The Wealth Accumulator: The principles of value investing

Many personal finance website recommend investing in index funds, and I also believe that index investing is the best option for most people. The high level of diversification and low cost will ensure that your performance will approximate "the market" (minus management expenses and transaction costs). Most actively managed mutual funds have, over the long term, underperformed the market and no-load low-cost index funds. As WarrenBuffett recommended, for know-nothing investors, they are better of investing in no-load low-cost index funds than an actively managed mutual fund.

As you may have read on my LinkedIn profile, I am the investment manager of a private investment company I setup for my family and relatives. Why do I actively manage investments when I recommended index investing? Because it is possible for those who put in the time and effort and have the right temperament to outperform the market.

I practice value investing because it is the method of investing that seems most logical and rational to me. The concept of value investing is very simple and understandable, though not necessarily easy to execute. While value investing is not the only way to invest actively, I am not convinced by other methods and do not have sufficient knowledge to practice them.

Introduction to value investing
Value investing is investing businesses at a discount to intrinsic value. The intrinsic value of a business can be determined, so the value of securities (stocks), which represent fractional ownership in the business, can be calculated. Basically, value investors want to use fifty cents to buy businesses that are worth one dollar.

Invest for the long-term: "Buy a businesses, don't rent stocks"
Stocks represent fractional ownership in the business behind it, so you should buy stocks with the same approach as you would when buying an entire business. If you buy a business, such as the neighborhood groceries store, you would want to own it for a number of years and let the business earn money for you. Similarly, you should be investing for the long term when you own a stock, rather than renting the stock for a day. As Warren Buffet says, "buy a business, don't rent stocks;" "if you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes."

Circle of Knowledge and Circle of Competence
These concepts are borrowed Warren Buffett. Everyone has a "circle of knowledge", meaning things that they know or have information about. Within that circle of knowledge, we have our "circle of competence" - things that we understand and are competent in doing. We should invest only within our circle of competence. If you want to invest in a business, not only do you need to know or have information about the business, you must also be competent enough to understand and analyze the business.

Invest in great business
Here are some traits of great businesses that value investors look for:

Simple and understandable business: You should be able to understand the company's business model. In layman terms, you should understand what the company does and how it makes money. Everyone can understand how Coca Cola (KO) earns money, but no one understood how Enron earned money (it didn't).

Business operating in a stable industry: It is hard to predict what will happen to a business in fast changing industries, so intrinsic value will be difficult to determine.

Business operating in an industry with good economics: In an industry with good economics, even an average company can earn a lot of money for you. However, in an industry with bad economics, such as the airline industry, brilliant managers are needed just to give the business a fighting chance of maintaining profitability. But, as Warren Buffett said, "when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the the business that remains intact."

Business with favorable long-term prospects: We would, ideally, invest in a business that is going to continue operating and growing. Blockbuster (BBI), for example, is a business with poor long-term prospects - unless they change their business model, Netflix (NFLX) and online movie downloads will put them out of business.

Business with durable economic moats: Economic moats, or competitive advantages, allow businesses to operate with superior margins and returns. The economic moats must to durable, or sustainable, so the business can maintain long-term superior operation. You can think of it as, if you are given $1 billion, how badly can you hurt the business? It's hard for anyone to do serious damage to Coca Cola (KO) with $1 billion.

Business with low capital investment requirements: If a business does not require high capital investments to maintain its size and grow, most of the business's profits can be returned to the shareholders while the business continues to grow. See's Candies, for example, have low capital requirements, so it can pass most of its earnings to Berkshire Hathaway while it continues to grow.

Business that do not require superstar managers: If a business is easy to understand and operates in a stable industry with good economics, even an average manager can earn money for you. If the business require superstar managers, it will be in trouble if the manager leaves and an equally brilliant replacement cannot be found.

Invest with honest and competent management
While stocks represent fractional ownership, similar to partnerships, in a business. But, unlike partnerships, shareholders cannot participate in the day-to-day operations of the business. Shareholders are, essentially, silent partners. For us to be comfortable owning the business while it is managed by someone else, we need to invest with managers who are:

Able and competent: Nowadays, most CEOs and business executives are overpaid. The least we should get in return are able and competent CEOs and executives. Their abilities and competence can be measured by the business's performance (margins and returns, NOT stock price performance). We can also see if their business strategies and the actions they take make sense.

Directors should also be able and competent. Natalie Bancroft, for example, is a director of News Corp., but she does not appear to have sufficient business or industry experience to contribute much to the Board.

Energetic: Energetic leaders can energize the employees and lead the company to do great things; for example, Amazon.com's (AMZN) Jeff Bezos and Apple's (AAPL) Steve Jobs are leading energetic companies. On the other hand, Hewlett-Packard's (HPQ) former CEO, Carly Fiorina, drained the employees' creativity and energy and the company's performance suffered accordingly.

Honest and trustworthy: These are the most important quality of good managers. If they are not honest and trustworthy, investors will suffer from their ability and energy. While it is possible to detect earnings manipulation and similar unethical business behaviors, evaluating people for honesty and trustworthiness are subjective exercises.

Candid with shareholders: Good managers should communicate candidly with shareholders, informing the shareholders of things that they would want to know if their positions were reversed. In his letters to shareholders, WarrenBuffett readily admits his mistakes and shares his concerns and thoughts on Berkshire Hathaway's (BRK.A, BRK.B) businesses.

Rational and resist the institutional imperative: The institutional imperative is the "group think" or lemming-like behavior people and businesses engage in. It's the mindless imitation of what others do, no matter how irrational or self-destructive those behaviors are. Good managers should resist the institutional imperative and, instead, be rational in what they do.

Warren Buffett said it best: "(1) as if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction; (2) just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) the behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated."

The subprime financial crisis was (partly) caused by the institutional imperative when banks imitated each other and lend excessive amounts of money to people with poor credit history or without proof of income. Rational managers should realize the folly of such behavior and not bother to compete in that business. The few banks that avoided the institutional imperative, such as Wells Fargo (WFC) and JPMorgan Chase (JPM), will come out better and stronger after this crisis has washed out the weak.

Business Valuation
Value investors will run mathematical analysis, while keeping in mind the big picture, to determine the intrinsic value of a business. The process is called "business valuation". There are many ways to value a business, for example, discounted cash flow (DCF) analysis, dividend discount model (DDM), liquidation value, relative valuation, and option valuation. Aswath Damodaran, an NYU professor, generously distributes his class materials on valuation online and I recommend watching his course webcasts (you'll need to have some basic understanding of business and finance, though).

I believe, as Aswath teaches, there are no set Excel templates for valuing a business. Every business is different and you cannot just plug in numbers to a spreadsheet template and expect to come up with an intrinsic value that reflect the true value of the business. That said, Excel templates for various valuation models are good ways to approximate the value of a business.

When valuing a business, you should apply the Pareto Principle and find the small portion of the business data that are critical for determining the company's intrinsic value. Even though Warren Buffett suggests that DCF analysis is the way to measure a company's value, Charlie Munger said he never saw Warren do a calculation. Why? Perhaps, Warren Buffett distilled all the financial data on the business to the critical few pieces of information, then did a simple mental calculations to come up with the intrinsic value of the business.

Invest with a magin of safety
When we have determined that a company is worth one dollar, we will try to buy the company at fifty cents. We want a margin of safety to (1) minimize our potential losses (if we were wrong about the business's value), and (2) maximize our potential gains (if we were right about the business's value). For smaller and unstable businesses, we generally will want to have a larger margin of safety (50% or more). For large and stable businesses, we may be confident of our valuation and positive about the company's future, so we may be willing to accept a smaller margin of safety (say, 25%).

Concentrate investments
Diversification can minimize some investment risks, but the law of large numbers means that, the more you diversify, the closer to average your investment performance will be. Many mutual funds invest in hundreds of companies, and their performance are inevitably closely correlated to the market return. To exceed market returns, investors should invest with conviction and make big bets with ample margin of safety. No matter how sure you are, though, always under-bet the Kelly Formula. Generally, you can limit your portfolio to approximately 20 businesses you truly understand and you would have diversified away most "diversifyable" risks.

Another reason to concentrate investments is so that you can get to truly understand the businesses you invest in. Value investors filter and digest a lot of information before we find a great investment idea, and new information are always flowing from our investment holdings. If you diversify too much and hold too many investments, the information overload may lead to poor decision making and a bad financial outcome.

Recommended reading
I hope you now have a good understanding of the basic principles of value investing. There are much more to value investing that you can learn about. For starters, I recommend "The Intelligent Investor" by Benjamin Graham. My second recommendation is to read all the letters to shareholders and letters to partners by Warren Buffett. Finally, if you have gotten a good grounding in value investing and finance, read "Security Analysis" by Benjamin Graham and David Dodd.

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