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Buying a dollar for 50 cents

An introduction to Value Investing


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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.

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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.

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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


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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.
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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)

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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”

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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

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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.
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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%)
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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.

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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

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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
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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?
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Investing
• 4 Steps
– Search Strategy

– Valuation

– Follow up

– Risk management

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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/search-
strategy/)

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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
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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

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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

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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.

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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.
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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.

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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,

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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?

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