Value Investing Explained in 5 Levels of Difficulty

Summary

This video script offers an in-depth exploration of value investing, a proven investment philosophy that has enriched investors like Warren Buffett. It simplifies the concept by emphasizing the importance of buying assets at a bargain and understanding cash flows. The script delves into the intricacies of identifying true bargains through discounted cash flow analysis, the concept of intrinsic value, and the significance of a margin of safety. It also highlights the value investor's contrarian approach to seeking undervalued assets, often overlooked by the market.

Takeaways

• 😀 Value investing is a reliable and proven investment philosophy that has created great fortunes for many investors over the past century.
• 🔍 The core principle of value investing is to search for assets that can generate cash in the future and insist on getting a bargain price for them.
• 💰 Assets can include shares in companies, loans, real estate, and even more obscure investments like claims against a Ponzi scheme.
• 🛍️ Value investors are like shopaholics, looking for opportunities to buy assets when they are undervalued, akin to buying one-dollar bills for 50 cents.
• 🔄 Selling an asset occurs when it is no longer a bargain, which is when others are willing to pay close to the asset's intrinsic value.
• 💼 Value investors follow the flow of cash, looking at earnings per share for stocks, interest payments for bonds, and tenant payments for real estate.
• 📈 The E/P ratio is preferred over the P/E ratio for comparing investments as it directly relates to the cash an asset generates.
• 🎨 The intrinsic value of an investment is its value independent of market price, and value investors are not dependent on the resale price for profit.
• 📉 Value investors consider the time value of money, using discounted cash flow (DCF) analysis to determine an asset's worth today.
• 🛡️ A margin of safety is crucial in value investing, ensuring that the investment is undervalued enough to account for imprecision in valuation and unpredictability of the future.
• 🤔 The greatest value investors often avoid rigid DCF models with many decimal points, instead relying on a strong sense of an investment's potential and safety.
• 🏆 Value investors look for assets that are disliked or overlooked, as these are more likely to offer true bargains and a margin of safety.

Q & A

What is the core principle of value investing as explained in the script?

The core principle of value investing is to search for assets that can generate cash in the future and to buy them at a bargain price, ensuring a margin of safety.

Why is the E/P ratio considered better than the P/E ratio for value investors?

The E/P ratio is considered better because it is easier to compare to investments outside the universe of stocks and it directly reflects the return on investment in terms of earnings per share over the price paid per share.

What is the difference between a value investor and a speculator according to the script?

A value investor focuses on assets with intrinsic value and cash flows, and is not dependent on the resale price. A speculator, on the other hand, is more focused on the potential for capital gains through resale at a higher price.

What is the concept of 'intrinsic value' in the context of value investing?

Intrinsic value is the value of an investment independent of its market price, essentially the value of an asset as if it could never be sold, and it is a key consideration for value investors.

How does the time value of money play a role in value investing?

The time value of money is central to value investing as it acknowledges that cash received in the future is worth less than cash received today. This concept is applied through discounted cash flow (DCF) analysis to determine the present value of future cash flows.

What is the significance of a 'margin of safety' in value investing?

A margin of safety is necessary because valuation is imprecise, the future is unpredictable, and investors can make mistakes. It is the buffer that distinguishes value investors from others by ensuring they buy assets at a price significantly below their estimated intrinsic value.

Why do value investors look for assets that are disliked or overlooked?

Value investors look for disliked or overlooked assets because these are more likely to be undervalued and available at a discount, providing a larger margin of safety and potential for higher returns.

How does the script suggest finding overlooked assets for value investing?

The script suggests several methods, such as looking at lists of the biggest stock market losers, screening for small market cap companies, using quantitative systems like Joel Greenblatt's Magic Formula, or seeking out companies in industries that are generally considered unattractive.

What are the five risks that the script mentions to consider before investing in public companies?

The five risks mentioned are competition, management, regulation, suppliers, and customers. These factors can all potentially affect the company's ability to generate future cash flows.

How does the script illustrate the concept of a bargain in value investing?

The script uses the analogy of an auction where $100 bills are bid up to nearly their face value, whereas a large sum in Indian rupees is undervalued and sold at a significant discount, highlighting the importance of finding true bargains in assets that others may overlook.

What is the final updated explanation of value investing provided in the script?

The final explanation is to 'buy disliked or overlooked assets with cheap discounted cash flows, using a margin of safety, and sell when there is no longer a margin of safety.'

Outlines

00:00

🚀 Introduction to Value Investing and Its Proven Success

This paragraph introduces the concept of value investing, highlighting its reliability as an investment philosophy. The speaker outlines the approach's success, mentioning notable investors like Warren Buffett and Benjamin Graham. The goal is to provide an overview of value investing, emphasizing its simplicity: buying undervalued assets at a bargain price. Examples of different types of assets are discussed, and the importance of selling when the asset is no longer a bargain is introduced.

05:06

💰 The Intrinsic Value of Assets and the Difference Between Investors and Speculators

This section contrasts value investing with speculation by exploring the concept of intrinsic value. Using an NFT purchase as an example, the script explains how value investors focus on cash flows, unlike speculators who rely on reselling assets for profit. The intrinsic value is presented as the cash flow an asset generates, independent of market price. The paragraph underscores that value investors prioritize steady cash flows, making them distinct from speculators.

10:10

📉 Understanding Risk and the Margin of Safety in Value Investing

This paragraph delves into the concept of risk in value investing, discussing how it relates to the possibility of permanent capital loss or inadequate returns. Using the examples of bonds, PepsiCo, and Kindred, it explores the factors that could impact the future cash flows of these investments, such as competition, management stability, and regulation. The idea of a 'margin of safety' is introduced as a crucial element in value investing, ensuring that investments are made with a sufficient cushion against risk.

15:12

🛒 Finding True Bargains in Overlooked and Disliked Assets

In this concluding section, the script explains how value investors search for overlooked or disliked assets to find true bargains. The analogy of an auction highlights how obvious value is often bid up, making it hard to find genuine bargains. The paragraph then discusses strategies used by famous value investors, such as Seth Klarman and Peter Lynch, to identify undervalued assets. The summary encapsulates the value investor’s approach: seeking out-of-favor assets with discounted cash flows, applying a margin of safety, and selling when this safety is no longer present.

Keywords

💡Value Investing

Value investing is a strategy that involves buying assets that appear to be trading for less than their intrinsic value, with the expectation that the market will eventually recognize their true worth. In the video, it is the central theme and is described as a reliable and proven investment philosophy that has created wealth for many investors. The script emphasizes the importance of seeking assets that can generate cash in the future and buying them at a bargain price.

💡Intrinsic Value

Intrinsic value refers to the true value of an investment, irrespective of its current market price. It is the concept that guides value investors in determining whether an asset is undervalued or not. The script mentions that the father of value investing, Benjamin Graham, would argue that an NFT with no cash flows has no intrinsic value, highlighting the importance of this concept in value investing.

💡Cash Flows

Cash flows are the streams of income that an investment generates over time. Value investors are particularly interested in the cash flow an asset can produce, as it is a key determinant of its value. The video script illustrates this with examples of different investments, such as US government bonds and shares in PepsiCo, and how they generate cash flows for investors.

💡Discounted Cash Flow (DCF)

Discounted Cash Flow analysis is a method used to evaluate the value of an investment by estimating the total amount of cash it will generate in the future and discounting it back to its present value. The script explains that value investors use DCF to understand how much an investment is worth today, taking into account the time value of money and the risk associated with future cash flows.

💡Margin of Safety

The margin of safety is a principle in value investing that emphasizes the importance of paying less for an investment than its calculated intrinsic value to account for uncertainties and potential mistakes in valuation. The script uses the concept to explain how value investors seek a buffer against loss and ensure that they are getting a true bargain.

💡Earnings Yield

Earnings yield is the inverse of the price-to-earnings (P/E) ratio and represents the return on investment in terms of earnings per share relative to the stock price. The video script points out that earnings yield is a useful metric for comparing investments across different asset classes and emphasizes its role in determining the attractiveness of an investment.

💡Risk

In the context of the video, risk is associated with the possibility of permanent capital loss or an inadequate return on investment. It is a fundamental consideration for value investors who aim to balance potential returns with the level of risk undertaken. The script discusses various aspects of risk, such as competition, management, regulation, suppliers, and customers, and how they can impact an investment's future cash flows.

💡Contrarian Investing

Contrarian investing involves making investment decisions that go against the prevailing sentiment or trend, with the belief that the consensus view is incorrect. The video script describes how value investors are contrarians, seeking out assets that are disliked or overlooked by the majority, as these are more likely to be undervalued.

💡Speculator

A speculator is someone who invests with the hope of making a profit by predicting price movements of an asset, often without regard to its intrinsic value. The script contrasts speculators with value investors, who focus on the intrinsic value and cash flow generation of an investment rather than short-term price fluctuations.

💡Bargain

In the context of value investing, a bargain refers to an asset that is purchased at a price significantly below its intrinsic value, offering a margin of safety and the potential for profit. The video script uses the term to illustrate the value investor's goal of finding undervalued assets that can generate a satisfactory return.

💡Warren Buffett

Warren Buffett is one of the most successful investors in the world and a prominent figure in the value investing community. The script mentions Buffett as an example of someone who has used value investing principles to achieve significant wealth and refers to his approach to risk and the use of the margin of safety.

Highlights

Value investing is a reliable and proven investment philosophy that has created great fortunes for investors like Warren Buffett.

The essence of value investing is to search for assets that can generate cash in the future and buy them at a bargain price.

Value investors are like shopaholics, looking for opportunities to buy when assets are undervalued, such as when one-dollar bills are offered for 50 cents.

Selling an asset occurs when it is no longer a bargain, which is when others are willing to pay close to its full value.

The concept of intrinsic value is central to value investing, representing the value of an asset independent of its market price.

Value investors focus on cash flows, which are the lifeblood of an investment, and compare different investments using the E/P ratio.

DCF analysis is a core tool for value investors, helping to determine the present value of future cash flows using a discount rate.

Great value investors like Warren Buffett rarely use DCF models rigidly, instead relying on a strong sense of a margin of safety.

A margin of safety is a critical concept in value investing, ensuring that there is a buffer between the purchase price and the estimated value of an asset.

Value investors look for assets that are disliked or overlooked, as these are more likely to be undervalued.

Ways to find overlooked assets include looking at lists of the biggest stock market losers or using quantitative systems like Joel Greenblatt's Magic Formula.

Risk assessment is an integral part of value investing, with value investors considering factors such as competition, management, regulation, suppliers, and customers.

The time value of money is important in value investing, with the principle that cash received sooner is more valuable than cash received later.

Value investors are contrarians, seeking out investments that differ from the crowd and are not popular at the moment.

An example of finding a true bargain is Cathie's auction analogy, where she purchases 100 notes of 1,000 Indian rupees for a significantly lower price than their value.

Peter Lynch's approach to finding overlooked assets includes looking for companies with boring names or those in industries that others find distasteful.

The final value investing formula includes buying assets with cheap discounted cash flows, using a margin of safety, and selling when the margin of safety is no longer present.

Transcripts

In this video, I’m going to explain how value investing works

in 5 levels of increasing complexity.

We’ll be starting with the most basic explanation,

but as we approach Warren Buffett’s hometown of Omaha,

we’ll get more detailed.

So, jump on the value investing hype-train

(if there ever was such a thing),

and join me on this ride!

This is the Swedish Investor,

bringing you the best tips and tools for reaching financial freedom

through stock market investing.

First and foremost

- why would you want to spend 20 minutes of your life on a subject like value investing?

Because it’s probably the most reliable and proven investment philosophy out there.

For almost a century, it has created great fortunes for investors such as Benjamin Graham,

Walter Schloss, Charlie Munger, William Ruane,

Joel Greenblatt, and of course, Warren Buffett.

I have even used it myself to beat the market by about 200 percentage points over a decade.

After devouring many of the greatest works within the field,

this is what I’ve discovered.

Value investing is actually really simple

– all you really need to do is search for assets that you can buy

and insist that you get a bargain price.

An asset, in the eyes of a value investor,

is anything that can be expected to generate cash in the future.

Shares in companies, loans issued in various forms, and real estate

represent perhaps the most common types of assets,

but there are value investors who hunt for more obscure things than that.

Seth Klarman, for example, famously invested in claims against the massive Ponzi scheme

of Bernie Madoff.

After finding an asset that you understand,

you should insist on a bargain price.

Basically, you are going on a treasure hunt.

Value investors aren’t pirates, of course;

we’re not trying to steal anything.

Rather, we are shopaholics.

When one-dollar bills are being offered for 50 cents, we go on a spending spree.

Buying, however, is just one-half of the value investing formula

(although it is the most important half …).

There is also selling.

A value investor sells his assets when they are no longer bargains.

So, when others are willing to buy back those one-dollar bills at close to a dollar,

we pocket the difference.

In reality, these statements are too vague to act on.

You’re probably already thinking:

“Alright, but when is an asset a bargain and where do I find one?”

Let’s start with what creates a bargain.

It’s cash.

Value investors follow the flow of cash like a bloodhound.

Investors in real estate look at tenant’s payments minus expenses,

investors in bonds look at interest payments and the repayment of the principal,

and investors in stocks,

although I’m simplifying a little now,

look at earnings per share.

In theory, any investment is worth the net amount of cash that it pays out to its owners

from today until judgment day.

Let’s observe what the two value investors Arnold and Tom are doing.

They’re both obsessed with cash flows, like all value investors are.

Arnold has bought $1,000 of 10-year US government bonds that pay him $40 per year.

Arnold’s return is 4% per year, $40/$1,000.

Tom has purchased shares in the public company PepsiCo.

They currently earn $7 per share,

and they cost $180 each,

so his return is also 4% per year, $7/$180.

This is the E/P ratio, and it is better to use than the more commonly known P/E ratio

because it is easier to compare to investments outside the universe of stocks.

For Arnold’s bonds, the payment of $40 per year is fixed,

but that’s not the case with PepsiCo’s earnings.

If the earnings increase in the future, Tom’s return will be higher than 4%.

PepsiCo has more than doubled its earnings per share since 2007,

so we have a good reason to believe that it will increase in the future as well.

At this stage, we could expand our definition of value investing to

“buy assets with cheap cash flows and sell them when they are no longer cheap.”

As it seems like Tom purchased a superior stream of cash flows for the same amount of money

can we conclude that he’s the better value investor?

Well, maybe, you know I like Tom, but before we get to that, let’s talk about Felix.

Felix just purchased an NFT representing a Picasso painting for $1,000.

He hopes to resell this NFT to someone else at a higher price somewhere down the line.

Is Felix a value investor?

Unlike Arnold’s and Tom’s investments, Felix’s has no cash flows.

The father of value investing, Benjamin Graham, would say that the NFT has no “intrinsic value”.

The intrinsic value of an investment is independent of its market price.

Essentially, think about it as the value of an asset as if you could never sell it.

The NFT throws off exactly $0 per year,

you know, year after year after year after year,

and the only way that Felix can expect to make any money on this lazy investment

is by selling it to someone else.

A value investor is never dependent on a resell price.

Both Arnold and Tom are perfectly happy if no one ever wants to buy back their securities,

as they can just sit on them and collect the cashflows.

That’s the primary difference between a value investor and a speculator.

Value investors adhere to the wisdom of Mark Twain, who said:

“There are two times in a man's life when he should not speculate:

when he can't afford it, and when he can.”

Value investors can distinguish between Picasso and PepsiCo.

Let me ask you a rhetorical question:

Would you rather have $1 million today or $1 million in 20 years?

The answer should be quite obvious,

not only because money may have more utility for you when you are younger,

but also because money can be used to generate more money.

It matters not only how much cash flow we receive from our investments,

but also when we receive it.

The sooner, the more valuable the investment.

This is the core of the discounted cashflow (or DCF) analysis where we use a discount rate

to reduce the value of future cash flows.

If we use a low discount rate,

money in the future is worth quite a bit,

but if we use a higher one, the value diminishes quickly.

After we’ve taken the time value of money into account,

we simply sum up these reduced cash flows to see how much the asset is worth today.

This of course raises an important question:

How much less is cash in the future worth?

It depends on how well you expect that you’ll be able to perform as an investor.

One might, for instance, use the historical average that the stock market has returned,

which is around 8-10% per year.

The greatest value investors, such as Warren Buffett,

use a sort of moving target that depends on where the US 10-year currently stands.

Also, they never settle for less than the historical average of 8-10%,

no matter where the 10-year is.

We can update our value investing formula to

“buy assets with cheap discounted cash flows

and sell them when they are no longer cheap.”

However, a word of caution here.

Although your college professor in finance probably wouldn’t like to admit it,

actually plugging values into a DCF model

is something that the greatest value investors rarely do.

Why?

You know, Warren talks about these discounted cash flows.

I’ve never seen him do one.

Yeah.

If it isn’t pluperfect obvious that it’s going to work out well, if you do the calculation,

he tends to go on to the next idea.

Yeah, it’s sort of — it is true.

You don’t —

if you have to actually do it on —

with pencil and paper,

it’s too close to think about.

I mean, it ought to just kind of scream at you that you’ve got this huge margin of safety.

Simply put – if you must use a DCF model

to verify that you’ve found a good investment opportunity

it isn’t good enough.

That’s not good enough!

Benjamin Graham would say that there isn’t a big enough margin of safety,

a really important concept that we’ll get back to later.

The greatest value investors know in their spine that

future cashflows are worth less than cashflows today

and that the return you require should differ with the economic climate,

but they stay clear of calculating net present values with many decimal points.

For example, it is perfectly obvious that the US 10-year is not going to be able to

make Arnold that minimum 8-10% return per year.

In fact, even Tom’s investment in PepsiCo seems highly unlikely to yield something like that.

He doesn’t need to enter numbers into a spreadsheet to understand that.

Luckily, for us and our illustration here,

Tom recently found out about the Swedish gambling company Kindred.

The earnings of Kindred are a little more volatile,

but if we assume that the company can earn $0.9 per share moving forward,

they are already at an 8% earnings yield.

Moreover, its historical growth is even more impressive than that of PepsiCo.

Again, Tom needs no DCF analysis to understand

that a company with this type of historical performance

at such a price tag has at least the potential to return more than 8-10% per year.

However, he does need one more thing …

The value investor is always looking to get as much return as possible for a given risk.

When this relationship is really skewed,

the value investor can be said to get a bargain.

Unfortunately, assets do not come with nutritional facts revealing precise risk numbers.

“I know that investment, it’s 42 grams of risk per 100.”

No.

Here’s Warren Buffett’s definition of risk:

I mean, that would be part of our course on how to value a business.

It would also be, how risky is the business?

And we think about that in terms of every business we buy.

And risk with us relates to …

Well, it relates to several possibilities.

One is the risk of permanent capital loss.

And then the other risk is just an inadequate return on the kind of capital we put in.

Basically, the risk that our assumptions about the predicted cashflows are wrong

or that we paid too much for them.

With that in mind, let’s get back to Arnold and Tom and the investments that they are considering

– bonds, PepsiCo and Kindred.

We’ve said that Arnold’s return is 4% per year,

assuming that he’ll get a coupon of $40 per year for 10 years

and then his $1,000 back at the end of it.

Are there any risks that the US government won’t be able to pay him back?

Nah, I highly doubt it.

However, there is a risk that his coupons do not end up being as valuable as he thinks

due to inflation.

Because of this, Arnold’s investment scores very low on the risk-return scale.

Now, what about Tom’s idea to invest in PepsiCo or Kindred?

A few risks that I always like to think about before I invest in public companies are these 5:

Competition,

Management,

Regulation,

Suppliers and Customers.

They all have the potential to ruin our guestimates about future cash flows.

- Competition – has it increased lately, are there strong up-and-comers?

PepsiCo’s industry is more or less a duopoly, while iGaming is more fragmented.

- Management – is it stable and trustworthy?

Is the management invested alongside their shareholders?

There’s been some flux in PepsiCo’s management lately,

and insiders hold around 0.2% of the company

which I think is a fairly low number.

In Kindred, there’s also been some flux at the top management level,

and managers hold 1% of the company, which isn’t too much either.

- Regulation – what’s society’s standpoint on the industry?

Is it likely to cause trouble?

For PepsiCo, I think this risk is negligible, but it certainly isn’t for Kindred.

Regulators change their opinion on online gambling all the time.

- Suppliers – are input costs likely to increase?

Is the company dependent on a single or a few key suppliers?

PepsiCo does what Warren Buffett likes the best

– buying commodities and selling brands.

Kindred has more risk here as they are dependent on a supplier called Kambi for their sportsbook, for example.

- Customers – are there only a few big customers or are there multiple ones?

Will customers continue to buy even in an economic downturn?

Both of these businesses are B2C,

and they sell products that are in demand no matter the economic cycle.

When Tom pits these two companies against each other,

I think it should be clear that Kindred is riskier than PepsiCo.

The implication is that Tom should require a larger margin of safety

when investing in Kindred compared to PepsiCo.

Seth Klarman probably explained the concept of a margin of safety the best:

“A margin of safety is necessary because valuation is an imprecise art,

the future is unpredictable,

and investors are human and do make mistakes.

It is adherence to the concept of a margin of safety

that best distinguishes value investors from all others,

who are not as concerned about loss.”

With that said, we can update our explanation of value investing to:

“buy assets with cheap discounted cashflows,

using a margin of safety,

and sell when there is no longer a margin of safety.”

Once again, just like the DCF analysis,

this is only a guiding principle for the greatest investors,

not a rigid formulaic approach.

Here are three examples of a margin of safety:

- When a company is already yielding as much as you require

and it is also growing, such as Tom’s Kindred.

- When a company is currently yielding more than you require

- When a company is yielding about as much as you require,

but it also sits on a massive net cash position.

Benjamin Graham is famous for having loved this specific type of margin of safety

that can be found on a company’s balance sheet.

At a strange and charitable auction house in the US,

where cell phones aren’t allowed,

the following takes place.

“Today we have something really special for you.

10 $100 bills, as real as they come!

We’re accepting your bids!”

The people in the auction start to bid up the price.

“$300!”

“$600!”

“$900!”

“$999!”

“Sold to the man in the grey suit for $999!

Now, our next item is something even more special.

Here’s 100 notes of 1,000 Indian rupees!

Let the bidding war begin!”

After 30 seconds of hesitation, Cathie gets up and says:

“Ehm … $300!”

“Sold to the lady in the grey suit for $300!”

Now, what happened here, and why is this analogy important for value investors?

When value is too obvious, it is seldom possible for investors to find true bargains.

Why?

Because prices are bid up too high.

Netting $1 is quite nice, but not that impressive.

The 100,000 Indian rupees, on the other hand, were a true bargain.

Cathie knew this and she downplayed her confidence on purpose.

She had no competition here, zero.

Although this is a dumbed-down version of reality,

I hope that it conveys the message.

Value investors’ primary hunting grounds are in assets that are disliked and/or overlooked.

Value investors are contrarians,

we search for opinions that differ from the crowd.

For example, there are currently 26 analysts, according to Yahoo Finance,

who have an opinion about what the earnings per share of Apple will be in the next quarter.

When so many people try to dissect a company,

it’s very unlikely that you can ever pick it up at a large discount from its intrinsic value.

Well, where should we look, then?

Here’s how three famous value investors find disliked or overlooked assets:

Seth Klarman says that you can look at lists ranking the biggest stock market losers of,

for example, the last year.

Why the losers and not the winners?

Because it is too popular to invest in the winners,

so they seldom represent bargains.

The young Warren Buffett used to search for overlooked securities listed in places

like the Pink Sheets.

This list no longer exists,

but if you want to emulate his approach,

just screen for companies with market caps of,

say, less than $100 million.

My preferred approach comes from Joel Greenblatt,

who uses a quantitative system called

The Magic Formula to find his investments.

If you want to know more about it,

head over to my summary of The Little Book that Beats the Market.

The funniest approach to finding overlooked assets comes from Peter Lynch, though.

In his book One Up on Wall Street,

he says that he is looking for companies with boring names

and those that are in businesses that others find distasteful.

Think oil, gambling, weapons, porn, or funerals.

The closer we are to danger, the farther we are from harm.

So a value investor attempts to:

“buy disliked or overlooked assets with cheap discounted cashflows

using a margin of safety,

and sell when there is no longer a margin of safety.”

Cheers!