Approaches to Investing Long Term Short Term Efficient

Approaches to Investing Long Term Short Term Efficient Market • Asset Allocation • Cost Minimization Fundamental Technical (Value) • Momentum • Price/Volume Patterns Levels • Mkt. Price vs. Value Changes • Current Price + Forecast Change • Micro • Macro We Are Here Relative Rarely Done Well (Shliefer, Vishny, Lakonishok) 1

Essentials of Value Investing Long-Term Fundamental (Look at Underlying Businesses) Specific Premises: • Mr. Market is a Strange Guy l Prices diverge regularly from fundamental values • You Can Buy Underpriced Stocks l Fundamental values are often measurable • Fundamental Value Determines Future Price l Buying underpriced stocks plus patience implies superior returns 2

Real S&P 500 and Trend 3

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Value Investing in Practice Long-Term Fundamental (Look at Underlying Businesses) 1) Look Intelligently for Value Opportunities (low P/E, M/B) • Mr. Market is not Crazy about Everything • This is the first step not to be confused with Value Investing 2) Know What You Know • Not All Value is Measurable By You (Circle of Competence) 3) You Don’t Have to Swing • Value Implies Concentration not Diversification (look for Margin of Safety) • At Worst, Buy the Market 9

Microsoft Valuation (in 2000) Assume: l 50% dividend payout (now zero) l 40% annual growth in sales, earnings (by 2010 – 28 times current size) l 15% discount rate (15% desired return) Terminal Value Valuation: (depends on conditions in 2010 & beyond) 2000 2010 Dividends 15%Value 85%Value = current price (i. e. 110) 80 x earnings. 10

Value Investing the Approach Search (Look systematically for undervaluation) Value Review Manage Risk 11

Search Criteria • Obscure • Undesirable −Small Capitalization −Spin-Offs −Boring (Low Analyst Coverage) − Financial Distress, Bankruptcy − Low Growth, Low P/E, Low M/B − Industry Problems (Bad Loans, Regulatory Threat, Overcapacity) − Company Problem (Lawsuit, Poor Subsidiary Performance, Poor Year) − Disappointing (Long-Term Under performance) • Supply, Demand −Privatizations Imbalance - RTC 12

Stocks as Underpriced Assets • Stocks historically outperform bonds, etc. • Stocks are not that much more risky But today… Stocks: E/P = 4% + 1½ % = 5½ % vs. 11% Inflation Historical Bonds: 5% vs. 3½ % at comparable inflation rates Notes: 4 ½ % vs. 2% Stock under valuation not so clear 13

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Systematic Biases 1. Institutional l Herding – Minimize Deviations l Window Dressing (January Effect) l Blockbusters 2. Individual l Loss Aversion l Hindsight Bias l Lotteries 17

Loss Aversion - Example • In addition to whatever you own, you have been given $1000. Choose Between: – $1000 with Prob. 5 $ 0 with Prob. 5 – $500 with Certainty • In addition to whatever you own, you have been given $2000. Choose between: – -$1000 with Prob. 5 $ 0 with Prob. 5 – -$500 with Certainty 18

Summary of Search • Low M/B, P/E, Growth • Disappointing Rtns • Institutional Psycho • Logical Rationale Search (Look systematically for undervaluation) • Obscure • Undesirable • Supply. Demand Imbalance Value Review Manage Risk 19

Value Investing the Approach Search (Look systematically for undervaluation) Value Review Manage Risk 20

Valuation Approaches – Ratio Analysis Cash Flow Measure x Earnings Depends on: (Maint. Inv. = Depr + A) EBIT (Maint. Inv. = Depr + A; Tax =0) (Maint. Inv. = Depr only) (Maint. Inv. = 0) • Economic position • Cyclical situation • Leverage EBIT - A EBIT-DA Multiple • Mgmt. Quality • Cost of Capital (Risk) • Growth Range of Error (100%+) 21

Valuation Approaches Net Present Value of Cash Flow Value = CF (1 +1 R ) t=0 t t = CF 0 * 1 R-g Note: NPV Analysis encompasses ratio analysis (NPVdiseases are ratio analysis diseases) Note: NPV is theoretically correct In Practice: Revenues Parameters: l Market Size l Market Share l Market Growth l Price/Cost l l Margins Required Investments Tech Investment Management Performance Cash Flows Cost of Capital Forces: l l Consumer Behavior Competitor Behavior l Cost Pressures l Technology l Tech l Management Performance X NPV </> Market Value 22

Shortcomings of NPV Approach in Practice (1) Method of Combining Information 20 NPV = CFo +CF 1 1 1+R Good Information (Precise) + … +CF 20 1 +. . . 1+R Bad Information (Imprecise) = Bad/Imprecise Information (2) Sensitivity Analysis is Based on Difficultto-Forecast Parameters which co-vary in fairly complicated ways Profit Margin Cost of Capital Required Investment Growth 23

Valuation Assumptions Traditional: Strategic: • Profit rate 6% • Industry is economically viable • Cost of capital 10% • Investment/sales 60% • Entry is “Free” (no incumbent competitive advantage) • Profit rate +3% (i. e. 9%) • Growth rate 7% of sales, profits • Firm enjoys sustainable competitive advantage • Competitive advantage is stable, firm grows with industry 24

Value Investing Basic Approach to Valuation “Know what you know”; Circle of competence 1. Organize valuation components by reliability Most Reliable Least Reliable 2. Organize valuation components by underlying strategic assumption No Competitive Advantage Growing Competitive Advantage 25

Basic Elements of Value Strategic Dimension Growth in Franchise Only Franchise Value Current Competitive Advantage Free Entry No Competitive Advantage Asset Value Reliability Dimension • Tangible • Balance Sheet Based • No Extrapolation Earnings Power Value • Current Earnings • Extrapolation • No Forecast Total Value • Includes Growth • Extrapolation • Forecast 26

Industry Entry - Exit Industry Market Value Net Asset Value Entry Chemicals (Allied) $2 B $1. 5 B $1. 0 B $1 B $1 B Yes (P MV ) Yes Stop Automobiles (Ford) $40 B $30 B $25 B Yes (Sales MV ) Yes Stop Internet $10 B $0. 010 B ? Remember, Exit is Slower than Entry. 27

Asset Value Assets Basic Graham. Dodd Value Cash Accounts Receivable Inventories Book Reproduction Value Book + Allowance Book + LIFO PPE 0 Orig Cost Adj Product Portfolio 0 Years R & D Customer Relationships Organization Licenses, Franchises Subsidiaries 0 0 Year SGA Book Fair Market DCF Private Mkt. Value Liabilities A/P, AT, AL Debt Def Tax, Reserves Bottom Line Net Wk Cap Net Repro Value 28

Asset Value Approaches Approach Graham Book Reproduction Opportunities None Limited More Extended Value in Practice Yes Yes None Extensive Industry Knowledge None Stability/Reliability High Low Intermediate Goodwill 0 Historical Reproduction Debt Book Est Market (Low Debt) (0 Enterprise) Remember, Low M/B is very hard to beat. 29

Asset Value Issues • Management • Good adds value • Bad subtracts value • Private Market Values • Potentially highly unstable (EBITDA multiples of Internet subs) • Reproduction vs. Book • Better where accountants misestimate Tech trends l Real estate l Intangibles l • M/B indicator close to M/Repro value • Improvement requires discipline • Non Viable Industries • Value = Zero (except NWC) 30

Asset Value Risk Management • Private biases • Personal computer industry • Psychological experiments • Evidence of investment behavior in life • Catalysts • Takeover • Reorganization • Management change • If don’t know, don’t play • Importance of industry knowledge (Circle of Competence) • Hedging • Limited Ultimately, “Margin of Safety” is risk management tool (Otherwise diversify) 31

Earning Power Value l l l Basic Concept – Enterprise value based on this years “Earnings” Measurement 1 – Earnings Power Value = “Earnings” * Cost of capital Second most reliable information earnings today Calculation – “Earnings” – Accounting Income + Adjustments – Cost of Capital = WACC (Enterprise Value) – Equity Value = Earnings Power Value – Debt. Assumption: – Current profitability is sustainable 32

Earning Power Value Adjustments “Earnings” = EBIT (From Financial Statement) + One Time Charge Adjustment (if charges before tax average 20% of EBIT – 5 years – then reduce EBIT by 20%) +Cyclical Adjustment (calculate peak-to-trough EBIT variation – say 20% of average. If a peak subtract 29% of EBIT) +Tax Adjustment (apply average tax rate to EBIT – debt tax shield in WACC) + Depreciation Adjustment (Depr + Amort – Zero Growth Capex) + Subsidiary Earnings Adjustments + Other Adjustments (Temporary Problem, Unused Pricing Power). 33

Earning Power Value Calculation WACC = Cost of Capital = (Fraction of Debt) (RD) (1 -Tax) + (Fraction of Equity) (Cost of Equity) Fraction of Debt = 1 - Fraction of Equity Actual or Potential Zero Growth Capex = Actual Capex - Growth Capex = (PPE/Sales) * Sales Balance Sheet 34

Earning Power and Entry - Exit Value Lost to Poor Management and/or Industry Decline Case A: Asset Value EP Value Free Entry Industry Balance Case B: Asset Value EP Value Consequence of Comp. Advantage and/or Superior Management Case C: Asset Value EP Value “Sustainability” depends on Continuing Barriersto-Entry 35

Franchise Value Calculation (A 1) Cost of Capital = 10% (A 2) Asset Value “AV” = 1200 M (A 3) Earnings Power Value = 2400 M = 240 M X (1 / 10%) “Earnings” • Competitive “Free Entry Earnings” = 120 M = Cost of Cap. X Asset V = 10% x 1200 • Franchise Earnings = “Earnings” – “Free Entry Earnings” = 240 - 120 = 120 (A 4) Sales = 2000 M (Tax Rate = 40%) Power Value = 2400 M = 240 M X (1 / 10%) • Franchise Margin = 120 M ÷ 2000 M = 6% after tax • Franchise Margin (pre-tax) = 10% = (10% - 40% X 10% = 6%) Tax EP Value Implies Sustainable 10% Cost and/or Pricing Advantage 36

Earnings Power Value Issues l Nature and sustainability of barriers-toentry (competitive advantage) l Sustainability of management quality l Quality of reinvestment opportunities l Value of cash – Subtract interest earned from – EBIT add – Cash to EP value l Inflation adjustment 37

“Real” Earning Power Value “Real” Earnings = “Earnings” – Inflation driven Investment “Real” Cost of Capital = WACC – Inflation Rate Inflation Driven Adjustment = Net Assets (Not including ‘goodwill’ items) * Rate of Inflation Example: (A 1) EP Value = 2400 M = 240 M * 10% (A 2) Net Assets (not including goodwill) = Cash + AR + Inv. + PPE – A/P – AL – AT = 800 M (A 3) Inflation rate = 2% • Inflation Driven Adjustment = 2% * 800 M = 16 M • “Real” Earnings = 240 M – 16 M = 224 M • “Real” Earnings Power = 224 = 2800 M 10% - 2% 8% 38

Summary of Basic Valuation Compute: Asset Value (Most reliable) EP Value (Second most reliable) Case A: Asset Value ³ EP Value = EP Value (500 M) (300 M) + Catalyst Value Case B: Asset Value = EP Value = 500 M (500 M) Case C: Asset Value £ EP Value = Asset Value (500 M) (1000 M) + Sustainable Fraction of Franchise Value (1000 M-500 M) 39

Summary of Valuation Strategic vs. Traditional Approach Traditional Revenue Oper Income (EBIT) Cash Flow NVP Market Size Estimate Market Share Operation Margin Investment Cost of Capital National Income, Growth, Consumer Trends Competitive Responses; Entry/Exit Technology, Costs; Prices; Input Costs Technology, Growth Financial Market Conditions; Risks Value Strategic: Is this the South Bronx of the Investment World? 40

Basic Strategy Framework Porter Five Forces – Probability Determinants Substitutes Suppliers Customer Industry Competition Entrants Four Forces too many 41

Strategic Investment Forces • Entry-Expansion – Barriers-to-Entry “Incumbent Competitive Advantage” Does this company enjoy competitive advantage that is significant? l Yes – Being industry creates value l No – Efficient Operation may create value l Others enjoy advantage – stay out. (Being in industry destroys value) What about entrant advantages? l No good – after entry you become incumbent. • Existing Competitor Dynamics Degree of Competition (Phillip Morris) • Share the Wealth (Workers, Customers) Value Chain Dynamics 42

Consequences of Free Entry Commodity Markets (Steel) $/Q “Economic Profit” AC ROE (20%) > Cost of Capital Entry/Expansion Price Firm Position Supply Up, Price Down Q (Efficient Producers) $/Q ROE = 12% AC No Entry No Profit Price Firm Position Q 43

Consequences of Free Entry Differentiated Markets (Luxury Cars) $/Q “Economic Profit” AC ROE (20%) > Cost of Capital Entry/Expansion Demand for Firm Demand Curve shifts left (Fewer Q sales at each Firm Position Price) ROE = 12% $/Q No Entry No Profit AC Demand Curve Firm Position Q 44

Barriers to Entry Incumbent Cost Advantage Entrant No “Economic” Profit Incumbent “Economic” Profit ROE = 20% Sources Proprietary Tech (Patent, Process) ROE = 12% Learning Curve No Entry Special Resources • Not Access to Capital • Not Just Smarter 45

Barriers to Entry Incumbent Demand Advantage Entrant Incumbent No “Economic” Profit Higher Profit, Sales ROE = 12% No Entry ROE = 20% Sources Habit (Coca-Cola) • High Frequency Purchase Search Cost (MD’s) • High Complex Quality Switching Cost (Banks, Computer Systems) • Broad Embedded Applications 46

Barriers to Entry Economies of Scale • Require Significant Fixed Cost (Internet) • Require “Temporary” Demand Advantage • Not the Same as Large Size (Auto + Health Care Co) 47

Barriers to Entry Economies of Scale • Advantages are Dynamic and Must be Defended • Fixed Costs By: • Geographic Region (Cohrs, Nebraska Furniture Mart, Wal-Mart) • Product Line (Eye Surgery, HMO’s) • National (Oreos, Coke, Nike, Autos) • Global (Boeing, Intel, Microsoft) 48

Barriers to Entry - Sustainability Static Demand Advantages • Tied Customers Exploitation • Pricing, focus on “Own” Customers • No advantage with Virgin customers • Shrinkage over time as base changes • Cost efficiency in “Own” technology Static Cost Advantages • No advantage with virgin technology • Shrinkage with technology change Economies-of-Scale + Dynamic Demand Advantage • Principal sustainable advantage • Constant vigilance 49

Other Barriers-to-Entry • Government, Regulatory, Public (Lead based Gas Additives; Cigarettes) • Informational (Who Knows What) (Banks, Financial Services, HMO’s) 50

Performing Strategic Analysis (1) Industry Map (2) Do barriers Exist? (3) What Competitive Advantages? (4) Future Strategy, Profitability Identify Industry History Demand? Cost? Economies-of. Scale? 51

Performing Strategic Analysis Apple Computer - Industry Map Industry: Chips Software Hardware Microsoft, Intel, AMD, Dell, HP, Gateway, Apple, Motorola, IBM, Compaq, Oracle, Apple Netscape Networks AOL Components Power Supply Co. ’s, etc. Step 1: • Identify Segments Step 2: • Identify firms in each segments Step 3: • If firms are the same, treat segments as Single Industry • If firms are different, treat segments as Separate industry • If in doubt, treat segments as separate industries For Apple Segment Are: • Chips • Hardware • Software 52

Performing Strategic Analysis Do Barriers/Competitive Advantage Exist 53

Performing Strategic Analysis Nature of Barriers-to-Entry Competitive Advantage 54

Other Strategic Considerations l Cooperation within Barriers – Coke – Pepsi – Cigarette Makers l Division of Spoils in Value Chain – Strategic alliances – You can not take home, if you don’t bring (Nu. Kote) – Employee Power (unions, Prof. Services firms) 55

Summary of Strategic Investment l l l Without Competitive Advantage – no Value in Franchise Competitive Advantage must be identifiable and sustainable In particular, Are existing Competitive Advantages Sustainable or are they likely to erode? If in doubt, do not pay for franchise Ideally look for ‘hidden’ franchise – Unused pricing power (Coke, Cereals) – Poorly performing divisions 56

Total Value Including Growth l l Least reliable - Forecast change not just stability (Earnings Power) Highly sensitive to assumptions Data indicates that investors systematically overpay for growth Strict value investors want growth for “Free” (Market Value < Earnings Power Value) 57

Value of Growth - Basic Forces At Work • Growing Stream of Cash Flows is more Valuable than a Constant Stream (relative to current Cash Flow) • Growth Requires Investment which reduces current (distributable) Cash Flow 58

Value of Growth - Basic Algebra 59

Valuing Growth Case 1: l ROC Return on Capital Cost of Capital R l Then ROC – G R–G = = 1 (for all growth rates) R–G e. g. (ROC = R = 10%) ROC = R when there are no Barriers-to-Entry (i. e. no competitive advantages – level playing field) then Growth has no Value. G = 0% ROC – G R-G = 10 - 0 =1 10 - 0 G = 2% ROC – G = R-G 10 - 2 = 1 10 - 2 G = 8% ROC – G = R-G 10 - 8 =1 10 - 8 60

Valuing Growth Case 2: l Competitive disadvantage with growth l l ROC less than cost of capital then ROC – G < R - G ROC – G < 1 R–G and ROC – G gets smaller with higher growth rates. R–G e. g. (ROC = 8%, R=10%) Higher Growth at a Competitive Disadvantage Destroys Value G = 0% ROC – G= 8 - 0 =. 8 R-G 10 - 0 G = 2% ROC – G = 8 - 2 =. 75 R-G 10 - 2 G = 8% ROC – G = 8 - 8 = 0 R-G 10 - 8 61

Valuing Growth Case 3: l ROC is greater than R – Firm enjoys a competitive advantage (franchise) Shares are stable G = Industry Growth Rate l then ROC – G is greater than R – G l and ROC – G is greater than 1 and increasing in G. R–G e. g. (ROC = 15%, R = 10%) G = 0% ROC – G = 15 - 0 = 1. 5 R-G 10 - 0 G = 2% ROC – G = 15 - 2 = 1. 625 R-G 10 - 2 Only within Franchise Growth creates Value G = 8% ROC – G = 15 - 8 = 3. 5 R-G 10 - 8 62

Valuing Growth Basics l l l Growth at a competitive disadvantage destroys value (AT&T in info processing) Growth on a level playing field neither creates nor destroys value (Wal-Mart in NE) Only franchise growth (at industry rate) creates value 63

Valuing Growth - How much Does it Add? 64

Valuing Growth High (Unstable) Growth 65

Valuing Growth Breakeven Growth Rate 66

Valuing Growth Keep-In-Mind l l Very hard to do Very hard to determine margin of safety Evidence is that Investors systematically overpay Best growth is hidden (zero cost growth) l Unused pricing power l Temporary problem l Underperforming divisions 67

Summary of Valuation Search (Look systematically for undervaluation) Value Review Manage Risk 68

Managing Risk – Overall Valuation l Review biases l Look for asset protection l Adequate margin of safety (1/3) l l Identify catalysts (create catalysts? ) Appropriate search rationale 69

Summary of Valuation Asset Value EP Value Most certain but mgt. ? Medium certain Sustainable? Growth Value MV < AV, EPV AV < MV < EPV AV, EPV < MV BUY Assess Comp. Adv. Lots of Luck Uncert ain Sustainable? Yes No BUY Lots of Luck 70

Summary of Valuation Strategic Dimension Growth in Franchise Only Franchise Value Current Competitive Advantage Free Entry No Competitive Advantage Asset Value Reliability Dimension • Tangible • Balance Sheet Based • No Extrapolation Earnings Power Value • Current Earnings • Extrapolation • No Forecast Total Value • Includes Growth • Extrapolation • Forecast 71