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The Evolution of a Value Investor

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The Science of Hitting
Jun 23, 2013
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“Develop into a lifelong self-learner through voracious reading; cultivate curiosity and strive to become a little wiser every day.”

- Charlie Munger

I’ve never gone wrong listening to Charlie, and the preceding quote has been the cornerstone of my development as an investor; small steps have led to a decent foundation, and I have no plans of slowing down. As time has passed, I’ve moved through different approaches. In my analysis, I’ve worked to continually improve my process in order to generate as much insight as possible when researching potential investments. Today, I would like to point out a few things that have become increasingly important in my approach that others may find useful; hopefully others will add their two cents in the comment section if they think of something indispensable to their own approach that I’ve overlooked. Here are three things I focus on that I didn’t used to a few years ago, but couldn’t imagine not doing today:

1) Pension Analysis – Most companies have defined benefit pension plans on their books; as a result, they segregate assets which will be used to fund future liabilities as they come due. Most investors will look at the pension obligation in comparison to the plan assets in order to determine the funded status; while this certainly is important, I find the assumptions baked into the calculations to be much more revealing. One example is the expected long term rate of return on plan assets: Berkshire Hathaway (BRK.B) uses a 6.6% return expectation, Ford (F) uses a 7.5% return expectation, and DuPont (DD) uses an 8.61% return expectation; this brings up an interesting question, considering all three have similar asset allocations/targets. In the case of DuPont, meeting this return expectation has meaning; if they only manage to squeeze out the 6.6% that Berkshire’s targeting, they estimate the impact would be a $360 million hit to pre-tax earnings – equal to 13% of DuPont’s net income in the most recent fiscal year.

2) The Proxy Statement – If you’ve never looked at the filing titled “DEFA14A”, you should start; the proxy statement lays out critical things like board composition, large shareholders, and executive compensation. In the case of J.C. Penney (JCP), the proxy statement showed that Ron Johnson made a personal investment of $50 million in 7.5 year warrants, which suggested a long term commitment to the company’s future; in addition, Mr. Johnson did not enter into an Executive Termination Pay Agreement when he was hired, meaning that if he left the company – with or without cause – he would essentially walk away with nothing. On April 8th, that’s exactly what happened. Regardless of the fact that his tenure at JCP did not go as planned, this is critical information to have when assessing whether or not management has your best interests in mind (asking isn’t enough – all management teams will tell you that they’re shareholder friendly).

3) DuPont Analysis – The best gets saved for last; DuPont analysis has fundamentally changed the way I look at potential investments. Prior to implementing DuPont analysis in my investment process, I suffered from a condition that (in my opinion) has a hold on the investment profession; the vast majority of the reports/articles that I read discussing potential investments rest upon the conclusion that the current P/E, EV/EBITDA, or some other multiple of earnings power is due for a change. I think the main reason that this has become the focal point of the investment community is because most people aren’t interested in what happens to the business over time; they plan on holding the piece of paper for a few months (or days) and only hope for speculative returns tied to valuation changes from Mr. Market. The long term investor should look at the bigger picture, as captured in this quote from Charlie Munger:

“Over the long term, it's hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you're not going to make much different than a six percent return - even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you'll end up with one hell of a result.”

Focusing in on the returns of the assets underlying the business, and thinking about what drives them over time, is critical in building return expectations; finding a great investment involves looking at more than the current multiple on earnings. DuPont analysis gives the numbers in the financial statements meaning; to me, this is epitome of accounting as the language of business.

The beauty of DuPont analysis not only comes from what it says; this exercise will often lead to more questions than answers – with those questions leading to the insights required to spot changed that most investors will have overlooked. This tool is an essential addition to any investor’s repertoire.

Hopefully you will find these three ideas useful in your own research; I would greatly enjoy hearing your own thoughts on what tools in your toolbox you simply could not live without.

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