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Search No More: Google Inc. is a Value Stock

May 28, 2010 | About:
Google’s (GOOG) stock has been punished thus far in calendar 2010 falling more than 20% from its 52-week high. Some of that can be blamed on the recent correction, but with the broad market indexes just about even for the year there is obviously something more. Much of the pessimism towards the internet search giant is related to its pull back from the lucrative Chinese market after a throw down over censorship, and Google’s pain has been Baidu‘s (BIDU) gain as their shares have grown nearly 80% already this year. Some of this shift in valuation is certainly warranted, especially for Baidu, however we think that the reaction has created an opportunity to pick up shares of the global leader in search advertising.

A recent info-graphic provided through Barry Ritholtz’s blog shows the degree to which “googling” has gone global (all statistics are as of February 2010). In the US, Google claims an impressive 72% percent of search market share despite established competition. However, to the south Google’s market share is stronger with Mexico and all of South America hovering around 90%. Google has all but squeezed out the competition in such European countries as the Netherlands, Belgium, Latvia, Lituania, Hungary, Romania, and Poland all with greater than 95% share. Interestingly, as of the time of the report, Google only claimed 26% of Chinese searches, but 81% from India.

A recent report out of Google claims the company generated $54 billion in US economic activity in 2009, apparently this tabulation accounts for revenues generated through ads placed by on Google search results (as opposed to being Google’s own revenue). The report laid out the value proposition for using their platform, “We conservatively estimate that for every $1 a business spends on AdWords, they receive an average of $8 in profit through Google Search and AdWords.” It would seem to me profit is the wrong term to use in this case, but you get the idea; the platform works.

gah.Web.Mvc.Views.Components.Charts.Cach

Clearly, internet search advertising is dominated by Google, and we have seen spending return as the economy has rebounded. We believe this trend will continue as keyword targeted advertising has become a key medium for small business ad campaigns, and economic recoveries are a time when many small businesses get off the ground. According to ZenithOptimedia, a London-based ad buyer, the internet’s share of overall advertising spending is expected to grow to 17% in 2010 from 13% last year.

So, is the China ordeal a red herring? We think it is, as the bigger picture is much more positive. Remember, Google has plenty of other businesses that are rolling along nicely. Their Android operating system has stormed the smartphone market and in a matter of months has surpassed the iPhone for smartphone marketshare in the US already claiming 28%, and its gaining on the leader Research in Motion (RIMM) quickly. Coincidentally, just today Google completed its acquisition of mobile advertising firm AdMob, which almost assures Google will be a key player in the rapidly expanding mobile search and advertising business. Consider this, mobile searching from Android devices, iPhones and Palm’s Pre rose 62% in the first quarter of this year sequentially from the last three months of 2009!

In the interest of brevity, we will not go into other high growth potential initiatives going on at Google right now, such as Google TV. At this point, we think it would be best to talk about the fundamentals of the company. Google may sound expensive at nearly $500 per share, but according to our valuation methodology the company is Undervalued. For example, Google has historically traded for price-to-cash earnings ranging from 25.6x to 52.3x, but using current estimates for this year that metric dips to just 17.5x. This valuation only becomes more attractive should you choose to back out the $83 per share of cash and equivalents on their balance sheet (with zero debt). The current price-to-sales per share of 7.3x while high, does not fall out of line with GOOG’s historical norms for price-to-sales of 6.1x to 12.5x.

Based on our analysis the stock appears priced attractively, and has plenty of growth potential in the years ahead with or without China in the picture. We are reiterating our Undervalued stance as of this week’s report, and we see this stock as a best of breed technology stock that has fallen out of favor because of a relatively minor scuffle (albeit noteworthy for many other reasons). After all, the fundamental growth continues to impress us and they have built a pretty high moat around their market share in some exciting spaces.

Ockham Research Staff

http://www.ockhamresearch.com/

About the author:

Ockham Research Staff
Visit Dividend Growth Investor http://www.dividendgrowthinvestor.com

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Rating: 2.6/5 (17 votes)

Comments

jhodges72
Jhodges72 - 4 years ago
The notion of GOOG being a value stock is one of the stupidest propositions I've ever heard.
superguru
Superguru - 4 years ago
10% lower than current price and I would call Goog a value stock too and growth stock as well. Best of both worlds.

Jhodges2 - take look at google's p/cf and PFE p/cf on morningstar you be would suprised they are almost same.
jhodges72
Jhodges72 - 4 years ago
Charlie Munger said that if he asked a classroom of students how to value a tech stock, he would automatically fail anyone who tried to accomplish the task. I tend to agree with him.
superguru
Superguru - 4 years ago
Google is a search and advertising company. It earns pretty much gets all its revenues through advertising. And Google has a strong moat as Yahoo found out when it miserably failed to take on Google. May be you can value Google now.

Yahoo is a media company.

Amazon is a retailer.

A good example of Hi Tech company would be NOC. I am sure Munger will fail me if I try to value it and I would not.

"Think Different" - Apple - another one, hmmm....Technology or Not...
vgm
Vgm - 4 years ago
Glen Greenberg, one of the investing greats, recently bought GOOG for his Brave Warrior fund, and described his justification in an interview in the Graham and Doddsville Spring 2010 issue (available here at GuruFocus).

It's very rare to have access to Greenberg's thoughts and insights and purchases. Well worth reading for anyone who has not yet seen it:

http://www.gurufocus.com/news.php?id=93311

vgm
augustabound
Augustabound - 4 years ago


Charlie Munger said that if he asked a classroom of students how to value a tech stock, he would automatically fail anyone who tried to accomplish the task. I tend to agree with him.


That was in reference to the thousands of start ups in the late 90's that had no earnings, tangible assets or cash flow and traded higher based entirely on the internet ruling the world one day.
jhodges72
Jhodges72 - 4 years ago
It doesn't matter if this article makes the statement that Google is a "value stock" nor does it matter how many posters here make the statement; the article didn't even attempt to value Google. If you think Google is a value stock, simply, put up some numbers and value it. What's the value of their assets? What's the value of their cash flows? Prove it with scientific evidence instead of simply making the very uneducated claim that it "is" just because you say it "is".
augustabound
Augustabound - 4 years ago
You mean simply saying, "Based on our analysis..." isn't good enough for you? ;)

vgm
Vgm - 4 years ago
...and that's why I recommended the Glenn Greenberg analysis (post 5 above). Please pay attention!

vgm
yswolinsky
Yswolinsky - 4 years ago
According to your logic if Google historically traded at a 500 P/E and it currently traded at a P/E of "only 100" that would make it undervalued.

That does not seem to be a proper way to access intrinsic value in my humble opinion.
jim.falbe
Jim.falbe - 4 years ago
Google is a Value Stock in the sense of Phil Fisher. If you read Common Stocks and Uncommon Profits and look through/actually engage in his 15 point checklist of great value stocks (which in all honesty haven't), I think you'd be surprised at how Google does.

Also, in Security Analysis, Ben Graham makes the argument that a fantastic company (read best in class - with amazing growth potential) could reasonably be bought with a P/E of 20 and still be called an investment vs. a speculation.

Google would be the best company in the world for the next 20 years without any new exciting growth avenues (read: YouTube, Android, Google TV, and the multitude of other purchases they've made recently). Why?

Pricing Power - Google could charge whatever they want for their advertising services, the fact that they are the cheapest advertising provider in the world is significant. This is a service that they could charge more for at any time, and is inflation proof (think Coca-Cola). And If times get hard, more money comes their way as opposed to more expensive ads.

Moat - Buffett and Munger stated that Google has one of the best moats they've ever seen. Their word is sufficient. I'm not going to ask about the last time you used Bing.

Growth - More people are using the internet every year. And those using the internet are using it more frequently. Google is not a technology company. It is the YELLOW PAGES of the Internet. As internet use increases, Google use increases. Inbound marketing as oppossed to traditional forms is the future. Google is inbound marketing at its best.

*Note that nothing short of the Apocalypse will stop the ever-expanding use of the Internet.

Non-Capital Intensive - Google has VERY-low overhead and capital infrastructure when compared with it's revenue. This is one of Warren Buffett's favorite traits. Consult his shareholder letters. This is a great inflation play.

Top notch management

Culture of Innovation

Great Talent Recruitment

Besides the crisis of last year (when I believe it hit 19), this is the only time that Google has traded close to a P/E of 20. Typical value investors might find this expensive, but is it for potentially the best company in the world of tomorrow?

It's not cheap because the P/E is lower than yesterday, but because the P/E finally reflects a "fair price for a great company." And like other value investors, I believe this is better than buying "a fair company for a great price."

-long GOOG (bought just this last week), side note this is also my first purchase outside the typical value fold.

batbeer2
Batbeer2 premium member - 4 years ago
The problem with this type of analysis is that it can be used to justify buying Google at 200, 400, 600, 800 and 8000.

Nothing wrong with your line of thought, but IMHO there is no margin of safety in that type of analysis. It's probably a great call but there's too much uncertainty there for me.

If Google is the best company on the planet, they should start buying back stock. Any other use of capital would be dilutive to current sareholders. Not only are they not buying back stock, they are continuosly issuing stock and certainly NOT because they need the capital !!

It may be a great company but it's certainly not being managed in the interest of shareholders.

I can imagine a world without Google in 2025. I can't imagine a world without say J&J, PG, KFT or BUD. I believe these are quite a bit cheaper.
jim.falbe
Jim.falbe - 4 years ago
No, I'm not talking about buying at any price. What I'm saying is that if you can get a really really great company at a multiple of 20, don't hold back.

Yes, they issued a lot of stock options in the beginning. The last 9 years of Google was exactly what you are describing; speculative. Google is now, for the first time, entering investment category. And it is a much, much better company today than it was 9 years ago.

Still, it might be too early for stock buybacks, this is a Phil Fisher company far more than a Ben Graham one.

If you want a Warren Buffett example of a company like this, think See's Candies; he didn't get it cheap. His margin of safety was the pricing power, and the necessity that consumers felt towards See's.

Google's Margin of Safety isn't in the price, it's in the pricing power. Even if someone comes along tomorrow with better search engine technology than Google. Can they maintain that lead over the ensuing 10 years, and who knows how much capital to ramp-up, enter every major language market, and form the literally millions of ad-revenue connections that Google already has?

No Google in 15 years? I've never heard of a company this size, with no debt, billions in cash, no risky investments, and a virtual monopoly in a market disappearing in fifteen years.

Google isn't a typical value-play; but value really means selling for less than what something is worth. Google's intrinsic value is higher than its market value, not 8000, though that would be nice...

batbeer2
Batbeer2 premium member - 4 years ago
Fair points all; I'm a Fisher fan.

1) In its day, Polaroid was Google. This was THE profitable company that would forever grow. This company had multiple barriers to entry. It had transformed itself from an innovative tech stock to a company with an enduring monopoly.

2) JVC (that japanese consumer electronics company) has a V for Victor. That comes from the american company aka Victor Talking Machine. They had a virtual monopoly producing phonographs.

Talk about a razor/blade business with high ROE... member of the DOW and all.... This was the tech company that had created multiple barriers to entry. No hope trying to compete.

I would be very surprised if Intel, Google, Apple, Cisco and Microsoft are all around in 15 years. Rapid change till now, why will it be different going forward. A number of these still depend on their brilliant founders. NOT something Fisher liked to see.
ma.gen.email
Ma.gen.email - 4 years ago
"No Google in 15 years? I've never heard of a company this size, with no debt, billions in cash, no risky investments, and a virtual monopoly in a market disappearing in fifteen years. "

I don't have examples handy but I'd think plenty of newspaper businesses would fall into this category over the last 15 years.

"Moat - Buffett and Munger stated that Google has one of the best moats they've ever seen. Their word is sufficient. I'm not going to ask about the last time you used Bing."

I was intrigued when they made this statement but if I recall correctly, Buffett made a similar comment about Microsoft in an email exchange he had with a Microsoft executive who asked him why he hadn't invested in Microsoft. To badly paraphrase his comment, he said yes Microsoft currently has a large moat, but he doesn't know enough to predict how the business will change over the following 10-15 years.

From what I've seen and read so far, I've inferred that when it comes to moat, Buffett & Munger look at two distinct aspects separately: (1) presence of moat and (2) sustainability of that moat over 10-15 year time frame (perhaps even more). On #2, the assessment of the odds of catastrophic, unknown unknowns takes precedence. And I don't think you need to be as smart and experienced as Buffett & Munger to realize that the odds of catastrophic unknowns is greater in search engine technologies versus things like chewing gum or eating candies.

I've heard the speculation that, in the next generation of iPhone expected to be released next month, Bing is replacing Google as the default search engine. This could have a huge impact on Google's mobile search volume considering the popularity of the iPhone and the general nature of iPhone users -- non-tech-enthusiasts who use what's easily available on the phone. These kinds of x-factors make the utility of valuing companies like Google questionable.
jhodges72
Jhodges72 - 4 years ago
You wrote: "Google is a Value Stock in the sense of Phil Fisher".

And therein lies the problem with your assessment. Phil Fisher was a "Growth Stock" investor, not a "Value Investor". Google very well could be a "Growth Stock" and I most likely wouldn't argue that point but it definately IS NOT a "Value Stock" as defined by Ben Graham. Growth and Value, even though they often interconnect, are much different valuation approaches.
Frank Lind
Frank Lind - 4 years ago
I'm not going to get into the pointless discussion of how Google is classified. But a qualtitative analysis, on the face of it, suggests a business with enormous potential.

This is actually from the Macforums [Apple].

Google Strategy: My Simplistic View

1. Best in Search (Algorithms and Scale)

2. Extend Market Position (old MSFT Strategy)

3. Commoditize Software to Monetize Search (Free Software)

-Platforms

-Smartphones: Android (a demonstrative success)

-Tablets (likely success due to similarity with Android OS)

-Desktops/ Laptops: Chrome OS (to be released shortly)

-TV (late fall introduction, 1st mover advantage?)

-Application Platform built into all OS

-games, books, magazines, applications, etc.

-advertising within all applications

-Internet Platform

-YouTube (Video Broadcasting: 2 billion streams per day)

-Tools (leader in cloud computing)

-Chrome: Internet Browser (quickly gaining share)

-Docs (future MS Office killer)

-Email: Gmail

-Calendar

-Photos: Picassa

-Navigation (already cannibalizing an entire industry)

-Commerce: Google Checkout (no traction yet)

-Numerous other Initiatives (Maps, Personal Medical Records, News, etc.)

No company is in a position to offer all of these software services for free. No company is willing to compete with this strategy. Google can commoditize software. No one can commoditize search, because second best is unacceptable for the user. This strategy is both an insurance policy for their core business and an entry into ancillary revenue streams in all related spaces. Google will not try to monetize their software until they have reached critical mass and have a near monopoly in their space(s). They may choose a monetization strategy similar to Adobe. It is too speculative at this stage to outline their monetization strategy but they will eventually be in a position to monetize each beachfront. This is the pre-internet strategy MSFT used to become the largest technology company in the world. Google’s upside is much greater than Microsoft’s ever was because of the scale the internet enables. There is no other business strategy that has this kind of virtually limitless scale and operating leverage. The search is business is not yet mature, as advertising is still shifting to the web. Desktop computing is still growing and the tablet market is in its’ infancy. I expect Google’s bottom line growth to accelerate going forward before their future revenue streams kick in. In other words, their growth may be backloaded. Either way, this industry is far from mature and Google’s position is essentially unassailable.

Competition:

Microsoft:

-Losing over 1 billion per quarter in an attempt compete in search. MSFT does not have the scale to generate the quality search results that Google’s size enables. A critical disadvantage.

-MSFT’s major revenue streams are threatened by Google’s free strategy (Smartphone, Desktop and Tablet OS and Office Suite). They will collapse as a competitor once Google’s free strategy starts eating into their revenues.

Apple:

-Apple can continue to generate massive profits and growth by producing the best combination of hardware and software at a premium price as well as leading in innovation. Apple has/ had successfully beaten MSFT, and all other companies in the smartphone space because of the application store. (Ironically, in the same way that Microsoft had previously beat Apple on the desktop). Unfortunately, Apple’s proprietary OS strategy cannot win market share against Android’s free OS without a clear advantage in applications. Unfortunately, Apple’s first mover advantage was not fast enough.

Facebook and Twitter:

-Social is still missing from Google’s arsenal. It will be a slow path to monetization for both Facebook and Twitter (not unlike YouTube). The threat remains that some new social site will usurp them as Facebook did to MySpace. They are not a threat to Google’s search business as Google’s technology will remain superior because of their search algorithms and their scale.

RIMM, PALM, NOK, YHOO- Irrelevant, for obvious reasons.

GOOG: All this for about 14 times next years earnings (net of cash, YouTube and the Android/ Chrome platforms)!

In my view, the biggest threat is Facebook.

jim.falbe
Jim.falbe - 4 years ago
Well, eventually we all have to make our own way in the world.

Buffett broke with Graham, and here I'm gonna do the unthinkable, I am going to break with Buffett and Munger.

I think they are wrong if they consider Google to be a technology stock. They're information organizers who advertise while they are at it, internet technology just happens to be the best way to access this information now.

Nothing is going to come along that is going to replace information. There will just be new ways of accessing it.

Google is going to be right there. - The biggest threat is government anti-monopoly action. Like with their book program. Do you know how long it takes to scan every book in the world? I don't.

The Internet itself, though I am sure it will change greatly and perhaps even be barely recognizable 20 years from now, will still be here. How we access it doesn't matter. It's the information that we want.

And people want information much more than they do chewing gum.

Sivaram
Sivaram - 4 years ago


You are going out on a limb there ;) I wouldn't mind taking the opposite side of that bet.

As crazy as this may sound to most conventional value investors, I think companies like Microsoft, Google, Amazon, Cisco, et al, will outlive Coca-Cola, Pfizer, Kraft, and the like. Companies like IBM or Dell I can see dissapearing but not these. What you guys are missing is that certain technology industries, such as new media, almost anything Internet, information-oriented technology (such as database companies, etc) and a few others, are the modern day equivalent to branded packaged consumer goods, radio, or automobiles in the 1920's. In other words, you are witnessing the birth of new industries and it just so happens that some of these companies are the survivors. If you assume some of these industries have a lifespan of 50 years (kind of like how radio probably went from 1920 to 1970), it is improbable that many of these established players will fail.

Some of these companies may dissapear (mainly due to management mistakes, bad marketing, horrible products, etc) but as time passes, it will become more and more difficult to dislodge them--just like how it was virtually impossible to dislodge Kraft or Wrigley's after they were established. To make matters even more favourable, some of these industries, especially in the Internet or anything-information-oriented, are winner-takes-all businesses.

For example, what are the chances of Ebay dissapearing any time in the next 20 years? I would say close to nil (ignoring buyout of the company.) Even a so-called failure like Yahoo! is quite dominant and I can see it surviving for decades (hte problem with Yahoo, like many other growth companies, is valuation.)

Now, as for the view that these industries change rapidly and hence there is a big risk of obsolescence, I present the Bill Miller argument. I know few hold him in high regard like I do but I rmeember Miller once pointing out how products and services change in the info tech sector but the market share of leading companies doesn't change much. Intel's products may change ever 5 years but you'll find that its market share is pretty resilient. Similarly, many thought Microsoft would continuously lose market share in the last decade but it has pretty much maintained its share for the most part.

Having said all that, I think people should be careful with the industries. I have low confidence in, say, a PC maker or a semiconductor company than the Internet space. Furthermore, almost all growth companies are richly priced and it's hard to tell what's overvalued for newbies like me. So, overpaying for them is a big risk.
jhodges72
Jhodges72 - 4 years ago
"For example, what are the chances of Ebay dissapearing any time in the next 20 years? I would say

close to nil..."

Ok, let's reverse that question to see if it makes logical sense. 20 years ago, what were the chances of Ebay coming into existence?

Assumptions have very little credence to the value philosophy.
Sivaram
Sivaram - 4 years ago


"For example, what are the chances of Ebay dissapearing any time in the next 20 years? I would say

close to nil..."

Ok, let's reverse that question to see if it makes logical sense. 20 years ago, what were the chances of Ebay coming into existence?


I'm not sure what you are getting at... ??
jhodges72
Jhodges72 - 4 years ago
Unless I'm reading your statement incorrectly, I believe you assumed that Ebay will be around for the next 20 years. I believe that is an illogical argument and one that provides very little certainty. Therefore, I turned you assumption around and asked the question in the reverse. My point is, 20 years ago there was no way of knowing the existence of Ebay therefore how could you be certain of its sustainability. A new company that does what they do more efficiently and cost effective could easily be the new "fad". I don't believe anything other than a business such as Coca Cola has any certainty in this ever changing world. That is always why I don't use the DCF in my valuations; because for me it is highly flawed. You are taking a short term discounted valuation and mixing it with a long term assumption. Anytime you mix a good and solid technique with a highly speculative technique, the result is often pure speculation.
Frank Lind
Frank Lind - 4 years ago
Mr Hodges,

What are the typical valuation measures you use?

Thanks.
Sivaram
Sivaram - 4 years ago


There is a serious bug on GuruFocus that seems to drop text that is bolded and/or italicized. Some of my posts are getting messed up because of it--my detailed response was against Batbeer although you are taking the same stance as him-and I hope GuruFocus fixes it. Anyway, I'll try not to bold or do any formatting on quotes...

JHODGES: "My point is, 20 years ago there was no way of knowing the existence of Ebay therefore how could you be certain of its sustainability. A new company that does what they do more efficiently and cost effective could easily be the new "fad"."

You are quite correct in suggesting that one cannot know with certainty what the future holds for any company. But I believe that, as investors, our goal is to make a judgement call. The amount of judgement you make depends on your investment technique and what you believe your skill is. I suspect your techinques may be very conservative--this is actually a good way to avoid losing money--and you may not think too much about the future.

People like me, on the other hand, are not really "value investors" and we think more about the future prospects of the firm. We are more growth-oriented, if you will.

I can't say my views will turn out right--my investing record is poor to say the least--but I do make the calls for the companies I'm interested in. The confidence in future earnings comes from my impression of the "moat" of the company and potential future trends (although many trends are unpredictable.)

I think you also think about the future but you probably attach low confidence in your forecast and probably don't think too far ahead. To see what I mean, consider what you said:

JHODGES: "I don't believe anything other than a business such as Coca Cola has any certainty in this ever changing world"

I would argue that you are actually making a judgement call about the future of Coca-Cola. People like me don't have much confidence in Coca-Cola in, say, 20 years whereas you have greater confidence in its survival. You are actually making a call. For instance, how do you know Coca-Cola isn't a 1980's Polaroid or a 1990's Washington Post?

The reality is that you are making a judgement call regardless of how far out you want to project earnings. If you don't make any judgement call on the company's business, then the only investment method that will work (other than trading or some such scheme) is classic value investing where you buy below liquidation value or below book value or someting like that. Otherwise, you HAVE to make a judgement call. I don't know the exact number but I would imagine that more than 80% of the top 5000 companies in USA trade above conservative estimates of book value. Even if you look at earnings, the market is generally discounting companies's earnings at least 10 or 15 years out. If you don't make a judgement call about the business of the company, you really can't buy these companies.

At a minimum, you probably cannot in any company with a moat (except distressed companies) if you don't predict earnings more than, say, 10 years out. I don't think can be a MODERN Buffett-like investor if you don't "forecast" the future of that business. We don't need to forecast to any high accuracy but I don't see how you can buy many stocks out there.

JHODGES: "That is always why I don't use the DCF in my valuations; because for me it is highly flawed. You are taking a short term discounted valuation and mixing it with a long term assumption. Anytime you mix a good and solid technique with a highly speculative technique, the result is often pure speculation."

I'm just a newbie and still not sure I know what the hell I'm doing but I don't use DCF either. I came to the conclusion that figuring out the growth rate, not to mention the terminal value, is too difficult to me. To make matters worse, the valuation is very sensitive to the growth rate and small changes lead to wild differences.

Having said that, I don't see how you can value many companies out there without forecasting future earnings. For instance, these days I just use a P/E (or sometimes P/FCF) multiple. Let's say I use a P/E multiple of 12. Then, I am implicitly assuming some number for the earnings of the copany for the next decade or more. This requires a prediction about the future of that company's business. At a minimum, one needs to predict that earnings won't fall off a cliff over the next decade.

How would you value a company without factoring in the future?

The only methods that don't require future earnings or some forecast about the company are those that rely on book value or liquidation value (or some similar backward-looking measure.) Is that what you use? Do you just buy below book or something?
jhodges72
Jhodges72 - 4 years ago
Frank,

I prefer Greenwald's EPV valuation method.
jhodges72
Jhodges72 - 4 years ago
SIVARAM: "You are quite correct in suggesting that one cannot know with certainty what the future holds for any company. But I believe that, as investors, our goal is to make a judgement call. The amount of judgement you make depends on your investment technique and what you believe your skill is. I suspect your techinques may be very conservative--this is actually a good way to avoid losing money--and you may not think too much about the future."

I am conservative in the sense that I adhere to a strict value discipline as defined by Ben Graham. In that regard, the assets of a business is the forefront to my valuation technique. However, I do look at the future prospects of the business as Graham did. The cash flows reveal the sustainability of the business and the chances that the asset values will be realized and/or improved upon in future years. As Graham pointed out in "Security Analysis":

_
"When in his capacity as investor or speculator the business man elects to pay no attention whatever to corporatte balance sheets, he is placing himself at a serious disadvantage in several different respects: In the first place, he is embracing a new set of ideas that are alien to his everyday business experience. In the second place, instead of the twofold test of value afforded by both earnings and assets, he isrelying upon a single and therefore less dependable criterion. In the third place, these earnigns statements on which he relies exclusively are subject to more rapid and radical changes than those which occur in balance sheets. Hence an exaggerated degree of instability is introduced inot his concept of stock values. In the fourth place, the earnings statements are far more subject to misleading presentation and mistaken inferences than is the typical balance sheet when scrutinized by an investor of experience."This is the backbone to my investment philosophy.

SIVARAM: "People like me, on the other hand, are not really "value investors" and we think more about the future prospects of the firm. We are more growth-oriented, if you will."

There was an article reprinted here at gurufocus not very long ago in which Warren outlined the definition of value and growth and how they interconnect. It was interesting in that he stated that they were much the same. I've thought long and hard on this subject to my own degree and I've came to the same conclusion. Many Growth investors look for the same qualities as the Value investor. High returns on invested capital, high returns on equity, conservatively leveraged companies, the existence of a moat, etc. The major difference betwen the two styles that I've been able to recognize is simply the price that is paid fo rthat particular investment.

SIVARAM: "I think you also think about the future but you probably attach low confidence in your forecast and probably don't think too far ahead."

That's somewhat accurate. I usually look to see how many years the company could sustain its operations based on the worst case scenerio of cash flows. In the worst case scenerio, if the company looks like it is eroding any sustainable qualities then I know that the cash flows of the business isn't protecting its assets and that growth will have an adverse effect.

SIVARAM: "For instance, how do you know Coca-Cola isn't a 1980's Polaroid or a 1990's Washington Post?"

I don't know and that was also my point. Coca-Cola has the strongest moat out of any company I know of, but even then - there is no way to calculate its future for certain. That was my point and why I don't agree with projecting cash flows out based on assumptions by the use of the DCF.


SIVARAM: "If you don't make any judgement call on the company's business, then the only investment method that will work (other than trading or some such scheme) is classic value investing where you buy below liquidation value or below book value or someting like that. Otherwise, you HAVE to make a judgement call."

M&A, Turnaround's, Bankruptcy's, Arbitrage, Liquidation. Furthermore, buying below book value, although is a good starting point, is not necessarily the most accurate one. There are very indepth techniques used to value the assets of a business as most companies report using a cost method that includes the often times non-cash amortization charge. Therefore, if a company, for example, purchased a piece of real estate in 1975 that cost the company $1 Million - amortization has discounted the value on the books as well as the "cost" of that item is stated on the books and not its economic value in today's money. After due dillegence is applied, the value investor will recognize that the amortization charge benefitied the company by providing a tax write-off and that the asset's true economic value today is closer to $4 Million. If you simply went by what is stated on the books, the average investor would have missed this potential opportunity.

SIVARAM: "I don't think can be a MODERN Buffett-like investor if you don't "forecast" the future of that business. We don't need to forecast to any high accuracy but I don't see how you can buy many stocks out there."

Its been stated many times by both Munger and Buffett that Warren has NEVER used a Discounted Cash Flow. Furthermore, I know for a fact that Warren doesn't even have 1) a computer nor 2) a calculator in his office. I've purchased over 20 businesses in the last 3 years, of course the recession has provided abnorman opportunities, in which I've been able to purchase outstanding business with large moats, high returns on invested capital, were not affected by the recession whatsoever, produced increasing earnings, and I earned hundreds and sometiems thousands of percentage point in. One example is CPY. $1.60 - $29.xx with a 48% annual dividend. It's the best investment of my 18 year career. Incidentally, nearly 100% of the investing community that I had conversations with disagreed with me and called me the dumbest investor they ever met because of my position in CPY. :)




SIVARAM: "Having said that, I don't see how you can value many companies out there without forecasting future earnings. For instance, these days I just use a P/E (or sometimes P/FCF) multiple. Let's say I use a P/E multiple of 12. Then, I am implicitly assuming some number for the earnings of the copany for the next decade or more. This requires a prediction about the future of that company's business. At a minimum, one needs to predict that earnings won't fall off a cliff over the next decade."

Most investors do and will get in to trouble using "reported" P/E. The key to using the P/E effectively is to find the true earnings of the business. Non-Cash events, non-operational events, one time events.




SIVARAM: "How would you value a company without factoring in the future?"

Refer to what is now called the Bruce Greenwald method which is actually the Benjamin Graham method. You can discount cash flows using 0% growth and finding their current worth. This is the sustainability of the business that will justify the asset values of the business. Research it, it's enlightening.
Sivaram
Sivaram - 4 years ago


Thanks for taking the time to reply JHodges72. Although I agree that value and growth are joined at the hip (i.e. the ideal stock is a growth stock bought at value prices), I, similar to the industry, like to separate them. You want both but the question is on the emphasis.

JHODGES: "Many Growth investors look for the same qualities as the Value investor. High returns on invested capital, high returns on equity, conservatively leveraged companies, the existence of a moat, etc. The major difference betwen the two styles that I've been able to recognize is simply the price that is paid fo rthat particular investment."

I don't think it's necessarily the price that identifies a growth investor. A lot of the time people say that because what they call growth investors are actually momentum investors and traders who buy at high prices irrespective of the business.

I think the key factor that determines growth investors is their emphasis on growth. In particular, I would say that growth investors value the income statement more than the balance sheet; whereas value investors put more weight on the balance sheet. My impression is that growth investors pay up for earnings power while value investors "pay up" for a stronger balance sheet (by "pay up," I'm referring to the propensity for someone to buy those companies. Value investors often buy secondary businesses with no moat, dubious corporate governance, and trading on unregulated or lowly regulated exchanges simply because of the balance sheet.)

JHODGES: "Furthermore, I know for a fact that Warren doesn't even have 1) a computer nor 2) a calculator in his office. "

I actually agree with your view that Buffett doesn't use DCF. However, I don't think the reasons you cited are strong reasons because Buffett has photographic memory and is very good at computing things in his head. He could probably do rough approximations of the DCF formula in his head. In any case, I think neither of us use DCF so no point talking about it.

JHODGES: "I've purchased over 20 businesses in the last 3 years, of course the recession has provided abnorman opportunities, in which I've been able to purchase outstanding business with large moats, high returns on invested capital, were not affected by the recession whatsoever, produced increasing earnings, and I earned hundreds and sometiems thousands of percentage point in."

I'm not taking anything away from your success but how was your record before the recent crash? The reason I am asking is because (i) valuations of certain companies look to have been extremely low last year (I, of course, never knew at that time) and (ii) I think the market is overvalued--this is a macro call and you may not agree--and big gains were seen in junk and low quality stocks. Many Graham-oriented investors invest in these low quality companies and they would have seen spectacular gains. Yet, I think it is totally unsustainable and have a feeling that many of the stocks with huge rallies will collapse.

So, the real test is how such strategies have performed over the last decade or two (pre-crisis.) One of the criticisms that I levy at balance-sheet-oriented strategies is that hardly any stock in a developed market satisfy those criterias. The last few years may be ok but that is almost a 30-year event.

JHODGES: "One example is CPY. $1.60 - $29.xx with a 48% annual dividend. It's the best investment of my 18 year career. Incidentally, nearly 100% of the investing community that I had conversations with disagreed with me and called me the dumbest investor they ever met because of my position in CPY. :)"

:) Congratulations. It's always good to see someone taking a contrarian position and realizing a big profit. Good job with that.

JHODGES: "Most investors do and will get in to trouble using "reported" P/E. The key to using the P/E effectively is to find the true earnings of the business. Non-Cash events, non-operational events, one time events."

People like me use normalized earnings--usually averaged over many years or what we think is a conservative estimate of future earnings. So the unusual events impacting earnings is more of an issue for the pros on the Street who have short-time frames and generally issue targets and buy things for only 1 or 2 years. For longer term investors, these events get smoothed out.

The real problem for newbies like me, who attempt to use a P/E or FCF multiple, is the difficulty in figuring out the owner earnings or the amount that actually ends up in your pocket. The hardest thing, especially when looking at free cash flow (FCF), is separating out growth capex from maintenance capex. It's tough for any company but is especially difficult for growth companies--it's just hard to tell if the money the company is reinvesting is needed to sustain the busienss or not.

JHODGES: "Refer to what is now called the Bruce Greenwald method which is actually the Benjamin Graham method. "

I took a cursory look at it a few years ago and didn't think much of it. Maybe I'm just dumb but I didn't think it was very helpful to me. I am also not a fan of the Benjamin Graham formula although I do use it as a rough benchmark (for instance, if you set growth to zero, the Graham formula implies that a company should have a P/E of 8.5 I believe. So a no-growth company should be purchased below a P/E of 8.5--but details matter too.)

JHODGES: "You can discount cash flows using 0% growth and finding their current worth. "

Yep. But the problem is that this is a just a rough guide. The details matter a great deal. For example, a zero-growth company that may lose market share in the future (because it isn't capable of growing anymore, say because their product is becoming obsolete) should be worth far less than what that formula produces. If you went with the formula and didn't consider the future scenarios, you may end up investing in value traps. In contrast, a zero-growth company that maintains market position (say there is no growth because they have saturated the market, not because the product is obsolete) is probably worth coser to what that formula suggests.

Anyway, good luck with your investing. It seems like you have develeopd some skill and hopefully you can keep it up.

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