The blog has moved and can be found at https://strictlyvalue.wordpress.com/

A crash course in value investing

I put together a quick curriculum to get up to speed on investing.

1.       Key concepts
Mr. Market (The Intelligent Investor chapter 8)
Margin of Safety (The Intelligent Investor chapter 20)
Risk (Howard Marks' memo)
 
2.       Basic technical skills 1: accounting
Wharton accounting class on Coursera
Exercise: read and understand a 10K
 
3.       Basic technical skills 2: valuation
Comprehensive books by McKinsey or Damodaran
Exercise: perform a valuation
 
4.       Buffett stocks: what is a good business?
Competitve advantage and moats: excellent books by Porter, Fisher, Dorsey
Capital allocation: it's all in The Outsiders (the author presents his key toughts in this video)
The Warren Buffett Way
 
5.       Graham stocks: net-nets
Very good introduction in The Manual of Ideas(chapter 2)
Jeroen Bos provides further details with interesting case studies (I reviewed his book here)
 
6.       Special situations
Joel Greenblatt explains spin-offs, merger arbitrage etc.
The insightful Value and Opportunity blog contains current examples
 
7.       Mindset and behavior
I like a lot James Montier's little book, Jason Zweig's thoughts and Guy Spier's Education of a Value Investor
 
8.       Checklist
You can find some basic ideas here
Chapter 11 of Guy Spier's Book is extremely useful
Exercise: develop your own checklist

9. Advanced technical skills: derivatives
You can easily skip this module... but I sometimes like to sell options

10. Portfolio construction

Book review: Deep Value Investing

Value investing is more art than science, and there are a number of important books that describe the principles underpinning the art. In contrast, there are relatively few detailed and recent case studies on value investments.

Deep Value Investing by Jeroen Bos fills the gap. It deals with a particular species of the value school. Target investments typically trade below the value of their current assets less all liabilities (so-called "net-nets" à la Ben Graham). No wonder these stocks are ugly, unloved, under-researched, ... and hence exciting!

The author, a former stockbroker turned investment manager in 2003, specializes in UK small caps with a penchant for asset-light businesses. He describes himself as "cheap and stubborn" and seems to possess the right mindset for deep value investing.

Each of the 15 case studies presented in the book is covered with a consistent approach (company background / investment case / outcome). The fact-based analysis starts with the balance sheet and continues with highlights from company results and announcements. Very helpfully, the book is accompanied by an appendix with 586 pages full of detailed disclosures about the analysed companies.

The results are spectacular: the average return of the 15 investments is 1.9x, including 2 failures (RAB Capital and Abbeycrest). The holding periods vary but were generally short (half of the investments were sold within a year). One investment (ArmorGroup) was sold after 4 months for 3x.

Throughout the case examples, the reader is exposed to a number of key value tenets:

• Stay within your circle of competence: for Jeroen Bos this clearly means small, UK services companies, including recruitment companies (Spring Group), defense contractors (ArmorGroup International, Morson Group), engineering companies (Velosi, Norcom), financial specialists (RAB Capital, Record).
• Focus on the balance sheet: Jeroen Bos first looks at the balance sheet, more specifically at net-net working capital. Earnings are secondary.
• Buy discipline: virtually each of the 15 companies was bought below its net-net value.
• Sell discipline: interestingly, unlike most value investors, Jeroen Bos does not necessarily sell when his investments reach fair value. He prefers to wait even more until some earnings momentum develops and the investments moves from an asset play to an earnings play (for instance, homebuilders Barratt Developments and MJ Gleeson, which had a fantastic run lately, are still the top 2 holdings of The Deep Value Investments Fund managed by Mr. Bos).
• Catalyst? It strikes me that the notion of a catlayst is absent in Deep Value Investing. Buy cheap enough and good things will happen. And indeed: a number of investments became (accidentally?) M&A targets, sometimes shortly after Mr. Bos invested.

An investing checklist

Checklists are useful tools for investment discipline. They have been popularized by the books of Atul Gawande (The Checklist Manifesto) and Michael Shearn (The Investment Checklist).

 Investment checklists come in many shapes and forms. Mohnish Pabrai is right: rather than using someone else's checklist, it is highly recommended to develop your own checklist that works for you.

 I've been using a very simple checklist that covers the following areas:

 

• Business understanding
• Do I understand the business and how it makes money?
• Who are the customers? Are they satisfied / sticky / growing?
• What will the business look like in 10 years?
• Business quality
• How have margins / returns on invested capital / free cash flows develop over time?
• Are the current earnings peak, normal or through?
• Moat durability
• What is the source of competitive advantage? Is it sustainable?
• How intense is the competition? Do we have pricing power?
• Valuation
• EV / EBITDA (compared with history and peers)
• Free cash flow yield (normalized)
• Balance sheet
• Debt to assets, debt to equity
• Adjust for intangible assets, non-financial liabilities
• Management
• How has management allocated capital in the past?
• Do I want to partner with these people? Why?
• Risks
• Business risk
• Leverage risk
• Valuation risk
• Investment thesis
• Why is this a good investment?
• At what price do I buy (more) and sell?

My checklist is a living instrument. It’s clearly not rocket science but it’s invaluable if it can help me avoid past mistakes, and take advantage of market volatility.

Listening to Superinvestors

The playlist below contains a number of videos from certain great investors.

Ten principles of value investing

Rather than dwelling on definitions of Value Investing, here are 10 principles that I follow, inspired by legendary investors (Graham, Buffett, Klarman etc.).

 

 

 

1. Never invest without a Margin of Safety. Investing involves a lot of uncertainty. To account for human mistakes, complexity, and bad luck, securities should always be purchased at prices sufficiently below intrinsic value (at least 30% discount compared to a conservative company valuation; see here for fundamental valuation techniques). Such a Margin of Safety is best achieved by buying securities that are "Safe and Cheap".

2. Do your own homework. Unfortunately, successful investing requires a lot of homework, including research and analysis. You can look at what other investors you respect do as a source of inspiration – copying is okay in investing – but you'll only have the confidence required to take sound decisions (and stick to them) if you do your own analysis. If you don't want to invest the time and effort, best would be to delegate your investments to professional managers.

3. Be contrarian. The most lucrative investing opportunities can often be found in out of favour, boring, odd, small, disappointing stocks (for instance, stocks trading at multi-year lows). If everybody loves a stock, it is likely to be quite expensive.

4. Be flexible. To capture value opportunities, you need to be flexible, agile and unconstrained. This is the great advantage of the small private investor over large institutions – use it. The only relevant constraint should be: avoid what you don't understand, put it in the "too hard" pile.

5. Be patient. Good things happen to cheap stocks – but the timing is unpredictable. Patience is critical to deal with the (inevitable) curse of being too early, and to be able to "wait for the fat pitch". I like to keep a substantial amount of cash as dry powder to be used when extraordinary opportunities arise (they often do eventually).

6. Buy and sell. This is possibly somewhat controversial (many value investors adopt a buy-and-hold approach) and could be perceived as contradictory to the "Be patient" principle. However, whilst I believe that you should always invest with a long-term perspective in mind, I also like to take advantage of market movements to buy more of stocks that have sold off, and trim positions that have appreciated.

7. Make volatility your friend. Too many investors are afraid of stock price volatility and assimilate volatility to risk. From my perspective, risk is the permanent loss of capital, not a number nor a Greek symbol. Volatility creates opportunities and as such is the value investor's friend.

8. Beware of debt. A rock solid balance sheet takes part of the financial risk of investing away. As a rule of thumb, I try to avoid non-financial companies with a debt to equity ratio above 1.

9. Don't over-diversify. You want to focus on your best ideas rather than overly diversify your portfolio. Buffett is right again: "Diversification is protection against ignorance".

10. Be disciplined. Investing is a highly emotional activity. Maintaining a disciplined approach (for example, by using a checklist) helps avoiding many traps like spending too much time on macro noise, getting seduced by the latest fads, falling in love with a stock, and panicking.

 

 

My favourite investing books

1. The Intelligent Investor by Benjamin Graham.

2. Berkshire Hathaway Letters to Shareholders by Warren Buffett.

3. Poor Charlie's Almanack by Charlie Munger.

4. Margin of Safety by Seth Klarman.

5. The Little Book That Builds Wealth by Pat Dorsey.

6. The Little Book of Behavioral Investing by James Montier.

7. The Education of a Value Investor by Guy Spier.

8. You Can Be a Stock Market Genius by Joel Greenblatt.

9. The Outsiders by William Thorndike.

10. Valuation by McKinsey.