Deep Dive: “The Little Book of Value Investing“
Christopher H. Browne‘s beginner-friendly book “The Little Book Of Value Investing” discusses successful application of a value investing strategy in the stock market.
In this chapter, we’ll take a look at:
Christopher Browne is considered to be one of the most influential value investors. He is most famously known as the former director of Tweedy, Browne, an investing firm, and was a strong proponent of value investing. He got interested in value investing after working with Benjamin Graham who bought shares from Tweedy, Brown and invented value investing at the Columbia Business School.
Written by Christopher H. Browne “The Little Book of Value Investing” offers a great introduction to the idea of value investing. This post summarizes the key points of Browne’s value investment strategy.
The Basics Of A Value Investing Strategy
A key issue with investing is that often decisions are based on emotions, rather than facts. One strategy which has proven itself is value investing which attempts to decouple investment decisions from short-term share price influences. They successfully buy bargain stocks which are being sold cheaply compared to their value.
Value investing is one of the most successful investment strategies which has been employed by some of the most successful investors, like Warren Buffett, Seth Klarman and Howard Marks.
“Value stocks are about as exciting as watching grass grow. But have you ever noticed just how much grass grows in a week?”
Investors should be buying stocks once the stock price is at least 2/3 below the intrinsic value. At this point the company will become a bargain stock. As Browne notes in the long-term the market always catches up with the intrinsic value. Therefore investors following a value investing strategy can buy stocks at a cheap price below the intrinsic value of the company and sell once it reached its fair price. This concept is called a margin of safety.
Narrowing Down Potential Investments
There are literally thousands of companies being traded around the world. That’s why narrowing down the list of companies as much as possible is a crucial step to identifying potential value investments. Browne uses multiple metrics to decide whether a company deserves a closer look or should go onto the “no thank you” pile.
“Risk is more often in the price you pay than the stock itself.”
Browne uses the price-to-earnings ratio (P/E ratio) as a first indicator to narrow down potential investments. It simply is the current stock price divided by the earnings per share (EPS) of the company. EPS can be calculated by taking the company’s profit and dividing it by all outstanding shares. Browne notes that it can be off due to granted options, bonds or preferred stock.
There are 2 types of P/E ratios which are being used to value stocks. The trailing P/E ratio is based on earnings of the previous year or quarter. On the other hand the forward P/E ratio is based on analysts estimates of the future prospects of the company.
For growth companies without a reliable history of earnings the forward P/E ratio can be a better fit. But since Browne looks for companies with a stable record of earnings the trailing P/E ratio should be used instead. Browne notes that in general companies with low P/E ratios are more resistant to disappointing news as the price is already cheap. Companies with high P/E ratios will have a much higher negative stock price effect as a result of higher expectations.
Browne also looks at the price change of share prices. He’s specifically interested into companies whose share price has fallen over 50% in the last 3 months. There of course are many valid reasons for a dropping price. For example the company might have been previously overvalued or newer financial results result in a new lower valuation. However if the price decrease is decoupled from the intrinsic value of the company a closer look might be worthwhile.
A Closer Look At The Company
Once uninteresting opportunities have been filtered out the next step is to evaluate the interesting ones on a deeper level. Evaluation good investment opportunities is based on both internal and external metrics.
A company provides investors with financial statements which detail the current state and earnings of the company. The balance sheet reports the company’s assets, liabilities and shareholder equity at the end of a given period. The income statement on the other hand is a record of how much was taken in (revenue/ sales) and out (expenses) in the same timeframe. In general Browne recommends to always avoid companies with complicated financial statements and rather focus on companies whose business and finances are easy to understand.
Apart from informations provided by the company there are also informations provided by external sources such as analyst estimates or news coverage. Browne also recommends to have a closer look what fund managers are investing into. Although for some of their investments the window of opportunity might’ve already been missed for others the timing could still be right.
Christopher Browne shows that a value investor should always evaluate trends instead of a single snapshot of the financial state of a company. He also deems it as essential to compare companies to others in the same industry.
Evaluating The Short-Term Financial State
The first step a value investor should take to understand the company on a deeper level is to have a look at the balance sheet. The balance sheet reports the financial state of the company in the form of assets and liabilities. To evaluate whether the company can survive in the short run a first look should be taken at the short-term financial state.
The current assets are assets which can be quickly (a year or less) converted to cash if needed. This includes inventories, products that already have been manufactured or other receivables from customers. On the other hand the current liabilities are short-term liabilities which are due in a year or less. Among others this includes interest payments, taxes owed but not paid or unpaid accounts with customers. As Christoper Browne shows these liabilities can be the deciding factor whether a company can survive during bad times, such as the current pandemic or a financial crisis.
Both values are combined in the current ratio. It is calculated by dividing current liabilities by current assets. This ratio reveals the ability of the company to pay short-term obligations. Browne recommends to consider companies with at least twice the amount of liquid assets than its debts and obligations. If the amount is higher than in other companies of the same industry or if its declining year over year it can be a warning sign.
Some investors prefer to calculate the quick ratio. This ratio is almost equivalent to the current ratio. However it excludes the values of inventories as they potentially can only be quickly sold at a discount.
Instead of a ratio one can also calculate the working capital which is being calculated by subtracting current assets from current liabilities. As Browne notes the more working capital a company has the better of an investment it is as it increases the chance of survival.
Evaluating The Long-Term Financial State
While the short-term state gives the investor good insights into the immediate survivability of the company the long-term finances can give an outlook how the company will be able to evolve in the future.
The long-term assets include fixed assets such as real estate, factories or warehouses. However it also includes other assets such as investments into subsidiaries, stocks which are not intended to be sold or intangible assets.
Intangible assets are assets that are not physical in nature. This includes for example a well known brand name like “Coca-Cola” or patents, trademarks or other copyrights. However according to Browne one of the most common intangible assets is goodwill which includes values like the customer loyalty or brand reputation.
In general, according to Browne, the long-term assets can be difficult to value since their value is only being realized in the long-term future. Also Browne strictly advises against including intangible assets into the value analysis as they’re value cannot be realized from a sale. Another aspect to watch out for is that some long-term assets might be understated due to appreciation. As an example he points to Lindt & Sprüngli AG which appreciated its factories at a higher rate for tax purposes.
The long-term liabilities include debt which is due in more than 1 year, bank loans, bond issues, long-term lease and others. As with the short-term liabilities the fewer a company has the better.
Final Conclusions Based On The Balance Sheet
Once the short-term and long-term finances have been analyzed a few more metrics can be evaluated. The book value (also known as shareholders equity) is being calculated by subtracting everything owned by the company (excluding intangible assets) from everything owed.
This metric can be used to understand how much money could be generated by paying off all debts and selling all assets. However as those assets can also generate earnings and therefore value it cannot be used to fully calculate the total company value. A company with a lower book value than its market capitalization might deserve a deeper look as it possibly cold be purchased at a lower price than the value generated from selling the company afterwards.
According to Browne, a low price-to-book ratio (P/B ratio) is the characteristic of a winning stock. The ratio determines whether a company is correctly valued. If the value is below one it might point to a undervalued company.
Finally, the debt-to-equity ratio is calculated by dividing the total debt of the company (both short and long-term) by its shareholders equity. It measures whether the company finances its operations through its own fund or from debt and points to its ability to pay back its outstanding debt. Browne prefers companies with as little debt as possible.
Evaluating The Income Statement
After looking at the balance sheet of a company the next step is to check out its income statement. It reports the earnings and costs of the business in a given timeframe. In general service companies report revenues while manufacturing companies report sales. Browne recommends to use the annual statement rather than the quarterly ones as they can be more reliable due to seasonality of some businesses. The annual income statement should always be compared to the one of the previous year.
Often the income statement is broken down by divisions of the company. Browne advises to have a close look at those. Some underperforming divisions might mask the overall strength of a company while over performing divisions can mask problems in the core business.
The costs of goods sold defines the direct costs of a business for producing a product or offering a service. It includes the raw material, manufacturing and labor costs. If this value is rising as percent compared to the earnings this is a sign that the costs cannot be passed to the customer. It can also mean that the company faces higher competition from other companies.
The gross profit is calculated by subtracting the costs of goods sold from the sales of a company. The higher the profit of a company is the better. The gross profit margin is being used to asses whether a company is in good financial health. It usually is being expressed as a percentage which is calculated by subtracting net sales from the costs of goods sold and then dividing it by net sales. The steadier the gross profit margin, the better the business.
Browne often has a closer look at the acquisition value of a company. If a company’s shares can be bought cheaper than what someone would pay for an acquisition it is being considered a great value investment. According to Browne the best metric to understand the acquisition value is earnings before interest and taxes (EBIT) (also known as operating profit). It indicates the profitability of a company and is being calculated by subtracting revenue from expenses excluding tax and interest. To calculate the final earnings, interest expenses, taxes and depreciation are substracted from the operating profit.
One-time expenses or earnings can significantly change the numbers of a business. For example if a company has increased expenses due to dismantling a unprofitable division it might appear as if the earnings of the company decreased. However the long-term impact on earnings will be positive. Similarly large one-time earnings, for example from a sale of a property, can make the company appear more profitable than expected.
For Browne stability is a key aspect of great value opportunities. As a result he is especially interested in companies with a stable record of earnings. Those should not be affected by cyclical fluctuation. For example earnings of consumer products are usually heavily skewed towards the end of the year due to their Christmas sales. If a company is inexpensive based on its earnings a closer look might be appropriate.
Once the earnings have been calculated the return on capital gives an impression how well the company can use its capital to earn money. It is being calculated by dividing earnings by the beginning years capital, stockholder equity plus debt. The higher the return on capital the better the company is to make money.
What Value Investors Should Look Into
Outstanding Shares
A closer look should be taken at the outstanding shares of the company. If there are still a lot of shares outstanding it might indicate that the investment will be diluted in the future. Those shares might be passed onto employees in the form of stock options which can be converted into shares. A high number of outstanding shares might also indicate that the company finances the company through stock offerings.
Earnings Improvements
Investors should not only consider the past performance but also the future prospects. It should be determined whether earnings can be improved by making adjustments to the products, their prices or their sales.
For example a company could be able to raise their prices or increases its sales. If sales can be increased it should be checked whether this can be done profitably. When a company has to hire more people for more sales it might not be worthwhile if it decreases the profit. Another impact on future earnings can be renegotiated prices with suppliers or ditching existing suppliers for cheaper ones altogether.
Spending Control
A company should be able to control their expenses and keep them consistent. For example during good times companies often hire more new employees than needed causing excessive spending. Also dependence on outside pricing can impact spending heavily. Airlines for example are highly dependent on the price of fuel. If the fuel price rises the profitability of their business is being reduced. If the expenses will change in the future it should be clarified how and why they will change.
Confidence Of The Management
It is important to understand how comfortable the management is with their own expectations and their ability to grow the company in the next 5 years. It is generally a good sign if the management think their own or external analyst projections seem reasonable and doable. If however the management feels pressured by expectations it might be a good sign to stay away from that company.
Competitors
Even if a company appears to be a great value opportunity it might be a bad investment compared to competitors. So analyzing competing companies is key to ensure that potential investments turn out well. As mentioned previously the level of debt might be a deciding factor whether a company can keep competing.
It is also worth it to understand what the management thinks of competitors and how they expect them to do in the future. In general Browne advises to stay away from companies that have cheaper or more efficient competitors.
Insider Activity
Insider activity can be a great indicator to determine whether a company might be a good investment. They usually have intimate knowledge of the business and prospects for improvement in current conditions. If insiders buy shares it may be a sign that there is great confidence into the future prospects of the business. Similarly when insiders sell their shares it might indicate that they are overpriced. However there might also be legitimate reasons for selling shares which are not connected to the current company’s state. For example an insider might simply need some cash.
Share Buybacks
Share buybacks are a great sign to signal confidence of a company into their own business. It indicates that the leaderships thinks that their shares are traded below their values and that they will increase in the future. Brown recommends to look for companies that announce share buybacks to identify great value opportunities. However he advises to keep track whether the company will follow through with the buybacks.
Portfolio Diversification
A diversified portfolio is important to ensure that its value is maintained in bear markets. However Browne points out that the level of diversification should depend on the risk tolerance of the investor. For example someone who depends on its investments to make a living should have a higher degree of diversification while a young person building up wealth can allow themselves to risk more.
The highest returns are usually being achieved in short periods of time. At the same time it‘s almost impossible to predict whether the value of a specific stock or the market itself will go up or down. As a result it is important to always be fully invested in the market. This ensures that high gains can be captured without needing a magic glass bowl to predict the future.
Another consideration is diversification, not only across industries but also across different markets and countries. While many available investing books are focused on the American market “The Little Book of Value Investing” stands out since it includes an entire chapter dedicated to investing foreign markets. Browne mainly focused on the USA, Europe and Japan where he made some great investments due to different market environments and financial regulations.
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