I am presenting my summary of thebook “The Little Book of Value Investing” by Chris Browne. ChrisBrowne who passed away in 2009 was one of the great value investors over the past 30+ years.
Chapter 1 : : Buy stocks on sale. The basic concept of Value Investing is “Buying abusiness for far less than it is worth”. Value investing is not a set ofhard and fast rules. When prices drop, people buy more of the things they wantand need, except in the stock market. Everyone seems to think that they shouldbuy stocks that are rising and sell those that are falling. Reasons: Herdmentality. It’s ok for me to lose money as long as long as others are alsolosing. Investors feel disillusioned when the stocks they own or marketsdecline significantly. This prevents them from buying stocks when they go down.They get scared. The time to buy stocks is when they are ON SALE and not whenthey are high priced because everyone wants to own them. Growth investing:There is nothing wrong with owning great businesses that can grow at fastrates. The fault lies in the price that investors pay. Just like it makes senseto buy cars and jeans on sale, it makes sense to buy stocks on sale too. Stockson sale will give you more value in return for your dollars.
Chapter 2: What’s a business worth? Two principles of value investing: What is a business worth(intrinsic value) Don’t lose money (margin of Safety) Intrinsic value enablesinvestors to determine if a particular stock is a bargain and also if a stockthey own is overvalued. When overvalued stocks are revalued by the market,there is permanent capital loss. Two approaches to intrinsic value. Financialratios are indicators of value. 2nd is the appraisal method. Stock prices oftentrade for far more or far less than intrinsic value. Most investors move fromextreme pessimism to jubilant optimism. These emotions drive stock prices toextreme overvaluation and under-valuation. Rational value investors sit backand wait for the market to offer stocks for less than they are worth and to buythe same stocks back for more than their worth.
Chapter 3: Don’t lose money. As a company increases it net worth or intrinsic value overtime, the value of the shares will increase. If the price of the stock rises fromless than intrinsic value to intrinsic value over time, you have a win/win.When you pay full price for a stock ( intrinsic value), future gains may belimited to company’s internal growth rate and dividends Graham wanted to buystocks selling at two-third (66%) or less of their intrinsic value. If correct,the stock could rise 50% and still not be overvalued (99% of IV). If the markethit a rough patch, he knew what he owned was worth more than what he paid forit. Avoid investing in companies that have a lot of debt relative to theirnet worth. Such companies are far riskier investments than companies withexcess cash. Also, such companies cede a measure of control to their lenders. Diversificationprovides a margin of safety and insurance against downturn in a few stocks/industries. Have a broadlydiversified portfolio of stocks across industries. Hold a minimum 10 stocks ina portfolio. Lets you be contrarian. Lastly, if stocks are cheap buythem. Ignore the noise around you and take advantage. Reverse is true also. Ifstocks valuations are reaching or exceeding intrinsic value and there is nomargin of safety, one must sell. Buy in bad times and sell in good times.
Chapter 4: Buy earnings on Cheap. (The lower the price, the higher the return) – Buying LowP/E has worked over the years in all countries all industries. – Earnings yield= inverse of P/E – Use it to compare to other investments. – Consider inflationeffects on purchasing power – Trailing P/E (rear view mirror) v/s Forward P/E (oftenoptimistic projections) – Graham looked for cos with stable record of earnings,predictable. – Buying cheap on past earnings for such stable cos is good. -Discussion on Cash flow and FCF and its merits. – Chris also looks at low P/Ein terms of their worth to a potential acquirer. – EBITDA and how LBOs useEBITDA. Measure of debt serviceability. – Low P/E works in good and bad markets- Wait longer in bear markets to see returns. Best part of Low P/E approach isthat it forces you to buy stocks when cheap and while fear is high. – Bestopportunities are preceded by much pain and not great times. – Low P/E stockare low expectation companies (as opposed to high p/e stocks). – When low p/ecompany reports bad news, effect is minimal as its priced in. Good news resultsin a pop. (opposite in high p/e)
Chapter 5: Low P/B stocks. When: Poor earnings, Poor Industry conditions. Buy belowbook value (BV) per share. Examples: insurance, banks. Use global searchapproach to uncover stocks below BV. Sometimes stocks sell below cash balances.Buying stocks that sell cheaply when compared to asset values works.
Chapter 6: Global search for value Global economy; high correlation in world markets; globaldiversification is tough. Real reason is to increase the number of potentialvalue ideas. At times of Regional economic problems, values can be found.Examples: Asian collapse in 98, Germany reunion in 80s. (My inference: Lookslike crisis in Europe would present good buying in companies that are strong,profitable, stable earnings and good balance sheet.) Rising interest rates areenemy of the markets. Sell offs happen. Value deals can be found. (This wouldhappen sometime in the future when rates go up).
Chapter 7: Value in friendlycountries– International investing is easierwith standardized international accounting (IFRS) Example of Roche which setupContingent liabilities reserves in profitable years. Then, after reserve wasreversed, they would add it directly to book value and not have to report asincome. (Swiss laws allowed this). Example of Lindt and Sprungli. 10x p/e. Swissmarket down due to higher inflation, CEO had divorced. Traded at 3.5x EBITDA.Similar companies bought for 20x earnings. Countries author avoids such asArgentina, Venezuela, Russian crisis example, Mexico, Bolivia, Asian financialcrisis. Now, China. Government control and policies, appropriation means thatmargin of safety is lacking. Author prefers looking at developed economies.
Chapter 8: Buy when insiders buy – Insider buying can help find companies whose fortunescould turn for the better. – Insiders could sell for various reasons and is notas useful. – there is only one logical reason to buy – they think stock priceis going up. – Insider buying of stocks selling at low P/E or below asset valueis even better. – Corp buybacks are another good sign. – Look for presence ofActivist investors. – Insider buying and activist investors can act as catalystfor stock appreciation.
Chapter 9: Falling prices can be adouble edged sword Markets fall time and again becauseof political or economic announcements. Similarly, individual stocks andsectors often fall on weaker than expected earnings or unforeseen events. Thisis the time to be buying, but investors panic and go to cash. Risk is moreoften in the price you pay than the stock itself Prices of solid companieswith strong balance sheets and earnings usually recover. If the fundamentalsare found, prices always have and will always recover. Today’s worst stocksbecome tomorrow’s best stocks and the darlings of the day turn into tomorrow’sspinsters. Don’t try to catch an overpriced, cheaply made falling knife.Example of S&L crisis (very similar to current financial crisis), Big bankssuch as Bank of America and Chase Manhattan Bank fell to prices at or belowtheir book value and had P/E ratios in single digits. Wells Fargo was hit harddue to high exposure to California real estate market (sound familiar ??).Investors who did their homework and investing in banks during this time earnedenormous returns over the decade that followed as the industry went through amerger boom. In 1992, health care reform proposal caused stocks of leading drugcompanies such as Johnson and Johnson to decline sharply. JNJ traded at 12xP/E. Amex after 9/11 sold at 12x P/E Bargains are found in new low lists.
Chapter 10: Seek value the modernway Describes Grahams Net-nets method.Net Current Assets = Current Assets (cash + inventory + receivables) – TotalLiabilities NCAV = Net current assets / Shares outstanding If stock is tradingat 2/3rd of NCAV or less, Graham bought it. Talks about how modern day screenersmake finding value easy. Lists of new lows WSJ, Barron’s, IBD are good startingpoints in search for value. He cautions that such lists or screened results arejust a starting point and not the destination. He expects the investor to examinethe firms to make sure they are good and cheap. Another approach is to look atwhat other value investors have in their portfolios via their quarterly lettersand from Morningstar. Look at what who else owns a particular stock. Look atprices paid in mergers and acquisitions to find stocks that are selling at asignificant discount to what they are worth to a knowledgeable buyer. Look atother companies in the same industry and compare P/E, P/S and P/B. When anacquisition happens, you can take the purchase price to calculate the P/S, P/E,P/EBIT/, EV / EBITDA etc and keep them for future reference.
Chapter 11: When a bargain is NOT abargain? This Chapter deals with companies toavoid. Many companies are cheap for a reason. They have fundamental problems.We have to determine why a company’s shares are cheap and which ones havelittle chance of recovery. Why do stocks become cheap 1) Company has taken ontoo much debt. – Future is unknown. If you have too much debt, smaller chanceof surviving an economic downturn. Graham’s simple method: Company should owntwice as much as it owes. Avoid others. 2) Company falls short of analysts’earnings estimates. – May create a value opportunity. However, if trendscontinue price likely to fall. 3) Cyclical stocks (automobiles, largeappliances, steel and construction) Avoid overly leveraged companies. 4) Laborcontract issues. (Big Three Auto, Airlines) – Unfunded pensions that are large.Companies may not be able to pay. Avoid such companies. 5) Increased competition- If facing strong competition from a more efficient competitor with lowercosts, then move on to the next candidate. 6) Obsolescence (Blockbuster) -Avoid companies that are subject to technological obsolescence. 7) Corporate oraccounting fraud. – No way to uncover before it becomes public – stay away fromcompanies whose financial reports are overly complicated. Best companies arethose that can be easily understood. And if they have a moat, it is evenbetter. Moat can be in the form of patents, brand name, or Size. (Walmart)Moats do not last forever, but allow a company to make profits for many years.Chris likes businesses he understands and for which there is ongoing needExamples: Banking, Food, and Beverage, Consumer staples like detergents,toothpaste, pens, and pencils. People tend to use the same products over andover again. Skepticism is needed when considering candidates.
Chapter 12: Balance sheet checkup– Start with the balance sheet. – Liquidity – Avoid too muchdebt. – Current ratio = current assets / current liabilities. Ability to payshort term obligations. Rule of thumb is 2. Could vary by business. Comparethis to other companies in the industry. Also look at it over several years.Declining ratio may indicate liquidity problem. – Working capital. – QuickRatio – Inventory level and growth with respect to sales over several years. -Check long term liabilities versus assets over years. – Computer shareholderequity or book value. Subtract intangibles (patents, trademarks) – Debt to Equityratio – Take both ST and LT debt./ shareholder equity. Compare this number toother companies in the industry – The less debt means greater margin of safety.- Evaluate levels and also the trends across years. – If BV is a lot ofintangible assets like goodwill or excess inventory in relation to sales, itmay not be quite the bargain on a P/B basis. – Sometimes BV is understated.Land or stock investments may be carried at cost. This has been true over theyears in foreign stocks in particular. Winning means not losing. Strong balancesheet shows ability to survive when the going gets tough.
Chapter 13: Income statement checkup
– Explanation of the key terms andline items of an income statement.
– Compare revenues across theyears to see growth.
– See revenues from differentdivisions to spot problems or spot strength in core business.
– See COGS as a % of sales.
– Steady gross profit means steadybusiness and the better it is.
– SGA, the lower this number as % ofsales the better.
– EBIT or operating profit is used bythe author in valuation ( also Magic Formula )
– Look closely at one timecharges. Back out one time charges as earnings may be grossly inflated due toone time gains or conversely earnings may look depleted due to one timecharges.
– Calculateboth EPS and Diluted EPS. If the difference is vast, then the stock isnot as undervalued as originally thought.
– Use EBIT to determine EPS andDiluted EPS as it’s an accurate measure of corporate earning power.
– Most revealing aspect of Incomestatement is the trend over 5 or 10 years.
– Revenues rising?
– Expenses in line with revenues?
– Consistency of profits
– Cyclical earnings
– Growing profits
– Lot of one time charges?
– Shares outstanding: Are they growing,flat or falling?
– Return on capital and trends.Minimum is stability. Growing is even better. Declining ROC consistently isbad. Poor management
– Net profit margin. Falling margincould indicate bloated overhead, careless management or high competition. He likes to see consistent profit margins at least.
If you cannot understand the incomestatement of a company, just walk away from it.
Chapter 14: Thorough examination ofan investment candidate (IMPORTANT)
Assume you have looked at book value;earnings are cheap, balance sheet analysis already.
- Does company have pricing power? What is the outlook for prices?
- Can the company sell more? Outlook for units?
- Can company increase profits on existing sales? Outlook for Gross profit margin as % of sales.
- Can the company control expenses? Outlook for SGA as a % of sales
- If company raises sales, how much of it will fall to the bottom line
- Can the company be as profitable as it used to be or at least as profitable as competitors?
- Does the company have one-time expenses that will not have to be paid in the future?
- Does the company have unprofitable operations that can be shut?
- Is the company comfortable with Wall Street earnings estimates?
- How much can the company grow over the next five years? How will growth be achieved?
- What will the company do with the excess cash generated by the business? Dividends? New stores/ factories? Acquisitions/ Buy back of shares?
- What does the company expect its competitors to do?
- How does the company compare financially with other companies in the same business?
- What would the company be worth if it were sold?
- Does the company plan to buy back stock? (Is the company following up on its announced buy back?)
- What are the insiders doing?
Chapter 15: Internationalaccounting
– Companies in US have two sets ofbooks, one for IRS and one for investors
– In Europe, only one set of books.
– Example of Lindt. P/E on surfacewas 10 which was attractive by itself for a major consumer brand. Looking atdepreciation and comparing to others, Lindt had high depreciation as % ofsales. Double of industry. After adjusting this, the P/E was 7.5.
– Usually such rules meant lowerearnings were reported and lower asset values (as compared to US rules).
– ADRs make it easy to invest ininternational companies.
Chapter 16: Currency issues, hedging
– When you invest in foreign stocks,another aspect to consider is the currency. Currency could fluctuate againstyour local currency. You could choose to hedge the currency so that your returnis dependent on the underlying investment.
– Example: If you buy 1000 poundsworth of a company stock, you could SELL a currency forward contract for 1000pounds.
– Another idea is to not hedge forcurrency. Over long periods, currency effects are neutral.
– What does not work is switchingfrom hedged to unhedged approach depending on your guess of the currencymovements.
Chapter 17: Market timing does notwork. Avoid it.
= 80-90% of the stock returns comefrom 2-7% of the time.
Chapter 18: Stocks versus Bonds.Avoid Bonds if you have a long term horizon.
In Jeremy Siegels’ book Stocksfor the Long Run, he shows that stocks as measured by an index beat bondsand cash in every 30 year rolling period from 1871 to 1992. In 10 yearrolling periods, stocks beat bonds 80% of the time.
– Keep 3 years of spending in shortterm bonds/ cash. You will then not have to sell stocks when they are at theirlowest.
Chapter 19: How do you pick a moneymanager?
1) Does the manager have aninvestment approach and can explain it to you or any layperson in plainEnglish. Has he applied it consistently over time?
2) How is his Track record? Min 5years, Prefer 10 years.
3) Whose record is it? Is it themanager who is presenting or his predecessor?
4) Do they eat their own cooking?
5) Does he own the investmentmanagement firm?
Chapter 20: Why do people notfollow value investing principles?
– Temperament: Read Behavioralfinance.
– Herd instinct. People feelconfident when investing with the crowd.
– Reputational and career risk ofbeing a contrarian.
– Periods of underperformance whenfollowing value investing.
– Courage is needed to buy out offavor companies. These are boring investments often.
– People seek instant gratification.
– Value investors are like farmers.They plant seeds and wait for the crops to grow.
– Overconfidence is another flaw ofinvestors.
– The investment world equatesactivity with intelligence.
– Good long term performance resultsfrom beating the market in bad times.
– Caution should not be seasonal.
– Maintaining a steady state of mindin good and bad times is the key to successful long term investing.
– Indexes can be victims of bubbles.SP500 in 1999 was 30% tech.
– Lot of pressures against valueinvestors.
Chapter 21: Stick to yourguns
– Value investing requires moreeffort than brains and a lot of patience.
– Growth and value are joined at thehip. Difference is a question of price.
– Track acquisitions. P/BV, EV/EBIT.Use this to screen companies that are selling in the stock market at asignificant discount to what an LBO group may pay. This is called the”appraisal method”. 3rd approach along with P/E and P/B.
– Buying stocks for less than theyare worth and selling them as they approach their true worth is at the heart ofvalue investing.
– Buy below intrinsic value with amargin of safety, exercise patience.
– Patience is the hardest part ofusing the value approach.