Value Investing 2014 Professor Fernando Diz

What is Value Investing?

One area of Fundamental Finance which includes:

Value Investing Distress Investing Control Investing Credit Analysis Venture Capital

What is Value Investing?

Value investing involves identifying and making passive financial commitments in securities that are priced at large discounts (30% or more) to what the business would be worth in a private transaction.

What do we need to understand and learn to be successful value investors?

Need to understand

We need to have a clear idea of what investing means to us.

Need to understand

We need to understand how businesses create value (wealth).

How do we view businesses?

Need to understand

We need to understand how value (wealth) created by corporations can be extracted by holders of securities.

Need to understand

We need to understand how to appraise the value created by businesses.

Need to understand

We need to understand if there are relationships between security prices and corporate values (if any) (i.e. understand what market efficiency depends on, and whether efficiency is prevalent or not and why)

How we shall use the word Investing

Investing as opposed to speculating We seek a precise definition of investing as opposed to speculation. WHY?

Failure to recognize the difference has led (in the USA) to the financial calamities of 1929, 1987, 1989, 2008-09, and many people actually losing a lot of wealth. Example: AAA rated RMBSs? More simply: if you do not know what you are doing you will get screwed. Academic guidance on this subject has been non-existent and what exists has largely contributed to the existing confusion about these two terms.

WHAT do we get from a definition of investing?

An objective benchmark with which to

contrast other financial operations. A checklist on what to look for and what to

avoid.

HOW do we get to a definition?

We all have some idea of what the differences between investing and speculating are.

You will be surprised to realize how misleading those ideas can be.

We shall explore a few of the misconceptions and by thinking about them, we shall refine our own definition.

1. Bonds vs. Common Stocks

What do you think, investment or speculation?

It used to be that Bonds were considered securities for investment purposes and common stocks for speculative purposes.

1. Bonds vs. Common Stocks The distinction seems to be focused on safety of

principal.

There is nothing inherently safer in credit securities in general. Credit securities issued by poorly capitalized companies may be very speculative in that they can permanently lose value. Example: below investment grade debentures.

In fact, Graham & Dodd suggested the purchases of credit instruments that had enough cash flow support and higher yields as an investment operation! What do you think?

1. Bonds vs. Common Stocks

The collateral securing a bond may lose value very rapidly. Example: Lehman Brothers. Term Fallen Angels and Michael Milkens assertion.

Also, there is nothing inherently riskier in common stocks. When the common stocks are issued by very well capitalized companies the common stock can be extremely safe.

1. Bonds vs. Common Stocks

NOTHING INHERENT TO THE FINANCIAL INSTRUMENT OR SECURITY THAT MAKES IT

EITHER AN INVESTMENT OR A SPECULATION.

ANALYSIS OF THE SPECIFIC CASE WILL HELP DETERMINE HOW SAFE OR NOT SAFE ANY

SECURITY OR CREDIT INSTRUMENT IS.

Credit Instruments vs. Common Stock

WHAT IS INHERENT TO A SECURITY ARE THE RIGHTS THAT THEY GIVE TO THEIR HOLDERS NOT WHETHER THEY ARE SAFE OR NOT.

THIS IS WHAT YOU MUST UNDERSTAND.

2. Outright vs. margin purchases 3. For permanent holding or a quick turn

The difference is between buying with or without using leverage and/or holding for long periods or short periods.

Buying stock outright does not ipso facto make it an investment.

Buying something on margin does not necessarily make it a speculation either.

Arbitrage on margin

Example:

Borrow $155,000 for a year at 5%.

Use the proceeds of the loan to buy 100 ounces of gold in the cash market for $1,550/oz.

Simultaneously enter into a forward agreement to deliver gold in a year and get paid $1750/oz.

Arbitrage on margin

In one year, you deliver 100oz of gold and get paid $175,000.

With the proceeds, you pay back the loan for $155,000 plus the 5% interest for a total payment of $162,750.

You make a profit of $12,250 without any risk of loss. Really?

Real world risks

If the price of gold one year from now goes to $1,000/oz your counter-party may want to renege on his obligation of paying $1,750/oz. Ways of handling this risk?

Dealing with credit worthy counter-parties that have the intention to pay.

Requiring escrow deposits for the amount owed. Requiring liens or pledges of collateral on property.

If the price of gold one year from now goes to $3,000/oz you may want to get out of your obligation.

Arbitrage on margin

This is an example where a profit is guaranteed on a transaction that has no risk of loss and was done entirely with borrowed money.

Moreover, it is done as a short term transaction.

Would you consider this a speculation? NO.

4. Income vs. Profit

Back in 1929, the typical investor was interested above all in safety of principal and the continuance of adequate income.

Since then the doctrine has shifted the emphasis from current income (dividends, coupons) to future income in the form of future enhancement of principal or capital appreciation. (common stocks that pay no dividends, for example)

4. Income vs. Profit Graham and Dodd on the new era style of

investment (back in 1934):

In its complete subordination of the income element to the desire for profit, and also the prime reliance it places upon favorable developments expected in the future, the new-era style of investment is practically indistinguishable from speculation.

4. Income vs. Profit Notice the paradox:

On the one hand, placing a large weight on favorable developments expected in the future sounds highly speculative.

However, can you dismiss the purchases of common stocks of companies that distribute little but accumulate surplus necessarily as a speculation?

Retained earnings may be the cheapest financing source (on a cash basis) that will support good things like high rates of growth, etc.

5. Safety vs. Risk of loss

Most people will immediately recognize this distinction as the difference between an investment and a speculation.

However, how do you evaluate safety?

There is a lot of room for what is indefinite and subjective in the evaluation of safety. i.e. A gambler betting on a sure thing is convinced that his commitment is safe.

5. Standards of Safety The concept of safety can only be of any use if it

is based on something more tangible than the psychology of the purchaser.

Safety must be assured or at least strongly indicated by the application of definite and well established safety standards.

Let us look at what we mean next:

5. Standards of Safety

What are the standards of safety that we use?

Standards of safety related to the issuer (company), i.e. strong financial position, shareholder friendly managements, etc. These are used to insure that the business is safe. Standards of safety related to the issue (terms of the

issue), i.e. a secured loan is over-secured with pledged assets of high quality. These have to do with the substantive characteristics of securities. Price of the issue.

What have we covered?

Summary There is nothing inherent to a security that makes it

either an investment or a speculation. Whether a security is purchased outright or on margin

has nothing to do with whether the operation is an investment or a speculation. The holding period, whether long or short, does not

necessarily discriminates between an investment or a speculation. Whether the security is purchased for income or profit

may not be related to whether it is an investment or a speculation. Safety of principal in the form of very low or non-

existent investment risk is a factor in determining whether the commitment is an investment or a speculation.

Definition of Investment

An investment operation is one which, upon thorough analysis, that can be justified on both quantitative and qualitative grounds, promises safety of principal and a satisfactory return. Operations that do not meet these criteria are speculative.

Components of the definition

Investment operation rather than an issue or purchase Investment character does not inhere in a

security per se.

We are interested in what people do, interested in whether a financial operation is investing or speculation.

Thorough analysis

Means the study of the facts qualitative and quantitative- in light of:

Established standards of safety For issuer:(reserves, capital adequacy, strong financial

position, claim paying ability, quality of resources). For issue: price of a security, terms, rights given, covenants.

Established standards of value security price at a discount of ascertainable asset net asset

value [NAV], workout values in Chapter 11

Satisfactory return

A broader expression than adequate income since it allows for capital appreciation.

It refers to total return

Conventional wisdom on risk and return

A general notion has developed that those who cannot afford to take risks should be content with a low return on their invested funds. (by the way, this is nonsense).

Academic finance has further mislead the public with Modern Portfolio Theorys statement that the rate of return that an investor should expect from their invested funds is more or less proportional to the risk (market risk) they are ready to assume.

Example

In 1934, GE special preferred, paid 6% interest on a $10 par and was callable on any dividend date at $11. Calendar quarters, dividend payment on the first week after the end of quarter.

On December 1934, the preferred sold at $12 .

Is buying this preferred in December 1934 an investment or a speculation and why?

Example continued

An investment operation is one which, upon thorough analysis that can be justified on both quantitative and qualitative grounds, promises safety of principal and a satisfactory return. Operations that do not meet these criteria are speculative.

Is buying the preferred a safe choice?

Example continued

Is the issuer safe? Yes

Are the terms of the issue safe? Yes

Is the price of the issue safe? No

Example continued

As far as the safety of principal is concerned, the buyer at $12 was speculating to the extent of $1 or 10% of his principal.

He was betting that the issue would not be called for years to come.

In fact the issue was called at $11 on April 5, 1935.

Example 2

After the call announcement was made in January 1935, the preferred promptly traded down to $11.

The actual call took place in April 1935, i.e. three months hence.

Margin borrowing costs were 2% per year.

Investment opportunity for margin-buying.

Example 2 continued

Borrow $110,000 at 2% per year.

Buy 10,000 shares of preferred at $11 per share.

Collect one dividend of 6%/4= 1.5% or 0.015*100,000= $1,500 in April 1935.

Pay 2%/4 = 0.5% on $110,000 or $550

Pocket sure profit of $950 in three months.

What have we learned? We need to have a clear idea of what we mean by

investing as opposed to speculation. We need to understand how businesses create

values (wealth). We need to understand how to appraise the values

created by businesses. We need to understand how value created by

corporations can be extracted by holders of securities.

We need to understand if there are relationships between security prices and corporate values (if any) (i.e. understand what market efficiency depends on, and whether efficiency is prevalent or not and why)