An Introduction to Value Investing

Buying a dollar for 50 cents An introduction to Value Investing ___________________________________________________________________

Adib Motiwala

Motiwala Capital LLC

About me • • • •

Adib Motiwala MBA (Finance) @UTD - Fall 2010 MS in Comp Sc. @ Texas A&M – Spring 2001 Passed Series 65.

• Started investing in 1999/2000. • Clueless speculator till Fall 2009. • Value Investor since Spring 2010. Motiwala Capital LLC

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Investment v/s Speculation • “An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative” - Graham and Dodd in Security Analysis (1934)

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What is Value Investing? • Hunting for bargains. – Buying a dollar for 50 cents. – Buying debt at 20c on the dollar – Buying security at prices WELL below their intrinsic value.

• Companies that are neglected, unloved, obscure are typically cheap [ and not necessarily low – quality ] • Contrarian / Go against the crowd. • Reversion to the Mean • Ben Graham – Father of Security analysis – The Intelligent Investor – Security Analysis. Motiwala Capital LLC

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Central Concepts • Investing in a stock is part ownership in a business • Circle of Competence • Mr. Market and Intrinsic Value • Margin of Safety • Think long term and stay patient and disciplined Motiwala Capital LLC

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Share holders • Can vote • Eligible to receive their share of the profits in the form of dividends. • Participate in the growth of the business in the form of capital appreciation and rising profits. Motiwala Capital LLC

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What Shares are not • Not just a ticker symbol • Not a lottery ticket • Not a way to get rich overnight.

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Circle of Competence • Buy what you know. Do your own research. • Don’t feel compelled to invest in an area just because every one is investing there. • Over time increase your circle of competence. • Investors get better as they age ( unlike sports or some other professions) Motiwala Capital LLC

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Mr. Market • “Manic-depressive” • Metaphor that explains how stocks can become mispriced. • He Buys High and Sells Low!!!

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Intrinsic Value • The underlying value of the business. • Not an absolute number but a range. • Various methods – – – –

Asset based approach Earnings / FCF based approach Private market value / Prior transactions Relative valuation

• “It is better to be roughly right than precisely wrong” Motiwala Capital LLC

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2 Rules of Investing

• Rule #1: DON’T LOSE MONEY

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2 Rules of Investing

• Rule#2: Don’t forget Rule#1 – Warren E. Buffett Motiwala Capital LLC

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Margin of Safety What is Margin of Safety ? Why is having a margin of safety important? •Valuation is an imprecise art •The future is inherently unpredictable •Having a margin of safety provides protection against bad luck, bad timing, or error in judgment. Motiwala Capital LLC

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Importance of downside protection Initial Percentage Loss

Required gain to break even

10%

11%

20%

25%

33%

50%

50%

100%

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Tortoise v/s Hare YEAR

TORTOISE

HARE

0

$1.00

$1.00

1

$1.07

$1.22

2

$1.14 (grows @7%annually)

$1.49 (grows 22% per year….)

3

$1.23

$1.89

4

$1.32

$2.22

5

$1.41

$1.11 ( 50% HAIRCUT)

Remember the saying:

“ Slow and Steady Wins the Race !!! “

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Magic of Compounding Years of Investment 7% return

12% return

18% return

20

4 times

10 times

27 times

40

15 times

93 times

750 times

60

58 times

898 times

20,555 times

Example : $100,000 investment made today will be $1 million in 20 years if investments compound annually at 12% and $9.3 million if invested for 40 years. A ‘meagre’ rate of 7% turns $100,000 into $1.5 million in 40 years. Keys: • • • •

Invest for the long term. Stay healthy and Live Longer!!! Start EARLY! Invest in your 20s and 30s regularly. Save money!!! 10$ could turn into $930 in 40 years!!! (@12%) Motiwala Capital LLC

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Why do stocks become cheap? • • • • • • • • • • •

Missing quarterly guidance/analyst expectations. Neglect from investors. (MSFT has been dead money for decade) Prior history of losses/ fraud/ accounting issues. Management issues (resignation, poor execution) Complicated business or unloved business (WM) Unrelated business in large conglomerate – Loews (L) Hated company (BP) Operates in an out of favor industry (Housing, Defense) Painted by a common brush (example: BP spill.) Small cap with no analyst coverage Cyclical at the bottom of the cycle. Motiwala Capital LLC

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Advantages of Value stocks • Bad news don’t hurt as much. • Stocks tend to do well on slightly good news. • Value to private owners. • Downside protection. – Think dividend yield Motiwala Capital LLC

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Areas of Value Investing • • • • • • • • • • • •

Net – Nets Special situation stocks (Spin-offs, Mergers, Bankruptcy) Out of favor blue chips Distressed industries Turnarounds Overlooked small caps. Fallen Growth Angels GARP Sum of the parts Discounts to cash Activist Opportunities Post bankruptcy

– Source: Value Investor Insight Motiwala Capital LLC

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What has worked in investing? Low price in relation to asset value Low price in relation to earnings/cash flows High dividend yield. Significant pattern of purchase by one or more insiders. • Significant decline in the stocks price • Small market capitalization

• • • •

– Taken from Tweedy Browne classic research paper.

• Is Value Investing based on ratios such as P/E , P/ B , P/S , P/ FCF, dividend yield? Motiwala Capital LLC

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Investing • 4 Steps – Search Strategy – Valuation – Follow up – Risk management Motiwala Capital LLC

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Business + Management + Price Business

Management

Price

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Search Strategy • • • • • •

52 week low list Low P/E, P/B, P/FCF, P/S, high dividend yield Screeners Fund manager 13F filings Magazines/newspapers/ ValueLine Blogs / Investment Clubs (SumZero, VIC)

(http://adibmotiwala.wordpress.com/2010/09/14/searchstrategy/) Motiwala Capital LLC

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Valuation • Start with the Balance sheet – – – –

Check debt levels (ST and LT) Check cash levels. Quickly know leverage D/E. Check interest coverage. Avoid highly levered companies

• Next move to Cash Flow Statement. – Check OCF, Capex. FCF = OCF – Capex. – How steady is FCF? In general, avoid companies without FCF

• Income Statement – Check Sales growth, Op income, Net income etc Motiwala Capital LLC

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Valuation (contd) • • • •

Use historical valuation as a guide Check valuation to peers. Use DCF / Inverted DCF. Multiples based valuation – Example: 15x P/E on normalized earnings.

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Management Evaluation • • • • • • • • • •

This is more qualitative than quantitative. Compensation levels. Duration of management Past decision making and results Past mistakes. Past promises. Dividend policy and record. Share buyback. Insider holding level. Insider buyback Cluster selling Motiwala Capital LLC

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P/E • What Is P/E ? • What is the P/E of 10 year Treasury ? • Express stock P/E as E/P to represent earnings yield. • Compare stock earnings yields to bond yields. • Example: P/E of 12 means 8% earnings yield.

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Idea # 1 : Aeropostale (ARO) Aeropostale, Inc. operates as a mall-based specialty retailer of casual apparel and accessories. It designs, markets, and sells merchandise principally targeting 14 to 17 year-old young women and men. Market Cap : $2.3 billion (Share $25.62 @1/21) EV : $2 billion (excess cash $300 million) Sales: $2.4 billion ; Net Income : $244 million FCF: $160 million EPS: $2.54 Motiwala Capital LLC

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1- Is it a good business? 1) ROE / ROIC • •

ROE > 15% Consistency of profitability and FCF.

2) Sales growth over 5 and 10 years 3) EPS growth over 5 and 10 years 4) FCF growth over the years

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2- Is Management good? • Share buy back policy • History of buybacks • Conservative growth policy – Abandoned a concept that did not work. – Slowly growing ‘PS from Aeropostale’ concept

• Negatives – Would have loved a dividend as well ( I’m greedy)

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3- Is the Stock Cheap? – Excellent balance sheet with excess cash offers margin of safety. – Cheap valuation by most metrics • • • • • • •

12.5X EV /FCF 10x P/E ( excluding cash 8x) 5x EV / EBIT 4.3x EV / EBITDA Relative valuation ( check against peer group, market) Historical valuation (via MorningStar.com) Open market transactions – Acquisition of JCG and GYMB at multiples 50% higher. Motiwala Capital LLC

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Why is ARO cheap? • Bear thesis – Co-CEO resigned recently. – Same Store Sales (SSS)declined in last quarter and December. – Company warned about rising cotton prices in 1H 2010. – Analysts worried about peak margins, cotton prices, rising fuel costs. – Consumers will upgrade to AEO and ANF as economy recovers. – Heavy discounting by competitors. Motiwala Capital LLC

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Final thoughts • Do your own homework. There are no shortcuts in investing. Ignore the noise. • Understand the business. If its too difficult, move to the next company. • Financials – understand them and know how to value the firm. • Evaluate management capital allocation, shareholder friendly decisions • Know the thesis on the opposite side. • Always invest with a margin of Safety. • Consider Risks before Returns. • Invest for the longer term. Compounding works very well over many, many years. • Patience is the toughest part of Value Investing. • Learn from your mistakes and of others. • Stick to your style. Don’t change your style like you change….. .

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Resources • Books for value investors – – – –

Intelligent Investor by Ben Graham Security Analysis by Graham and Dodd. Margin of Safety by Seth Klarman You can be a stock market genius by Joel GreenBlatt.

• Other books by Peter Lynch, Phil Fisher, Dremen, Greenblatt, Books on Buffett • Resources for learning – Value investors club, SumZero, GuruFocus – Letters by Buffett and Munger, Berkshire letters. – Letters by great hedge fund and mutual fund managers. Motiwala Capital LLC

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What was not covered? • Position sizing – How many stocks should I own in my portfolio?

• Risk Control • Other area of value investing – Distressed debt. Huge potential for those who can spend the time to study turnarounds – Special Situations • Spin-offs , Merger Arb, Motiwala Capital LLC

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Things to ponder… • • • • • •

What about DCF? What is Risk ? Is beta Risk? What about Efficient Market Theory? What about diversification? Does Value Investing always work? If its so great, why doesn’t everyone a value Investor? Motiwala Capital LLC

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