The Five Elements of Value

Many people will say that they are either Value Investors or Growth Investors. Many of the greatest investors are both (and in a sense they are two sides of the same coin). Being a great investor often involves changing a winning game. What has worked in investing in the recent past will not necessarily work in the future. So it may be important (especially for very large investors) to reevaluate strategies.

Where I differ from many investors is that I consider Margins of Safety to be more than just a discounted purchase price. I like to incorporate all the ways that an investor can reduce risk and increase returns into my investment strategy. There are five Elements of Value that I have identified. The more elements of value the better off the investor is. No one element is necessarily better than the other.

When investing in companies there are Five Elements of Value or five ways to establish Margins of Safety:

  • Cheapness

  • Growth

  • Quality

  • Control

  • Catalysts/Liquidity

Cheapness

This, along with growth, is one of the easiest ways to conceptually think about reducing risk. Buying a company at 2x earnings is way less risky than buying a company at 20x earnings almost regardless of growth. If you purchased an entire company at 2x earnings the per year returns assuming no growth would be 50% on the investment. If you purchased an entire company at 20x eanings the company would need to grow earnings by 1000% in the first year in order to equal the returns for the company bought at 2x which for all but a handful of companies is impossible. Of course in the long term if the company bought at 20x earnings continues to grow the returns may eventually be larger than the company bought at 2x earnings.

Growth

Buy a company and get the growth for free. A company that sums up this strategy fairly well is Alphabet. You could have bought the company in the recent past at prices that approximate the value of the company’s search division alone and got all the other “moonshots” for free.

Growth investing is probably the area where most new investors swarm to when they first start investing. It can be a very difficult path to follow with many investments in this category often becoming massive losers (depending on the strategy). A key to the more aggressive growth approach is to diversify more heavily than one would a regular portfolio so that the losers are more than taken care of by the winners. For the growth category it is also important to have the potential for astronomical returns. In other words whereas in the typical investment in value might require a 20-50% margin of safety an investment in a growth investment may require that the company has the potential to become 10-100x larger as a company.

Another way to reduce risk in this category would be to focus only on higher quality investments.

Quality

Quality means many things to many people. It could mean the quality of a companies balance sheet or it could be the moat and defensive characteristics of a security. In the bond realm it is the creditworthiness of the issue. In the stock market it may be the makeup of the companies underlying assets such as a great brand or the location of owned real estate. The highest quality asset of a company to the deep value investor is cash. The highest quality asset to a growth investor is something that gives the company a competitive advantage.

A company that has a return on invested capital of 20% and can maintain that for a period of 20 years is much better than a company with a return on capital of 10% for the same period of time. Even if the purchase price is substantially less for the company with lower Returns on Capital the company that has the higher return will eventually be a better investment in the long run.

A quality company may be able to grow or at least hold ground during a recession. Certain quality companies even welcome a recession so that they can take advantage of former competitors that are in a weakened position.

Control

Control is a fairly apparent way to achieve safety in an investment. The trouble is outside of real estate or startup businesses most people will never exercise this element of value. An activist investor with a large enough stake can effectively reduce his or her risk by attempting to influence the companies board of directors. If an activist buys into a turnaround situation and the company fails to perform the activist can change management or even sell the company.

Another aspect of control is that if an appropriate management team is in charge then the investment may have additional aspects of safety. For example Buffett has put in place a policy to purchase Berkshire stock if the stock runs under a certain multiple of book value. If one were to purchase stock slightly above that multiple then the downside is effectively limited by a put option. If an outstanding CEO/capital allocator steps into a dire situation at a struggling company then there is an added level of safety to the investment over a crappy CEO/capital allocator.

Catalysts/Liquidity

Catalysts are important to any investment. They are particularly important, however, to investments in bargain issues. Catalysts can be anything from an up-listing to spin-offs and mergers to liquidations.

Liquidity is meant to account for how quickly you can get out of an investment but also how quickly an investment is returned. If you invest in a merger arbitrage deal you should account for how quickly you can get your money back. Obviously a 5% return in 1 month is better than a 20% return in one year and in a sense less risky because money will be returned to you more quickly.

Illiquid investments are often referred to negatively. But most of the time illiquidity is more than made up for with a lower stock or bond price. If the returns are the same for both an illiquid and a liquid investment then one should obviously choose the liquid investment but that is seldom ever the case when comparing very similar situations.

Private business ownership is a different story. I have heard many stories of people running into trouble and not being able to save their businesses or sell them before they went under. Private business ownership is probably not more inherently risky than owning a smaller piece of a similar publicly traded company BUT they do have different risks. Illiquidity discounts can be more than made up for with control premiums.

There is no Magic Formula in investing or Business (other than THE Magic Formula)

There is no magic formula to investing or anything. That being said, there are a few guidelines that (much like bumpers on a bowling lane) can save you from going into the gutter. These guidelines aren’t 100% guarantees but will definitely put the odds in your favor.

First a note to new investors: When first starting out in investing it’s important to decide how active or passive you want to be in your investing endeavors. If you are going to actively pick stocks/investments you should know that this will take up at least a couple hours a week and may not result in you performing as well as you could by investing in a low cost index fund. The passive approach is usually an allocation approach where you or your adviser (which may or may not be a robot) decides on a breakdown between stocks or bonds and re-balances on a regular schedule. The active approach is one where the investor seeks out individual investments based on their own merit. The passive approach takes all investments given a simple criteria and buys them all. Even if they are dogs with fleas! Passive investors usually choose the S&P 500 but a more favorable category given the historical out-performance would most likely be a small cap-value ETF with sufficient diversification.

When first starting out in investing, rather than going through the specific details of what makes an investment a good deal in today’s market, it’s easier to look at individual characteristics of investments that have done well in the past.

So, what has worked in investing?

In the stock market it is Value stocks, Small Capitalization/illiquidity, certain special situations, Insider purchases or company buybacks and in a smaller subset of investments large earnings growth and high quality.

Growth Vs. Value

Low price/(earnings, assets, cash flow) investments are usually called value investments whereas low dividend yields and high price to earnings etc. are usually called popular or growth investments. Growth stocks may or may not also be associated with high returns on invested capital (ROIC) and high returns on equity (ROE) whereas value stocks may be low in regards to both categories. (Value stocks may have a low ROE simply because they have a lot of excess capital). There are many sub-styles of value investing where investors may or may not be concerned with a company being of high quality or not. Quality investing can be defined separately as investing in companies that are high ROE and ROIC or have large economic moats that competitors may find hard to penetrate.

On average and over long periods of time: value stocks perform better than growth stocks. The following chart sums this up fairly well.

Annual Returns S&P 500 Large Cap Growth Large Cap Value Small Cap Growth Small Cap Value
1992 7.62 5.94 11.12 7.84 23.42
1993 10.08 6.77 15.67 15.62 19.92
1994 1.32 0.9 -0.9 -2.06 -1.13
1995 37.58 36.05 35.8 33.77 23.58
1996 22.96 21.84 21.36 14.16 20.8
1997 33.36 29.04 31.83 12.09 30.3
1998 28.58 37.59 16.94 1.1 -6.58
1999 21.04 33.99 9.07 52.13 0.2
2000 -9.1 -21.05 4.48 -15.34 19.47
2001 -11.89 -22.15 -7.09 -11.1 15.61
2002 -22.1 -28 -17.6 -28.95 -11.32
2003 28.68 28.36 29.02 46.66 46.78
2004 10.88 6.88 14.25 12.55 21.45
2005 4.91 6.42 6.66 4.75 6.08
2006 15.79 6.9 20.27 12 20.31
2007 5.49 13.39 1.15 8.37 -7.18
2008 -37 -39.92 -36.93 -40.58 -30.87
2009 26.46 37.86 22.33 36.25 26.79
2010 15.06 15.92 14.27 27.59 25.12
2011 2.11 -0.13 -0.89 -3.16 -5.16
2012 16 15.59 16.69 14.77 16.81
2013 32.39 34.45 32.88 42.15 34.89
2014 13.69 11.69 12.23 3.79 3.63
2015 1.38 5.64 -3.74 -1.27 -7.32
2016 11.96 16.47 25.59 27.97 40.33
Average 10.690 10.418 10.978 10.844 13.037

So for the past 25 years large cap value has outperformed the S&P 500 (the standard passive investment vehicle for investors) by a measly couple hundred basis points. Whereas value has outperformed by 2 and 1/2 percent. It’s interesting to note that growth stocks on average have under-performed by a couple hundred basis points. During certain time periods, however, growth outperformed, for instance, the several years before the dot-com bust. All of these funds re-balance each year so that the constituents of the value or growth portfolios are not necessarily the same as they were the year before.

As unbelievable as it sounds. There are many companies available for sale in the stock market that are so cheap that their cash minus all of their liabilities is higher than the market capitalization of the company. For example a company may have $105m in cash and 5m in total liabilities with 50m shares outstanding. The company would have net cash of $2/share but the stock may trade for only $1. If the company makes money and is expected to into the future then the investment is a safe and cheap investment.

Many of the best individual stock investments of all time are companies that could be placed in the growth category. It would be hard to make 100x on your money from many deep value investments. To paraphrase famous Warren Buffett sidekick Charlie Munger: when you invest in a company that has a return on capital of 6% for 40 years you can’t expect to make much more than 6% a year. In other words in the short run it is very shrewd to hold onto value stocks but in the long run it probably isn’t. This brings up the issue with individual value stocks is that they can become value traps. If a company is worth $10 but never grows in value an investor that purchases the stock at $5 wouldn’t earn a decent return at all if the stock takes 20 years to realize the $10 value.

This is where THE Magic Formula comes in. The Magic Formula is a construct of Joel Greenblatt, an investor who has one of the best long term track records of all time. Taking notes from Warren Buffett’s investing style the screener attempts to find value stocks that are also high quality. The magic formula finds 30 companies ranked by the lowest earnings yield (defined as EBIT/Enterprise value) and highest returns on capital (defined as net fixed assets + working capital). The Magic Formula outperforms the market in most time periods studied. The interesting things is that, also in most periods, the Magic Formula itself under-performs just the simple earnings yield criterion by itself. This realization was tackled by Tobias Carlisle in his book, “Deep Value.”

Small Capitalization/Illiquidity

As we can also see from the previous chart. Small cap stocks of any variety usually outperform larger cap stocks. The reasons for this may be institutional to the fund management business. A fund manager with a $10b with 100 1% positions would invest $100m in each position. They can’t easily invest in many companies under $1b in market cap because they would own over 10% or more of a company which would limit the managers liquidity.

Illiquidity in and of itself is a great portender to returns solely because many investors psychologically are uninterested in being tangled up in an investment which they can’t sell at a moments notice. To longer term investors this is of no concern, particularly if the investment is a purchase at what may be considered well below what the Private Market Value of the company is. Another way to think about how irrationally the dislike of illiquidity is is that if something terrible bad happens to the company no matter if the company is illiquid or not the stock will drop.

Special Situations

This is somewhat of a catchall category that includes (and is not limited to) the following investments situations:

  • Merger Arbitrage
    • Standard Merger Arbitrage
    • Premergers
    • Bidding Wars
    • Appraisals
  • Spin-offs
  • Rights Offerings
  • Liquidations
  • Mutual Conversions

Merger Arbitrage occurs after a merger is announced between 2 (or occasionally more) companies. Mergers can be for cash, stock in the acquiring company or other securities of the acquiring company. The returns from this style of investment are usually small on an actual basis but since the investment is not tied up for a long period of time the annual returns may be substantially higher. If a merger is announced and the indicated return is 5% in 1 month then the annual return on that investment is nearly 80% on a compound basis.

Premergers are similar to merger arbitrage but they occur before a definitive agreement is in place. Premergers often times have an activist on-board of the company agitating to have the company sold at a premium.

Bidding Wars are among the best investment opportunities available in all of the markets. These occur when there are multiple acquirers that have made their intentions public. Occasionally astronomical returns can be made in very short periods of time.

Appraisal Arbitrage occurs when investors believe that the acquiring company of the investor is buying the target company for way below fair value. Investors in the target company can sue (or threaten to sue) in order to receive a greater return. Investors have occasionally been able to reap substantial returns from this strategy but investors have in very few cases actually received a lower price than the original merger price.

Spin-offs occur when a company with multiple divisions decides to simplify it’s business. A company will dividend stock in a subsidiary company so that the owner of the parent company will end up owning two different stocks at the end of the transaction. There are many angles to think about with this category which I will outline in other posts.

Rights offerings. A rights offering is when a company raises money from current shareholders of the stock. Rights offerings are particularly powerful when a company is in deep financial distress and the proceeds of the rights offering are used to pay off indebtedness.

Liquidations occur when a company decides to distribute assets to shareholders. The company may sell divisions or individual salable assets and then pay out dividends to investors. This is a particularly under-followed area of investing.

Mutual Conversions are a great opportunity for the current investment landscape. Mutual companies are companies which are owned by customers or suppliers. Most mutual conversion candidates are either insurance or bank concerns. The key about mutual conversions is that there are currently no stockholders of the company so when the company decides to IPO the proceeds go directly to the company and not to a third party. If a company IPOs at $10/ share you essentially get your $10 back and buy the company for free (minus a few investment banking fees). The initial opportunity to get in before the IPO is not often available for the outside investor. But the outside investor can take advantage of the fact that 70% of Mutual companies are eventually taken over at substantial premiums after consummation of a 3 year moratorium as required by law. This tied into the fact that banking concerns are already in the focus of the private markets only adds to the appeal.

Insider Purchases/Buybacks

Large insider purchases are an obvious indicator that an investment is cheap or it is a “tell” that a transaction may be undertaken in the future. The most recent newsworthy example of this was Jamie Dimon’s multi-million dollar purchase of JP Morgan stock during a lull in the early months of 2016. An investor following Dimon’s move would have made a ~50% return in a short amount of time.

Buybacks CAN also be a great indicator of future returns. In aggregate most companies make terrible capital allocation mistakes but a select few managers have delivered ginormous return through well-timed share buybacks. John Malone being perhaps one of the best users of this particular capital allocation tool. Several of the companies that Malone controls have bought back more than 30% of their stock in the past 10 years. An investment in Malone’s TCI corp and later various Liberty Media vehicles would have outperformed Buffett’s Berkshire Hathaway by more than 5-10% per year.

Buybacks can also be a signal in so called “mop-up” situations. A mop-up situation is where a company owns a significant portion of a publicly traded company say 89%. A company may announce a buyback of 1% in order to conduct a short-form merger. A past example of this activity was American Independence Holdings which was majority owned by Independence Holding. They initiated a tender offer which foretold an eventual take out at a price several times the going rate of the initial tender offer.

This about wraps up the preliminary post. In the future I’m going to elaborate more on the concepts mentioned above as well as write about investing in specific stocks, real estate, starting businesses and overall on the skills and knowledge necessary to become rich.