Bruce Greenwald on Value Investing

Value Investing: From Graham to Buffett and Beyond - Bruce Greenwald

Understanding, finding and creating value

It is important to recognise the components and drivers of value creation when investing. Important principles such as Benjamin Graham’s margin of safety, and a disciplined approach to assessing value can help us to find high quality stocks at attractive rates of return. Columbia University’s Bruce Greenwald provides a wonderful introduction into the concepts and methods of value investing in Value Investing, From Graham to Buffett and Beyond.

Like Aswath Damodaran’s Narrative and Numbers, Greenwald’s book benefits greatly from his case studies and details on process. It serves as a nice follow-up to more popular books, such as Robert Hagstrom’s The Warren Buffett Way, which focuses more on value tenets and less on process. In this post, we’ll review some of the lessons we took from Greenwald’s book. This includes an outline of his investment process, as well as his views on the value of growth, competitive advantages and the margin of safety.

Price is what you pay, value is what you get

The value investor tries to buys securities when its market price is well below his or her estimate of intrinsic value. Benjamin Graham once noted that this ‘margin of safety’ should not be less than one-third of fundamental value. Although price tends to mirror value, they can sometimes diverge significantly from one another – creating opportunity for the value investor.

The value anomaly

Empirically, cheap and small stocks tend to deliver out performance in the very long run. There are several possible explanations for this. For example, academic finance describes this as the trade-off between risk and return. That is, investors should expect greater returns for bearing greater risk over time.

Others academics have explained the value anomaly as the result of biases that institutions, institutional managers and individual investors face. For example, institutions can face policy and size restrictions. This can confine the universe of stocks that they can look at.

Similarly, institutional managers may make decisions to further their own interests. For example, managers may follow the crowd to reduce their career risk when they and the crowd are wrong. Finally, individual investors are risk averse and not always rational. This can also impair investment decision making.

In practice, the value anomaly is likely explained by some combination of academic finance and investment psychology. These reasons may cause the market to overpay for ‘winners’ and neglect ‘losers’ some of the time. It is also for these reasons that value-oriented investors might on occasions find opportunities to find stocks at exceptional rates of return.

Value investing theory

Greenwald notes that the successful value investor requires a repeatable search strategy, approach to valuation and method to portfolio construction. This will enable him or her to find and evaluate investment opportunities, navigate periods of euphoria and pessimism, and manage risk. This requires discipline and the right temperament. The value investor should understand his/her circle of competence and know the difference between under-pricing and value traps. Furthermore, great value investors will remain patient. They wait for investment opportunities to present itself and for the market to correct the value of their existing holdings.

The Graham and Dodd approach

The intrinsic value of a company is based on the present value of future cash flows generated for the owner. The problem is that future cash flows are uncertain and present value analysis relies on assumptions that are difficult to estimate. One solution to this, as taught at Columbia Business School, is the the Graham and Dodd approach. Their approach is threefold and involves understanding the company’s (1) value of assets, (2) value of current earnings and (3) value of profitable growth. The approach allows analysts to separate the sources of value creation and uncertainty. It also allows them to determine how much is paid for each incremental layer of value. We review each step in some detail as follows.

The value of assets

Value investors begin by examining the company’s balance sheet to determine its net asset value. This is the difference between realisable assets and liabilities, which can diverge materially from accounting value. Strategically, net asset value (NAV) represents the intrinsic value of a company in an industry of free-entry. In other words, this is a company with zero competitive advantage. However, for industries that are no longer economically viable or relevant, the value investor should value assets based on what its likely to yield in liquidation. Benjamin Graham adopted an even more conservative approach to valuing assets. He focused on net-net working capital. This is the difference between current assets and total firm liabilities.

Reproduction cost of assets

We can also interpret net asset value as the reproduction cost of assets. This is the estimated cost of replicating the company. Determining the reproduction cost is more difficult than just estimating book value or net-net working capital. It requires a deep understanding of the company and its industry. Greenwald notes that realising mispricing in net asset value tends to require some catalyst as well (e.g. activism, big news, etc.).

Net asset value adjustments

Greenwald notes that the investor may have to make some adjustments to estimate the reproduction or liquidation value of assets fairly. Cash should require little adjustment. We can say the same for marketable securities if it is valued at current market prices, and accounts receivables if allowances for unlikely payments are already made. However, inventories are trickier to value. It depends on the price trend of items and how fast inventory levels are growing. For example, the balance sheet may understate the reproduction costs of inventory if the company uses the LIFO method while the price of items are rising.

Adjustments for non-current assets may be even more substantial. For example, depreciation rules, inflation and the market value of debt can cause reported asset values to diverge significantly from the reproduction or liquidation value. Goodwill may also diverge from reproduction costs if management had previously overpaid for acquisitions. Furthermore, we may understate reproduction costs by ignoring operating expenses (‘off-balance sheet assets’) that contribute to value. This may include research and development, operating leases, advertising expenses, and business development costs.

Current earnings power

The second step in Greenwald’s approach involves estimating the value of current earnings. The earnings power value (EPV) of a company is:

EPV = Adjusted earnings / cost of capital

Adjusted earnings

Adjusted earnings describe the sustainable level of cash flows that can be distributed to owners. The formula’s assumption is that adjusted earnings remains constant into the future. In other words, this is the level of distributable cash flows that the company can achieve if it does not grow.

Greenwald suggests that to calculate adjusted earnings, the value investor should also remove one-time charges and adjust for discrepancies between depreciation, amortisation and the actual reinvestment required to maintain current earnings. Furthermore, the value investor should account for non-normal effects in current earnings such as the business cycle. They should also subtract debt and add excess cash to their estimate of EPV to make it comparable to the market price of equity.

Franchise value

A company’s franchise value is the difference between its estimated earnings power value and net asset value. If a company’s EPV equals its NAV, then the company has no competitive advantages. Its return on capital will equal its cost of capital. For these companies, growth has no value. If a company’s EPV is less than its NAV, then it is potential evidence of company mismanagement. The solution here is to improve or change management. If a company’s EPV is grater than its NAV, then it is evidence of a company with competitive advantages and/or an industry with high barriers to entry. The important question here is whether such competitive advantages and barriers to entry are sustainable.

Franchise value = EPV – NAV

Judgement is required in interpreting franchise value. For example, free-entry is not synonymous with commodity-type products. There are many industries with free-entry conditions that compete on differentiated goods. Furthermore, companies may be unable to sustain high franchise margins over time. This could be due to economic shock, corporate mismanagement or new entrants that disrupt the status-quo.

The value of growth

The final step for the value investor involves estimating the value of profitable growth. This stage is most sensitive to assumptions and error. Greenwald reminds his readers that growth in sales or earnings does not always create per-share value for owners. This is because growth requires reinvestment and additional liabilities.

For companies with zero competitive advantages, and industries with no barriers to entry, gains from new investments will be offset by the cost of capital. Only companies with franchise value can create value through growth. The higher the present value of a company whose cash flows are growing, the higher the margin of safety is for the value investor.

Margin of safety = PV / EPV

EPV = Adjusted earnings / R = Capital x (ROC / R)

PV = Initial flow / (R – G) = Capital x (ROC – G) / (R – G)

Readers should note that the adjusted earnings used for calculating profitable growth may differ from the adjusted earnings used to calculate current earnings power. The latter is concerned with earnings that are distributable to shareholders if the company decides not to grow. The former is likely to differ because growth requires additional investment.

Valuable growth

Two factors determine the value of growth. Firstly, more value is created when the difference between the company’s incremental returns on capital and cost of capital is larger. Put in other words, it is when the profitability of incremental capital employed is large. Secondly, value creation depends on how much capital is used to generate franchise returns. This depends as well on the franchise’ growth rate, noting that sustainable growth cannot exceed the cost of capital in perpetuity.

For an even stricter constraint, as described in Narrative and Numbers, Professor Aswath Damodaran highlights that long-run growth rate of companies are unlikely to exceed to the nominal growth rate of the economies in which it operates. While the ‘long-run’ may be many years or decades away for some companies, it is a helpful reminder about the constraints of growth and how optimism can balloon valuations.

Enduring value and advantage

The distinction between the value of assets, current earnings and profitable growth rests on the assessment of the durability of a company’s competitive advantage. Greenwald highlights that there are very few types of competitive advantages. These are demand advantages, supply advantages and economies of scale. He recommends investors think about how such advantage relates to the company’s profit equation (revenue minus costs).

Demand and supply advantages

Demand advantages describe goods and services with better access to customers, habit formation, high searching costs, high switching costs and/or large network effects. Government protections such as licenses, patents and copyrights can confer such advantages as well. Cost advantages describe processes and know-how that are difficult or costly for competitors to access or replicate over time. Investor Pat Dorsey shares similar sentiments in The Little Book That Builds Economic Wealth.

Economies of scale

Economies of scale, where the average cost per unit falls with each additional unit produced, is another potential source of competitive advantage. Companies that can combine economies of scale with a demand advantage are more likely to create enduring franchise value. Improved demand will enable such companies to translate scale into lower costs, higher margins and higher profits. This is particularly so for companies with high fixed costs. However, size does not automatically confer economies of scale. Greenwald notes that it depends as well on the business structure and relative market shares of companies in competition

Competition strategy

Management should implement business strategies that maximise their competitive advantages. For example, the company with economies of scale should focus on protecting market share. By contrast, the companies with ‘sticky’ customers should find ways to raise switching, raise searching costs and reinforce the habits of existing customers. Greenwald goes into great detail on competitive advantages and strategies in Competition Demystified, another important read for value investors.

Enduring advantage

It is important to consider the durability of competitive advantages. For example, rapid technology change can eliminate existing cost advantages and barriers to entry very quickly. Similarly, operating expenses in the form of R&D, advertising and business development may not improve a company’s advantage if competitors can match these initiatives easily. Such expenses are likely to become necessary for maintaining than growing current earnings power.

Graham’s margin of safety

Academic finance argues that higher expected returns are the rewards from taking greater risk. However, risk in academic finance is based on the annual variability of returns relative to a comparable portfolio (beta). This is not necessarily a measure of true risk, which is the permanent loss of capital. For some companies, a fall in its stock price may increase its volatility and beta, while improving its margin of safety.

With the margin of safety in mind, diversification is helpful for finding less correlated assets and ensuring that permanent loss of capital in any one stock is not crippling. Position limits for example can provide such protection. Similarly, insider purchases and positions taken by reliable investors may provide additional assurance (or confirmation bias if the arguments are incorrect).

Value investors manage risk by understanding the assets, earnings power, growth potential and competitive advantages of the business they buy . They control risk by reviewing and challenging their judgements. Additionally, they must understand why potential holdings are trading at discounts to intrinsic value and why the market’s thesis is incorrect.

Peter Lynch reminds readers in Beating the Street that investors should hold no more stocks than they can remain informed about. Those without the time or interest to undertake investment research should avoid stock selection themselves.

Bruce Greenwald on Value Investing, From Graham to Buffett and Beyond