SHARING OF FINANCIAL WISDOM

The Greenwald Method

One of the best ways of learning something is to teach it to The Greenwald Method
others. When Benjamin Graham, the father of value
investing, started teaching at Columbia University in 1928 There are a number of approaches to investing. If
he was already an accomplished investor but I’m sure that you are going to succeed as an investor you should
the process of articulating his investment strategy helped really pick just one or potentially two – in the latter
himself as well as his students. These classes also resulted in case they should be kept mentally separate.
the investment classic Security Analysis written together with
The first distinction to make is if you are a believer
Graham’s Columbia protégé professor David Dodd. It is
in efficient markets or not. If you are, you should
number 2 on our list of the best investment books ever.
simply index your securities holdings and focus on
Up until 1978 the value investing course was subsequently asset allocation and cost minimizing. If you are not
taught by Roger Murray who also edited several editions of (and you would have the evidence on your side),
Security Analysis. The list of investors who over the years you have to choose a strategy that fits your
have taken the course reads like a who’s who of successful personality and specifically whether you need
money managers including Warren Buffett, Mario Gabelli, instant gratification or not. If you do, you should
Charles Royce, Walter Schloss, Glen Greenberg and use a short-term strategy – either a technical
countless others. If there is one institution in the teaching of momentum style or a short-term fundamental
value investing, this is it. Columbia, one of the six Ivy strategy. Momentum trumps value in the short
League business schools and situated on Manhattan, is still term - even though you will have the trading costs
retaining this proud heritage and the person carrying the working against you. There are successful
torch for the last several decades is Bruce Greenwald who managers in the technical quant type of camp with
teaches the present course in value investing. Other high Renaissance Technologies as a shining example.
profile investing names currently associated with Columbia The problem is that the short duration of the
are Jean-Marie Eveillard and Joel Greenblatt. strategies they are using makes them have to
reinvent themselves every 12 or 24 months. Very
With an academic background in electrical engineering and few firms have this capacity. Most investors, and
a Ph.D. in economics Greenwald might not strike you as the almost the entire sell side, are short term
obvious candidate as Graham’s successor but he’s grown into fundamentalists who try to forecast short term
being one of the world’s premier authorities on value changes in corporate financials – typically estimates
investing. The New York Times has – no doubt to his of EPS – and map this against consensus numbers.
liking - dubbed him “a guru to Wall Street’s gurus”. The issue here is that this is a strategy that depends
Greenwald has also co-authored numerous books on on an information advantage and since everybody
investments and strategy including Competition Demystified crowds into this space, that advantage of having
and Value Investing, number 5 and 18 on our top list of information that no one else has is really, really
investment literature. All those who have taught the value hard to sustain.
investing course over the years have developed their own
personal touch with regards to what they present. So what is This leaves us the longer term investing
it that Bruce Greenwald teaches, what is the Greenwald approaches such as so called growth investing or
Method? Given his background he has carved out a very value investing where you aspire to buy securities
interesting niche in-between the areas of microeconomics, that are priced lower by the market than you think
corporate strategy, franchise value investing and deep value they are fundamentally worth. The notion here is
investing. that price and value are not the same; “price is
what you pay, value is what you get.” Value
This is “the story of investing according to Bruce” as I to my investors have dubbed the discrepancy between a
best ability can interpret it.* After an introduction the text security’s price and its intrinsic value “margin of
will cover Greenwald’s process that consists of a search safety” and often demand a 30 to 50 percent
strategy, a valuation method, a research method and a risk discount to be interested in a stock. Value investing
management practice. In the end we wrap up. is simply looking for bargains in the financial

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 SHARING OF FINANCIAL WISDOM
markets. This is a strategy that in fact almost 1. The Process
everybody claim they use. Certainly few claim to be
buying securities for a higher price than they think One aspect of the efficient market theory is
they are worth. Further, the evidence is quite clear actually correct. In aggregate all investors cannot
that – while value investing works - investors outperform the market as they constitute the
overpay for stocks with the highest expected market. Investing is in this respect a zero sum
growth rates with underperformance as the result. game. The average investor will perform in line
So in this longer-term area, value investing is the with the market less costs (meaning 70 percent will
more rational choice. underperform after costs). In every transaction
performed in the stock market there is a buyer who
There are a number of premises underlying value buys a stock thinking this will make him
investing and the ability to buy securities at a lower outperform and a seller who sells the same stock
price than their intrinsic value. The first is that the thinking this will make him outperform. One of
price of a stock fluctuates more than the intrinsic them will be wrong. The interesting question is
value of a stock and thus that the two regularly how you as an investor should behave to more
diverge. It is market irrationality that creates often than not be on the right side of this
opportunities. A second premise is that the transaction – how can you develop an edge to
intrinsic value is measurable. Not only that, it must outperform the market over time? Why are you the
be reliably calculable for you specifically as an one who is right, and the person who is trading
investor. To be able to do this you must stay within with you is wrong? What is your edge? That is the
the area you understand - your so-called circle of most fundamental aspect of investing and investors
competence. Finally, fundamental value must should be more humble about it than is often the
determine the price in the long run, i.e. the price case.
must fluctuate around the value creating periodic
disappearances of the market miss-valuation. By Basically, a) you will need a better and more
buying stocks with a margin of safety the investor rational process than others and execute it expertly.
will bag not only the underlying trend growth in Also, b) you will need to specialize in some way to
corporate value, but also the catch up movement get the upper hand with regards to understanding
when the undervaluation corrects. the situations you are in, the motivation of those
on the other side of the trade and the quality of
The evidence for premises one and three are quite information at hand. If you are a generalist on the
overwhelming. The trickiest is the second one. To other side of a trade with a specialist you will
succeed you need to look intelligently for value probably not fare well. You are not going to be
opportunities, ascertain what you know as not all good at valuing everything. You have to
value is measurable – either by you due to your concentrate on what your own particular circle of
limited circle of competence or by anyone due to competence is. You have to know what you know
the unpredictable type of investment. Also, you and what you don’t know. Specialization could be
need character and patience to wait for the really done in a number of ways. The obvious one is to
good opportunities and further concentrate your focus on a few sectors to get an edge but it could
portfolio holdings in these best ideas. also be done by regional segmentation or by
focusing on one specific niche, style or method.
There are plenty of securities that no one can value
effectively. They have few assets and the future is It’s not what is within your circle of competence or
highly uncertain with a wide distribution of how large the circle is that matters most. The trick
payoffs. Make sure you don’t design a process is to refrain from venturing outside it where you
around the premise that you are the one that can are at a competitive disadvantage. Deep domain
value these companies. Ask yourself how much of knowledge within a circle of competence trumps
the future returns you are reasonably able to the benefits of being able to search value over a
anticipate? How much corporate value will be larger opportunity set. If you try to be an expert in
created in the near future and how much in the everything, you will be an expert in nothing.
distant future? Buffett has done well in insurance, media,

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 SHARING OF FINANCIAL WISDOM
consumer durables and to some extent in banks, continuing trend for the next 12 months. Instead
but actually not so well when he ventured into look for the really ugly, crappy and disappointing
currencies, airlines, metals etc. ones that have underperformed other stocks the
most during the last 3 years and be prepared to
In practical terms, with regards to the process, you hold them for about the same time going forward.
need 1.1) a search strategy that increases your Simply looking for boring stocks is usually not
chance of being on the right side of the trade when enough if they are boring but widely analyzed.
you are looking for opportunities, 1.2) a Boring has to be combined with obscure.
differentiated and better method to value stocks
and better than others understand the intrinsic If you see large investors from a particular
value, 1.3) a more effective and relevant research discipline systematically outperform the market it is
method than others and 1.4) a rational risk an indication that this particular discipline has
management practice, including a reasonable advantages. Those who like Warren Buffett,
strategy for what you are going to do when there Michael Price, Mario Gabelli have gotten very rich
are no obvious opportunities and you are growing are to an extraordinary degree concentrated among
impatient to act. value investors.

1.1 Search Strategy Ironically, the most well-known academic proof

that value investing is a corner to focus on comes
A well-formulated way to find opportunities from Eugene Fama - one of the high priests of the
should zero in on the areas with the least efficient market theory - plus Kenneth French,
competition. In which corners of the market can who showed that in the US stock market between
you search to get an upper hand? Where are you 1963 and 1990 the cheapest decile of stocks on
“the smart money”? Any obscure corner would be price-to-book outperformed the market by 0,4
a good place to start. It’s probably hard to lose percent a month, while the most expensive ones
money over time if you invest in companies where underperformed by 0,6 percent. Buying cheap
you are the only professional investor that has works. At the same time the decile of stocks with
visited them. Ideally you want to be the only one the lowest market capitalizations outperformed by
seriously studying a particular security or one of a 0,2 percent a month and the largest companies
few people. You will have a higher probability of underperformed with 0,3 percent. Again, the
being on the right side of the trade in small and relative performance of the deciles in the middle
micro-cap stocks and in boring stocks with low doesn’t differ that much from the market so it’s the
analyst coverage. really small and really cheap you want to look for
(quintiles at the very least). In the really cheap
Secondly, you should search for irrational or forced
decile actually 2/3 of the companies ended up in
sellers creating a supply-demand imbalance. This
bankruptcy but the ones that survived performed
means looking at spin-offs, stocks falling out of
so much that they made up for all the others.
indices, distressed companies, stocks with low
liquidity (which you care less about as a long-term It also turns out to be really hard to improve on
investor, at least if you have an equally long term buying this group of stocks. For example, the
client base) and other situations where investors cheapest stocks that also rank among those with
don’t want to be. Finally, you should seek the the highest growth rate do not materially
undesirable that gets oversold. Look for low outperform the market. Joel Greenblatt and Joseph
growth, industry and company problems, Piotroski have both constructed methods to try to
disappointing long-term performance and above all screen out the value traps among the cheap stocks
look for low valuation multiples. Industry and by adding various quality measures. Greenblatt has
company problems are your friend as long as the performed spectacularly but could have performed
industries and the companies are viable. In this you even better only using his valuation measure and
don’t want to look for the stocks that have been Piotroski didn’t succeed especially well when
disappointing for the last 12 months as the setting up a real life portfolio. What they ended up
momentum effect on average will create a doing was diluting the positive ugliness-effect.

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 SHARING OF FINANCIAL WISDOM
To be convinced that the value effect will stay in 1.1.1 Barriers to Entry
place also in the future you must understand why
it’s there to start with. There are really two types of Given the importance of competitive advantages
systematic biases that create the opportunity. First and barriers to entry we will take a deep dive into
there are psychological biases of the individual the subject before again returning to valuing
investor. People like lotteries even though the growth later on. Identifying franchise businesses is
payoff from putting money into them is terrible. key to identifying good businesses. The protection
The parallel high-payout-but-minuscule- from structural barriers to entry for competitors
probability-venture on the stock market are the get allow franchises to generate plenty of reliable cash
rich quick glamour stocks and as a consequence flow where a large part is possible to re-deploy at
they are overvalued and subsequently high incremental returns on investment. High
underperform. People like speculative situations capital intensity could create a barrier to entry but
and exciting industries. This is not where you want will also necessitate heavy capital expenditures,
to be as it minimizes your chance of being at the often making returns no more than average. On
right side of the trade. Overconfidence further top of barriers to entry that shut competition out,
makes people much too sure about their abilities to the company must be well run. Cash flow comes
predict the future of stocks and markets. When from assets plus effective management. Therefore
afterwards they turn out to be wrong - because the management must both be good capital allocators
brain wants to suppress uncertainty - they revise and efficient business operators. It’s important to
their memory to actually believe that they knew all note that what is needed is competitive advantages
along that what happened would happen and for the incumbent companies of an industry. If it’s
hence they learn nothing from the experience. the new entrants who have competitive advantages
People mistakenly think they know what’s going for example through newer technology then it’s a
on and they forget what they really did. They erase recipe for hyper-competition and constant change
their mistakes from memory. Further, loss aversion in market leadership.
makes people irrational sellers of what is ugly and
An analysis of the competitive advantages of a
boring and to avoid losses, people will take
company should a) start with an industry map
unreasonable risks.
describing the environment the company is in.
You would think that the professional institutional Divide the corporate landscape around the
money manager organizations would be perfectly company into segments of the value chain and list
placed to capitalize on the biases of the individuals the companies with the largest market shares in
– instead they tend to amplify them. The big risk each. b) Next, look to history to get a feel for if
for an institutional money manager is the career barriers to entry exist. The two best clues are
risk and this risk is only really acute if he sustained and high ROIC, especially for the
underperforms the market materially. The rational dominant competitor, and stable market shares
cause of action is then to be a closet indexer and to over time. If there are barriers to entry there
herd into what is popular for the moment together should be share stability. Look to average market
with everybody else. Portfolio managers don’t want share change over the last 10 years for the largest
to expose themselves to the risk of not embracing competitors. For both the beginning and ending
an institutional trend among peers. Add to this the years of the period, list the market shares of the
selling that is done to window dress the portfolio largest competitors, adjust the shares to sum to 100
so that the customers will not spot the – now percent, look at the change in absolute share for
cheap - stocks in the portfolio that are mentioned each company during the period and calculate an
as disasters by the press. All in all it’s hard to see average of those. Also, ask yourself if the dominant
much of the above changing and so the value competitor has changed and if there are new
effect will probably be there also going forward. entrants. An additional clue is if it’s hard to list the
Therefore, specialize and capitalize on these biases. dominating companies. In this case there are
Value investing is in this respect a rational and seldom any competitive advantages. Finally, c) you
disciplined approach to navigating financial must analyze what the competitive advantages are
markets. based on to be able to understand their

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 SHARING OF FINANCIAL WISDOM
sustainability going forward (or if they will erode) impacted by the increased supply). In aggregate
and the effects of this on future profitability. several firms will increase capacity, supply will go
Competitive advantages should be identifiable to up and prices will go down to a level where return
function as a base for an investment. Look for on capital equals the cost of capital – or often even
hidden franchises such as unused pricing power, lower. One additional problem is the exit costs
good businesses hidden among several bad after the investments have been made; the industry
divisions of a company etc. In doubt, don’t pay for will be stuck with the added capacity for a very
the franchise – instead focus on the AV. long time. In industries like this it’s only the firms
that have a sustainably lower cost structure than
There are a number of overrated competitive their competitors that can earn a return slightly
advantages. Access to broad asset pools or higher than the cost of capital.
resources such as capital (“deep pockets”), Chinese
labor, high quality staff etc. are seldom a The consequences of free market entry in a market
sustainable advantage as competitors will get equal with differenced products such as luxury cars are
access to them sooner or later. Even locations like very similar. In this market the demand curve is
woodlands with access to timber can be bought negatively sloped – the higher the price the lower
and sold and they have an opportunity cost. the sold quantity. The cost curve is relatively
Judging from the companies that have succeeded similar to the one in the steel market where the
in the past, first mover advantages are also often average cost per sold quantity first decreases and
over-rated and further there is a low correlation then starts to increase. The consequence of new
between the level of prestige associated with entrants, say when first BMW and Mercedes and
brands and profitability. Also, differentiation - the later Lexus and Infinity started to compete with
standard recipe if there are no barriers to entry – Cadillacs and Lincoln Town Cars in the US, isn’t
will not be sufficient to protect a company if there always lower prices but instead lower volumes for
is nothing stopping competitors entering and the individual firms, in the end equalizing the price
copying the strategy. Differentiation is only of and the cost. A Lincoln Town Car might have a
value if there is something that gives you discretion prestige brand with differentiation but so has
over the price you are going to charge. Then there Mercedes and luxury car buyers are more than
has to be something that interferes with the happy to try out new vehicles.
process of market entry.
Moving on to potentially durable competitive
Let’s first look at the consequences of free entry in advantages. The first class of sustainable barriers to
a commodity market such as the steel market. In entry are supply side incumbent advantages. These
markets like this the market price of the products cost based advantages could come from a
will as a general rule be the same for all proprietary technology, access to specialized niche
competitors and it will not be dependent on the resources or an accumulated body of experience
sold quantity. The average cost per sold quantity taking the company further down the learning
will however decrease as the quantity increases and curve. These advantages are rare and they are often
fixed costs are spread over larger volumes. At a the weakest kind. Proprietary technology is most
certain point diseconomies to scale will however common in industries with quick technical
dominate scale economies and the average cost per development making it less valuable, as it sooner
sold unit will increase as volumes increase further. rather than later will be replaced by a new
If the average cost for a company at a specific technology. In industries with less change
volume is lower than the market price it will make proprietary technology is much less common.
money to cover the cost it has of capital. The
problem is that capacity increases are relatively easy The second class of barriers to entry are demand
to make both for new companies but especially for side advantages. These advantages give the
the existing ones. As individual companies they incumbent preferential access to customers – a
would all improve their profits if they increased customer captivity - that others lack. My
their capacity and the others didn’t (even though competitors can’t compete with me because I have
the market price would be somewhat negatively access to demand they cannot match. For products

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 SHARING OF FINANCIAL WISDOM
with high frequency purchasing such as Coca-Cola within each local market and a locally dense retail
the advantage is often due to habit in combination network also facilitates easier supervision and
with a brand loyalty. In situations of high management. The investor has to segment the
complexity the advantage comes from the high market in a way that is economically relevant. For a
search cost of finding a replacement. The food retailer the relevant market to dominate is
advantage could also be based on a high switching local and then national or international reach is less
cost for example due to the high risk or difficulty important for scale economies than the local
for a customer of changing products that have market share. In pharmaceuticals, sales and
been integrated into the current production and marketing towards doctors are the largest costs.
workflow. Examples of sectors with high switching Doctors are organized in medical faculties making
costs are banks and computer software. Over time this the relevant economic market and the
there is however a turnover in the total customer companies that have shown the highest
base and there is always a risk that the advantages profitability therefore are those that dominate
die with the customers. specific product niches. If the market a company
serves is global there will seldom be scale
The third and most important competitive economies that create a competitive advantage.
advantage is economies of scale. The advantage of This is because the market will be large enough to
spreading costs over larger volumes is more support most companies’ fixed cost bases. Large
economically important in sectors with high fixed global markets are difficult to dominate. Smaller
costs as the average cost per sold quantity will markets are susceptible to domination. The result
decrease even when the quantity a firm sells goes from this “market relative scale effect” is that most
from very large to even larger. The fixed cost effect sustainable competitive advantages are found
will trump any scale disadvantages in those cases. within smaller market niches such as geographies,
The incumbent with higher volumes will then product segments, customer segments etc.
always have a beneficial cost structure to
opponents. However, to be enduring the In terms of corporate strategy this means that the
economies of scale will have to be complemented advantage of being a “one stop shop” seldom
with some measure of customer captivity for exists and that the best expansion strategies start
example due to networking effects, switching costs with local domination and then gradual expansion
etc. Take for example a high fixed R&D cost into close adjacent areas. A more general strategy
necessary to keep up with a technological road map for companies to follow will look as
development in combination with high switching follows.
costs if the products are integrated in the
customers’ process. The incumbent’s scale
advantage will create a positive feedback loop
where the higher sales than that of the competitors
leave room for higher R&D, further expanding the
product advantage and driving higher sales and so
on. Scale economies in themselves are not
sufficient to create a competitive advantage.
Without some measure of customer captivity a
competitor with deep pockets will eventually step
in and share the volumes and also the scale
economies as nothing stops customers from The fact that scale economies must be set in
leaving the incumbent. relation to the size of the relevant market and to
the competitors’ size points to a need of vigilant
Note that the high fixed cost is not an absolute
defense of the incumbent’s position. As long as the
number. Importantly, the cost should be high in
size difference remains versus the other
relation to the size of the relevant market and to
companies, the incumbent will have the lower cost
the major competitors. For example in food retail
structure and can set prices that put pressure on
there are fixed costs in distribution and advertising

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 SHARING OF FINANCIAL WISDOM
the others. If the difference becomes smaller the almost completely ignores the information in the
relative scale advantage will quickly diminish, balance sheet and as no one is looking at this key
creating a double whammy of lost sales and lost financial statement it probably should be a
profitability level. This is why customer captivity is competitive advantage to do so. Further, a DCF
key but it also points to that the incumbent must mixes information like current year’s sales and cash
be very active in matching any price threat from flow that you can estimate with a decent accuracy
competitors. Advantages are dynamic and must be with very imprecise estimates of economic
defended. variables further out in time. Unfortunately the bad
information tends to dominate the good when for
In addition to the barriers to entry above there are example a terminal value five or ten years out is the
a number of others and they are often based on basis for half or more of the estimated value.
either the state as in the case of licenses, permits, Finally, the analysis is really sensitive to changes in
concessions, regulations and patents (all these tend difficult-to-forecast parameters that on top of
to be as fickle as the politicians who ultimately everything else co-vary in complex ways that are
grant them) or on informational advantages where very hard to understand. The ranges of possible
banks, financial services, HMO’s etc. have the values are too wide to be of practical use. This
upper hand in relation to customers. Other aspects makes using DCF’s a stupid thing to do. It also
of market behavior include cooperation within makes scenario analysis hard as you – again - pretty
barriers to entry (cigarette makers) and strategic much end up with the outcome you seek.
alliances to divide the spoils of a value chain.
So how do you construct a better valuation
1.2 Valuation Method method to have the upper hand in the trades you
make? You want an approach that will restrict you
With this overview of barriers to entry out of the
to making decisions on the basis of what you really
way we are now turning to the topic of valuing
know. A valuation method is like a machine for
stocks. The intrinsic value of a stock is only
translating from the assumptions that you reliably
possible to approximate. The dominant method of
can do about the future to the present day value of
valuing a stock among practitioners is to multiply a
the security. How do you construct this machine to
cash flow proxy measure – for example EPS - with
value things more effectively? You should 1) use all
a discretionary chosen multiple, often based on the
of the financial information that is of value and
average multiple currently priced by the market
also be able to cross-correlate that information, 2)
among comparable companies. There are huge
the valuation components should be organized by
problems with this. First it’s hard to find true
reliability so you know what you can be relatively
comparables as economically motivated multiples
sure about as well as what you must take with a
are effected by differences in economic situation,
pinch of salt and finally 3) it should use strategic
cyclical situation, leverage, management quality,
information that effects the value of the company.
return on capital, cost of capital, growth etc. and
secondly, the relative valuation might turn out to Instead of, as in a DCF, using unknowable factors
be misleading anyway if all the other companies are such as a company’s margins or investment rate
over- or undervalued. The range of error is more ten years from now, it is possible to use knowable
than 100 percent and hence with this method the factors such as if an industry is economically viable
investor really has full freedom to decide the during the time frame in question, if there are
intrinsic value he wants. barriers to entry to an industry and if a firm has a
sustainable, stable competitive advantage. The fact
The preferred method among academics and the
that these later factors basically never are
more financially advanced practitioners is to use a
considered when it comes to valuation, makes
DCF. The NPV in a DCF is the theoretically
using them a competitive advantage.
correct intrinsic value. But as they say, in theory
there is no difference between theory and practice, Greenwald for the sake of better clarity divides the
in practice there is. Several factors conspire to value of a company into three elements: a) a
make DCFs almost unusable. To start with, a DCF tangible and balance sheet based Asset Value (AV)

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 SHARING OF FINANCIAL WISDOM
that uses no extrapolation or forecasts, that is the The first thing to decide when performing an AV
most reliable measure and the AV is all there is if is if the industry is a viable one or not. If it’s not
there are no barriers to entry in the business and then the company will be liquidated and the assets
thus the company has no competitive advantages should be valued at their liquidation value in a fire
and b) a current earnings based Earnings Power sale. In this case you are going down the balance
Value (EPV) which extrapolates current sheet seeing what is recoverable. Specialized
normalized profitability and assumes that it is equipment and intangible assets will yield little
sustainable, but uses no further forecasts of the value. Cash and marketable securities are marked
future. If the EPV is larger than AV then this is to market and should be valued at full value.
because there exists a franchise value as the Accounts receivable should be paid in principle but
company currently has a competitive advantage. use an 85 percent number to be on the safe side.
Finally, c) the most unreliable element called Total What you will get for the inventory will depend.
Value (TV) which includes projections of future The more generic it is the higher the recovery ratio
profitability and growth. Historically all those have – an inventory of cotton is better than one of
been used separately by a number of successful ready-made T-shirts. The value of property, plant
value investors. By using them all together an and equipment will vary widely. Generic offices in
investor will be able to look at a broader spectrum good location will sell at little discounts (or even
of investment cases. premiums) while specialized production plants in
locations off the beaten track will have substantial
discounts. You can also compare the net
Growth%in%
Franchise%value.% liquidation value you got with the simple Graham
and Dodd liquidation value: working capital minus
Franchise%Value.% all the liabilities – so called net net working capital
Current%Compe9vive%
Advantage% – as that might be a useful substitute of liquidation
value.
Free%Market%Entry.%
No%Compe9vive%
Advantage.% If the industry is viable and the company a going
Asset%Value% Earnings%Power% Total%Value%
concern, then a company’s productive ability
(AV)% Value%(EPV)% (TV)%
constantly has to be renewed to be competitive, i.e.
the assets have to be replaced over time. Hence,
You should start with the AV, the Asset Value, as
you have to look at the cost of reproducing those
it’s your most reliable information, using no
assets with today’s technology and prices. You
projections of an unknown future. You could
have to look at the reproduction value of the assets
technically go out and look at almost everything
that have the same level of productive capacity if
that is on the balance sheet. It’s also the case that
the same business would be set up anew. The task
for most companies over time there are no barriers
is to understand what the most capable and
to entry or sustainable competitive advantages and
efficient possible new entrant would have to pay to
then the AV is in principle all you need. Why
have the same capacity. This requires industry
should the AV correlate to the intrinsic value of a
knowledge. The result could be viewed as a refined
company? Because there is a market for corporate
and more correct version of the book value.
control and for corporate assets. If there are
returns generated above the cost of capital in an Again no adjustments would have to be made to
industry, new and old competitors will want to cash in this calculation. A firm’s account
invest in new industrial capacity. This could be receivables probably contain some allowance built
done either by new green-field investments or by in for bills that will never be collected. A new firm
brown-field investments buying existing assets if starting up is even more likely to get stuck with low
they are valued to low. Asset pricings which quality customers so the cost of reproducing a
deviate too much from the value they have as firm’s accounts receivables is probably more than
return generators will trigger M&A. As such the the book amount. If the bad debt allowances are
AV works as a backstop for what a company is specified these should be added back. The stated
worth, capping the downside for the investor. value of inventory could be too high or low by

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 SHARING OF FINANCIAL WISDOM
substantial amounts. If inventory days have been value is to estimate how many months of SG&A
building up lately more of it will probably have to (and especially the amount of A&P, advertising
be discounted and the value should be lowered. By and promotion) it will take before a new business
contrast, if the company uses a last-in-first-out- is up to full sales capacity with established
method of recording inventory costs and prices customer relationships. In this business
have been rising, the reproduction cost will be fundamentals vary even within the same sector. It
higher than the book value as a new entrant cannot takes 3 months to build traffic for a clothing
buy an inventory at prior year’s prices. retailer situated in a mall while it takes 4 years until
a Home Depot gets up to full capacity. Other
Property as land is booked at cost and depending hidden assets could be organizational design,
on location this can mask substantial licenses and franchises, subsidy businesses etc. A
undervaluations even if there would be a cost certain amount of creativity is warranted when
related to selling the land. Plant could be anything estimating a reproduction value and the further
from an office, a motel chain, a factory or an oilrig. down the list of assets you go the trickier it gets.
Inflation in combination with a lack of alignment See to what costs have been, make simple common
between depreciation periods and the life of the sense calculations, look at prices in private
economic value of the asset conspire to make the transactions or at insurance values etc. Try to
calculation a tough one. Use common sense to get triangulate and get input from several angles.
approximate values. Equipment is easier as it is
Assets Graham-Dodd Value Liquidation Value Reproduction Value
often depreciated over its useful life. The Cash Book 100% 100%

adjustments to book value will most probably be Accounts Receivable Book 85% Add bad debt allowances. Adjust
for collections

small enough to ignore. Inventories Book 10% – 50% Ad LIFO-reserve, if any. Adjust
for turnover.

Property, Plant & Equipment 0 10% - 90% Original cost plus adjustment.

Product Portfolio 0 0 Best estimate

Goodwill and other intangibles represent the Customer Relationships 0 0 Best estimate

largest challenge. In themselves the numbers may Organization

Licenses, Franchises
0

0
0

0
Best estimate

Best estimate

reflect nothing else but an expensive acquisition Subsidies 0 0 Best estimate

but they also represent the economic value of the Liabilities

non-physical assets of a company. All companies Accounts Payable, Accrued

Taxes and Accrued Liabilities
Book 100% Book

have these intangible assets that most often don’t Debt

Deferred Tax, Reserves

Book

Book
100%

100%
Market value if available or Book

Book

appear on the balance sheet – they are hidden

Bottom Line Net Net Working Capital Net Liquidation Value Net Reproduction Value
assets. These assets can include the product
portfolio, customer relationships etc. In trying to
estimate the intrinsic value of the company we By deducting the value of the company’s liabilities
need some way to estimate the worth of these a net reproduction value is generated and this is
hidden assets. Remember, the aim is to estimate then divided by the number of outstanding shares
what it would take to rebuild the productive to get an estimate of the net asset value per share.
capacity. A product portfolio is built of prior R&D If possible the value of the interest bearing debt
and different products have different average should be the market value. If this is too hard to
lifespans. Here you need to understand the estimate the book value will often be a sufficient
business to make reasonable estimates of how approximation. One problem is that in highly
many years of R&D it would take to rebuild an leveraged companies slight errors in estimating the
equivalent product portfolio. If it’s like the auto value of the debt will create huge swings in the net
companies where it takes six years to produce a production value. Many value investors will
product portfolio, you will have 6 years of R&D therefore shy away from this kind of situation, as
spending and this is the reproduction value. An the margin of safety will be highly uncertain. Also,
aircraft has an average life span of 15 years while in the case of a balance sheet dominated by
some garments will be unfashionable in 6 months. intangibles that are difficult to appraise, the AV
might not be the reliable backstop to the valuation
Developing customer relationships also costs
as in the normal case.
money and this asset never appears on the balance
sheet. One way of estimating the reproduction

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 SHARING OF FINANCIAL WISDOM
This brings us to the Economic Power Value, relationships, brands and other intangible assets.
EPV, which is an estimate of the corporate value After deducting taxes you will arrive at an adjusted
based on the earnings power of a company’s NOPLAT. EBIT less taxes is also often called
current sustainable distributable earnings. As it NOPLAT, net operating profits less adjusted taxes.
builds on today’s earnings it’s the second most You shouldn’t necessarily use official tax rates as
reliable type of valuation. EPV estimates the companies structurally pay a lot lower taxes than
enterprise value by dividing an earnings measure that, but you will have to adjust current levels that
with the weighted average cost of capital (WACC, are not reasonably long term.
that is the cost of debt multiplied with the weight
of debt in the company’s financing, plus the cost of Further you need to make sure that the
equity multiplied with the weight of equity depreciation represents the investments in capex
financing). Then add excess assets, i.e. assets like needed for guaranteeing a going concern. Since the
excess cash (anything above 0,25 to 0,5 percent of EPV represents a no growth case, adjustments for
sales as a rule of thumb) which is not needed for investments in working capital to support sales
the operations, deduct debt and divide by the growth will not be required. Depreciation today
number of outstanding shares to get EPV of equity tends not to reflect true no-growth depreciation.
per share. This is comparable to the AV per share True depreciation is what it would cost to put the
net of debt (i.e. the net net working capital value, company in the same condition at the end of the
net liquidation value or net reproduction value per year as it was at the beginning of the year.
share). Don’t make the mistake to compare an Compare the level of both depreciation and capex
enterprise value to an equity value. over a number of years to get a feel for
discrepancies and trends. There are two main
To correlate with the enterprise value and to be adjustments: first possible under or over
neutral to a company’s leverage the calculation uses depreciation and secondly adding back the growth
EBIT as its starting point. You then have to adjust capex. Excess depreciation could come about in
for any accounting shenanigans that are going on, situations where input prices for capex are going
you have to adjust for the cyclical situation, for a down over time. In this case a part of the
tax situation that may be short lived, for excess depreciation has to be added back to EBIT. When
depreciation over the cost of maintenance capital looking at capex and depreciation you should
expenditures and really for anything else that is differentiate between the part in current capex that
going on that is causing current earnings to deviate is maintenance capex and the one that is growth
from long run sustainable earnings. What you are capex, as the later should be added back to the
after is a number that adequately represents the profit. The EPV is a valuation of current earnings
current sustainable distributable cash flow. If the level so it should only be burdened by the
company is facing disruptive structural maintenance capex level. The simplest way to
developments the advice is to stay clear of estimate the growth capex is to look at the capital
investing altogether as estimating the company’s intensity of the business (property, plant &
value will be inside no-one’s circle of competence. equipment-to-sales), say it’s 20 cent of PPE per
USD in sales on average over the last 5 years (i.e.
When cyclically adjusting EBIT you should 20 percent), and multiply this with the dollar
preferably look to two business cycles to get a growth value in sales. The adjusted NOPLAT
better picture. A good practice to estimate a further adjusted for any over or under depreciation
cyclically adjusted EBIT is to apply the average and growth capex will give us the figure for a
historical EBIT-margins to current sales. Any distributable cash flow that we are after.
extraordinary items not normal to the operations
will need to be adjusted. One time charges are With regards to the WACC the advice is to not get
however sometimes more periodic than the too technical. The beta used in a CAPM calculation
companies would admit. Look to average levels is too unstable to be of any use and the equity risk
over time and normalize. The amortization of premium nobody knows what it should be. Look at
goodwill should be added back as the R&D and what the cost of corporate debt is in the market
SG&A include costs for sustaining customer and adjust for unsustainable situations or look at

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 SHARING OF FINANCIAL WISDOM
the level of government debt and apply an valuations. The stock could still be a
appropriate spread. The cost of debt is calculated worthwhile investment if the margin of safety
post tax. The cost of equity lies somewhere in is large enough (for example due to cyclically
between the pretax cost of debt and the returns or temporarily depressed earnings). If the two
that are demanded of venture capital funds. Say figures are the same although the company
that those numbers are 5 and 13 percent, then the does have clear sustainable competitive
average is 9 percent and reasonable estimates for advantages due to barriers to entry this is again
another type of corporate mismanagement.
cost of equity for low, medium and high risk
3. The EPV is greater than the AV creating a so
companies could be 7, 10 and 13 percent.
called franchise value (EPV minus AV equals
After estimating an EPV you have got two pictures the franchise value). In the long run this
should only be the case if the company can
of a company’s value. Two observations give the
earn a return on capital that is higher than the
opportunity to triangulate and by this comparison
cost of capital. Due to the functionality of
get valuable insights into the key issues of the
capitalism this must be because there are
investment case. A better clarity of a situation is barriers for competitors to enter the industry.
generated by separating various aspects of value. The key task to determine whether EPV or
There are three possibilities: AV is the better estimate of the value, is to
understand if the current competitive
1. The AV is greater than the EPV. Either you advantage is sustainable. If the competitive
have missed to pick up that this is not a viable advantage that created the current franchise
company in a viable industry and that you in value is not deemed sustainable you should
terms of AV should have performed a never pay more than the AV. A higher EPV
liquidation valuation instead of a reproduction than AV could also be due to superior current
valuation, or – more probable - this is a case management. This is however seldom
of a corporate mismanagement. The nice thing sustainable in the long run as management
of the valuation approach is that it tells you teams will be changing and the advantages
the current cost that management is imposing then disappear. As the most important
in terms of lost value. Good management competitive advantage is scale, shrinking
always adds value to the assets. Bad franchise businesses experience nasty dynamic
management subtracts value. So which is the effects that are seldom appreciated by
correct value to use? It depends on what investors beforehand. A combination of
happens with management. Ask yourself if the declining profits due to declining sales plus
asset value can be realized. Is it possible to get declining ROIC is not a pretty development.
rid of the management and get to the assets?
Or is it possible that a new management will The third estimate of a company’s value is the
be reinstated that can utilize the assets better? Total Value (TV) that includes the value of growth.
If so, the higher AV might be relevant. If not, This is the least reliable estimate of value as you
the lower EPV is a better guide. All in all, this have to forecast change - not just stability in
points to the key issue for this company: it is a earnings power – and the estimate is highly
search for catalysts that will surface the true sensitive to the assumptions made. Data indicates
value of the company. Make sure you’re not
that investors systematically overpay for growth
going to be trapped with old management
and strict value investors therefore want growth
(value trap). A third explanation is that the
for free, i.e. they don’t pay more than EPV. The
industry is one of overcapacity, so it’s not the
standard view of analysts is that growth is your
fault of the management. The trigger then
becomes changes in the industry structure, friend, that growth is always valuable. This is
which is harder to orchestrate for example for wrong. In fact growth is relatively rarely valuable in
an activist. the long run. Growth at a competitive disadvantage
2. The AV essentially equals EPV. The probable has negative value and the only case where growth
reason is that there are no barriers to entry and has a positive value is where it occurs behind the
no competitive advantages. If this sounds protection of an identifiable competitive
reasonable you have a fair grip of what the advantage. This for example makes the use of
stock is worth from two independent PEG-ratios without reference to sustainable ROE

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 SHARING OF FINANCIAL WISDOM
levels absolutely crazy. If return on capital roughly value for shareholders. So far so good, but if we
equals the cost of capital for a company there is in look further on valuing growth it becomes
principle no need to further calculate TV. apparent how unstable a valuation including a
growth factor is. If R, i.e. the WACC, is 10 percent
Looking at the value of growth it is on the one and G, the growth rate, is 5 percent then the cash
hand obvious that a growing stream of cash flow is flow is multiplied with a multiple of 20 times. If we
more valuable than a constant stream everything change R to 11 percent and G to 4 percent the
else alike. On the other hand growth requires multiple is 14. With the same one-percentage point
investments to come about which reduces the cash changes in the other direction to 9 and 6 percent
flows that are realized. So the value of growth the multiple becomes 33. Hence, small adjustments
depends on the balance between the utility of a or errors in input parameters leave us with huge
growing income stream and the downside of swings in corporate valuations.
having to invest to get that growth. Which force is
most important turns out to depend on the barriers This fundamental problem makes placing an
to entry for competitors. Say that a company absolute TV on a stock a very precarious thing to
invests USD 100 million in a project and that the do. Especially if the current growth is high and the
cost of that invested capital is 10 percent, then the industry is hard to forecast due to quick change. In
investment obviously must return more than 10 his book Value Investing: From Graham to Buffett and
percent to create value. The only way this can Beyond Greenwald still presents how the TV could
happen is in an industry where the higher returns be calculated while in his class he has favored a
on investments are protected by barriers against yield based approach instead. We will take a look at
competition. Otherwise competition will make sure both methods.
that the return on capital is the same as the cost of
capital and the investment of USD 10 million will The only technically slightly tricky point in the first
match the USD 10 million you generate from the method is to calculate the proper number for CF0.
investment. Say that the no growth earnings power (E) of a
company as used in the EPV-calculation for
The TV is separated from the other valuations as it example is $20mn. This will in itself by definition
is the most difficult part of the corporate value to be equal to the amount of capital (C) times the
estimate but when isolated it doesn’t interfere with return on capital (ROC), in this case $200mn * 10
the more reliable parts of the value. Investing in percent. The investment (I) to support an annual
the TV requires a larger margin of safety than growth (G) of 5 percent is in this case 5 percent of
investing in the AV or EPV. As noted above, a the capital base, that is I = C * G or $200mn * 5
positively growing stream of cash flows is more percent = $10mn. The distributable cash flow
valuable than a constant steam everything else (CF0) equals the no growth earnings power minus
alike. That is, if growth (G) is positive number, the investment or $10mn. The present value (PV)
then: of a growing cash flow is PV=CF0 * [1/R-G]
where (R) is the cost of capital and the cash flow is
( CF0 * [1/R-G] ) > ( CF0 * [1/R] ) CF0 = (C*ROC)-(C*G) = C*(ROC-G), then
follows that PV = C*(ROC-G) * [1/R-G] which
CF0 is the cash flow the current year and R is the
translates to a calculation of a present value of:
required cost of capital, i.e. the WACC. The thing
is that, everything else isn’t alike. The cash flow in PV = C * [(ROC-G)/(R-G)]
the growth case to the left will be the cash flow
after the investments needed to support the In our case this is $200mn = $200mn * [(0,1-
growth – the two cash flow numbers are not the 0,05)/(0,1-0,05)]. Also, just to double-check, the
same. The value of the future increased cash flow value $200mn also checks out with the original
will have to be balanced against the value of the equation of CF0 * [1/R-G] since $10mn * (1/(0,1-
invested capital and most of the time the value of 0,5)) is $200mn. What does this say? As long as the
growth amounts to nothing. In the case where the return on capital (ROC) is the same as the cost of
TV is lower than EPV, growth will have destroyed capital (R), then the level of growth will not matter.

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 SHARING OF FINANCIAL WISDOM
But if it they differ from each other the growth rate a) The earnings return or earnings yield is simply
will impact value. If ROC > R any increase in G the inverted PE (1/(p/e)). Simple enough, but
will create value and any decrease in G will destroy the earnings number to use in the p/e-ratio
value. If ROC < R any increase in G will destroy has to be the adjusted sustainable earnings as
value and any decrease in G will create value. The used in the EPV-valuation. Say that the p/e-
estimates of the present value will vary widely with ratio is 14, then the earnings yield is (1/14) 7,1
small adjustments of the input values of the return percent.
b) Say further that the dividend yield is 2,1
on capital, the cost of capital and the growth rate.
percent and that the company net buys back 1
Also, the equation breaks down when the
percent of the share count a year, then the
estimated G equals R. Further, as G assumes
cash distribution return “d/p” will be 3,1
constant growth the estimate made cannot deviate percent and the remaining 4 percent of the
too much from the general economy growth rates earnings (that is “(e-d)/p”) will be reinvested.
over time. Try to normalize the distribution policy of the
company and use a sustainable level of cash
We now move to the second method of valuing distribution.
growth companies. Warren Buffett who invests in c) The competitive analysis and the investor’s
franchise GARP-stocks has solved the problem of view of the barriers to entry will govern the
the huge swings in estimated absolute intrinsic spread he thinks the reinvested capital will
values of growth companies by looking to expected earn over the cost of the capital. If ROIIC,
returns (for example 11 percent annual return) Return on Incremental Invested Capital, is 15
instead of trying to estimate an intrinsic value. This percent and the WACC is 10 percent then the
method has the advantage of using more robust return on reinvestment will become 0,04 * 1,5
inputs such as current valuation and the existence = 6 percent. A higher reinvestment rate is
of competitive advantages. Looking at the yield will beneficial with a high ROIIC. In estimating
provide more analytical insights for example on the ROIIC, analysis and some creativity is
whether capital should be reinvested or distributed needed. Historical levels of ROIC and ROIIC
give a baseline but you can make a better
to the owners. The downside of using a yield and
prediction by looking at what current
not an intrinsic value is that you’ll have no price
incremental investments actually fund. What is
target to sell at. In Greenwald’s opinion sell rules
the management doing with the money?
are always more or less arbitrary anyway and he’s Remember, it is hard to grow and sustain the
set his sell rule at a p/e-ratio of 27,5 to remind him historic level of ROIC. There is always a risk
of the discretionary nature of his rule. Seth that the franchise will erode and ROIIC will
Klarman sells when the p/e-ratio goes above 20. decrease.
Warren Buffett has stopped selling. d) The growth factor, i.e. (g*(v/p)), is
complicated as the “v/p”, that is the value-to-
Greenwald’s method of calculating expected price multiple, creates a feedback loop since
returns goes through the following steps a) valuing the company is what we’re ultimately
calculate an earnings return (or earnings yield), b) after. Therefore this multiple is by Greenwald
split this into cash distribution returns and set to 1/1 making it redundant and just leaving
reinvestments, c) identify the return on us to estimate the organic growth rate. If in
reinvestments and d) identify the returns from the end the total return of the investment
organic low investment growth. e) The total return turns out to be relatively high it’s fair to
of the investment is the cash distribution return assume that v > p. The organic growth should
plus the reinvestment return plus the organic be the long run nominal figure. In reality this
growth, or put differently TR=(d/p)+(((e- equals nominal GDP with slight adjustments
d)/p)*(ROIIC/WACC))+(g*(v/p)). This model for long-term structural factors (often 4,5
percent +/- 2 percent). The number assumes
uses the assumption that the stock market
constant long-term growth so it cannot deviate
multiples that the company is priced at will not
too much from the economy. The number
change. Let’s look at the steps one by one:
should not include growth coming from
changes in market shares. In markets where
there are franchise values, market shares don’t

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 SHARING OF FINANCIAL WISDOM
change much. For example, our case company their initial P/B-based screening. You will need a
is expected to have an organic growth of a research process that will not dilute what you
relatively low 2,9 percent. searched for to begin with. Still, you should add
e) The total return of the investment is 3,1 fundamental research to a numeric process, as you
percent + 6 percent + 2,9 percent = 12 want to make sure that you are on the right side of
percent. Depending on the investment the trade. You want to be able to explain why a
objectives of the investor this total return stock is cheap to validate the investment. And you
should be compared with the target return
have to have some rationale why this opportunity
yield that the investor has, alternatively to the
exists. Always be vigilant to make sure the
estimated total stock market return or the
investment is not a value trap.
return of alternative investment opportunities
in general. If the total expected yield is
A general rule is to be flexible and to use a broad
comfortably higher than the target giving a
toolbox as no one-valuation method fits all
margin of safety and the analyst is relatively
companies or all situations. To be able to value a
certain about the inputs, the stock could be
worth buying. company the investor needs to understand how
competitive advantages arise industry per industry.
Note the effects of shrinking earnings. If the Don’t generalize. Instead look at how each division
expected organic growth for example had been -7,1 of a company has performed over time. A deep
percent a year the total yield would have been a understanding makes it possible to zero in on the
meager 2 percent. Shrinking franchises often turn few key issues that will determine the financial
out to be bad investments. To invest in shrinking future of the company. The three valuation
franchises you must really make sure that the net methods above will further give clear hints on key
present value of the conservatively estimated cash issues to analyze. If you are buying earnings power
distributed to the owners - for example over the and especially if you value the growth, the crucial
coming 10 years - covers the price paid. On the issue is the strength of the franchise. If you are
other hand a growing franchise that can redeploy buying the assets the critical issue is the
capital at high returns will compound the capital management. Never the less, a broader checklist is
and generate huge returns over time. Investing is in a valuable research tool as it helps you cover
essence an allocation of capital. Warren Buffet likes relevant issues and not be swayed by the topics
to invest in companies that do the job for him by management wants to bring forward. Another
investing in high ROIIC-projects saying “Time is great tool is to write an investment diary where you
the friend of the wonderful business and the in some form that fits you note the deals you do,
enemy of the mediocre.” the motivation for them, the expectations you have
on the investment and also perform a post mortem
1.3 Research Method
of sold shares. Importantly – and often forgotten –
To be able to add value to the statistical process of you need to set aside a regular scheduled time to
looking to valuation multiples the research must be read through the notes, seek for patterns, reflect
tailored to the type of situations at hand. Without and learn from mistakes made.
this adaptation there is a great risk that the research
Other collateral information to look at in the
will subtract from the statistical analysis, as the
review process are a) what deals insiders are doing
researcher will be subject to various psychological
in the stock, b) who the other investors in the
biases. For example, Sanford Bernstein is a top tier
company are and c) what the Wall Street consensus
asset manager who combines quantative screening
view of the stock is. Insiders’ dealings in the stock
and fundamental research, employing over 200
can give you a hint of what they really think rather
analysts. They have about USD 500 billion in
than what they want you to believe. If a stock is
AUM and have outperformed the market with a
decreasing in price, you start to find the stock
remarkable 3 percent a year over the last 25 years.
attractive but the management is selling for all that
Yet, when they looked at their returns they
they are worth, you might want to reconsider your
discovered that they would have outperformed by
investment thesis. In companies where the
almost 4 percent a year if they had simply followed
investment case depends on a trigger such as

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reference is made to investingbythebooks.com.  
 SHARING OF FINANCIAL WISDOM
management changes, increased ownership from 20 to 30 offsetting positions with different
an activist investor is a great sign. Also, you will business drivers should balance the risk of
only earn a different return than the market if you becoming an index fund with the risk of making a
have a variant view of a stock from the consensus. costly research mistake in a stock. You will make
To be able to assess this you need to understand mistakes; try to make sure the effects of them are
the view Wall Street has of a stock. How else not correlated. Further, more money should be
would you know that you are right and the other placed in the stocks in the investor’s portfolio with
investors are wrong? more potential. That is, position sizes should be
differentiated after the risk/reward of an
You need to understand which psychological investment.
irrationality among other investors you are
profiting from. At the same time it’s important to The volatility of the market will create temporary
understand your personal biases to not fool losses in the portfolio. An investor should have a
yourself in the process. You have to rigorously strategy for liquidity to not be stopped out in the
track your own performance. If you make a low point of a crisis, unnecessarily making
mistake that is fine, but if you make it again you temporary capital losses permanent. Leverage,
have not done your homework. Use the either in the portfolio or in the portfolio
investment diary to this effect. companies, will greatly increase the risk of
permanent loss of capital as it either might force
1.4 Risk Management the portfolio to realize losses at the wrong time or
simply because the portfolio companies go
You now have 1) a good search strategy, 2) a good
bankrupt. For the long-term investor economic
valuation technology and 3) careful review of the
macro events seldom give rise to permanent loss of
crucial issues. And finally 4) you have to have a
capital, only temporary losses. As long as
good process for managing risk. In value investing
economies have developed robust economic and
the fundamental way you manage risk is to know
social institutions they have proven extremely
what you are buying. “Use knowledge to reduce
durable against macro shocks.
uncertainty.” For a combined portfolio consisting
of several sub-portfolios it is the total risk that is The margin of safety, i.e. the demanded price
relevant and the risk in a number of portfolios discount to the intrinsic value is not only a return
should because of this be centrally managed. generator but also a protection against mistakes.
With a 50 percent margin of safety the estimate of
In traditional portfolio theory risk is specified as
intrinsic value can be off quite a bit without
the relative or absolute volatility. Volatility
threatening the undervaluation. Different investors
however assumes a randomness that isn’t there, it
demand different size and type of margin of safety.
punishes positive upside movements and it ignores
Seth Klarman seeks a 15 percent investment return
the fat tails of the distribution. Volatility assumes a
if he can see a trigger for a revaluation in the
linear relationship over time but this has been
investment within one year, a 30 percent return if
proven to be false as there are momentum trends
he believes the trigger is two years out, a 45
over time horizons up to 12 months and reversal
percent return with a horizon of 3 years and so on.
trends after that. Thus, volatility is not a good risk
The basic way for an investor to analyze risk is to
measure.
ask; what price am I paying; what am I buying;
Instead an investor should focus on long term what discount am I getting and how sure am I of
downside risk - that is, permanent impairment of those characteristics. Beyond that diversification
capital. The advantage is that permanent helps.
impairment of capital is often company or industry
A huge risk to protect against is the investor’s own
specific which makes it analyzable and it also
impatience and lack of discipline. At times the
makes the risks diversifiable. As a rule value
stock market will be expensively priced and it will
investing implies concentration to your best ideas
be hard to find good investment ideas. Plenty of
instead of diversification, so don’t overdo it with
money has been lost because investors felt the
regards to the number of securities owned. Around

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pressure to act or because they were bored and in Historically the most important macro risk factors
the end they, after researching stock after stock have been inflation and economic recessions (or
without finding a compelling case, bought the next depressions). Looking to the vulnerability of
stock that landed in front of them. You have to various assets an investor will get decent protection
take what the market gives. Chasing opportunities from these two risks by holding a mix of fixed
is a bad idea. So you should have a good default income, real assets and franchise businesses.
strategy. A default strategy is a plan for what you Depending on the investor’s risk tolerance he can
are going to do if you have no ideas. What you construct a total portfolio with a preferred mix out
should do is to minimize risk. The way to minimize of those three assets.
risk depends on the portfolio; for a relative
Asset Inflation vulnerability Recession vulnerability
investor the no-risk alternative is the index, for an Fixed Income High Low

absolute investor it is cash and other investors Real Assets Low High

instead phase in a statistically generated portfolio Franchise Businesses Low Low

of the very safest high quality, low risk stocks.

Gold could be used instead of cash but those who
Fixed income doesn’t have to be government
own gold for some reason have a tendency to keep
bonds but could instead be high quality corporate
it and miss the opportunity to buy equities when
bonds that over time will yield slightly more. The
they have fallen and prices again are cheap.
risk in bonds issued by Nestlé is probably lower
Greenwald prefers phasing in high quality, low risk than that of almost any state. Real assets include
stocks. The difficult issue with cash is that over real estate or land, but could also be non-franchise
time the mistakes made trying to time the market – based deep value stocks instead. All those
more often than not being too early - generally will categories rely on asset values that should rise with
lower the performance more than the money saved inflation.
by having cash (compared to high quality, low risk
2. Wrap up
stocks) in a downturn. For most long term
investors being out of the stock market is generally What you are looking for in investment
not a good idea. The best short seller in the management is a) a good search strategy preferably
business is Jim Chanos and even his long-term looking for the cheap, ugly, obscure or otherwise
track record is a 3 – 4 percent annual total return. ignored; b) a good valuation technology that
Sell options is another way to protect the portfolio differentiates between the asset value, the earnings
if they are used opportunistically. The good thing is power value and the franchise value giving at total
that when the economy is great, stock markets are value; c) a good review process looking to key
on their all-time highs, the volatility is low and issues, collateral evidence and personal biases; and
therefore the risk for a downturn in reality is the d) a sensible risk management strategy using a
largest, the sell options will be the cheapest. Buy margin of safety, some diversification and an
them when they almost don’t cost anything and get impatience/default strategy.
insurance practically for free. You don’t know if
there will come a downturn but if it does you have All the elements have to be in place. Value
protection and if it doesn’t you haven’t lost much. investing in theory and in practice has done
extraordinary well in all those areas but the
The macro economy generally cannot be predicted, investment method is psychologically hard to
but the investor can prepare for possible scenarios. handle. Greenwald finds that about 1/3 of his
Through scenario planning and identifying risks he trainees remain as value investors. The balance
can understand his vulnerabilities and manage the reverts to old habits of herding and trying to buy
consequences before running into acute problems. lottery tickets.

Mats Larsson, July 27, 2015

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* Disclaimer: Please note that the above text is simply my interpretation of Bruce Greenwald’s opinions on investing. They are
neither necessarily a true reflection of those opinions or the same as my personal opinions on investing. To form your own
interpretation on what professor Greenwald thinks, I strongly advice you to take the course at Columbia and read Greenwald’s
books. You will be richly rewarded in knowledge and likely also in wealth.

   

Others may quote and refer to the contents on this website provided that they have the author's consent and proper
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 SHARING OF FINANCIAL WISDOM
 

Others may quote and refer to the contents on this website provided that they have the author's consent and proper
reference is made to investingbythebooks.com.