount to their liquidation value (called a net-net; current assets minus all liabilities, which is an even more rigorous standard than book value, which is simply all assets minus all liabilities). But net-nets are very rare these days and I know few people who practice this style of investing today.
I use book value as a tool most often in two situations: a) For certain types of companies such as insurers, it remains a valid and useful valuation metric. Buying good insurance companies close to book value will generally work out well – there was a wonderful opportunity to do so at the peak of the internet bubble in early 2000, for example; and b) Assuming book value is good (and not artificially inflated by goodwill or other intangibles; one should strip these out and look at tangible book value), book value can be a good estimate of a company’s liquidation value and balance sheet strength, which can provide downside protection on an investment. Be careful, though. I’ve recently read some analyst reports recommending US homebuilder stocks, saying that historically it’s been a good time to buy them when their valuation drops to 1x their book value. The problem with this analysis is that their book value may be inflated by assets such as land and inventory that are being valued on the balance sheet at bubble prices. If these assets prove to be worth a lot less and the companies have to mark them down, then you’re not really buying the stocks are book value.
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Alex Paylan, Canada: How can I start my own investment fund? I’ve been managing my own money for the last 10 years with better results than most money managers. My investment approach is based on Buffet and Munger’s teachings blended with my personal experiences running a manufacturing business. Thanks Alex Paylan.
Whitney Tilson: It’s very easy to start an investment fund (in the U.S. anyway – I don’t know the law in Canada). Assuming you’re starting a private partnership (rather than a mutual fund), a lawyer can set you up within a month or two and you’re in business! Then, all you have to do is raise money, invest it successfully and take case of building a business – what could be easier, right? Well hold on… It may sound simple in concept, but all of these things are quite difficult. I can assure you that managing your own personal account is very different from managing other peoples’ money. It’s also brutally difficult to raise money – who’s going to give an unproven manager money? (Few people will care how you did with your personal account.) So, my advice is the same as if you came to me and told me you’d taught yourself to be an excellent pilot and wanted to fly 747s: get yourself a job in the business, learn from others (and make mistakes on someone else’s nickel) and when you’ve developed a good track record, reputation, credibility and experience, THEN go out on your own. For more on how to get a job in the business, see my column Breaking Into Money Management.
PS—I don’t write this to be harsh, but rather to be helpful (to you and everyone reading this) since I see this all of the time: true value investors will cringe and toss your resume into the trash if you claim to be a fan of Buffett’s yet spell his name wrong.
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Chris James, New York: I graduated from college two years ago with a degree in Economics. Since graduating I have worked for a local District Attorney’s office. I want to switch careers and go into investment. I love value investing and would like to learn as much as possible. Do you have any suggestions?
Whitney Tilson: I’ve been asked how to get a job in the business so many times that I finally wrote an article about it: Breaking Into Money Management. I’m also frequently asked for my reading recommendations for those who wish to become better investors and learn more about value investing, so I’ve created an entire web site dedicated to this: www.tilsonfunds.com. I’d suggest starting with the page on Recommended Reading. (Forgive the shameless self promotion, but I think the newsletter I co-founded, Value Investor Insight, is a no-brainer for those interested in value investing; you can sign up for a free trial.) Then, I’d read everything I’ve collected on Berkshire Hathaway, Wesco, Buffett and Munger
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Jo Green, Walthamstow: In your view, is ‘value investing’ genuinely opposed to growth investing, or are these terms misnomers?
Whitney Tilson: The distinction between growth and value is largely meaningless to true value investors – as Charlie Munger once said, “All sensible investing is value investing. Growth is merely one component of value.” Nirvana to a value investor is paying a cheap price for a company that is growing in value every year at a nice rate – this largely explains why today we own stocks like Berkshire Hathaway, McDonald’s, Wal-Mart, Microsoft, Costco and Anheuser-Busch.
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Andras Tothfalussy: Dear Mr. Tilson, Investments nowaday cannot lack an international dimension. I would like to ask your opinion about how you can apply the techniques of Mr. Graham and Mr. Buffett to less developed markets. Is there any possibility to merge the traditional value investing approach with macro-based strategies? (Not necessary with outright macro-forecasts) If yes, how?
Whitney Tilson: I’m not sure what you mean by “macro-based strategies,” but I absolutely agree that value investing can be applied to less developed markets. In fact, I have no doubt that there is MUCH greater opportunity to make serious money applying value investing in such markets, given how picked over and efficient the U.S. market is. The only reason we don’t do more of it ourselves is that investing in any country requires detailed knowledge of that country’s accounting standards, laws, business norms, etc. – and the only market I know is my own (and, to some extent, Canada’s; we own Tim Hortons, for example). But I have a good friend who runs a fund in Italy and he’s been knocking the cover off the ball, thanks in part to the fact that almost nobody practices value investing in Italy and thus he’s able to find remarkable bargains.
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John Authers: According to Bruce Greenwald, professor of value investing at Columbia Business School, it is hard to find value in the middle of a thundering herd. Does this mean that the current vogue for activist investing, where fund managers often join in herds to try to force change out of company boards, is not really value investing? And if it isn’t what else might act as a catalyst to release value from companies that are not run in shareholders’ best interests?
Whitney Tilson: In general, I agree with Greenwald’s statement, but I don’t think there’s a thundering herd – or anything close to it – when it comes to activist investing. It may seem like this is the case, given the paucity of investors who stood up for their rights in the past, but I’d guess that 98 per cent or more of companies have NOT been targeted by any activists in the past few years, so I still think there’s plenty of room for activism to grow – which is a good thing, in my book.
It’s also important to keep in mind that, as Ben Graham once said, “You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”
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Background
What is value investing? Is it a search for under-researched small stocks, or is it possible to find value among the biggest names in corporate America, such as Microsoft, as Tilson contends?
Can value investors also be active investors? The first Value Investing Congress last year provided the stage for activists to lay out their own alternative plan for McDonald’s. Several other speakers aggressively attacked managements. But other value investors suggest this kind of approach cannot work, and that it is difficult to find value in a glare of publicity.
And can value investing really continue to out-perform growth investing. It has done so, according to most indexes, every year since the internet bubble burst in early 2000. Is there really any more value to be found? Tilson has turned himself into an influential voice in these debates, and he will be available to answer questions on all aspects of the subject.
Whitney Tilson’s columns at FTWealth:
Opportunity to sample the treats
Massaging figures is more widespread than you think
The undermining effects of overconfidence
Mining for gems among the overlooked small caps
Patience can find a virtue in market inefficiency
Value Investing Congress 2005, New York
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