One of the best books ever written on value investing is Bruce Greenwald’s Value Investing: From Graham to Buffett and Beyond. So starting this week we’re going focus on one chapter from the book. This week we’ll take a look at the chapter on value investing legend Glenn Greenberg. Here are some excerpts from the chapter:
The Two-Inch Putt: Selecting Stocks for a Concentrated Portfolio
Glenn Greenberg is not an ordinary investor, not even a typical value investor according to the principles of value investing as we have described them in this book. He and John Shapiro, his partner at Chieftain Capital Management since they founded the firm in 1984, have produced extraordinary returns on the money entrusted to them.
From 1984 through 2000, their accounts have achieved a compounded annual growth rate of 25 percent per year (before deducting advisory fees), compared with 16 percent for the Standard & Poor’s 500. For a value investor to have outperformed the index during the best seventeen-year run in its history, when growth stocks did especially well, is remarkable.
These favorable returns are the result of the iconoclastic approach to investing that he and his associates practice at Chieftain. The Pudd’nhead Wilson quotation regarding the wisdom of putting all your eggs in one basket only hints at the implications of a concentrated investment strategy. For starters, it is far more important to select the proper eggs to put into that basket than to watch them once they have been chosen. No amount of vigilance will make a rotten egg palatable. Greenberg attributes a great deal of his success to the firm’s approach to finding the right stocks.
Valuation of Shares in a Concentrated Portfolio
Valuation is central to all value investors. For someone like Glenn Greenberg, running a portfolio committed to a select few companies, valuation is especially crucial. He has to be very confident that he knows the real worth of the companies he looks to buy. Diversification is not going to bail him out. He can’t depend on the law of large numbers to turn his rough estimates into good enough guesses; his sample size is too small.
Also, given the kinds of companies he is looking for, he needs a valuation method appropriate to their features. He isn’t a vulture investor. Because he doesn’t expect his selections to expire, it isn’t relevant to him what their carcasses will fetch. And he is skeptical about applying an asset-based approach to the kind of companies he likes.
As he points out, many old industrial firms, such as steel mills and textile plants, had assets on their books that no longer produced income. Competition from abroad, sometimes subsidized by governments or able to take advantage of labor costs many times lower than their domestic counterparts, drained the value out of the bricks, mortar, and equipment of these firms.
Unless there are industrial buyers for their plant and equipment, which isn’t likely given the specialized uses for which they were built, the assets aren’t worth much even in liquidation. Benjamin Graham would not have disagreed. He sought to buy shares in a company for less than two thirds of its net working capital, ascribing no value at all to the fixed assets.
Greenberg likes companies that produce a stream of free cash flow, so it makes sense that he uses an estimate of cash flow to tell him the value of those firms. Before the arrival of the personal computer and the electronic spreadsheet, he and his partner would analyze a company by isolating its business segments and projecting revenue and expenses no more than two or three years into the future.
By assuming that it would grow steadily from then on, they could calculate its current value by discounting that cash flow back to the present, using only a hand calculator. Now, with spreadsheets, they can make their projections more detailed and carry them forward further in time. Discounted cash flow analysis, a method about which we expressed some reservations in the first part of this book, is Greenberg’s valuation technique of choice for all the investments he makes.
Greenberg’s discounted cash flow approach is bounded by a set of restrictions that keep him securely within the value investing camp. He is only interested in companies with stable earnings and relatively predictable cash flows. He subjects every investment to an “Internet test,” trying to anticipate how its business might be affected by this new and disruptive technology. He does not invest in companies that have never earned any money on the expectation that they will be stars in the future.
He doesn’t depend on heroic and unsustainable rates of growth to multiply the cash flow four or five years down the road. He invests in companies in which the terminal value-what the projections indicate the company will be worth 10 or more years in the future-does not dominate the cash flows of the near and intermediate-term future.
And he is careful to make sure that all of the assumptions that are built into a present value analysis are reasonable and conservative: sales growth rates; profit margins; the market prices of assets such as oil, gas, and other fuels; capital expenditure requirements; and discount rates. Common sense serves as the touchstone against which all spreadsheet projections are assessed. He uses the model; he doesn’t let it control him.
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