Applied Value Investing Session 1

Session 1
APPLIED
VALUE
INVESTING
Session 1
Introduction to long-ter m oriented value investing
1
Agenda
• Introduction to the course
• Why invest in stocks for the long-term
• Introduction to value investing
• Foundations of long-term investing
• Developing an investment hypothesis
• Breaking down a hypothesis into work streams
• Seeking evidence to prove / disprove your hypothesis
2
Welcome
• Thank you for investing your time, and signing up for a new course!
• This course hopes to be a step on your lifelong journey to become
a good investor
• You are likely to get the highest return on your investment in this
course if you review the reading material ahead of a session,
participate in discussions during the class, and attempt the
(optional) homework – but of course you already knew that
• Reminder: Have you done the ‘pre-work’ exercise and created a
paper portfolio of ₹ 100,000, online at
etportfolio.economictimes.indiatimes.com?
• Occasionally, you will see a slide with the heading ‘Food for
thought’ and this sign – please ponder over the questions raised on
such slides as part of your preparation for the class, as we will
discuss further in class
Food for
thought
3
Disclaimer – this is not the usual
stuff in fine print, so please do read!
• Please assume that I am interested / have a position in all the
stocks discussed through the course
• Please do not assume that a discussion on a stock is a
recommendation to buy or sell it
• Please do your own research before buying / selling any stock
• All examples are only meant to illustrate concepts and help you
learn
• The course really contains no ‘secrets’ – I have mostly synthesized
and built on the thoughts and ideas of hundreds of people who
have taught me in class, in conversations and through their books
• All copyrights and trademarks are acknowledged, and images
drawn from searches on the Internet are the property of their
respective owners
4
We will look at investing in stocks
through a particular lens
• ‘Bottom-up’ – not driven by a view of the macro-economy
• ‘Value-oriented’ – seek to buy stocks at below their ‘intrinsic value’
• ‘Long-only’ – buy stocks that offer good value, do not buy stocks
that do not offer good value
• Long / short funds also sell short stocks, but we will not discuss
shorting during this course
• ‘Active’ – picking stocks, rather than investing in an index fund /
Exchange Traded Fund (‘ETF’)
• ‘Long-term investing’ – at least a 2 year investment horizon
• A practitioner’s perspective – will build on (and may occasionally
depart from!) theory
5
Welcome to part 1 of the course
• In sessions 1 to 7, we will learn the building blocks of long-term
investing
• Session 1: Introduction to long-term oriented value investing
• Session 2 and 3: Assessing business quality
• Session 4 and 5: Assessing management quality
• Session 6: Financial analysis and forecasting
• Session 7: Valuation
6
Objectives of the course
Help build the technical

and psychological toolkit Help develop sound
to become long-term investment judgement
investors
7
Let us now imagine that we are a
few months in the future
Congratulations! You have recently

joined the (fictional) investment firm
Long-Term Partners as an analyst.
You are encouraged to present an

investment idea to the team.
How would you go about it?
Note: A hat tip, and a thank you is due to

Prof Sobhesh Agarwalla for framing the
course in this manner
8
9
Imagine that your helpful colleagues at Long-Term
Partners have given you a framework that they use
Let us
review
what they
look for
while
evaluating
a company
10
First,
some
back-
ground
11
A quick
snapshot
of the
company’s
past and
present
12
Summary
financials
to get a
sense of
scale
13
On to the
industry
section
14
Some
quick
context
about the
industry
We will
learn about
‘scuttlebutt’
in session
3
15
We will
learn to
assess the
structural
attractive-
ness of an
industry in
session 2
16
We will
learn to
empirically
assess the
attractive-
ness of an
industry in
session 2
17
We will
learn to
assess the
‘winners’
and
‘losers’
in an
industry in
session 2
18
And finally
onto the
company
itself
19
We will
assess the
quality of a
company’s
business
in session
2 using its
Return on
Tangible
Capital
Employed,
and the
extent of
stability of
margins
20
We will
assess
whether a
company is
likely to
earn
returns on
capital
above the
cost of
capital, in
session 3
21
Growth is a
key driver
of the value
of a
company,
as we will
see in
session 3
22
The extent of
variability of
earnings and
cash flows
over a
business or
commodity
price cycle is
an important
factor in
assessing
the quality of
a business,
as we will
see in
session 3
23
We will learn
about
integrity, the
most
important of
the four
dimensions
on which to
evaluate
management,
in session 4
24
We will
evaluate
whether a
management
team has run
a business
well, in
session 4
25
We will
assess if a
management
team has
sensibly
invested the
cash
generated by
a business,
in session 5
26
We will
assess if a
management
team is
incentivized
to deliver
long-term
returns for
shareholders,
in session 5
27
We will
evaluate the
historical
performance
of a company
by analyzing
its financial
statements,
in session 6
28
We will learn
to build
financial
models and
make
financial
forecasts, in
session 6
29
We will use
multiple
techniques to
triangulate
the value of a
company, in
session 7
30
We will worry
about what
can go wrong
throughout
the course,
but especially
in sessions 2
to 5
31
We will try to
understand
the market’s
expectations
implicit in the
stock price, in
session 7.
This will force
us to assess
if our
expectations
are already
‘in the stock
price’
32
We will learn
about
catalysts later
in session 1
33
We will learn
about the
psychological
biases and
institutional
issues that
hamper long-
term
investment
performance
(and how
using a
‘devil’s
advocate’
perspective is
one way to
overcome
some of
these
handicaps) in
session 11
34
Actively
considering
the opposing
case and the
possibility
that our
decision may
be wrong
forces us to
‘think thrice’
and makes
our decisions
more robust,
as we will see
in session 6
(on
forecasting)
and session
11
35
End with your
‘buy’ or ‘sell’
recommend-
ation!
Consider this course as a kind of training

for your fictional job at Long-Term Partners!
36
All that said, becoming a good investor
can take a lifetime!
37
Agenda
38
The primary objective of investing is
to support consumption in the future
• During working years, set aside a portion of salary or

other income for the future Investing can
Saving
go beyond
being saving for
consumption in
• Invest savings in real assets (like a home) and financial the future, to
assets (like stocks, bonds, fixed deposits)
Investment become an
important
source of
• Draw down on the accumulated savings later in life,
when there is often no salary wealth creation
Withdraw • The returns on investments should be sufficient to
saving account for inflationary increases in cost of living
39
Investing in stocks can deliver good returns:
the very long-term experience of the US
Note that these
are real returns
(net of inflation)
Small changes
in the rate of
return can lead
to very large
differences in
value when
compounded
over long
periods – bonds
earn 6.3x the
returns from
bills, though
bonds earn only
0.9 percentage
points per year
Source: From ‘Stocks for the long run’ by Prof Jeremy Siegel, via
more than bills
http://viniyogindia.com/public/stocks-for-the-long-run-an-indian-perspective/ 40
Investing in stocks can deliver good returns:
our relatively short experience in India
Note that these
are nominal
returns (NOT
net of inflation)
Admittedly, ~40
years is still a
relatively short
period,
compared to
200+ years of
data we have
from the US
As every mutual
fund ad tells
you, past
performance is
not an indicator
of future returns
Source: http://viniyogindia.com/public/stocks-for-the-long-run-an-indian-perspective/
41
While long-term charts of the index
look like smooth upward-sloping lines…
S&P 500 index, monthly, 1950 to 2017
BSE Sensex, monthly, 1980 to 2017
Source: finance.yahoo.com, bseindia.com

42
… they do include periods of
stomach-churning losses
Period Change in Period Change in

S&P 500 Sensex
8/2000 to 9/2002 -46% 12/2007 to 2/2009 -56%
12/1972 to 9/1974 -46% 3/1992 to 4/1993 -50%
10/2007 to 11/2008 -42% 2/2000 to 9/2001 -48%
11/1968 to 6/1970 -33% 7/1997 to 11/1998 -35%
8/1987 to 11/1987 -30% 8/1994 to 4/1995 -32%
11/1980 to 7/1982 -24% 12/2010 to 12/2011 -25%
12/1961 to 6/1962 -24% 4/1996 to 11/1996 -25%
What would you do after a 50% loss?

Source: Data from finance.yahoo.com and www.bseindia.com
43
Most institutional investors appear to
have a < 2 year investment horizon
Source: https://www.mfs.com/content/en_us/mfs-insights/lengthening-the-investment-time-horizon.html
44
But holding periods vary from a few
micro-seconds to decades (!)
Micro- High Frequency
seconds Traders buy / sell
in micro-seconds
Day traders buy

Hours and sell (many
times) during a day
1-2 years Most institutional

fund managers are
in this range
Investors like
Warren Buffett and
Decades Charlie Munger,
who hold for
decades, are rare
45
Over time, average holding periods
have shortened
46
Having a long-term horizon offers
opportunities for stock pickers
At very short
horizons, most
stocks earn
similar returns
At longer
horizons,
‘winners’ and
‘losers’ are
separated more
clearly
While it is hard to beat a market index (especially net of fees),

investors can develop the skills required to outperform the index
47
Most importantly, having a long
horizon improves the odds…
Rolling 5 year compounded annual return on Sensex,
1 year return on Sensex, 1980 to 2017
1985 to 2017
Rolling 10 year compounded annual return on Sensex, Rolling 15 year compounded annual return on Sensex,
1990 to 2017 1995 to 2017
Source: Data from bseindia.com 48

… of realizing attractive returns
from investing in stocks
Compounded
Period Mean Standard % of time % of time
deviation compounded compounded
annual returns
annual annual returns are nearly
returns < 0% over 10%
always positive
1 month 43% for 10+ year
1 year rolling 20.9% 36.6% 29% 57% horizons
returns
5 year rolling 16.5% 13.1% 8% 64%
annual returns
The probability
10 year rolling 16.1% 7.9% 1% 78%
of annual
annual returns returns from
15 year rolling 14.9% 4% 0% 93% stocks beating
annual returns
the average
~10% returns
from fixed
deposits in
India increases
as the horizon
lengthens
Source: Data from bseindia.com 49

In practice, it can be hard to invest
for the long term
• Most clients (whose capital is managed by investment
Limited availability managers) have a relatively short horizon, and are hence
of long-duration unwilling to ‘lock up’ their capital for long periods with an
capital investment manager
• Most of the capital that investment managers receive from their

clients can be redeemed by their clients with a few days /
“Asset liability
weeks notice
mismatch” • As a result, if investment managers invest for the long-term,
there is usually a significant mismatch between the duration of
their ‘assets’ (investments made with a long-term view) and
their ‘liabilities’ (capital from clients that can be redeemed at
relatively short notice)
• This mismatch could lead to an inability to truly invest for the
long-term, as well as redemptions by clients (and hence forced
selling by the investment manager) during a period when stock
prices fall
We will revisit these issues in session 11
50
All that said, there are many ways to
invest successfully
Finding the
investment style
that resonates
with you
intellectually and
psychologically
is an intensely
personal journey,
and can take a
long time
51
For the rest of this course, we will focus on building the
toolkit to become long-term oriented value investors
52
Agenda
53
What is value investing?
• Our working definition: Value investing is an approach to buying
stocks for less than their ‘intrinsic value’
• It may be easier to first explain what value investing is NOT
• “Company X’s stock has risen 2% every day for the last 3
days, so I will buy X today”
• “Company Y is loss making and trades at 100x revenues, while
a comparable company is growing slower and trades at 130x
revenues, so I will buy Y today”
• “Company Z should report good results tomorrow and the
stock may rise, so I will buy Z today”
• A value investor might instead say something like “Company V is
currently trading at ₹ 100 per share, while I think ‘intrinsic value’ is
₹ 180-200 per share. So I will buy company V stock today”
54
Another perspective, from a great
investor
• “Value investing is at its core the marriage of a
contrarian streak and a calculator”
- Seth Klarman, Baupost Group
55
What does it mean to be a
contrarian calculator?
• ‘Contrarian’ implies that a value investor should be willing to
take an opposing view to the ‘herd’ mentality often found in
the stock market, as stocks that are unpopular among other
investors are more likely to offer bargains
• The ‘calculator’ refers to the investor’s ability to reasonably
assess the ‘intrinsic value’ of a company
• In most situations, the ‘intrinsic value’ of a company can
be assessed relatively easily
• But there are exceptions – for instance, consider the
case of a small biotech company which is working on
an early-stage pipeline of promising products, The
company has no revenues, and the success or failure
of this pipeline may become clearer in 4-6 years. The
range of outcomes on the ‘intrinsic value’ of the stock
are even wider than the range of outcomes on the drug
pipeline – the company may go bankrupt or be worth a
few billion dollars!
56
Benjamin Graham is the father of
value investing
• Born in 1894, Benjamin Graham graduated from Columbia
University in 1914
• Weeks before graduation, he received offers for teaching positions
from three different departments at Columbia – Greek and Latin
philosophy, English and mathematics – but he went to work on
Wall Street and ultimately co-founded an investment firm called the
Graham-Newman Partnership
• Graham taught investing at Columbia Business School from 1928
to 1955
• Graham’s books laid the foundation for value investing
• In 1934, Graham co-authored ‘Security Analysis’ with
Columbia professor David L. Dodd
• In 1949, Graham authored ‘The Intelligent Investor’
Source: http://c250.columbia.edu/c250_celebrates/your_columbians/benjamin_graham.html
57
The three foundational concepts of value
investing were detailed in Ben Graham’s books
Stocks represent part-ownership of a business (so try to

1
understand and value the business before buying the stock)
2 Mr. Market
3 Margin of safety
58
1
Part-ownership of a business
(1 of 2)
• Equity shareholders are the ultimate owners of a company and the
residual claimant to company’s cash flows (after all claims from debt
and other providers of capital have been settled)
• So the value of equity shares is inextricably linked to:
•The future cash flows generated by the business, and
•The quantum of debt and other claims to these cash flows
(including instruments such as stock options and securities
convertible into equity)
• “In the short run, the market is a voting machine but in the long run, it
is a weighing machine.” – Benjamin Graham
• While stock prices in the short-term can, akin to a popularity
contest, be affected by investor sentiment and other factors (the
“voting machine”), over the long run, the stock market usually
appropriately reflects the underlying ‘intrinsic value’ of the
business (the “weighing machine”)
59
1
Part-ownership of a business
(2 of 2)
• Figuring out what the Mona Lisa is worth is a really hard
• Assessing the ‘intrinsic value’ of companies is easier, and we can relylouvre.fr
on a few techniques (which we will learn more about in session 7),
including
•
Method A: Realizable value of assets, net of liabilities
•
Method B: Discounted present value of future cash flows
•
Method C: Valuation multiples of comparable companies
•
Method D: Prior trading ranges of the company and / or its peers,
especially if it is large, widely-researched and publicly traded for
many years
• Always try to triangulate value using many of the methods above
• In shorthand, we refer to this triangulated valuation of the company on
a stand-alone basis as the ‘intrinsic value’ of a company
• We will explore how the value of a company when it is acquired
(called the ‘private market value’) will likely be higher than the
value on the same company on a stand-alone basis, in session 7
60
2
Mr. Market (1 of 3)
• Imagine you have a partner called Mr. Market in your business.

The company is not publicly traded, and there are no other
partners
• Mr. Market is quite a character – he swings between extreme
optimism (when he offers to buy out your share of the business,
worth, say ₹ 100, at ₹ 200) and extreme pessimism (when he
offers to sell you his share of the business, worth say, ₹ 100, at
only ₹ 50)
• The key thing to remember: You are not obliged to act, and can
ignore Mr. Market (Mr. Market does not mind!)
• Much like Mr. Market, the stock market periodically offers
opportunities to buy into businesses at bargain-basement
prices, or to sell shares at irrationally-exuberant prices
• Like with Mr. Market, there is no penalty for not trading on the stock
market
61
2
Mr. Market (2 of 3)
62
2
Mr. Market (3 of 3)
• Ted Williams was one of the greatest batters in the

history of baseball, and the author of a book ‘The
science of hitting’
• In the book, Williams broke the ‘strike zone’ (the
area where the ball was usually pitched) into 77
squares, each the size of a baseball, and assessed
the probability of hitting the ball well in each of
these squares
• According to Williams, “A good hitter can hit a pitch
that is over the plate three times better than a great
hitter with a questionable ball in a tough spot”
• According to investor Warren Buffett (who we will
hear from a lot during the course!), “The trick in
investing is just to sit there and watch pitch
after pitch go by and wait for the one right in
your sweet spot. And if people are yelling,
'Swing, you bum!,' ignore them”
Source: https://www.fs.blog/2013/07/make-better-decisions/ 63
3
Margin of safety (1 of 4)
• Margin of safety is the extent to which the current stock price (due
to the whims of Mr. Market!) is lower than ‘intrinsic value’ (which is
assessed based on the value of part ownership of the business)
• Margin of safety thus integrates the first two foundational concepts
of value investing
• Margin of safety is usually expressed as a percentage of the
‘intrinsic value’
• If a stock is trading at ₹ 90 and ‘intrinsic value’ is estimated to
be ₹ 100, the margin of safety is 10% [(100-90)/100]
• An investor might say that he wants to buy the above stock
with a 30% margin of safety, implying that he would buy at ₹ 70
64
3
Source: www.valuewalk.com
65
3
• Why buy with a ‘margin of safety’

• ‘Intrinsic value’ can be hard to assess
• Things often do not go to plan – consumer tastes
evolve, competitive intensity increases, top
management leaves…
• Valuing a business often involves having a view on the
future, and most forecasting is really hard - more on this
in session 6
• We are human, and (systematically) make lots of
mistakes - more on this in session 11
66
3
• Buying with a large margin of safety can be a

significant driver of investment returns. Here is a
simple example
• Suppose the intrinsic value of company X is
₹ 100 per share and the current price per
share is say ₹ 60, implying a 40% margin of
safety
• Assume that the stock pays no dividends
• Suppose intrinsic value is expected to grow at
15% per year. This implies that the intrinsic
value of the stock will be worth ~ ₹ 150 in 3
years
• Assume that the stock will trade at intrinsic
value of ~ ₹ 150 per share in 3 years
• So, your returns from investing in the stock
today = {[(150 / 60) ^ (1/3)] – 1} which is
~36% per year
• 36% returns are much higher than the 15%
annual growth in intrinsic value, due to buying
the stock with a large margin of safety
67
68
A short history of value investing:
Benjamin Graham (1 of 2)
• Benjamin Graham emphasized the importance of buying stocks at
a discount to net realizable value of assets on the balance sheet
• As you might expect, companies that are trading at large
discounts to the realizable value of assets are usually not very
good businesses and / or are going through very difficult times
• Graham’s approach focused on the ‘here and now’ of a
company’s net assets, and did not care much about the
business or its future prospects
• Graham recommended holding a widely diversified portfolio of
such companies
69
Benjamin Graham (2 of 2)
• Benjamin Graham sought out ‘net nets’, which are stocks where
the realizable value of assets (net of debt) was less than the value
of the company
• In July 2018, Applied Genetic Technologies (‘AGTC’), a biotech
company that is in the process of developing genetic therapies
for rare diseases, had a market value of $74mm, and net cash
and investments of $112mm as of March 2018. For the quarter
ended March 2018, AGTC had operating and net losses as
well as cash outflows from operating activities of ~$8mm
• AGTC is a ‘net net’ as the market value of the company is only
2/3 of the net cash on hand
• This approach can be applied to situations where a company has
realizable fixed assets (such as surplus real estate) or other assets
such as investments that are collectively (net of debt) worth more
than the market value of the company
Source: https://finance.yahoo.com/quote/AGTC/key-statistics?p=AGTC
70
71
buy ‘cheap stocks’ (1 of 3)
• Benjamin Graham’s insight can also be extended to situations where
a stock screens as cheap on valuation multiples such as Price /
Earnings, Price / Book, Enterprise Value (‘EV’) / Sales, EV / EBITDA,
EV / EBIT and EV / Free Cash Flow – we will call this approach
‘quantitative value’
• Portfolios which use a ‘quantitative value’ approach usually have 30-
50 stocks, and are rebalanced periodically
• Academic researchers found that the Capital Asset Pricing Model
(‘CAPM’) was not able to fully explain the returns on stocks, and that
stocks that screened as ‘cheap’ on valuation metrics delivered
‘excess returns’ (i.e., delivered returns in excess of what CAPM
would predict)
72
• So Prof Eugene Fama and Prof Ken French created a ‘value’ factor
which they called HML – stocks are sorted based on book / market
value, and the stocks with the highest book / market value are
designated ‘value’ stocks
• HML, which is short for High Minus Low, is the excess return by
going long the stocks that have the highest book / market value
(the cheapest stocks, by this metric) and shorting the stocks with
the lowest book / market value (the most expensive stocks, by this
metric)
• The Fama / French data library is at
http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_libra
ry.html
• Fama-French factors for the Indian market have been computed by
Prof Sobhesh Agarwalla, Prof Joshy Jacob and Prof Jayanth Varma
• The Indian Fama-French factors are at
http://faculty.iima.ac.in/~iffm/Indian-Fama-French-Momentum/
73
Periods where the Fama-French value

factor underperforms the S&P 500
Buying ‘cheap stocks’ does outperform on average,

but it shows extended periods of underperformance
74
Philip Fisher had a very different
approach to Benjamin Graham
• Philip Fisher was an investment manager who started his own investment firm
Fisher & Co in 1931
• Fisher’s approach was to own high-quality stocks for the long run, and he
famously owned Motorola from 1955 till his death in 2004
• Fisher’s book ‘Common Stocks, Uncommon Profits’ was the first investment
book to make it to the New York Times bestseller list
• Fisher emphasized the importance of investing in companies with strong R&D
and sales capabilities, run by high-quality management teams, and operating
in large and growing end markets
• Fisher thus looked primarily at the long-term outlook for a company, and
actively sought out good companies and ignored poor businesses.
• In contrast, Graham mostly sought to find companies that were trading so
cheap that their current market value was less than the realizable value of
their assets, without thinking much about the long-term outlook for these
companies
• Fisher also popularized the concept of ‘scuttlebutt’, which we will look at in
session 3
Source: www.forbes.com/free_forbes/2004/0426/142.html
75
Warren Buffett and Charlie Munger independently
had exceptional investment track records in the
1950s and 1960s (1 of 2)
• Warren Buffett was a student of
Benjamin Graham at Columbia
Business School, and worked from
1954 to 1956 at the Graham-
Newman Partnership
• From 1956 to 1969, Buffett
managed the Buffett Partnership,
mainly using a Graham-like value
investing approach
• The Buffett Partnership delivered
unbelievable results – 30%+ annual
returns that beat the index by 20+
percentage points with less volatility
than the index, all without a single
down year!
Source: The Warren Buffett portfolio by Robert G. Hagstrom
76
Warren Buffett and Charlie Munger independently
had exceptional investment track records in the
1950s and 1960s (2 of 2)
• Buffet’s friend (and future partner)
Charlie Munger was a lawyer, and
Buffett convinced Munger to take up
investing
• Munger ran an investment
partnership from 1962 to 1975,
holding a more concentrated (and
more volatile) portfolio than Buffett,
but still delivered outstanding long-
term results
• According to Buffett, “The blueprint
he (Munger) gave me was simple:
Forget what you know about buying
fair businesses at wonderful prices;
instead, buy wonderful businesses at
fair prices”
Source: The Warren Buffett portfolio by Robert G. Hagstrom
77
Charlie Munger encouraged Warren Buffett to
combine Graham and Fisher’s approaches when
they became partners in Berkshire Hathaway
• Warren Buffett and Charlie Munger partnered to set up Berkshire
Hathaway. In 1972, Berkshire Hathaway acquired See’s Candies for
$25mm - the seller wanted $30mm and Munger thought it was worth
as much, but Buffett bid $25mm but “wasn’t all that enthusiastic even
at that figure”
• Ultimately, the seller agreed to sell at $25mm, which was ~13x
earnings
• Buffett says Munger convinced him to pay up for See’s, a good
business that earned 50% return on capital – though the multiples
were much higher than what Buffett had paid for businesses in the
past (“A price that was 3 times net tangible assets made me gulp”)
• Buffett also credits Munger’s insight into the importance of the quality
of the business for Berkshire Hathaway’s subsequent investment in
many high-quality businesses like The Coca Cola Company
• “If we hadn’t brought See’s, we wouldn’t have bought Coke”
• “Through watching See’s in action, I gained a business education
about the value of powerful brands that opened my eyes to many
other profitable investments”
Source: https://25iq.com/2016/11/25/a-dozen-things-warren-buffett-and-charlie-munger-learned-from-sees-candies/
http://www.berkshirehathaway.com/letters/2014ltr.pdf 78
Buffett and Munger thus took value
investing into unexplored territory
Buy good businesses for Buy at reasonable prices,

the long-term, per Fisher per Graham
Buy good businesses at reasonable prices,

and hold for the long-term
79
Other investors have extended value
investing into newer areas
All these books are
must-reads
High-yield and
Howard Marks
convertible debt
Distressed debt,
Seth Klarman bankruptcy and
restructuring
Spinoffs, post-
Joel Greenblatt bankruptcy stocks,
‘magic formula’
investing
80
Does value investing work? We need to
look at the two broad schools of value
• There is good evidence that buying ‘cheap

‘Cheap stocks’ stocks’ works on average
• Note that ‘value’ in this case is defined relatively
easily (as the cheapest segment of the market,
based on a number of valuation multiples)
• Many value investors today try to invest in high

quality businesses at reasonable prices - let us
Good business at call this approach ‘QARP’ for Quality at
reasonable prices Reasonable Price
• In evaluating QARP, it is obviously harder to
quantitatively measure what is a high-quality
business, as well as what is a reasonable price
• Can we prove that QARP works, beyond
anecdotes about Berkshire Hathaway and some
well-known investors? We will look at the
evidence
81
Buying ‘cheap stocks’ clearly works
– a closer look at HML for US stocks
‘Cheap
stocks’ HML annual returns (%), 1927 to 2016
40
30
20
10
0
1927
1931
1935
1939
1943
1947
1951
1955
1959
1963
1967
1971
1983
1987
1991
1995
1999
2003
2007
2011
2015
1975
1979
-10
-20
-30
-40
-50
 Average HML return 4.2%, Standard deviation 14.2%, Sharpe ratio 0.3
 HML is positive in 55 of 90 years, but of course is negative in 35!
 Note the large underperformance in 1934,1938, 1939, 1980, 1991,
1999, 2007
 Also see extended underperformance in 1937-1940, 1989-1991,
1998-1999, 2013-2015
Source: Data for Fama-French factor HML from http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/ftp/F-F_Benchmark_Factors_Annual.zip
82
Buying ‘cheap stocks’, using P/E,
EV/EBITDA and P/Book works in the US
All the value
‘Cheap portfolios beat
stocks’
the S&P500,
EV/EBITDA with better
Sharpe and
Sortino ratios
This is a good book for anyone interested in

quantitative approaches to value investing
Source: Quantitative value by Wesley R. Gray and Tobias E. Carlisle

83
Buying ‘cheap stocks’ works outside the
US, with multiple measures of ‘cheapness’
‘Cheap
stocks’
https://www.aaii.com/journal/article/why-value-beats-growth-a-brief-explanation.touch
84
Buying ‘cheap stocks’ thus has
conclusive evidence in its favour
‘Cheap
stocks’
But what about

QARP?
85
One approach to ‘buy good business at
reasonable prices’ is Magic Formula Investing
QARP
• Joel Greenblatt quantitatively marries
the 2 key aspects of the ‘Buffett /
Munger’ approach – good business
and reasonable prices, in a way that he
calls ‘Magic Formula Investing’
• Greenblatt uses return on capital to
assess if a business is ‘good’ and EBIT
/ Enterprise Value measures
‘reasonable price’
• Greenblatt ranks stocks on both these
dimensions, added the two ranks
together, re-ranked stocks based on
the sum of the two ranks, and annually
builds an equal-weighted portfolio of
the 30 best stocks in this way The ‘magic formula’ approach
outperformed the index from
1988 to 2004, even if limited to
the largest, most liquid stocks
Source: The little book that beats the market by Joel Greenblatt
86
Gray and Carlisle applied the ‘Magic Formula’ for 1964-
2011 in their book ‘Quantitative Value’, with similar results
QARP
The Magic
Formula (‘MF’)
portfolio
significantly
outperforms the
S&P 500,
delivering
higher returns
as well as
Sharpe and
Sortino ratios,
with lower
drawdowns

87
But there are some practical issues
that pure valuation screens may miss
QARP
Unreliable financial • The implicit assumption while using valuation

metrics linked to the financial statements of a
statements
company, is that these statements are reliable
• However, many companies actively ‘manage’
earnings to deliver ‘smooth’ results that meet
analyst expectations
• In addition, many companies are outright frauds
• A company that has a high risk of bankruptcy is at

Financial distress risk of permanently impairing the value of the
company’s shares

88
Gray and Carlisle create a quantitative process
that is similar to what QARP investors use
QARP
• Remove stocks that have risk of being potential frauds and

earnings manipulators
Clean the • Remove stocks with a high risk of financial distress
universe
• Find the cheapest stocks by ranking stocks based on EBIT

/ Enterprise value
Find the
cheapest
stocks
• Identify stocks that are strong businesses, reflected in

metrics such as those with high return on assets and
Find the stable margins, in addition to financial strength (relatively
highest low leverage and high free cash generation)
quality
stocks

89
The quantitative replication of a QARP
process delivers strong results
QARP
Gray/ Carlisle
Magic Formula
The Gray/
Carlisle portfolio
significantly
outperforms the
Magic Formula
as well as the
S&P 500,
delivering
higher returns
as well as
Sharpe and
Sortino ratios,
with lower
drawdowns
But the Gray / Carlisle strategy is but one way to implement QARP
Source: Quantitative value by Wesley R. Gray and Tobias E. Carlisle 90
The plural of anecdote is not data
QARP
• Berkshire Hathaway’s exceptional
success has inspired a
generation of investors to follow
in the footsteps of Warren Buffett
and Charlie Munger with QARP
• There are many mutual funds
and hedge funds that follow
QARP, with a long track record of
outstanding performance
• That said, there really is no data
to objectively assess how the
entire universe of investment
managers applying a ‘buy good
businesses at reasonable prices’
have fared
91
So, in summary, does value investing
work?
‘Cheap stocks’ • Buying ‘cheap stocks’ conclusively outperform
the index, both on a raw and risk-adjusted basis
• The Magic Formula and Gray / Carlisle methods

of quantitatively testing a process conceptually
Good business at similar to the process followed by QARP
reasonable prices investors, deliver robust results for both raw and
risk-adjusted returns
• However, there are other approaches to QARP
that are used in practice by investors, which have
not been considered
• In addition, these tests do not go back prior to
This course will 1960s or extend to non-US geographies, unlike
primarily use a tests for ‘buy cheap stocks’
QARP approach • It is probably fair to conclude: the hypothesis that
QARP delivers good returns has NOT BEEN
NEGATED so far, though more evidence may
be required to conclusively accept this
hypothesis
92
93
But why does value investing work?
• ‘Cheap stocks’ deliver higher raw and risk-adjusted returns
• While the introduction of the HML factor is a way to explain stock returns
beyond CAPM, it is unclear even to academics as to what ‘risk’ is really
Reward for risk?
being priced in
• Value investing is psychologically hard to do - a number of deep-seated

biases lead investors to over-react to bad news and makes them ‘loss
Psychological
averse’. As a result, it is difficult to buy stocks that have performed poorly
biases in the recent past (and which are now trading at attractive prices)
• Value can under-perform for extended periods, while the clients of an

investment manager may measure performance over shorter horizons
• As a result, investors who care about protecting assets under
Institutional management (and the related fees, as well as their jobs) may give up on
issues
‘value’ when it is not working
We will dive into the psychological biases and institutional issues in

session 11, as these appear to be the reasons why value investing works!
94
A short detour: understanding the
role of a catalyst (1 of 2)
• A catalyst is an industry-wide or
company-specific trigger that is expected
to close the gap between current stock
price and ‘intrinsic value’
• New products, better-than-expected
financial performance, settlement of a
long-standing dispute are all examples
• Corporate actions like buybacks, spin-
offs or the company getting acquired
are generally hard to predict, but can
also have a significant impact
• Additional disclosure of segment
information in a company with multiple
businesses can help investors better
assess and value the company
95
A short detour: understanding the
role of a catalyst (2 of 2)
• Many investors seek ‘value with a catalyst’
• A near-term catalyst reduces the risk of
being stuck in a ‘value trap’, when a stock
persistently remains cheap, and the market
price does not converge with (your estimate
of) ‘intrinsic value’
• A near-term catalyst can be particularly
valuable in a poor or declining business
• Other investors believe that ‘value is its own
catalyst’
• Low expectations implied by the stock price
may be exceeded as the business
performance ‘mean reverts’
• Takeover offers from strategic or financial
investors, or interest from activist investors
(more on them in session 5) may become
possible
• But activism / M&A are unlikely where
there are controlling shareholders
96
Agenda
97
A simplified view of the corporate
investment and growth cycle
Value of Present Value of

assets in Growth Opportunities
Value of firm
place (‘AIP’) (‘PVGO’)
Investments increase Investments may

the future value of AIP increase PVGO
Assets
Retain and invest cash
generate
for future growth
cash
Return to
providers of
debt / equity
98
The contribution of AIP and PVGO in the
‘intrinsic value’ of a business can vary widely
Indicative illustration of the share of AIP and PVGO in ‘intrinsic value’

100%
90%
80% 30%
70%
60% 70%
50% 100% 100%
40%
30% 70%
20%
10% 30%
0%
Benjamin Slow growing Acyclical Lossmaking but
Graham style cyclical steadily growing fast growing
'net net' business business tech startup
Assets in place PVGO
99
As the investment horizon lengthens and the share of
PVGO in ‘intrinsic value’ rises, it becomes more
important to understand the business and management
When AIP as % of ‘intrinsic value’

Investment horizon
is very high, there are few growth

opportunities and the business is
Long- Understanding
less likely to grow in value over
term time. So there is less reason to the business
hold such a business long-term and evaluating
management
The focus here is on matters the
valuing AIP, not PVGO most here!
Short-
term
Low High
PVGO as % of ‘intrinsic value’
100
101
An introduction to the ‘investment
process’
• The ‘investment process’ refers to the series of steps taken by an
investor before deciding to (or not to) make an investment
• With experience, investors refine and customize their investment
process to identify good investments and avoid ‘unforced errors’
• Thus, the investment process adopted by an investor tends to
reflect the lessons learned from prior investing experience
• A novice investor’s investment process, which may rely primarily
on tips from friends and brokers, is less sophisticated than a more
skilled investor
• In this way, the degree of sophistication of the investment process
usually reflects the investor’s level of skill
102
A sound investment process for a
long-term investor…
• Traders who buy and sell a stock intra-day are focused primarily on
factors such as news flow, market sentiment and stock price
movements, as intra-day stock price moves have relatively little to
do with the long-term fundamentals of the business
• On the other hand, investment outcomes of long-term investors are
primarily affected by the long-term fundamentals of the business
• Understanding the quality of the business and management, and
analyzing financial statements, is therefore an integral part of any
long-term investor’s investment process
• That said, the actual level of diligence conducted by a set of
long-term investors can vary widely
103
… emphasizes detailed work on the business,
management and financials
Lessons from
business Hypothesis Start with the
diligence and hypothesis. The
financial analysis hypothesis drives
lead to updated work on assessing
hypothesis and the business and
conclusions Learnings from financial management
analysis feed into
business diligence
Business
Financial diligence on the
analysis business and
management
Learnings from business diligence feed

into financial analysis
104
So, in step 1: Understand the
business
Lessons from
business Hypothesis Start with the
diligence and hypothesis. The
financial analysis hypothesis drives
lead to updated work on assessing
hypothesis and the business and
conclusions Learnings from financial management
analysis feed into
business diligence
Business
Financial diligence on the
analysis business and
management
Learnings from business diligence feed

into financial analysis
105
Step 2: Understand the expectations
implicit in the stock price
““How do you find attractive odds in the investment business?
You must locate gaps between current expectations and
where expectations will likely stand in the future. While
many probabilistic fields post their odds — handicapping
and sports betting, for example — stock markets investors
must learn to read the odds by deciphering the
expectations built into prevailing prices… When a company
possesses strong fundamentals, investors tend to buy
irrespective of expectations. Similarly weak fundamentals
cause investors to avoid a stock. These tendencies lead to an
inability to properly calibrate odds, producing suboptimal
performance.”
- Michael Mauboussin
The ‘reverse DCF’, which we will learn about
in session 7, is the best tool for this purpose
106
Step 3: Assess the odds
Your view of the long-

term outlook for the > Market implied
company, based your ~= expectations embedded
understanding of the
business and
< in the stock price
management
107
Step 4: Act if the odds are in your
favour
Company Very low chance
Industry Stock implies
gaining some that the implicit
growth 18-20% long- Avoid
share over last expectations will
6-8% term growth
5 years be met
Company
Industry Stock implies Unclear if implicit
gaining some
growth 12-14% long- expectations will
share over last
6-8% term growth be met
5 years
Company High likelihood

Industry Stock implies 4-
gaining some that the implicit
growth 6% long-term Buy
share over last expectations will
6-8% growth
5 years be exceeded
108
A good investment process improves
the odds of good outcomes
Hypothesis
Likely to
lead to Likely to
fewer lead to a
mistakes good long-
Financial Business term
analysis diligence Likely to investing
lead to more track record
good
investments
Your view of the
Market
long-term outlook
for the company, > implied
expectations
based your ~= embedded in
understanding of < the stock
the business and
price
management
109
Focus on the investment process,
not on investment outcomes (1 of 2)
• While the investment process is related to the level of skill, the outcomes
associated with any set of investment decisions are affected by both the
skill of the decision maker and randomness (i.e., luck)
• But luck tends to average out over time, and so a long-term investing track
record therefore primarily reflects the investors’ level of skill (i.e., the
investor’s investment process)
• So, the right mindset for an investor is ‘process over outcome’
• A good process helps maximize the odds of ‘deserved success’ – see the
table below
Source: Decision-making for investors by Michael Mauboussin, at http://www.retailinvestor.org/pdf/decisionmaking.pdf
110
Focus on the investment process,
not on investment outcomes (2 of 2)
“While satisfactory long-term outcomes ultimately define

success in probabilistic fields, the best in their class focus
on establishing a superior process with the
understanding that outcomes take care of themselves.
Probabilistic endeavours require a focus on process

because, by definition, poor decisions will periodically result
in good outcomes, and good decisions will lead to poor
outcomes.“
Source: Decision-making for investors by Michael Mauboussin, at http://www.retailinvestor.org/pdf/decisionmaking.pdf
111
112
Agenda
113
What is a hypothesis? (1 of 2)
• A hypothesis is “a proposition, or set of propositions, set forth as
an explanation for the occurrence of some specified group of
phenomena, either asserted merely as a provisional conjecture to
guide investigation (working hypothesis) or accepted as highly
probable in the light of established facts.”
• Developing a hypothesis is thus a key step in the ‘scientific
method’
• Observation (which often triggers a research question),
• Hypothesis (a guess about a plausible answer to the
question)
• Experimentation (developing appropriate tests to assess if
your hypothesis is valid)
• Observation (conducting the experiments and collecting their
results)
• Inference (a logical conclusion based on the results of the
experiment)
Source: www.dictionary.com/browse/hypothesis
114
What is a hypothesis? (2 of 2)
115
Hypotheses are easier to test in the
physical sciences than in business
• For example: X observes a dead plant in a dark room, conjectures
that the plant may have died due to lack of light and develops an
experiment to test this hypothesis
• Randomly divide a group of say 100 similar (and healthy)
plants of the same species into two rooms, one of which is
dark and the other well-lit, and otherwise treat the plants in
each room the same way (such as the amount of water and
manure that the plants receive) over the next two weeks
• At the end of two weeks, observe that plants in the dark room
die while those in the well-lit room are alive and healthy
• Infer that plants in the dark room died due to lack of light
• Hypotheses such as the one above are easily testable in the
physical sciences, but testing is usually harder in the world of
business (and the world of social sciences more generally)
116
What is an investment hypothesis?
• The investment hypothesis (and
related sub-hypotheses) can
therefore be viewed as a set of
provisional conjectures, based on
some preliminary background
knowledge about a company we are
evaluating
117
Investment hypotheses are the starting
point of diligence on a company
Hypothesis
Financial Business
analysis diligence
118
Investment hypotheses about a company
can be structured into five broad areas
1 Industry
2 Company position and performance
3 Management and governance
4 Risks
5 Valuation
119
How to develop investment
hypotheses
• Develop a quick sense of the company’s business, possibly by reading an
annual report or investor presentation
• Review summary historical financial information for at least the last 3-5 years
• Reflect on what makes this company a good business, and why you like this
management team
• Identify the 4-5 ‘need to believe’ issues that need to be studied in depth
• Drill down into each of these issues and create sub-hypotheses
• Identify the types of work / analysis that need to be done on each sub-
hypothesis
• Make each of the sub-hypotheses ‘testable’
• Structure the tree of sub-hypotheses into smaller work steams such that the
information you gather while exploring each of the individual ‘branches’ rolls up
to your investment decision
• Recognize that some of the sub-hypotheses are more important than others –
a key sub-hypothesis (or a group of them) being disproven could lead you to
walk away from the investment
120
This is best understood through the
example - Colgate-Palmolive India
• Colgate-Palmolive India (‘CP India’) is a branded, consumer staples
(or FMCG) business, primarily in oral care (toothpaste / tooth brushes)
• The ultimate controlling shareholder of CP India - which has been
listed in India since 1978 - with 51% of the equity, is Colgate Palmolive
Company (which is listed in the US)
• For background, review the investor presentations at
http://www.colgateinvestors.co.in/media/1367/analystpresentation2016
.pdf
5faeeba83ef54755b29a2db64f9a4647.pdf and
.pdf
• Then, take some time to draft the investment hypotheses that
you think need to be tested before investing in CP India, before
moving to the next slide
121
122
Here are first level hypotheses for
Colgate India (as of July 2018)…
Industry The Indian oral care industry is very attractive
Company position CP India has a strong operating and financial track record,
and performance which is likely to sustain in future
Management and CP India’s management team is stable and appropriately

governance aligned with minority shareholders
Increased competition (especially from Patanjali in the ‘natural’

Risks toothpaste segment) is the primary risk, which CP India can
fend off
CP India stock trades at an attractive valuation, considering

Valuation
the quality of its business and the risks
123
… which we drill down into sub-
hypotheses (page 1 of 2)
1. The Indian oral care industry is very attractive
Industry 1a: Oral care in India has acyclical demand with long runway for structural growth
1b: Oral care has high entry barriers due to the need to (i) build a trusted brand,
(ii) set up deep distribution especially in rural India and (iii) constantly develop
new products to suit evolving consumer tastes
1c: The consolidated industry structure and the focus of key players on profitable
growth lead to high returns on capital and strong cash generation for the industry
Company position 2. CP India has a strong track operating and financial track
and performance record, which is likely to sustain in future
2a: CP India is the dominant market leader with the strongest brand, widest
distribution and regular, relevant new product launches
2b: CP India has held or increased market share over many years, despite new
entrants and changing consumer tastes
2c: CP India has delivered excellent financial results – steady growth with high
returns on capital, strong cash generation and sensible capital allocation
Management and 3. CP India’s management team is stable and appropriately

governance aligned with minority shareholders
3a. CP India’s management team is stable and is incentivized to deliver strong
operating results
3b. There are no material red flags on ‘related party transactions’ with other
Colgate-Palmolive group companies
124
… which we drill down into sub-
hypotheses (page 2 of 2)
Risks
4. Increased competition (especially from Patanjali in the
‘natural’ toothpaste segment) is the primary risk, which
CP India can fend off
4a. Colgate India has lost market share to Patanjali (which is not fully reflected
in Nielsen market share data) due to the growing consumer preference for
‘natural’ toothpaste
4b. Colgate India’s launch of ‘Vedshakti’ toothpaste in the ‘natural’ segment has
been well-received, and has stemmed the loss of market share
4c. Colgate India has fought off efforts of competitors such as Hindustan
Unilever, Dabur and Procter & Gamble (‘P&G’) in the past with little loss of
market share, and will likely fend off Patanjali’s efforts too
4d. ‘Natural’ toothpaste is likely to remain a segment of the toothpaste market,
and Colgate can stay #1 in oral care even if it is not #1 in the ‘natural’ segment
Valuation 5. CP India stock trades at an attractive valuation,

considering the quality of the business and the risks
5a. Colgate is a ‘compounder’ that is likely to grow at a steady rate with relatively
low risk
5b. CP India is an attractive investment for a long-term shareholder despite the
recent loss of market share to Patanjali
125
Sub-hypotheses are broken down
further into work streams (1 of 2)
Sub-hypothesis Work stream Source of info Priority
1a: Oral care has acyclical demand with long runway for structural
growth in India
Oral care has - Analyze oral care industry - Nielsen market research Medium
acyclical demand volume and value data for India data
for the past 10-15 years to
assess cyclicality of demand
- Review industry data from other - Management of CP India
low-income and middle-income or their competitors, oral
emerging markets to assess care companies in other
cyclicality of demand, if any emerging markets
Oral care has - Analyze penetration, per capita - Nielsen market research High
long runway for consumption volume and per unit data
structural growth price trends for last 5-10 years for
in India tooth brush, tooth powder and
tooth paste in India
- Compare India with other low- - Management of CP India
income and middle-income or their competitors, oral
emerging markets to assess care companies in other
runway for growth emerging markets
- Data from market
research firms like
Euromonitor
126
Sub-hypotheses are broken down
further into work streams (2 of 2)
Sub-hypothesis Work stream Source of info Priority
2b: CP India has held or increased market share over many years,
despite new entrants and changing consumer tastes
CP India - Analyze Nielsen survey data to track CP - Nielsen market Medium
has held or India’s market share over 10-15 years research data,
increased - Deep dive in particular into significant adjusted for Patanjali
market decreases in CP India market share (such sales
share over as to Hindustan Unilever Limited (‘HUL’) - Annual reports of
many years during 1999-2004), and how CP India was CP India and HUL
despite new able to recover subsequently for 1999-2004
entrants - Deep dive into periods where a credible new - Press articles from
player (such as P&G) entered the market – 1999-2004 / 2013
how did CP India react and what was the - Employees of P&G/
impact on CP India’s market share HUL / CP / Dabur
CP India - Analyze movements in the share of newer - Nielsen market High
has not sub-segments of the oral care market (such research data,
faltered as gels, ‘naturals’, sensitive) over time adjusted for Patanjali
despite new - Assess if the growth in these sub-segments sales
entrants was led by CP India, or whether CP India - Annual reports of
and was responding to competition CP India and
changing - If CP India is a follower in newer segments, competitors
consumer assess how quickly did it take to become a - Current / former
tastes credible player / leader in these segments employees of CP
- Understand how CP India launched India and
‘naturals’ that are not in CP’s global portfolio competitors 127
128
Food for thought: 1 of 1
Food for
thought
• We have seen a few examples of going from hypotheses to sub-

hypotheses, and identifying the work streams that can help assess
a sub-hypothesis (see examples for sub-hypothesis 1a and 2b
above)
• Pause here, and assess how to test the following sub-hypotheses
• 3b. There are no material red flags on ‘related party
transactions’ with other Colgate-Palmolive group companies
• 4a. Colgate India has lost market share to Patanjali (which is
not fully reflected in Nielsen market share data) due to the
growing consumer preference for ‘natural’ toothpaste
• We will discuss this in class
129
Agenda
130
While gathering information to prove / disprove
your hypothesis, it is better to start with the
‘facts’ before getting into the ‘story’
“I teach my students and analysts: start first with the SEC filings, then
go to press releases, then go to earnings calls and other research.
Work your way out. Most people work their way in. They’ll hear a
story, then they’ll read some research reports, then they’ll listen to
some conference calls, and by that point may have already put the
stock in their portfolio. It’s amazing what companies will tell you in
their documents…
This way you are looking at the most unbiased sources first. People
on earnings calls will try and spin things, and analyst reports will
obviously have a point of view. All of that is fine, because hopefully
you will have first read the unvarnished facts. Primary research is
crucial and not as many people do it as you think. Because there
is so much information out there, it almost behooves people to read
the source documents.”
- Jim Chanos, Kynikos Associates
https://www8.gsb.columbia.edu/sites/valueinvesting/files/files/Graham%20%26%20Doddsville%20-%20Issue%2015%20-%20Spring%202012.pdf
131
There are many ways – some more reliable
than others – to understand a company
during the diligence process
Relatively less Conference

Annual Meetings with
reliable call
reports management
sources, transcripts
produced by
the company
Regulatory Investor Press

filings presentations releases
Relatively
more reliable Ex-
Competitors Vendors
sources, not employees
‘managed’ by
the company
Physical
Industry
Customers visits to
experts
stores
132
A short detour: evidence and
validating a hypothesis
No amount of evidence can conclusively prove a hypothesis
Evidence
Prove a
Evidence hypothesis
Evidence Evidence
… but a single piece of evidence can disprove a hypothesis
Evidence Disprove a
hypothesis
133
In 1650, you could not confirm the
hypothesis that all swans are white…
In the mid 1600s, every

person in London believed
that all swans were white
in colour – those were the
only colour they had ever
seen!
134
… but the sighting of a black swan in
1697 (in Australia) disproved it
The metaphor of the

‘black swan’ was
popularized by Nassim
Taleb in his must-read
books ‘Fooled by
Randomness’ and ‘The
Black Swan’
135
In summary: evidence and validating
a hypothesis
“No amount of experimentation can ever prove me right; a single

experiment can prove me wrong.”
- Attributed to Albert Einstein
136
The right way to test investment
hypotheses
During diligence, investors tend to seek out evidence that
confirms their hypothesis…
Evidence
Prove a
Evidence hypothesis
Evidence Evidence
… while they should instead actively be seeking out

DISCONFIRMING evidence which is contrary to their hypothesis
Evidence Disprove a
hypothesis
We will look at this issue in greater detail in session 11, but it is

important to keep this in mind through the rest of the course
137
138

Applied Value Investing Session 1

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Applied Value Investing Session 1

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Session 1

Help build the technical

Congratulations! You have recently

You are encouraged to present an

How would you go about it?

Note: A hat tip, and a thank you is due to

Consider this course as a kind of training

• During working years, set aside a portion of salary or

BSE Sensex, monthly, 1980 to 2017

Source: finance.yahoo.com, bseindia.com

Period Change in Period Change in

12/1972 to 9/1974 -46% 3/1992 to 4/1993 -50%

10/2007 to 11/2008 -42% 2/2000 to 9/2001 -48%

11/1968 to 6/1970 -33% 7/1997 to 11/1998 -35%

8/1987 to 11/1987 -30% 8/1994 to 4/1995 -32%

11/1980 to 7/1982 -24% 12/2010 to 12/2011 -25%

12/1961 to 6/1962 -24% 4/1996 to 11/1996 -25%

What would you do after a 50% loss?

Day traders buy

1-2 years Most institutional

While it is hard to beat a market index (especially net of fees),

Source: Data from bseindia.com 48

Source: Data from bseindia.com 49

• Most of the capital that investment managers receive from their

We will revisit these issues in session 11

Stocks represent part-ownership of a business (so try to

• Imagine you have a partner called Mr. Market in your business.

• Ted Williams was one of the greatest batters in the

• Why buy with a ‘margin of safety’

• Buying with a large margin of safety can be a

Periods where the Fama-French value

Buying ‘cheap stocks’ does outperform on average,

Source: The Warren Buffett portfolio by Robert G. Hagstrom

Source: The Warren Buffett portfolio by Robert G. Hagstrom

Buy good businesses for Buy at reasonable prices,

Buy good businesses at reasonable prices,

• There is good evidence that buying ‘cheap

• Many value investors today try to invest in high

This is a good book for anyone interested in

Source: Quantitative value by Wesley R. Gray and Tobias E. Carlisle

But what about

Source: Quantitative value by Wesley R. Gray and Tobias E. Carlisle

Unreliable financial • The implicit assumption while using valuation

• A company that has a high risk of bankruptcy is at

Source: Quantitative value by Wesley R. Gray and Tobias E. Carlisle

• Remove stocks that have risk of being potential frauds and

• Find the cheapest stocks by ranking stocks based on EBIT

• Identify stocks that are strong businesses, reflected in

Source: Quantitative value by Wesley R. Gray and Tobias E. Carlisle

• The Magic Formula and Gray / Carlisle methods

• Value investing is psychologically hard to do - a number of deep-seated

• Value can under-perform for extended periods, while the clients of an

We will dive into the psychological biases and institutional issues in

Value of Present Value of

Investments increase Investments may

Indicative illustration of the share of AIP and PVGO in ‘intrinsic value’

Assets in place PVGO

When AIP as % of ‘intrinsic value’

is very high, there are few growth

Learnings from business diligence feed

Learnings from business diligence feed

Your view of the long-

Company High likelihood

Source: Decision-making for investors by Michael Mauboussin, at http://www.retailinvestor.org/pdf/decisionmaking.pdf