Dialogue between a Newbie and a Value Investor
NEWBIE: “I am new to stock market and looking to make some money, can you please guide me”.
VALUE INVESTOR: “You will need to search for stocks whose intrinsic value is greater than their price. For instance if the stock’s intrinsic value is
around $35 to $45 range and its selling for $15 then just buy it and hold it tell it gets to $45.”
NEWBIE: “What is intrinsic value?”
VALUE INVESTOR: “It’s the net future discounted free cash flows of the business”
NEWBIE: “OK, maybe you will need to explain me with an example. Let us say Walmart’s stock is selling at $75/ share. Should I buy it???”
VALUE INVESTOR: “You can buy Walmart's stock at $75 if you feel Walmart’s intrinsic value range is way more than $75/ share. At least in the range of $120-$130 range”
NEWBIE: “How Do I find out Walmart’s intrinsic value range???”
VALUE INVESTOR: “Intrinsic value is the net discounted future free cash flow of a business. You will need to calculate that for Walmart. It’s very important
to note that, the intrinsic value / share is always a range of numbers, it’s never a perfect value. The best way to start is by first analyzing how much free cash
flow the business has generated in the past, based on that make your judgment if the business has capacity to repeat or improve the past.
But remember , the investment analysis is not just about plucking numbers from the financial statement and putting into a formula and
get an output. The main part of Investment analysis is using your business acumen to decide what to input. Thus if you want to be successful in investment
you will first need to develop business acumen.
NEWBIE: “OK Got it, so how do I develop my business acumen???”
VALUE INVESTOR: “I can certainly guide you how to develop your business acumen. But a lot will depend on how you adapt yourself in the development process.
It’s like learning to play Tennis. You can get coaching on how to hit different shots, but you will need to do the heavy lifting of developing you’re playing style.”
VALUE INVESTOR: OK , so your first lesson is to learn about the institutional Charecteristic nature of stock market.
INSTITUTIONAL CHARECTERISTIC OF STOCK MARKET
Any person who has worked in the Information Tech (IT) department of any large enterprise might be familiar with the notorious “Estimation template” .
This is basically a long list of questions and multiple choice answers. In order to estimate the cost of the project the Project manager asks his Tech lead
to use the template to come-up with the total number of development hours that will be needed for the project.
The rationale for this process is that it gives the top management an input to figure out the feasibility of the project. On an average the estimation process does a
decent job. The final cost of the project is always within 20% range. But for certain projects, the estimate is way off.
Why is it that this process does not work for certain project? Let us assume that one of the main drivers of the final estimate is the number of
lines of legacy code that the developers need to analyze to arrive at their Integration solution. Basically this is the solution that integrates the new
system to the present legacy system. The legacy code is designed in such a way that certain programs have large data structures (called copybooks) embedded
in them. Even though this technically increases the total lines of code of the program , but the developers spend very less time analyzing them because the
core business logic is very small. Thus whenever a project involves such modules, the estimate gets bloated.
Let us imagine that there are a set of Vendor managers who bid for the projects. One of the Vendor manager is called “Value Vendor manager” .
The “Value Vendor manager” just bids at selective projects where he has enough information about the loophole of the estimation process. In
this case he knows the loophole to do with lines of code. He undercuts his competitors by pricing the project at 10% less cost than what they bid for and
hence wins the project. Other Vendor managers think he is a big fool in making a money loosing deal. But in fact he has played an almost risk less game.
Following figures explain his perspective.
Estimation as per template: 10,000 hrs.
Cost of Developer time: $80 / hr.
Vendor offer = 10,000 x $80 = $800,000 x 0.9 (10 % discount) = $720,000.
Actual development hours : 6,000 hrs.
Actual cost = 6,000 x $80 = $480,000.
Gross profit = $720,000 - $480,000 = $240,000.p>
Project overheads = 10% of Gross margin = $24,000.
Net profit from the project = $240,000 - $24,000 = $216,000
Net margin = $216,000 / $720,000 = 30%.
Thus the “Value Vendor manager’s” factor of safety was $216,000. As he was confident that this cushion was good enough to avoid any loss, thus he could
offer the 10% discount.On the flip side there might be some programs that seem somewhat small, but involve large nested IF statements. These programs take a lot higher time to analyze
than what actually they are estimated for. The “Value Vendor manager” would judiciously avoid any projects that involve such programs and will let other vendors
fight for the tiny profit that comes with large risk. The above scenario gives a very simple example as to how one can benefit from a process that is institutionalized.
Just like the IT department, stock market is also institutionalized to its core. Overall the process works for the market, but there are odd balls when its process
fails miserably. This is where Value investors jump in and benefit from those odd balls. Important thing to remember is that these are “Odd balls”. In other words
Value investing candidates are very rare. If you analyze 10 stocks and find 8 of them worth investing , then you can assume that you are not investing but speculating.
This is very important to understand, because it will set our expectations from beginning that what we are hunting for is a very rare species, thus we are well
aware of the efforts and patience needed to discover them.
Golden rule of estimation - Its always done for a range : Following can be a fun exercise that explains the point.
1. Visit your nearest Starbucks coffee shop and predict the number of customers that will be buying coffee in next 15 minutes.
2. Sit near the counter and count how many folks actually walk in the store and buy coffee in the next 15 minutes. It’s very likely that your prediction will not be correct.
3. Repeat this step a couple of more times and the chances are you will still get your prediction wrong.
4. Let us say that the first 15 minutes 22 people bought coffee, the next 15 minutes 27 people bought coffee and the next 15 minutes 19 people bought coffee.
Thus we are getting a range of numbers here that range from 19 to 27. The fourth time, change your approach. Instead of predicting an exact number ,
TRY PREDICTING A RANGE.Conceptualize your puzzle by answering Yes / No to the following questions
(i) Do you think that the number of customers buying coffee can be less than 5 in next 15 minutes?
(ii) Do you think that the number of customers buying coffee can be greater than 75?
One can fairly answer both the above questions as
(i) No
(ii) No.
It’s very likely that you will be correct in your prediction. CONGRATULATIONS!!! You just cracked your first puzzle. The point here is that in the fourth instance, instead of picking an exact number, you predicted if a range of outcome was possible. In other words you were very comfortable in predicting the range that the number of customers will be very likely between 5 and 75 for the next 15 minutes.
Estimation for a Value investor is all about playing around the ranges. The more cretain we are about a business' future prospects, narrower is the range and vice-versa
Investment vs Speculation Let us assume that each employee working in the job market is considered as a stock whose value is the net earnings that
employee is going to earn in his life. Its quite well known that the highest earners in the corporate world are the CEOs of the blue chip companies. Most of them
have a MBA degree from an Ivy league college like Harvard or Stanford.
Even though a fresh Ivy league MBA might just earn around $150,000 per year, one can be tempted to value him as if he earns $10 million per year
assuming that in near future he would become CEO of a large blue-chip company.
If we look carefully, a fresh MBA has just basic knowledge of management. Most of the knowledge needed for the CEO’s job is obtained in the course of his work
experience. Thus when one is betting on a fresh MBA graduate to become a CEO, one is betting that he will obtain that knowledge in the course of his experience
and thus will become CEO. In other words one is betting on something that is not present today. Hence this bet can be termed as speculation ,
because we are betting on something that's not present.
Instead of betting on fresh MBA graduates, let us assume a scenario where we bet on workers with salary over $100,000 , but who right now are on a short term
disability and earning just $30,000. The market is valuing them as if they will just continue earning $30,000 for the rest of their working career. Over here
if we are able to analyze the short term disability’s reason and feel assured that they will return to work and earn their “present full potential” ,
this bet can be termed as Investment. Because we are betting on something that’s already present , which is the ability to earn $100,000.
Its just that because of a temporary situation the complete intrinsic value of the asset is not evident. If we buy the stock for this employee at a
price equivalent to him earning $30,000 / year, it can be termed as Investment , because there is high probability that the employee will return to full time work and start earning $100,000. This gives us the margin of safety.
Over here the core competence of the value investor is his ability to forecast whether an individual who is in short term disability will return to work or will go
towards long term disability.
