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I finished reading Value Investing: From Graham to Buffett and Beyond which is written by Bruce Greenwald, and Judd Kahn. The book was published in 2001, which is 11 years old now. The book is broken up into 3 sections: Section 1 is an introduction to Value Investing, Section 2 discusses the three sources of value, and the last section covers profiles of eight value investors.
Section 1: Introduction to Value Investing
The first section is a pretty basic introduction to value investing, covering definitions, along with some results to provide credibility to value investing. This section just provides a background to people new with value investing. It creates a baseline to move into the next section which starts to get into depth of Greenwald’s valuation methodologies.
Section 2: Three Sources of Value
Section 2 begins to provide value to the reader and covers the three sources of value according to Greenwald. At a high level, it is a basic philosophy at a valuation framework for companies. As Greenwald explains each source, the complexity of valuing companies becomes apparent because the math and processes become more involved.
The most accurate valuation technique, is to value the assets of a corporation. Valuing the assets incurs the least amount of error, and becomes the most accurate way of valuing a company. It’s a simple process, and Greenwald covers the reasoning behind most companies being valued at their reproduction costs (value of their assets). The reproduction costs is the cost to an entity that would be needed to recreate the same business that is being valued. In other words, how much money would it take someone or entity to recreate the assets of a business and begin to receive the same income stream. Most businesses will be valued at their reproduction costs because very few business actually have a competitive advantage which creates a high barrier to entry. If a company does not have a strong barrier to entry, then someone can spend cash equal to the reproduction costs to recreate the same business thus people will not value the business for more than it costs to recreate it. This is a simple principal, and a fairly simple process to calculate the reproduction costs of a business. If a company is in a business that is most likely to go towards bankruptcy, the companies assets should be valued at liquidation value instead of reproduction value. Valuing assets does not take into affect any future earnings, because those are harder to accurately predict, so the first level of valuation is to value the assets and compare to the current market price.
The first source of value is the liquidation cost, and should be used for business that are believed headed for bankruptcy. An investor does not want to pay more than liquidation value if heading towards bankruptcy. The second source of value is the reproduction cost of assets, and is used for a going concern that has no barrier to entry and valued a 0% earnings growth.
The third source of value is the Earnings Power of Value (EPV) which takes into consideration the earnings of a company. EPV is less accurate than just valuing the assets, but can add more value to the overall business. Greenwald discusses the problems with using a Discounted Cash Flow (DCF) analysis to value a company. The DCF calculation places a lot of value on the terminal value, which is generally 10+ years in the future. It is virtually impossible to accurately predict earnings that far into the future, and small changes can affect the valuation tremendously. The EPV process takes a shorter term view, and does not use a terminal value. A simple overview of EPV: Calculate the normalized earnings (over the past 3, 5, 10 years) and discount the cash flows by a discount rate. The discount rate should be equal to the level of return that an investor would need given the risk level of the company. The EPV calculation provides a valuation method to incorporate earnings, but in a more conservative way than DCF.
If the EPV calculation is greater than the Reproduction Costs of the business, than the company has some kind of competitive advantage or barrier to entry. Most businesses will have their EPV=Reproduction Costs. If the EPV of a business is higher than the reproduction costs and the business does not have a barrier to entry, another business will enter the market and the difference between EPV and Reproduction Cost will be erased, thus eliminating the extra profits for that business.
For value investors, searching for companies that are selling for less than their reproduction costs of assets is the best way to make money. Of course, value investors will always require a margin of safety, because the calculations will never be 100% accurate, thus requiring a margin of safety.
Section 3: Value Investing in Practice: Profiles of Eight Value Investors
The last section covers profiles of eight well known value investors, and discusses their background and method of investing. This is an interesting section, and discusses the differences among the different investors.
Value Investor Profiles: Warren Buffett, Mario Gabelli, Glenn Greenberg, Robert Heilbrunn, Seth Klarman, Michael Price, Walter and Edwin Schloss, Paul Sonkin.
Conclusion
I really enjoyed this book, and found the first couple of sections to be really valuable to my valuation techniques. The last section was interesting, and demonstrated how each value investor needs to pick a style that fits their personality and goals. There are different styles in value investing, and each investor will need to pick a style that they are comfortable with, and thus become an expert, otherwise it is hard to beat the market and all of the other investors.
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