The Value of (Almost) Everything
A cynic, according to Oscar Wilde, knows the price of everything and the value of nothing. As a Value Investor, you can apply this label to speculators and even many other investors. Many of these folks tend to focus on price simply because it is easily known. Our cynic can find the price of almost everything from countless brokers, services, and websites. There’s not much mystery there.
The key to a Value Investing philosophy is knowing both the price and the value of an opportunity and only investing when value exceeds price by a wide margin. You may make a mistake or things may happen that you did not anticipate. The margin between value and price should be wide enough to allow you piece of mind not to worry about these bumps too much.
So what is Value? When a farmer (call him Jones) goes to buy a goat (she can be Muriel) he considers how old Muriel is, how healthy she is, how much milk Muriel will produce, and how much he can charge others for her milk. He will only buy Muriel for less than what he expects to gain over time from selling her milk. Change Muriel to a business and her milk to products or services and this is essentially Value Investing. Choosing the right “goat” is best accomplished through fundamental analysis of the business (checking Muriel’s health and milk-producing ability).
BOTTOMS UP
By starting with fundamental analysis of a business, a Value Investor begins with the most certain aspects of an investment and avoids the unpredictability of a top-down approach. Jones doesn’t begin picking his goat by predicting next year’s weather. He can’t predict the weather - not precisely - no one can. A top-down approach relies on predictions of economic forces and connects those forces to specific investment ideas. Top down approaches try to predict the weather.
A top-down investor may predict that US interest rates will increase over the next year. From this and other data, he might conclude that inflation will decline. And from that conclusion, he may decide more stable component prices will allow electronics manufacturers to earn more cash which will increase their Value and he might express this view with an investment in Intel Corporation (INTC).
This is a risky strategy. If the investor is wrong about any prediction in the series, the whole investment may turn out badly. For example, interest rates may rise, but, unexpectedly, inflation may rise, too. What does this mean for the investor’s conclusions? Is INTC still undervalued? It’s hard to say what happens when one link in the chain breaks. Does it negate the entire process or just make it weaker? Does it mean the investor should sell? Who knows?
Value Investing recognizes that investors can draw more certain conclusions about specific opportunities than they can about the economy at large. By starting with fundamental analysis specific to a particular company, the Value Investor crafts a stronger basis for investment.
A bottom-up approach begins with the smallest unit of investment. You may look at Carefusion Corp (CFN), a medical technology company, and examine the cash earnings of CFN over the next several years under various scenarios: growth, decline, profit compression, profit expansion, etc. You might review the balance sheet of the company to assess the value of the physical assets and debt. You may conclude that the company is worth at least $40 per share, well in excess of its current price of $25.66. What happens if things for CFN take a turn for the worse or the analyst missed a few factors? The Company may only be worth $30 per share. Well, that’s still higher than its current price.
This approach recognizes that precisely predicting the future is a risky proposition: you will be wrong most of the time. Rather than trying to predict the unknowable, Value Investing analyzes the many scenarios that may play out for an investment in the future. The goal of these analyses is to choose opportunities that turn out well for the investor in all, or at least in the majority of cases. By doing this, Value Investing relies less on a single premise and is able to assess the ongoing Value of an investment when things don’t go perfectly.
WHAT'S THE DIFFERENCE?
Once you establish the Value of your target, you must compare it to the price of the investment in order to determine whether it is worthwhile, like you did for CFN. If the price is greater than Value, you can move on to the next opportunity. If Value is greater than the price, you must then judge whether the difference between Value and price is great enough to compensate for risk. Here, the difference between Value and price should be as wide as possible. You will make mistakes, analysts will be wrong, and risk will manifest itself through real losses. While there is no objective yardstick for this task, the most helpful measure may be whether the difference between value and price is enough to allow you to sleep peacefully at night.