Sunday, 24 April 2016

Value Investing in a nutshell

As an entrenched value investor, I'm often asked to explain quickly and in simple terms what value investing is all about. And I'm always afraid of failing spectacularly in the task.

The difficulty doesn't lie however in the investing philosophy's extraordinary complexity. The opposite is the case: the value investing's principles are truly so simple and powerful that I'm always afraid to introduce complexity where there is none.

So, what is value investing? It is investing in companies that comply with the combination of 3 plus 5 principles:

Three qualitative principles:
1. Simple, understandable business models

2. Businesses with an intrinsic durable competitive advantage ("moat")

3. Talented management team, with high ethical standards, whose interests are aligned with those of the shareholders

Five quantitative principles:
a. Follow the cash: sustainably cash-flow generative businesses

b. Businesses whose return on capital employed is sustainably above the cost of capital (reflects the existence of a moat). For the overwhelming majority of investors this would be enough as an indicator of the existence of a moat. But it is not. If a business benefits from a moat, you should expect it not only to successfully defend its market share but actually to increase it over time. Meaning: you should expect to see a (10-year) track-record of continuos sales and (cash) earnings growth. If you are facing a business whose return on capital is above its cost of capital but whose sales and (cash) earnings are on a downward trend, it may rather signal a declining business. Whith no moat. And where a return on capital still above the cost of capital is a legacy feature that will tend to disappear over time (think Nokia or Blackberry two years after their sales started to decline)

c. Bridge to the future: sound capital structure (low debt levels) and liquidity position

d. No accounting shenanigans (reflects management team with high ethical standards)

e. Margin of safety: the company is trading at a discount of at least 30% to its conservatively estimated fair value

You may find my explanation too long and wordy. In that case, worry not:

Charlie Munger is alive, well, and kicking. In YouTube.

After listening to Charlie Munger you will understand why Leonardo da Vinci once said that "simplicity is the ultimate sophistication".

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