Value investors are investors who invest in companies which are currently trading at a price lower than the predicted future earnings of the company (intrinsic value). These earnings are called “owner’s earnings”. Owner’s earnings are simply earnings after tax plus depreciation and amortization less capital expenditures.
When owner’s earnings are growing year after year, then the company is deemed to do well. For the owner’s earnings to increase and for a company to be worthy of investing, several factors have to be in place. The company has to:
- Be engaged in a business the investor understands
- Have a strong and durable economic franchise (wide economic moat)
- Have an honest and competent management
- Have financial strength
Even if a company possess the following, one cannot just go and purchase the company’s shares. The investor then has to calculate the intrinsic value of the company and then determine a suitable price to buy at after factoring in a margin of safety. Margin of safety is simply the difference between the current stock price and the calculated intrinsic value. The more the margin of safety, the better it is. Margin of safety is essential as during the research of the company, the investor could have overlooked certain factors and calculated things wrongly. This margin of safety ensures that the risk is minimized even further, making value investing almost risk-free.
The summary of the framework is presented below:
A business you understand
A successful investor evaluates a business successfully. A favourite trick of outstanding investors to be in a frame of mind to be a business analyst is to imagine purchasing 100% of the company (or that they inherited it). In that way, the analysis will be thorough and not slip-shot. Furthermore, they imagine it is their only business asset. This helps them to focus on key questions such as how is the firm going to compete? What are its strengths and weaknesses? Who are the customers? Will the firm be positioned well in 20 to 30 years’ time? To find answers to the above questions, investors can:
- talk to customers, employees, suppliers, competitors (scuttlebutt method by Phil Fisher)
- Read annual reports of company and competitors, industry reports, analyst reports
- Trying the company’s products, quizzing the managers and directors
Basically, investing should be within your circle of competence and not out of it. If you don’t understand the oil and gas stocks, don’t invest in them even though they may be the next big thing.
Strong economic franchise
The company must have a wide moat with a competitive advantage. Think of McDonald’s, Wal-Mart, SGX, Starbucks, Nike. These companies have a wide moat that isn’t very easily penetrated by competitors.
Honest and competent management
If there are no honest and competent managers running the business you invest in, then your money invested in the company would not be safe at all. There are many important indicators of good managers, such as:
- Owner-orientated. Their aim is to maximize shareholder’s wealth for the long term.
- Passionate about their work
- Excellent in both day-to-day operational management and long-term planning
- Highest integrity
- Follow a rational dividend and share buy-back policy (repurchase stock when priced below intrinsic value)
- Ignore even the most enticing propositions falling outside their area of special competence.
- They don’t allow shareholder wealth destroying mergers
- Report both bad news and good news
- Treat staff with respect and fairness
- Have tight cost control all the time
- No accounting gimmickry
- Decent behaviour
- The management team has depth and breadth.
The company must have:
- Earnings and free cash flow growth year-on-year
- Little or no debt
- Considerable amount of cash in hand but not in excess
- Low capital expenditures (CAPEX)
Finding of intrinsic value will not be covered in this post as it will take substantial time to explain. I will cover it in future posts.