is value investing the “holy grail” of financial investing ?

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Value Investor

Is Value Investing the “Holy Grail” of finance investing ?

Few slides to explain because the value investing is working well vs fundamental analysis and technical analysis

Some simple flowcharts to describe the Value Investing process on stocks and Bond-Stock allocation, bond and Etf, because we are focusing only on process of value investment

Update February 2017, included new

section on Value Disinvesting on

stocks and ETF stocks

Value Investor

Because value investing works

Value investing process on stocks

Bond-Stock allocation in value investing

Value investing process on bonds

Value investing process on ETFs

Value Disinvesting on stocks and ETF stocks

Conclusion

Comment

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Value Investor The idea is inside four books and …:

• Security Analysis, Graham & Dodd

• Intelligent Investor, Graham & Dodd

• Value Investing, Greenwald & …

• Stocks for the long run, Siegel

• Some my idea to make easier process

Introduction, always every investor is going to buy low and sell high, in addition all of them admit to buy securities at low price than the underlying real value

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Value Investor quote

“To invest successfully over a lifetime does require a stratospheric IQ, unusual business insights, or inside information, it is enough. What's needed is a sound intellectual framework for making decision and the ability to keep emotion from corroding that framework.” Warren Buffet

In few words to be a Value Investor.

“Simplicity is the ultimate sophistication“. Leonardo Da Vinci

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Because fundamental analysis and

technical analysis do not work

1. Technical analysis: based on analysis of particular chart shape on

price and volume, to forecast the next price movement

• Do you buy an house only because its price or trade volume is rising ?

• Do you buy a particular car model only because its price chart has a

“special shape”

Any Intelligent Investor answers NO, so there isn’t any reason because

technical analysis works well

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2 a. Fundamental macro analysis: many economic factors

unemployment rate, GDP, inflation and interest rate to forecast

economic trend and so to decide what group of securities to buy or sell

2 b. Fundamental micro analysis: analyzes the economic fundamentals

of the company and predict the future price of securities estimating the

cash flow or earning for next 10 years (not much easy)

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• Do you think is possible to do a reliable revenue forecast or profit forecast in next ten years ?

• Do you remember IMF forecast on emerging market (Brazil, Russia, …) in 2010 ? They was very brilliant but now in 2016 are in recession

Economic forecast in micro or macro area for long period (10 year) is extremely difficult, even in 3/5 years, in fact it is impossible

Intelligent Investor answers NO, so there isn’t any reason because fundamental analysis works well

However in each of these areas there are famous successful investor

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Because Value Investing works

1. Markets are not efficient and it is moody, swings between

depression and euphoria

2. Figure out balance sheet without extrapolation

3. Earning and revenue no forecast

4. Earnings Power value & Moat

5. There are not good or bad stocks, but there are good stocks where

there is good price

Afterwards, the value investing process is easy

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Value Investing on stocks

“Simplicity is the ultimate sophistication” in the Value Investing

is to identify stocks whose value as a business is reliably calculable by you

HOW

Low price book

Low P/E

Significant dividend yield and paid in last ten

years

Upward trend in profit in last ten years

Earnings Stability + Growth

Low value of debt

Strong financial condition

Durable competitive advantage (moat)

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Value Investing process on stocks

• Stock market in depression mood, least down 10%

• Cheap p/e market index compare 10y bond rate > 2% / 3%

(1/p/e) *100 - 10y A rate bond yield > 2% / 3% or great two third than bond rate. Least a 30% of safety margin

Stocks

• Normally Ignored

• Unfashionable

Next step “Valuation Criteria”

Environment criteria

No extrapolation

No forecast

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• price book < 2

• How: use book value easy to get it

• p/e < 15

• How: use earning average five past years

• however price book * p/e < 25

• Significant dividend yield and always paid in last

ten years great than 1%

• Upward trend in profit and revenue in last ten

years at least grown 10%

• However earning stability over the time

Valuation criteria

No extrapolation

No forecast

Revenue > 500m

Public utility, asset > 1B

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• Strong financial condition

• Debt / Equity < 1

• Current ratio > 2

• in public utility

Debt < 2 * book value

Next step “Competitive Advantage”

Valuation criteria

No extrapolation

No forecast

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Earning Power Value

• Epv:= earning x 1/cost of capital

How: earning avg five past years

-cost of capital > A 10y bond + 3%

Compare Asset Value

and Earning Power

How: Asset Value book value

Epv < Book value Value Lost to Poor

Management and/or Industry

Decline

Epv = Book value Free Entry, Industry Balance

Epv > Book value Consequence of Comp.

Advantage and/or

Superior Management

Epv > book value * 1.5

Competitive Advantage

Extrapolation

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“Sustainability” over the time depends

on continuing protection Barriers-to-Entry

that create value

Meaningful Management Performance

Product Differentiation

Customer Captive

Cheap Cost

Negative Evidence

Company evaluation

products, quality, news,

we understand the business …


Forecast

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Where is the margin of safety ?

if selected stock meets all the criteria, then

you have chosen a cheap stock, hence you

are in a real safety margin

Don’t forget diversification, about 30 stocks and patience

Only long (you have advantage of secular GDP growth), never short

imp

ort

an

ce

Bond-Stock allocation

There are a huge number of securities type, but we identify

only some securities where the value is reliable and easily

calculable by you.

Stocks

Bonds

In addition we use also ETF

on stocks and bonds

Investment

Fund

Cfd

Certificate

Stock

Currency

Commodity

Etc

Etf

Convertible

bond

Bond

Securities

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• Investor should never have less than 25% or more than 75% in

common stocks

• so inverse range between 75% and 25% of bond

• reduce stocks below 50% to 25% if the market is too high or too

expensive

• increase stocks upper 50% to 75% if the market is cheap or there are

many special bargains

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Bond-Stock allocation Bond-Stock allocation

Stocks: 25% to 75%

Bond: (100 – stocks range )%

Reduce stocks range Increase stocks range

dividend yield below

two-third of bond yield

Cheap p/e market index compare

10y bond rate < 2%

(1/p/e) *100 - 10y A rate bond yield < 2% or 2/3

Mean reversion

on a diversified portfolio of stock is nearly 7%

annual real return the United States

Compare a expecting the stock market growth

with historical growth

No one criteria matches

with “reduce stocks range”

Huge number of IPO Few stocks meet value investing criteria

Market mood in euphoria

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Bond-Stock allocation There are two ways to compute anticipated long-term returns (LTR)

LTR:= Nominal World GDP + dividend yield

or

LTR:= E/P + inflation

based on Graham formula where g is the growth expected in next seven to ten years and V is value

V= EPS * (8.5 + 2g)

we can make the converse of it and to determinate the growth rate anticipate by current market price

g=(p/e)/2 - 4.25

So we compare g, LTR and mean reversion of historical stocks yield

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Work out: measuring the US stock market (June 2016)

world GDP 3.5

S&P Value 2112

P/E 24.2

Dividend Y% 2.18

Inflation 2.2

A Bond Y% 2.73

Avg return 5Y 10.45

Avg return 10Y 5.33

trailing P/E 24.2 forward P/E 18.57

LTR (gdp) 5,70 5.70

LTR (e/p) 6,30 7.58

g Graham 7.75 5,03

Stock Y% 4,13 5.38

Using trailing or forward P/E

You may be taking on a little risk in stocks

today. Probably slightly less than 50% in

stocks is better allocation

If you are used to using forward P/E, then increase the value of 20%, because it is always historically overvalued 20

Value Investing process on bonds

Also here there are a huge number of bond type, but we identify only some bonds where the value is reliable and easily calculable by you. So we accept only plain vanilla bonds

Government Bonds

Corporate Bonds

Since the main emphasis must be placed on avoidance of loss, bond selection is primarily a negative art. It is a process of exclusion and rejection, rather than of search and acceptance. In first we get only investment grade bond (minimum BBB rate), only in exceptional situation we could invest also into speculative grade bonds.

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Bond allocation

• Investor should never have less than 50% or more than 95% in government bonds in relation with previous bond-stock allocation

• so inverse range between 50% and 5% of corporate bond

• reduce corporate bond below 50% to 5%, if exist very few corporate bonds that match with criteria

• increase corporate bond upper 5% to 50%, if exist many corporate bonds that match with criteria

So some criteria of value investing process on corporate bond is most import task of bond allocation.

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Value Investing process on corporate bond

There four principles for the

selection of corporate bonds

I. Safety is measured not by

specific lien or other contractual

rights, but by the ability of the

issuer to meet all of its

obligations. Senior Liens Are

to Be Favored, Unless Junior

Obligations Offer a Substantial

Advantage

II. This ability should be

measured under conditions of

depression rather than

prosperity.

III. Deficient safety cannot be

compensated for by an

abnormally high coupon rate.

Risks of losing principal should

not be offset merely by a high

coupon rate

IV. The selection of all bonds for

investment should be subject to

rules of exclusion and to

specific quantitative tests

corresponding to those

prescribed by statute or sound

rules. Typically investment

grade bond

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• Bond market in depression mood, least down 10%

• Yield to maturity compare AA government bond > 1.5%

or great two third than AA government bond.

Least a 30% of safety margin

Next step “Valuation Criteria”


No extrapolation

No forecast

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Valuation criteria

No extrapolation

No forecast

Size of Enterprise and rating

•Revenue > 500m

•Public utility, asset > 1B

•Investment grade bond great

than BBB rate

Utility Industrial

Interest coverage > 2 Interest coverage > 3

Stock value ratio > 0.5 Stock value ratio > 1

Interest coverage = EBIT / Interest Expense

Stock value ratio = Market Cap / Bond long term debt

Unavailability of sound bonds is NOT EXCUSE for buying poor ones 25

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Value Investing on stocks ETF

ETF is really a disruptive instrument in the financial sector

ETFs are a true democratization of investment management and

capabilities. Now there is availability of once-exclusive investing techniques

to a wider range of investors. ETFs today represent a vibrant and diverse

array of investment strategies.

We can apply the same previous process of value investing on stocks

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Value Investing on stocks ETF

Since we would like to use the same process, we need independent and trusted data on the

same parameters (p/e, book value, dividend, …)

So far, only Morningstar into free area provides trusted and accurate data on ETF. The Value

Investing process on stocks ETF is to identify ETF whose value as a business is reliably

calculable by you. So we choose only between country ETF and sector ETF with simple

strategy, the new generation like smart, beta, high/super strategy, leveraged are not eligible

because they are too complex.

Price/Prospective Earnings*

Price/Book*

Dividend Yield %*

Long-Term Earnings %*

Historical Earnings %

Book-Value Growth %*

* Forward-looking based on historical data. Since the economist’s

address is always highly optimistic. They predict that corporate profits,

one of the major factors driving stock prices, will increase at double-digit

annual rates for at least the next three years. So we should increase

p/e, dividend yield and price/book at least 20%

and decrease at least 20% the other ones

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Value Investing process on stocks ETF


No extrapolation

No forecast

Environment criteria remain the same of value investing on stock,

like stock market in depression mood, cheap p/e market, …..

In EFT sector we have also the criteria normally ignored and

unfashionable

Valuation criteria

No extrapolation

No forecast

• price book < 2

• p/e < 15

• however price book * p/e < 25

• Dividend yield great than 1%

Long-Term Earnings % > 0

Historical Earnings % > 5%

However earning stability over the time

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• Strong financial condition for all selected stocks

• Debt / Equity < 1

• Current ratio > 2

• in public utility

Debt < 2 * book value

Next step “Competitive Advantage”

Valuation criteria

No extrapolation

No forecast

We do not have direct financial parameters, so we have to

compute them. We get the first ten stocks ranked by weight

inside the Etf and figure out debt/equity and current ratio for

each of them.

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Earning Power Value

• Epv:= earning x 1/cost of capital

Compare Asset Value

and Earning Power

Epv < Book value Value Lost to Poor

Epv = Book value Free Entry

Epv > Book value Consequence of Comp.

Advantage

Country Etf

Epv > book value * 1

Sector Etf

Epv > book value * 1,5


Extrapolation

We divide Etf in two groups, country Etf

and sector Etf. The competitive advantage

is more meaningful in etf sector.

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Value Disinvesting on stocks and

ETF stocks

When you have to say farewell to someone of your securities in

your portfolio (selling time)

In previous slide we have explained the criteria to get a good

value securities

However over the time, they can lack the label of value. Right

now we identify the criteria to exclude them from your portfolio.

When & Why

Every six month you have to check your securities portfolio

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Value Disinvesting on stocks and

ETF stocks Valuation criteria

No extrapolation

No forecast

There are two different situation, however is enough that at least

one criteria is true to trigger the selling action

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Stock

too expensive

Price book > 3

p/e > 25

pb * p/e > 50

Stock

Quality is reducing

Debt / Equity > 1.5

Current ratio < 1

Utilities sector

Debt > 3 * book value

Dividend cancelled for two years

Reduced competitive advantage

Epv < book value There is not a trigger criteria on environment

Value Investor

Because value investing works

Value investing process on stocks

Bond-Stock allocation in value investing

Value investing process on corporate and government bond

Value investing process on stocks Etf

Value investing process on bond Etf

Workout on real stocks, bonds and Etfs

Conclusion

Comment

Next future slides

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But if Value Investing is so easy, why isn’t everyone a value investor ?

Value stocks don’t tend to have big payoffs. Their success is incremental;

they are not a lottery tickets, so they do not promise a immediate wealth.

Sometimes the price stays low also for long time and to wait for long time

up to fair value

Stocks that are cheap are ugly stocks, with boring stories. People sell

them and buy expensive success story

People are over-confident, we think a growth stock will continue to grow

and a value ugly stock will only continue to go down.

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Comment on competitive advantage

There is a competitive advantage if a company has some aspects like meaningful

management performance, product differentiation, customer captive, cheap cost, patent, …

However the “Sustainability” of it over the time depends on continuing protection barriers-to-

entry that create value.

Can I calculate if there is a real competitive advantage ?

Book Value (definition)

is in theory, what would be left over for shareholders if a company shut down its operations, paid off all its creditors, collected from all its debtors, and liquidated itself. It refers to the amount of net assets belonging to the owners of a business based on the balance sheet values.

Yield% of book value [YBV] = (earning / book value) * 100

If YBV is great than A 10y bond + 3% (cost of capital) then there is a real competitive advantage, otherwise should be better to precede to shut down the company and to invest the liquidated cash in bond market (less risk). A “great YBV” should be over the time at least 5/7 years

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Comment on competitive advantage

If the competitive advantage is verified over the time then we should wonder

is there a strategic position ?

what and where is the moat ?

where are the competitors if YBV is more then 3 times of cost of capital ?

why do customer pay more my products

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Value Investing

Is Value Investing the “Holy Grail” of finance investing ?

Yes it is.

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Fabio Michetti

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is value investing the “holy grail” of financial investing ?

Economy & Finance