Last year Bruce Greenwald did a great interview with Leslie Norton at Barron’s in which he discussed his ‘spin’ on value investing and how it can significantly improve your results.
Here is an excerpt from that interview:
Norton: Isn’t value investing about buying cheap stocks?
Greenwald: There’s a Graham and Dodd overlay that goes by the name of value investing, which is this idea that you will do much better with ugly diseased stocks than glamorous stocks. People have always shied away from ugly diseased opportunities. So you can take advantage of their loss aversion. What amplifies this is that people think they know much more than they do. The whole discourse about stocks is not “this is a good stock with a 65% probability” [of success]. It’s “this is a good stock for sure,” or “this is a piece of crap.” That’s just not the way reality is. It exaggerates the value of glamorous stocks and radically and consistently undervalues diseased stocks.
Norton: What’s the Bruce Greenwald spin [on value investing]?
Greenwald: Let’s start with having a better value approach. If everybody else is just doing ratio valuations, I’m not going to do better than them. Many business-school graduates try to do discounted cash flows. They estimate cash flows for five or six years, then do a terminal cash flow on a terminal growth rate and a terminal cost of capital and get a terminal value. They do a lot of variations on the assumptions and think they know what’s going on. But they never look at the balance sheet. There is a fundamental stupidity about discounted-cash-flow valuations. Depending on what you plug into the equation, you can get widely disparate multiples. You are combining very good information, your estimate of near-term cash flow, with very bad information, your estimate of distant cash flow. When you add bad information to good information, bad dominates.
We start with the balance sheet, which doesn’t project anything. If it’s a nonviable industry, I can make assumptions about liquidation value, or if it’s viable, about how the assets can be reproduced in the most efficient possible way.
The second-most reliable piece of information is the profit-generating capacity of that business, normalized for accounting distortions and cyclical factors. Forget the growth and the forecasting. Let’s look at what is there today.
Norton: Is there a third element?
Greenwald: Yes. It has to do with the Warren Buffett instinct, the strategic assumptions. So Buffett tries to incorporate these judgments directly in his valuation. Let me give you three examples. In case one: A company has an asset value of $8 billion, and earnings power of $4 billion [normalized earnings, divided by the cost of capital]. Asset value vastly exceeds earnings-power value. The takeaway is that value is being destroyed by weak management. If they borrow to grow, they’re destroying the capital. That’s where value traps come from. Does a discounted cash-flow calculation tell you that story? Not in a million years.
Case two: Asset value and earnings power are about equal, which is exactly what would happen in a competitive market. Growth is worth zero, because competitors enter and drive the earnings down.
Case three: Asset value is $8 billion, and let’s assume earnings-power value is $40 billion. This is the Coca-Cola (ticker: KO) case. For that to be sustainable, there have to be barriers to entry. This is Buffett’s moat stock. Are there economies of scale, barriers to entry, customer captivity? I can look at reproduction value, which is a hell of a lot better than some forecast 10 years into the future.
Graham and Dodd concentrated on the competitive businesses and the badly run businesses—the cigar butts. Buffett started to analyze those first, but today he prefers franchise businesses, or those with moats.
He talks about a circle of competence. He doesn’t mention the obvious extension of that, which is to say, “Look, everybody has got a limited number of specialties, and they ought to stick to that.” It applies to Warren Buffett, too. So if you look at his performance in insurance, banking, in consumer nondurables, and—until it fell out of bed—media, it is much better than his performance in other areas. Now his performance in other areas is good because he is a phenomenal investor, but even for him, specialization applies.
You can find the entire interview at Barron’s here.
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