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TAKING STOCK
Professor Bruce Greenwald believes that value investing is all about buying bargains as it’s difficult for investors to outperform the market
Professor Bruce C N Greenwald, professor of finance and asset management at Columbia Business School, is the academic Director of the Heilbrunn Center for Graham & Dodd Investing. Described by the New York Times as “a guru to Wall Street’s gurus,” Greenwald is an authority on value investing. Greenwald has been recognised for his outstanding teaching abilities. He has been the recipient of numerous awards, including the Columbia University Presidential Teaching Award which honors the best of Columbia’s teachers. His classes are consistently oversubscribed, with more than 650 students taking his courses every year in subjects such as Value Investing, Economics of Strategic Behavior, Globalization of Markets, and Strategic Management of Media. He has co-authored the hugely popular “Value Investing: From Graham to Buffett and Beyond” (2001) and “Competition Demystified: A Radically Simplified Approach to Business Strategy” (2005). In an interaction with Outlook Profit, Greenwald talks about, among other things, how a valuation model used by value investors is far more reliable than the traditional discounted cash-flow model used by most analysts. Excerpts: Can you tell us why value investing can result in out performance? Value investing, developed by Benjamin Graham and David Dodd at Columbia University, and practised by Warren Buffett and Gabelli among others has historically outperformed the market by 3-5 per cent. Value investing is all about buying bargains. The efficient market theory says that investors can’t really do better than the market, so it’s best to diversify, minimise your transaction cost and not try to guess which stocks are going to go up. What people have discovered is that there are, in fact, ways of statistically picking stocks that can outperform the market. But when you go in the investment business, notwithstanding the statistical evidence, there is an unavoidable
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way in which markets are efficient, and it is this there are two sides to every trade and one of us is always wrong. Therefore, one way to think of efficiency is to see what it is that makes your portfolio decisions better the market. Basically, what Ben Graham recognised is that there were ways to look at cheap stocks, many of which were practically obscure. Statistics shows these kinds of stocks ultimately outperform the market. In every society, people buy lottery tickets which have always been a crappy investment. People will overpay for the dream and the reverse side of that is something that looks ugly, so people will irrationally sell off or shy away from it. If, I am a fund manager, I’m going to lose the funds under management if I under-perform in a significant way. So I copy everybody and buy the same lottery-ticket stocks which are going to get bid up more and more. It is an echo chamber that amplifies these behavioral irrationalities and people never learn. Can you tell us about the method you use to arrive at the correct value of a stock? When you buy a stock, when you think you have found an opportunity, it’s cheap, it’s ignored, and it’s a small-cap stock. If you want to decide whether to buy it or not, the conventional way to go about it would be to do a discounted cash flow for 6-7 years, by getting a terminal value and calculating the net present value of all future inflows. Now in theory, if you know the right numbers, this will give you the right answers. In practice it is an incredibly stupid way to value stocks. And I think there three reasons for that -- two are quite obvious and one, a little subtle. The most obvious reason why it’s a
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bad way to value a stock is that to take the sum of discounted cash flows, you have to first estimate near-term cash flows which is very good information; then estimate the distant-year cash flow; finally, you have to find out the terminal value, which is very bad information because you don’t really know what that value is. And when you add bad information to good information, you end up with bad information. So what you want is a different procedure where you can say ‘this is value that I’m confident of’; the second piece is intermediate quality information that I have semi-confidence in; and the third piece where there are mistakes and on which I’m not going to rely on that much. Discounted models don’t do that. The second thing is that there is one very important piece of information that this model throws away is the balance sheet information. The balance sheet describes the company and any asset it has. These are very important elements to think about when you are buying assets, yet DCF models ignore the balance sheet. The third reason is a little more subtle and I will explain it in the context of Tata Motors and their 1 lakh rupee car. If you wanted to value that enterprise, you would have to estimate sales over the next 15 years, estimate margins which is a number, estimate capital intensity which is a ratio, estimate the cost of capital which you may not be able to do accurately especially as you go deep into the future. A valuation procedure is a machine

into which you take assumptions like that, put them and crank it up and wait for it to throw out a valuation. Now if the assumptions are bad, you won’t get a good answer. If it was the best you could do, that would be fine because you got to put a number to it. So how do you deal with it? There are assumptions that we can make with confidence about the future of the Tata Motors’ car. For example, will there be a market for the 1 lakh rupee car 15 years from now? We think there will be; this is an economically viable market. The second question is do we think that Tata Motors is the only one who can do this? Bajaj just announced that they are going to do it as well, so has Honda. So Tata Motors is going to have no competitive advantage in that market and 15 years from now everybody is going to be making these cars. Those are strategic assumptions we like to use. So what Graham and Dodd developed although they were never explicit about it is to organise the information by way of a ‘reliability class’. You start with the most reliable information that is the balance sheet. For instance, in the case of Tata Motors which is in a viable industry, sooner or later those assets will have to be reproduced or replaced in the most efficient manner. Just work down the balance sheet and you can look at the reproduction value. If the company is in a viable industry, compute the asset value and if it’s in an unviable industry, look at the liquidation value.

can’t copy. That is a barrier to entry, so Then what you look at is the nearthe key research question is looking at term earnings power of the business. the structure of competitive advantage Let’s forget growth altogether and we in the market and finding out whether average out for the business cycle and that gap is sustainable. we undo all accounting fallacies, we get The other possibility is that the aswhat is the real distributable cash flow. set reproduction value is 5 billion ruRather than using accounting deprecipees and the business earns 5 billion ation we ask, what will we have to pay rupees. That’s exactly what you would in investment to return the company expect to see if there at the end of the year were no barriers to to the state at which it entry and Tata Motors was in the beginning If you want to decide didn’t enjoy any comof the year? That is a whether to buy a petitive advantages. much better number Now you have two because that is what stock or not, the independent obseryou need to really reconventional way to vations on what that invest. go about it would be company is worth and So you get a good to do a discounted that is going to be far idea of what the aftermore reliable than tax earnings power of cash flow for 6-7 DCF . the business is and years, by getting a The third possibilif it went on forever, terminal value and ity is the assets are what would the busicalculating the net worth 10 billion runess be worth? This pees and earnings are is your second piece present value 5 billion rupees. Well, of most reliable inforassuming that it is not mation. Two things a dying industry and can happen: one is you have not over-esthe day the earning timated the value of the assets, that’s power is 10 billion rupees (say for Tata got to be crappy management because Motors) and the assets are worth 5 bilthey are taking 10 bn of assets and prolion rupees. Since there are no barriers ducing 5 bn of earnings. In this case, to entry in this industry, people could what you care about is whether you create 10 billion in earnings for 5 bilcan get rid of these guys. And so you’re lion rupees in investments and that’s going to study the proxy statements; when the Bajaj and the other foreign the activist investor will focus on that. car companies are going to come in. Notice that in each case, it ties the ultiIf you saw that and if there was a mate valuation to a critical single quesdiscrepancy between earnings power tion. value and asset value and the earnings power are higher, then Tata Motors better do something that other people How do you value growth?

What I told you is our basic framework. We haven’t talked about growth at all because it a complicated question. What you have to understand about growth is while everybody says growth is good, it is not. It is a two-edged sword. A growing income stream is worth a lot more than a flat income stream. But usually to get the growing income stream you have to invest. And the more you invest, the smaller the distributable income is. Growth, in cases where the asset value is greater than the earnings power value, is actually bad. I don’t care if I’m in India or China. If it is a crappy management investing money in a stupid way or at a competitive disadvantage, growth is your enemy. Let us take the case of Tata Motors, where there are no barriers to entry. I am going to invest 10 billion rupees and I have to pay 10 per cent to the people who provided it. If competition is out there, then basically it is not going to earn two billion a year because competition will enter and eliminate that. So I am going to earn a billion rupees a year and I pay a billion to the people who provided that capital. Growth has no value here. That’s the situation in companies like Mittal Steel which are expanding capacity in India while demand is expected to grow by 12 per cent or so, which means they will not make much money. So when you look at growth in India, you have to be very selective. There is also a lot of stuff that Reliance Industries is doing by setting up retail all over India and this is also going to destroy value. The growth that creates value is only where you are protected by barriers to entry - where you pay 10 per cent and get 20 per cent, where earnings power value is decisively greater than as13 June 2008 Outlook PROFIT

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ery country, the toothpaste segment has a single dominant competitor, and that’s because people use the same toothpaste forever and ever. They don’t switch their colas easily either: look at Coca Cola – people have been drinking it for a hundred years now. Similarly, people don’t switch cigarettes easily. But shampoos, they switch all the time. The shampoo business is, therefore, more like steel! The point here is that people who try to compete without a competitive advantage will usually lose their shirts. The famous example of that is AT&T, which decided in 1982 to go after IBM in the information processing business. IBM had captive customers in the business and enjoyed big economies of scale. AT&T did not have either but still it was considered a ‘strong competitor’ because it had tons of money. In the next fifteen years or so, AT&T lost about $100 billion and it’s no longer even there. set value. Take Hindustan Unilever which enjoys economies of scale and also commands the loyalty of customers. If you are 50 per cent of the market and competition has only 10 per cent of the market, you could kill them and still make a ton of money. Unilever India has got all powerful competitive advantages and they are going to make money out of the growing market whereas Mittal Steel is a very different story. Two prime drivers for Indian software service companies have been a depreciating currency and cheap labour. Would you call these competitive advantages? Ask yourself what elements constitute as barriers to entry and these are the competitive advantages that an incumbent enjoys. There are three types of competitive advantage: customer captivity; proprietary technology; and economies of scale. The strength or weakness of a currency cannot be a competitive advantage. If a currency is undervalued or overvalued, the situation will soon correct itself and the advantage will go away. The low cost you described is not an advantage. You have to differentiate between what is good for the country and an individual company. Besides, competitive advantage has to be measured against your strongest competitors, not your weakest ones. They do not have proprietary technology or a cost advantage over the rest of the Indian players. But what they do have is customer captivity which is a relatively useful competitive advanOutlook PROFIT 13 June 2008

tage. These companies have long-term customer relationships which are going to be hard to displace. But over time, their customers would look to source the same services more cheaply from other service providers. If you look at the top 10 Chinese companies by market value (remember they all have got cheap labour and great manufacturing capabilities) none of them are manufacturing companies – instead, they are natural resources companies. There are only two manufacturing companies in the top 25: Shanghai Motors and China FAW and they make 2-4 per cent on equity. They are not profitable as they have to compete with other Chinese companies. So China is doing great, wages are rising and output is expanding but are companies profitable? No, because they have to compete. Despite boasting powerful brands, some consumer goods companies compete fiercely in the market place. Does that not destroy value? Look at their margins and return on capital -- it has been going up. People tell that story because in some industries it matters but when it comes to consumer goods, people are fanatically loyal, for example, to their detergents. P&G can work like crazy but they are going to see stable market shares at best. So for these companies, you have to look at each product segments and consumer behaviour in that segment, not the company as a whole. By the way, consumer behaviour is surprisingly uniform across the world. In ev-

So do you mean new companies can’t challenge established players? They can but they need to act smart. The challenger has to attack the incumbent where the latter is the weakest. So if P&G was smart, they would look at markets where Unilever has the smallest share geographically and would set up base there. When Pepsi went up against Coke, they targeted the new generation – who had not taken to the drink yet. They targeted the north-east and the mid-west where Coke was the weakest. They targeted grocery stores where Coke did not have a distribution network. Smart companies don’t run head-on with a competitive disadvantage. So these dominant companies are safer bets? It depends on what multiples they trade at. But they are safer because they have competitive advantages and their growth is valuable. For the secondary companies trying to fight their way in, growth, more often, has negative value because they are competing with a disadvantage. How do you factor in liquidity into stock valuations? We don’t! We ignore it completely. Liquidity gets built into the price, it doesn’t get built into the value. Value is concerned with what is this thing going to earn? What does it cost to reproduce the assets? These are the fundamentals. For value investors, liquidity is not a concern and macro is not a concern. p

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Valuable resources
BOOKS
The Intelligent Investor –Benjamin Graham’s The Intelligent Investor still considered the Bible of value investing – a book no value investor can start without. Security Analysis – Comprises Benjamin Graham’s courses in Columbia University. Originally part of Dodd’s notes that he transcribed during Graham’s classes. Interpretation of Financial Statements – Graham’s first book for the non- finance people. It instructs how to read the balance sheet and the income statement. Janet Lowe’s The Rediscovered Benjamin Graham – Treasure trove of Graham’s articles, lectures and interviews that he gave. Straight from the Master. Must Have! The Memoirs of the Dean of Wall Street by Benjamin Graham– Again straight from the Master himself. Contains his memoirs as he traces back his life through all its ups and downs. Benjamin Graham on Value Investing: Lessons from the Dean of Wall Street by Janet Lowe – A concise yet comprehensive coverage of Graham’s life, his strategies and his key lessons.

GRAHAM’S DISCIPLES – VALUE INVESTORS’ HALL OF FAME
Warren Buffett – The Undisputed successor and most successful value investor everyone knows about. Read the Berkshire Hathaway Annual Letters if you want to learn from the most successful investor of all times, straight from Warren at www.berkshirehathaway.com/ letters/letters.html Christopher H Browne author of “The Little Book of Value Investing”. Read the Tweedy, Browne Letters and Articles resources available at www.tweedy.com/content. asp?pageref=reports Martin J Whitman – Legendary value investor. Read his letters to shareholders of Third Avenue Funds to gain profitable insight into value investing at www.thirdavenuefunds. com/taf/aboutusshareholder-letters.html Other famous value investors that you must read up on include: William Ruane of the Sequoia Fund, Jean-Marie Eveillard of First Eagle Funds, Walter and Edwin Schloss

PAPERS AND LETTERS
The Original Graham and Newman Letters brings alive the Graham Newman Corporation, the stocks that they bought, the times they operated in and their performances. Benjamin Graham: The Father of Financial Analysis by Irving Kahn and Robert D. Milne, 1977. What has worked in Investing: Studies of Investment Approaches and Characteristics Associated with Exceptional Returns by Tweedy, Browne Company LLC – A study of various approaches to investing and their respective performances. Testing Benjamin Graham’s Net Current Asset Value Strategy in London by Ying Xiao and Glen C Arnold –Their study done for the period 1981 to 2005 on stocks trading with net current assets/market value greater than 1.5 found them giving annualised return up to 19.7 per cent per year over five holding years. The Superinvestors of Grahamand-Doddsville by Warren Buffett – Based on his 1984 presentation to the Columbia University – challenges the Efficient market hypothesis and Graham’s contribution to making money through market inefficiencies. Grahams lectures from the series entitled Current Problems in Security Analysis that Graham presented at the New York Institute of Finance from September 1946 to February 1947 available at www.wiley.com/ legacy/products/subject/finance/ bgraham/index.html

WEB RESOURCES AND BLOGS
The Heilbrunn Center for Graham & Dodd Investing has a page on profiles on various value investors at www. gsb.columbia.edu/valueinvesting/ schlossarchives/public www.gsb.columbia.edu/students/organizations/cima/newsletter.html for the Graham and Doddsville newsletters www.gannononinvesting.com Value investing blog and value investing podcast influenced by Benjamin Graham, Joel Greenblatt, and Warren Buffett’s value investing model. www.stocksbelowncav.blogspot.com - Cheap stocks: Below net current asset value, real estate, and other value strategies www.grahaminvestor.com Value Investing Benjamin Graham style http://valueinvestingresource. blogspot.com Value investing resources www.moderngraham.com Devoted to the study and modernisation of the theories of Graham and Buffett.

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