an introduction to value investing

Buying a dollar for 50 cents An introduction to Value InvestingAn introduction to Value Investing

Adib Motiwala

Motiwala Capital LLC

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About me

• Adib Motiwala

• MBA (Finance) @UTD - Fall 2010

• MS in Comp Sc. @ Texas A&M – Spring 2001

• Passed Series 65.• Passed Series 65.

• Started investing in 1999/2000.

• Clueless speculator till Fall 2009.

• Value Investor since Spring 2010.

2Motiwala Capital LLC

Investment v/s Speculation

• “An investment operation is one which, upon

thorough analysis promises safety of principal

and an adequate return. Operations not and an adequate return. Operations not

meeting these requirements are speculative”

- Graham and Dodd in Security Analysis (1934)


What is Value Investing?

• Hunting for bargains.– Buying a dollar for 50 cents.

– Buying debt at 20c on the dollar

– Buying security at prices WELL below their intrinsic value.

• Companies that are neglected, unloved, obscure are typically cheap [ and not necessarily low – quality ]not necessarily low – quality ]

• Contrarian / Go against the crowd.

• Reversion to the Mean

• Ben Graham – Father of Security analysis– The Intelligent Investor

– Security Analysis.


Central Concepts

• Investing in a stock is part ownership in a business

• Circle of Competence

• Mr. Market and Intrinsic Value

• Margin of Safety

• Think long term and stay patient and disciplined


Share holders

• Can vote

• Eligible to receive their share of the profits in

the form of dividends.the form of dividends.

• Participate in the growth of the business in

the form of capital appreciation and rising

profits.


What Shares are not

• Not just a ticker symbol

• Not a lottery ticket

• Not a way to get rich overnight.


Circle of Competence

• Buy what you know. Do your own research.

• Don’t feel compelled to invest in an area just because every one is investing there.

• Over time increase your circle of competence.

• Investors get better as they age ( unlike sports or some other professions)


Mr. Market

• “Manic-depressive”

• Metaphor that explains how stocks can

become mispriced.become mispriced.

• He Buys High and Sells Low!!!


Intrinsic Value

• The underlying value of the business.

• Not an absolute number but a range.

• Various methods

– Asset based approach– Asset based approach

– Earnings / FCF based approach

– Private market value / Prior transactions

– Relative valuation

• “It is better to be roughly right than precisely wrong”


2 Rules of Investing

Rule #1: DON’T LOSE MONEY• Rule #1: DON’T LOSE MONEY


2 Rules of Investing

Rule#2: Don’t forget Rule#1• Rule#2: Don’t forget Rule#1

– Warren E. Buffett


Margin of Safety

What is Margin of Safety ?

Why is having a margin of safety important?

•Valuation is an imprecise art•Valuation is an imprecise art

•The future is inherently unpredictable

•Having a margin of safety provides protection against bad luck, bad timing, or error in judgment.


Importance of downside protection

Initial Percentage Loss Required gain to break

even

10% 11%

20% 25%

33% 50%

50% 100%


Tortoise v/s Hare

YEAR TORTOISE HARE

0 $1.00 $1.00

1 $1.07 $1.22

2 $1.14 (grows @7%annually) $1.49 (grows 22% per year….)

3 $1.23 $1.89

4 $1.32 $2.22

5 $1.41 $1.11 ( 50% HAIRCUT)

Remember the saying: “ Slow and Steady Wins the Race !!! “


Magic of Compounding

Years of Investment 7% return 12% return 18% return

20 4 times 10 times 27 times

40 15 times 93 times 750 times

60 58 times 898 times 20,555 times

Example : $100,000 investment made today will be $1 million in 20 years if Example : $100,000 investment made today will be $1 million in 20 years if

investments compound annually at 12% and $9.3 million if invested for 40

years.

A ‘meagre’ rate of 7% turns $100,000 into $1.5 million in 40 years.

Keys:

• Invest for the long term.

• Stay healthy and Live Longer!!!

• Start EARLY! Invest in your 20s and 30s regularly.

• Save money!!! 10$ could turn into $930 in 40 years!!! (@12%)16Motiwala Capital LLC

Why do stocks become cheap?

• Missing quarterly guidance/analyst expectations.

• Neglect from investors. (MSFT has been dead money for decade)

• Prior history of losses/ fraud/ accounting issues.

• Management issues (resignation, poor execution)

• Complicated business or unloved business (WM)

• Unrelated business in large conglomerate – Loews (L)

• Hated company (BP)

• Operates in an out of favor industry (Housing, Defense)

• Painted by a common brush (example: BP spill.)

• Small cap with no analyst coverage

• Cyclical at the bottom of the cycle.


Advantages of Value stocks

• Bad news don’t hurt as much.

• Stocks tend to do well on slightly good news.

• Value to private owners.

• Downside protection.

– Think dividend yield


Areas of Value Investing

• Net – Nets

• Special situation stocks (Spin-offs, Mergers, Bankruptcy)

• Out of favor blue chips

• Distressed industries

• Turnarounds

• Overlooked small caps.• Overlooked small caps.

• Fallen Growth Angels

• GARP

• Sum of the parts

• Discounts to cash

• Activist Opportunities

• Post bankruptcy

– Source: Value Investor Insight


What has worked in investing?

• Low price in relation to asset value

• Low price in relation to earnings/cash flows

• High dividend yield.

• Significant pattern of purchase by one or more insiders.insiders.

• Significant decline in the stocks price

• Small market capitalization

– Taken from Tweedy Browne classic research paper.

• Is Value Investing based on ratios such as P/E , P/ B , P/S , P/ FCF, dividend yield?


Investing

• 4 Steps

– Search Strategy

– Valuation– Valuation

– Follow up

– Risk management


Business + Management + Price

Business

Price

Management


Search Strategy

• 52 week low list

• Low P/E, P/B, P/FCF, P/S, high dividend yield

• Screeners

• Fund manager 13F filings• Fund manager 13F filings

• Magazines/newspapers/ ValueLine

• Blogs / Investment Clubs (SumZero, VIC)

(http://adibmotiwala.wordpress.com/2010/09/14/search-

strategy/)


Valuation

• Start with the Balance sheet– Check debt levels (ST and LT)

– Check cash levels. Quickly know leverage D/E.

– Check interest coverage.

– Avoid highly levered companies– Avoid highly levered companies

• Next move to Cash Flow Statement. – Check OCF, Capex. FCF = OCF – Capex.

– How steady is FCF? In general, avoid companies without FCF

• Income Statement– Check Sales growth, Op income, Net income etc


Valuation (contd)

• Use historical valuation as a guide

• Check valuation to peers.

• Use DCF / Inverted DCF.

• Multiples based valuation• Multiples based valuation

– Example: 15x P/E on normalized earnings.


Management Evaluation

• This is more qualitative than quantitative.

• Compensation levels.

• Duration of management

• Past decision making and results

• Past mistakes. Past promises.• Past mistakes. Past promises.

• Dividend policy and record.

• Share buyback.

• Insider holding level.

• Insider buyback

• Cluster selling


P/E

• What Is P/E ?

• What is the P/E of 10 year Treasury ?

• Express stock P/E as E/P to represent earnings

yield.yield.

• Compare stock earnings yields to bond yields.

• Example: P/E of 12 means 8% earnings yield.


Idea # 1 : Aeropostale (ARO)

Aeropostale, Inc. operates as a mall-based specialty retailer of

casual apparel and accessories. It designs, markets, and sells merchandise principally targeting 14 to 17 year-old young women and men.

Market Cap : $2.3 billion (Share $25.62 @1/21)

EV : $2 billion (excess cash $300 million)

Sales: $2.4 billion ;

Net Income : $244 million

FCF: $160 million

EPS: $2.54


1- Is it a good business?

1) ROE / ROIC

• ROE > 15%

• Consistency of profitability and FCF.

2) Sales growth over 5 and 10 years2) Sales growth over 5 and 10 years

3) EPS growth over 5 and 10 years

4) FCF growth over the years


2- Is Management good?

• Share buy back policy

• History of buybacks

• Conservative growth policy

– Abandoned a concept that did not work.– Abandoned a concept that did not work.

– Slowly growing ‘PS from Aeropostale’ concept

• Negatives

– Would have loved a dividend as well ( I’m greedy)


3- Is the Stock Cheap?

– Excellent balance sheet with excess cash offers margin of safety.

– Cheap valuation by most metrics

• 12.5X EV /FCF

• 10x P/E ( excluding cash 8x) • 10x P/E ( excluding cash 8x)

• 5x EV / EBIT

• 4.3x EV / EBITDA

• Relative valuation ( check against peer group, market)

• Historical valuation (via MorningStar.com)

• Open market transactions– Acquisition of JCG and GYMB at multiples 50% higher.


Why is ARO cheap?

• Bear thesis

– Co-CEO resigned recently.

– Same Store Sales (SSS)declined in last quarter and December.

– Company warned about rising cotton prices in 1H – Company warned about rising cotton prices in 1H 2010.

– Analysts worried about peak margins, cotton prices, rising fuel costs.

– Consumers will upgrade to AEO and ANF as economy recovers.

– Heavy discounting by competitors.


Final thoughts

• Do your own homework. There are no shortcuts in investing. Ignore the noise.

• Understand the business. If its too difficult, move to the next company.

• Financials – understand them and know how to value the firm.

• Evaluate management capital allocation, shareholder friendly decisions

• Know the thesis on the opposite side.• Know the thesis on the opposite side.

• Always invest with a margin of Safety.

• Consider Risks before Returns.

• Invest for the longer term. Compounding works very well over many, many years.

• Patience is the toughest part of Value Investing.

• Learn from your mistakes and of others.

• Stick to your style. Don’t change your style like you change….. .


Resources

• Books for value investors– Intelligent Investor by Ben Graham

– Security Analysis by Graham and Dodd.

– Margin of Safety by Seth Klarman

– You can be a stock market genius by Joel GreenBlatt.–

• Other books by Peter Lynch, Phil Fisher, Dremen, Greenblatt, Books on Buffett

• Resources for learning – Value investors club, SumZero, GuruFocus

– Letters by Buffett and Munger, Berkshire letters.

– Letters by great hedge fund and mutual fund managers.


What was not covered?

• Position sizing

– How many stocks should I own in my portfolio?

• Risk Control

• Other area of value investing• Other area of value investing

– Distressed debt. Huge potential for those who can

spend the time to study turnarounds

– Special Situations

• Spin-offs , Merger Arb,


Things to ponder…

• What about DCF?

• What is Risk ? Is beta Risk?

• What about Efficient Market Theory?

• What about diversification?• What about diversification?

• Does Value Investing always work?

• If its so great, why doesn’t everyone a value

Investor?


an introduction to value investing

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