Value Investing – Holistic Approach (Lesson 4)
“The man who moves a mountain begins by carrying away small stones… It does not matter how slowly you go so long as you do not stop”.
Proper planning and preparation prevents piss-poor performance, an old military adage fits well the systematic approach value investing takes. By conducting modeling backed by financial metrics, value investors set buy and sell points for respective stocks. The buy and sell points are actually percentage discounts and recovery points of a particular investment. This allows the investment’s actual market share price to fluctuate to any extent and it is of no concern to the value investor. Once the market price crosses the respective threshold of either the buy or sell preset price, the transaction is automatically generated.
To illustrate, assume ABC Company’s most recent high in the stock market was $147.65. ABC Company is a member of a pool of similar investments, i.e. same industry, financial size, product and processes. The value investor did all the preparation by determining intrinsic values for each company in the pool, creating the financial metrics and reviewed key performance indicators to create each member’s respective discount and sell triggers. For ABC Company, the value investor determined that a 12% discount on any prior peak warrants a buy of the respective stock. In addition, the value investor determined it was best to sell the stock once the stock price recovered to 101% of the prior peak price. For ABC, the discount buy point is 88% of the prior peak or $129.93. Once the market’s share price reached $149.13 (101% of $147.65), the stock is sold.
The value investor creates computer orders for the respective values and the number of shares to buy and an equal corresponding sell order.
ABC’s stock fluctuates over four months around $139. Suddenly, Congress enacts a law requiring those in this industry to modify their facilities to include additional environmental controls. ABC’s stock suddenly drops to $127.44. As the stock slid past $129.93 the computer order at the brokerage automatically bought the respective number of shares or pool allowance. Over the next five months, the stock slowly recovers and finally hits $150/share in the market. At $149.13, the computer order automatically sold the stock. The value investor earned a gain of $19.20 per share. Since the invested amount was $129.93, the respected return on the investment equaled 14.78%. However, it took five months, thus the effective annual return was 35%.
Even if it took the stock nine months to recover, the effective annual return still exceeded 19% which is an excellent return on one’s investment.
This case is similar to all value investment transactions. There are several underlying elements that make value investing so successful. Value investors cover all the respective elements no differently than how many people thoughtfully resolve problems. An holistic approach towards investing is utilized. This refers to gaining an understanding of the respective industry and its members; i.e. understanding what makes the pool of investments work. Next, value investors identify key indicators of success and for comparison among the members of the pool of potential investments. Discovering why one member is so much more successful than others allows the value investor to gain perspective and use this to fully understand operations of all members of the pool of investments. With this knowledge, it is easy to develop a set of financial metrics that quantifies or ranks the respective members in the pool. This ranking is essential with establishing the respective buy/sell points. Finally, each member’s intrinsic value quantifies the overall desirability of the respective company. Now it is merely a process of enacting the model and allowing the model to do its job.
This lesson covers this holistic approach and explains in more detail the respective underlying elements of this approach. The first step is gaining an understanding of the respective industry and its members.
Value Investing – Gain an Understanding of the Industry
Of all the holistic steps involved, this one is the most critical. When a value investor understands the industry, the terminology, the players and how outside forces impact the industry; it becomes easy to grasp the overall financial information reported along with key performance indicators. Think of this like any major sport. You have the players, coaching staff, venues, and even how well funded the organization is as the database of information. Each of these contribute towards the success of the team. With college football, when you look at the rankings, the top four or five in the Associated Press pole dominate the next tier of six to eight teams. Even these next tier six to eight teams have command over the remaining dozen in the top 25 rankings.
With business it is the same. Within each industry, certain companies dominate their respective field. Others don’t come close. With those companies that dominate, it is their model that others want to emulate in order to move up in the rankings. Value investors understand this concept. Thus, when they create a pool of similar investments, they identify the key company to compare against. It is even unlikely that this particular company will be bought and sold as an investment solely due to its superior performance. However, this isn’t the goal; the goal is use this company as the standard for comparison. Are the other members improving or veering away from the standard? Those that are improving have less risk (Lesson 2) and will have faster recovery cycles related to the buy/sell cycle. For those members that are having difficulties, value investors modify the buy/sell points to incorporate this additional risk and the corresponding likelihood of extended recovery periods.
The key is truly understanding what works and what doesn’t within this industry. As an example, look at NextEra Energy the number one diversified energy supplier. It’s stock price rarely deviates (with the exception of the COVID market decline in the Spring of 2020). In accordance to its website, NextEra generates 45.9 Gigawatts of energy with receipts of more than $17 Billion per year.
The share price rarely deviates more than 5% from the trend line over this five year period (Covid-19 exception noted) and thus is not an ideal potential investment. However, it sets the standard for utilities. Value investors would include this stock in the utilities pool solely for the purpose of setting the standards of performance (financial, production, key performance indicators, ratios and systems).
With an understanding of the best, it is easy to discover the issues with other members and how they compare. With this knowledge, the value investor knows what makes this respective industry tick.
Value Investing – Key Indicators of Success
Each industry is different as it relates to their production systems and processes used within those systems. Value investors identify the industry standard player in order to understand what works and what doesn’t. Thus, a typical pool of potential investments will have from four to eight members. These members are similar with what is produced and/or the processes they exercise to generate revenue and control costs. The standard bearer acts as the gauge against which the other members are evaluated. During Phase Two of this program, there are lessons that teach how to understand the respective measurements that generate success and then how to acquire the data used to determine the relative position of the other members in the pool. In addition, some algorithms are presented to use with determining outcomes.
There are generally two different types of indicators used and in most cases, they are used in conjunction to calculate position within the pool. The first is financial in nature and the second ties to units of production.
The number one financial indicator of success for most businesses is the gross profit margin. The gross profit margin represents the percentage of sales earned after deducting the respective cost of sales. Every industry defines cost of sales differently. The textbook definition exists only to illustrate the concept, but far too many entrepreneurs believe that the definition is exclusive. The reality is far different. To illustrate, in the real estate investment industry, commonly referred to as REITs, local real estate taxes are included in cost of sales. Whereas with manufacturing, real estate taxes are customarily excluded from the cost to produce widgets. Thus, it is important for value investors to understand the definition related to cost of sales for their respective pool of potential investments.
The units of production indicator is customarily non-financial, however, it can be measured in dollars. With REITs, tenant occupancy rates are the number one production indicator. With most REITs, investors are looking for occupancy rates of more than 92%; in this industry, the standard bearer is at or above 96% occupancy rate. Another example of a units of production measurement in dollars would be average rental charges tied to zones of apartments. This information is presented in a REIT’s quarterly and annual reports.
Common non-financial indicators of success include:
- Market Share,
- Renewal Rates,
- Units Produced,
- Inventory Turnover Rates,
- Revenue Ton Miles
- Utilization Rates
Value investors want to have three to five key indicators of measurement with the respective pool of members. Remember, this pool restricts their members to operating within a certain industry and in rare cases a sector of the economy. No pool should have members outside of the respective industry. You can’t compare production metrics nor financial information.
Once the key indicators of success are set and quantified, the value investor can now formulate financial metrics as a part of the holistic approach.
Value Investing – Financial Metrics
Each industry is unique in how their financial information is presented. Furthermore, each industry has it own normalcy tied to financial performance. There should be little deviation from normal as it is practically impossible to significantly outperform competition. All members of a pool of investments face similar barriers, restrictions and opportunities; thus, it is unlikely one member will surpass another member with financial performance. The actual results are diametrically different though. It is quite common to find one member of the pool with such high performance outcomes that they in essence, blow the competition away. In effect, they have figured out their respective industry, whether its with secrets, or good contracts or some other system that has them at a different level. The key for value investors is to figure out the best player in the pool and then compare all the other members within that pool against the best.
An illustration is appropriate here. Think of the top two beer companies in the U.S. – Anheuser-Busch and Heineken. The process to produce and distribute beer is the same for all beer companies. So why is it that Anheuser-Busch is the leader? Let’s compare their respective income statements for the most recently competed full year (2019) to see the significant difference.
. Anheuser-Busch Heineken
Sales $52.3B $24.0B
Costs of Sales 20.4B 14.6B
Net Profit 9.2B 2.2B
Anheuser’s net profit equals 17.6%; Heineken’s equals 9.2%. Anheuser’s cost to produce one hectoliter of beer is around $40; whereas Heineken pays $60 to produce the same volume. Why there is such a difference is unknown; but this is exactly what value investors would research. Anheuser is the standard bearer when it comes to the beer industry.
Financial metrics exist for all the financial statements including the notes to financials. The metrics are further developed into business ratios to understand trends. These trend lines are used to determine the overall position the member company holds within the pool of investments.
The key with financial metrics is to discover if the respective company is improving against the standard bearer. If yes, it is a preferred investment over others, in effect, the discount buy price for others must be greater to protect against the additional risk and additional time to price recovery of that investment.
The final step with holistic thinking is confirming intrinsic value against the financial metrics to ensure the potential investment does indeed have value, especially during economic downturns that can last for extended periods of time.
Value Investing – Intrinsic Value
Intrinsic value refers to value in isolation. In effect, what are the assets less liabilities worth if they stood on their own?
With business, the idea is to take assets and turn them into profits either by selling the assets at a greater price, such as inventory; or using the assets to produce products/services sold in the market. But intrinsic value refers to the financial value of the core assets in isolation. For example, what value would the company receive for current assets in the market. Well, in general current assets will bring anywhere from 90% to 100% of their listed basis on the balance sheet. Here are some examples:
- Cash and cash equivalents will bring 99 cents on the dollar since there are some costs to transfer ownership of cash, it will not bring 100 cents on the dollar in the market.
- Inventory often is worth around 95 cents on the dollar; finished goods a bit higher, whereas raw materials not quite 95 cents on the dollar as there are costs to physically move the respective material.
- Accounts receivable are almost similar to cash, but most factoring companies will effectively pay around 92 cents on the dollar for receivables; naturally the higher the quality of the receivable account the better the value.
This intrinsic thinking continues into fixed assets and with other assets. Since other assets are mostly intangible in nature, their respective true market value in isolation is significantly less than all other assets. For example, goodwill would be worth nothing in isolation since its true value only exists if the business continues operation. Copyrights and patents have some value depending on the respective future cash flow related to the respective ownership rights.
The key here is that every company has intrinsic value. Depending on the industry and the weighting of assets on a balance sheet determines the overall intrinsic value. For example, REITs generally have high intrinsic values because fixed assets are commonly more than 90% of the assets on a balance sheet. The actual fair market value of these assets less loans tied to the assets and a cost to dispose of them in the market is often greater than the cost basis net of corresponding liabilities. Whereas, in retail, fixed assets rarely carry similar fair market value formula as a REIT.
Value investors learn about the intrinsic values of their respective investment pools in order to determine the true fair market value per share of the respective companies within the pool.
Summary – Holistic Approach Towards Value Investing
Value investing relies on a holistic approach towards investing. This thinking is oriented towards a well developed understanding of the respective members of a pool of similar investments. In effect, the value investor understands what makes the particular industry and its members work. A value investor discovers the standard bearer, typically the best company within the pool and uses their financial and physical production metrics to gauge all other potential members of the pool. The value investor creates a ranking profile and then sets the respective buy and sell trigger points.
This holistic thinking is based on good research work, preparation and proper planning. The first step is to gain an understanding of the industry, its members and how they compare against each other. Secondly, the value investor researches in-depth the best company within this industry to learn what works and how they make their money. The key question answered is ‘Why are they so much more successful than other similar operations?’. With this knowledge, the value investor creates a set of key performance indicators whether financial or units of production to gauge other members against.
Next, the value investor creates financial metrics, customarily a table of results for all members of the pool. In addition, business ratios assist in determining trend lines and patterns. This assists with evaluating risk and ranking of the respective members of the pool.
The final step is setting the intrinsic value of each member within the pool. This helps the value investor to understand the floor investment value of each respective member in the pool. Thus, there is a safety net that the value investor can have high confidence that the stock price will not go below or the minimum value per share for the respective company.
There are four key principles tied to value investing. The holistic approach covers these four principles of:
- Risk Reduction – buying stock at a good price is the best risk reduction principle available to value investors;
- Intrinsic Value – understanding the true fair market value of the underlying assets substantiates the floor value of stock;
- Financial Analysis – with a full understanding of the financial and performance metrics a company presents, value investors can key in on the important bits of information for the respective industry; AND
- Patience – it is OK for it to take time to drop in price to buy and recover to a value set by the investor to reap the rewards.
The next section of Phase One with value investing covers these four principles in detail. Section ‘A’ of Phase One introduced the member of this club to value investing. Here, you learned that the key is to be reasonable with your expectations; reducing risk is essential to be successful; market fluctuations are driven by three different types of forces and finally; holistic thinking gives confidence to value investors with the decision model they build for their respective pool of investments. Act on Knowledge.