Value Investing: An Introduction

Recently I attended a course at Stanford on Value Investing: An Introduction. The course was taught by Kenneth J Marshall who is a value investor and Chairman at Judicial Capital. It is one of the best course I have ever attended on value investing. In this post I will write about my learnings from the course.

1. Do you understand the business?

You should be able to explain the business of a company in a paragraph. It should be written in a simple way so that a 4^th grader can understand the business. It should contain the following information (1) Where are they located (2) Does it sell a good or service (3) Who are its customers. Does it sell to consumers or other enterprises (4) How does it distribute these goods and services to the customers (5) What industry does the company operate in (6) Is this a growing or a shrinking industry.

By writing it in your own words, you will gain a better understanding of how the business operates. If you can’t do this then you don’t understand the business and you should not proceed further. If you can then you should proceed to the next step.

2. Is it a good business?

To know if a business is good we will look at two performance metric (1) Return On Invested Capital (ROIC) (2) Free Cash Flow Return On Invested Capital (FCFROIC). Let us understand these performance metric in detail. Every business has a core which is represented by the triangle in the center. It is then surrounded by its capital structure which tells how a company is financed. It is then surrounded by the tax structure which tells how much tax the business pays to the government authorities.

In order to understand how the business performs we need to calculate the return generated by the core business. ROIC is the metric which measures this. It is calculated by using the formula

ROIC = Operating Earnings / Invested Capital

Since we all understand the basics of real estate, I am going to use it to explain ROIC and FCFROIC. Imagine that you purchased a single family home for $100,000 and it was a cash purchase. The property generates an annual rental income of $10,000. The property has some expenses like (1) HOA (2) Insurance (3) Property Management (4) Property Tax. Let us assume that the annual expenses comes to $5,000. The property earns you $5,000 ($10,000 – $5,000) annually before tax. The purchase price for the property is the invested capital. In this case it is $100,000. The earnings after operating expenses is called as operating earnings. In this case it is $5,000. Hence the ROIC is 5% ($5000 / $100,000).

Let us assume that you pay $1,000 as income tax. Your net income is $4,000 ($5,000 – $1,000). You spend $1,000 for maintenance and repair of the property. This expense of $1,000 spent on maintenance is called as capital expenditure. You are left with $3,000 and it is the free cash flow. You can take this money and do whatever you want and it will not affect the future earning potential of this property. The FCFROIC is 3% ($3,000 / $100,000).

Let us apply this understanding to a real business. Let us calculate ROIC and FCFROIC for Chipotle for the year 2012. You can find its annual report here. Given below is the annotated balance sheet of Chipotle. On 31^st Dec 2012 it had Total Assets of $1,668.66 million as indicated by (A). From this I am subtracting $186.85 million of current liabilities as indicated by (B) and $167.05 of deferred rent as indicated by (C). Hence the total invested capital is $1,314.76 million. Why am I subtracting (B) and (C)? Chipotle does not pay any interest on this liability and hence there is no cost associated with this.

Let us find out its operating earnings. Given below is the annotated income statement. From this we can see that its operating earnings is $455.86 million. Hence the ROIC is 34.7% ($455.86 / $1,314.76)

Let us calculate FCFROIC. Given below is the cash flow statement. We can see that cash from operations indicated by (A) comes to $419.96 million. Of which $197.03 million is the capital expenditure (capex) which is indicated by (B). Hence the free cash flow comes to $222.93 million ($419.96 – $197.03). FCFROIC is 16.95% ( $222.93 / $1,314.76). There are two types of capex (1) Maintenance (2) Growth. Maintenance capex is used for the upkeep of the existing property. Growth capex is used for expanding the business. Since Chipotle opens a lot of new store every year most of its capex will be for growth. For calculating free cash flow we should only subtract maintenance capex. Since it is hard to find out the split I have subtracted the entire capex.

Compared to the US 30 years treasury yield of 3.64%, Chipotle’s ROIC of 34.7% and FCFROIC of 16.95% is terrific. Hence it is a good business. I did this exercise for a single year. But it should be done for at least 5 years and then look at the average ROIC and FCFROIC to get the true picture. Higher the ROIC and FCFROIC better the business. For me ROIC greater than 15% and FCFROIC greater than10% are good and I will continue further with the analysis. If not I will not proceed further.

3. Will this be a good business in future?

The price you pay for the stock is for the future earning potential of the business. Hence you need to make sure that the business will be able to sustain its ROIC and FCFROIC for a long time. For this you need to do a Porter’s five force analysis. I have written about it in detail here. The five forces are (1) Threat of New Entrants (2) Bargaining power of suppliers (3) Bargaining power of buyers (4) Threat of substitutes (5) Rivalry among existing competitors. Lower the forces better the business. If all the five forces are low move on to the next step. If one of the forces is high then understand its implications. If more than one force is high then do not proceed further.

4. Is the business inexpensive?

If you pay an exorbitant price for a terrific business you can still lose your money. The price you pay to buy a business is very important. The metric that is used to value a business is called as price metric. Following are some of the key price metrics.

EV / EBIT – EV is the acronym for Enterprise Value. It is the measure for calculating how much it would cost to buy a company’s business free of its liabilities. It is very hard to calculate. You can look it up using yahoo finance. For Chipotle EV is around $17 billion. EBIT is the acronym for Earnings Before Interest and Taxes. In 2013 Chipotle had an EBIT of around $535 million. Hence EV / EBIT is around 32.

Times Operating Earnings – You get this value by Market Capitalization / Operating Earnings. For Chipotle market capitalization is around $18 billion. Its operating earnings in 2013 is around $533 million. Hence times operating earnings is around 34.

Times Free Cash Flow – You get this value by Market Capitalization / Free Cash Flow. For Chipotle market capitalization is around $18 billion. Its free cash flow in 2013 is around $329 million. Hence times free cash flow is around 55.

Price to book – You get this value by Market Capitalization / Book value. For Chipotle market capitalization is around $18 billion. Its book value on 31^st Dec 2013 is around $1.5 billon. Hence its price to book is around 12.

If these values are lesser than 10 then I would proceed to the next step. If not I will add it to the watch list.

5. Do it

If the business falls into the top right quadrant then you should go ahead and buy it.

6. Things to Avoid

They key to successful investing is to understand human behavior and its short comings. Some of the key psychological biases that we should avoid are

1. Social Proof – Do not buy a stock because your friends are buying it.
2. Authority – Do not buy a stock because a well known celebrity is buying it.
3. Liking – Do not buy a stock because you like the companies product.
4. Scarcity – Do not buy a stock when someone tells you that you might miss the opportunity to buy at a low price.
5. Commitment and Consistency – Do not hold on to a stock if the business fundamentals are deteriorating.
6. Reciprocation – If you are an investment professional do not recommend a stock because the company invited you for a party.
7. Cleverness and Uniqueness – You do not need a lot of clever and unique ideas to be successful in investing. It’s ok to step over a 1-foot bar instead of a 7-foot bar.

I would highly recommend listening to the speech of Charlie Munger to learn about all the human psychological biases.

7. Books to read

Kenneth recommended couple of books.

1. On Investing – The Dhandho Investor by Mohnish Pabrai
2. On Psychology – Influence by Robert Cialdini

8. Idea Generation

One of the best ways to generate investment ideas is to look at the stock purchases of experts and rediscover the reasons behind their actions. In the US, institutional investment managers with over $100 million in assets should file a form called 13-F with the SEC. This form, which must be filed within 45 days of the end of each quarter, contains information about the investment manager and potentially a list of their recent investment holdings. I found this website really useful to learn about the holdings of experts. Cloning is a powerful mental model.

9. Closing Thoughts

You need to have an edge to be a successful investor. There are three ways an edge can be created (1) Informational (2) Analytical (3) Behavioral. You develop informational edge by working in an industry for a very long time. You develop analytical edge by reading annual reports and analyzing financial statements for a very long time. You develop behavioral edge by knowing about yourself. Behavioral edge is the most important edge you need. Without it you are doomed to fail. Using the framework I did a complete analysis for IBM.