Value investing tools and techniques for intelligent investment PDF room

TableofContents

TitlePage
CopyrightPage
Dedication
Preface
PartI:Whyeverythingyoulearnedinbusinessschooliswrong
PartII:Thebehaviouralfoundationsofvalueinvesting
PartIII:Thephilosophyofvalueinvesting
PartIV:Theempiricalevidence
PartV:The‘DarkSide’ofvalueinvesting:Shortselling
PartVI:Real-timevalueinvesting
Foreword


PartI-WhyEverythingYouLearnedinBusinessSchoolisWrong

Chapter1-SixImpossibleThingsbeforeBreakfast,or,HowEMHhasDamaged
ourIndustry


THEDEADPARROTOFFINANCE
THEQUEENOFHEARTSANDIMPOSSIBLEBELIEFS
SLAVESOFSOMEDEFUNCTECONOMIST
PRIMAFACIECASEAGAINSTEMH:FOREVERBLOWING
BUBBLES
THEEMH‘NUCLEARBOMB’

Chapter2-CAPMisCrap


ABRIEFHISTORYOFTIME
CAPMINPRACTICE
WHYDOESCAPMFAIL?


CAPMTODAYANDIMPLICATIONS


Chapter3-PseudoscienceandFinance:TheTyrannyofNumbersandthe
Fallacy...


BLINDEDBYPSEUDOSCIENCE
WATCHINGTVIMPROVESYOURMATHSABILITY
SEDUCTIVEDETAILS
APPLICATIONSTOFINANCE
CONCLUSIONS


Chapter4-TheDangersofDiversificationandEvilsoftheRelative...


ONTHEDANGERSOF‘NARROW’DIVERSIFICATION
EQUITYPORTFOLIOS:THEOTHEREXTREME
RELATIVEPERFORMANCEDERBYASASOURCEOFPOOR
PERFORMANCE!

A(VERYSHORT)PRACTICALGUIDETODIVERSIFICATION


Chapter5-TheDangersofDCF


INTERACTIONPROBLEMS
ALTERNATIVES


Chapter6-IsValueReallyRiskierthanGrowth?DreamOn


RISKI:STANDARDDEVIATION
RISKII:CAPMBETAANDCO.
RISKIII:BUSINESSCYCLERISK


Chapter7-Deflation,DepressionsandValue


VALUEANDJAPAN
VALUEANDTHEGREATDEPRESSION
WHYTHEDIFFERENCEBETWEENTHEGREATDEPRESSIONAND
JAPAN?



PartII-TheBehaviouralFoundationsofValueInvesting
Chapter8-LearntoLoveYourDogs,or,OverpayingfortheHopeofGrowth

(Again!)


OFDOGSANDSTARS
ANALYSTEXPECTATIONSANDIMPLIEDGROWTH
BRINGINGINVALUATION
ACASEINPOINT:MINING


Chapter9-Placebos,BoozeandGlamourStocks


PAINKILLERS,PLACEBOSANDPRICE
DOESEXPENSIVEWINETASTEBETTER?
GLAMOURSTOCKS
BEATINGTHEBIAS


Chapter10-TearsbeforeBedtime


BUILTTOLAST
ADMIREDORDESPISED?
DON’TBEANUGLYDEFENDANT
ANALYSTS’VIEWSONGROWTH
CONCLUSIONS


Chapter11-ClearandPresentDanger:TheTrinityofRisk

VALUATIONRISK
BUSINESS/EARNINGSRISK
BALANCESHEET/FINANCIALRISK
PUTTINGITALLTOGETHER


Chapter12-MaximumPessimism,ProfitWarningsandtheHeatoftheMoment




EMPATHYGAPS
PREVENTINGEMPATHYGAPSANDTHEPERILSOF
PROCRASTINATION
MAXIMUMPESSIMISMTRADES
PROFITWARNINGS
LOCK-INS
CONCLUSIONS


Chapter13-ThePsychologyofBearMarkets


FEARANDBEARMARKETS
ASTIMEGOESPAST
THEIMPACTOFBRAINDRAIN
THEBLANKSLATE

Chapter14-TheBehaviouralStumblingBlockstoValueInvesting


KNOWLEDGE≠BEHAVIOUR
LOSSAVERSION
DELAYEDGRATIFICATIONANDHARD-WIRINGFORTHESHORT
TERM
SOCIALPAINANDTHEHERDINGHABIT
POORSTORIES
OVERCONFIDENCE
FUN
NO,HONESTLYIWILLBEGOOD


PartIII-ThePhilosophyofValueInvesting
Chapter15-TheTaoofInvesting:TheTenTenetsofMyInvestmentCreed


THEAIMOFINVESTING
TENETI:VALUE,VALUE,VALUE
TENETII:BECONTRARIAN
TENETIII:BEPATIENT


TENETIV:BEUNCONSTRAINED
TENETV:DON’TFORECAST
TENETVI:CYCLESMATTER
TENETVII:HISTORYMATTERS
TENETVIII:BESCEPTICAL
TENETIX:BETOP-DOWNANDBOTTOM-UP

TENETX:TREATYOURCLIENTSLIKEYOUWOULDYOURSELF
CONCLUSION


Chapter16-ProcessnotOutcomes:Gambling,SportandInvestment!


THEPSYCHOLOGYOFPROCESS
CONCLUSIONS


Chapter17-BewareofActionMan


GOALKEEPERSASACTIONMEN
INVESTORSANDACTIONBIAS
BUFFETTONTHEFATPITCH
BIASTOACTIONPARTICULARLYPRONOUNCEDAFTERPOOR
PERFORMANCE
CONCLUSIONS


Chapter18-TheBullishBiasandtheNeedforScepticism.Or,AmIClinically
Depressed?


THEBULLISHBIASINFINANCE
THESOURCESOFBULL
SCEPTICISMASADEFENCE
ARATIONALEFOREVIDENCE-BASEDINVESTING

DEPRESSIVEREALISM


Chapter19-KeepitSimple,Stupid


ISMOREBETTER?
KISS:KEEPITSIMPLE,STUPID


LESSONSFROMHEARTATTACKS
WHY?
CANANYTHINGBEDONE?
SIMPLICITYISKEY
EXPERTSFOCUSONTHEKEYINFORMATION
FROMTHEEMERGENCYROOMTOTHEMARKETS


Chapter20-ConfusedContrariansandDarkDaysforDeepValue


DARKDAYSFORDEEPVALUE
DEEPVALUEWORKSOVERTHELONGTERM
VALUEOUTOFVOGUE
SHORT-TERMUNDERPERFORMANCEISABY-PRODUCTOFA
SENSIBLEINVESTMENTPROCESS
ISTHERELIGHTATTHEENDOFTHETUNNELFORVALUE?


PartIV-TheEmpiricalEvidence

Chapter21-GoingGlobal:ValueInvestingwithoutBoundaries


THEEUROPEANEVIDENCE
DEVELOPEDMARKETSEVIDENCE
BRINGINGINTHEEMERGINGMARKETS
PATIENCEISSTILLAVIRTUE
CONCENTRATEDPORTFOLIO
CURRENTPORTFOLIOSTANCES
CONCLUSIONS


Chapter22-Graham’sNet-Nets:OutdatedorOutstanding?


GOINGGLOBAL
THECURRENTNET-NETS
PERMANENTLOSSOFCAPITAL
CONCLUSION




PartV-The‘DarkSide’ofValueInvesting:ShortSelling
Chapter23-Grimm’sFairyTalesofInvesting
Chapter24-JoiningtheDarkSide:Pirates,SpiesandShortSellers


VALUATION
FINANCIALANALYSIS

CAPITALDISCIPLINE
PUTTINGITALLTOGETHER


Chapter25-CookingtheBooks,or,MoreSailingUndertheBlackFlag


COMPANIESLIE,SHORTSELLERSPOLICE:THEEVIDENCE
WHOISCOOKINGTHEBOOKS?THEC-SCORE
DOESTHEC-SCOREWORK?


Chapter26-BadBusiness:ThoughtsonFundamentalShortingandValueTraps


ATAXONOMYOFSHORTS
BADMANAGERS
BEHAVIOURALFOUNDATIONSOFBADMANAGEMENT
BADCOMPANIES
BADSTRATEGIES


PartVI-Real-TimeValueInvesting
Chapter27-OverpayingfortheHopeofGrowth:TheCaseAgainstEmerging
Markets


THESORRYTALEOFSIRROGER
EMERGINGMARKETSASTHESIRROGEROFINVESTMENT
CONCLUSIONS

Chapter28-Financials:OpportunityorValueTrap?


Chapter29-Bonds:SpeculationnotInvestment


ALONG-TERMVIEWOFBONDS
INTRINSICVALUEFORBONDS
PUTTINGITALLTOGETHER
INFLATIONORDEFLATION
ISTHEUSAJAPAN?
CONCLUSIONS


Chapter30-AssetFireSales,DepressionandDividends


DIVIDENDSWAPS:PRICEDFORWORSETHANDEPRESSION!
DIVIDENDSASANINFLATIONHEDGE
FORCEDSELLERSANDOVERSUPPLY


Chapter31-Cyclicals,ValueTraps,MarginsofSafetyandEarningsPower


THEEMPIRICALEVIDENCEONTHEEARNINGSPOWER
APPROACH
USINGGRAHAMANDDODDPEsINOURSCREENING

Chapter32-TheRoadtoRevulsionandtheCreationofValue


VOLATILITY-NOTUNPRECEDENTEDNORUNPREDICTABLE
THECREATIONOFVALUEI:DEBTMARKETS
THECREATIONOFVALUEII:EQUITYMARKETS
THECREATIONOFVALUEIII:CHEAPINSURANCE
CONCLUSIONS:THERETURNOFTHECOFFEECANPORTFOLIO


Chapter33-RevulsionandValuation


BOTTOM-UPPERSPECTIVE
CONCLUSIONS


Chapter34-BuyWhenit’sCheap-IfNotThen,When?
Chapter35-RoadmaptoInflationandSourcesofCheapInsurance



FISHERANDTHEDEBT-DEFLATIONTHEORYOFDEPRESSIONS
ROMER’SLESSONSFROMTHEGREATDEPRESSION
BERNANKEANDTHEPOLICYOPTIONS
INVESTMENTIMPLICATIONS:CHEAPINSURANCE

Chapter36-ValueInvestorsversusHard-CoreBears:TheValuationDebate


ATOP-DOWNCHECKONROBUSTNESS
NORMALIZEDEARNINGS:ABOTTOM-UPVIEW
CONCLUSIONS


References
Index




Copyright©2009JamesMontier
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Montier,James.
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Preface


PartI:Whyeverythingyoulearnedinbusinessschooliswrong
In fairness I should have entitled Part I ‘Why Everything you Learned in
BusinessSchoolisWrong(unlessyouwenttoColumbia)’.EquallywellIcould
haveusedthetitle‘SixImpossibleThingsBeforeBreakfast’.
The seductive elegance of classical finance theory is powerful, yet value
investing requires that we reject both the precepts of modern portfolio theory
(MPT)andalmostallofitstoolsandtechniques.TheexistenceofMPTwouldn’t
bother me nearly as much as it does, if real-world investors didn’t take its
conclusions into investment practice. Sadly, all too often this is exactly what

happens.Unfortunately,theprescriptionsofMPTendupthwartingtheinvestor.
Theyleadusastrayfromthethingsonwhichwereallyshouldbeconcentrating.
MiltonFreidmanarguedthatamodelshouldn’tbejudgedbyitsassumptions
but rather by the accuracy of its predictions. The chapters in Part I attempt to
demonstrate that the basic edicts of MPT are empirically flawed. The capital
asset pricing model (CAPM), so beloved of MPT, leads investors to try to
separate alpha and beta, rather than concentrate upon maximum after tax total
realreturn(thetrueobjectofinvestment).Theconceptthatriskcanbemeasured
bypricefluctuationsleadsinvestorstofocusupontrackingerrorandexcessive
diversification, rather than the risk of permanent loss of capital. The prevalent
useofdiscountedcashflowmodelsleadstheunwarydowntheroadofspurious
accuracy,withoutany awarenessoftheextremesensitivityoftheirmodels.As
ThirdAvenueManagementputit:DCFisliketheHubbletelescope,ifyoumove
itaninchyouendupstudyingadifferentgalaxy.Thus,followingMPTactually
hindersratherthanhelpstheinvestor.


PartII:Thebehaviouralfoundationsofvalueinvesting
MPT holds that all returns must be a function of the risk entailed. Thus, the
believers in this approach argue that the outperformance of value stocks over
timemustbeafunctionoftheirinherentriskiness.I’vealwaysthoughtthatthis
wasaclassicexampleoftautologicalthinking.ThechaptersinPartIIattemptto
demonstrate an alternative perspective - that the source of the value
outperformanceisafunctionofbehaviouralandinstitutionalbiasesthatprevent
manyinvestorsfrombehavingsensibly.
Wewillcoverthemostdangerous(andoneofthemostcommon)errorsthat
investorsmake-overpayingforthehopeofgrowth(orcapitalizinghopeifyou
prefer).ThechaptersinPartIIalsotrytoprovideyouwiththetoolstoenable
youtostartthinkingdifferentlyaboutthewayyouinvest.Valueinvestingisthe
one form of investing that puts risk management at the very heart of the

approach.However,youwillhavetorethinkthenotionofrisk.Youwilllearnto
think of risk as a permanent loss of capital, not random fluctuations. You will
alsolearntounderstandthetrinityofsourcesthatcomposethisrisk:valuation,
earningsandbalancesheets.
InPartIIwewillalsotrytointroduceyoutowaysofoverridingtheemotional
distractions that will bedevil the pursuit of a value approach. As Ben Graham
said:‘Theinvestor’schiefproblem-andevenhisworstenemy-islikelytobe
himself.’


PartIII:Thephilosophyofvalueinvesting
ThechaptersinPartIIIsetoutthecoreprinciplesinvolvedinfollowingavalue
approach. The first chapter lays out the 10 tenets of my approach to value
investing, and details the elements you will need to be able to display if you
intendtofollowthevalueapproach:
•TenetI:Value,value,value
•TenetII:Becontrarian
•TenetIII:Bepatient
•TenetIV:Beunconstrained
•TenetV:Don’tforecast
•TenetVI:Cyclesmatter
•TenetVII:Historymatters
•TenetVIII:Besceptical
•TenetIX:Betop-downandbottom-up
•TenetX:Treatyourclientsasyouwouldtreatyourself
Theremainingchaptersexploresomeoftheissuesinmoredepth,suchasthe
need for patience, and the need to think independently. One of the most
importantchaptersinPartIIIconcernstheroleofprocessversusoutcomes.As
wehavenocontroloveroutcomes,theonlythingwecancontrolistheprocess.
Thebestwaytoachievegoodoutcomesistohaveasensibleinvestmentprocess

asthismaximizesthechancesofsuccess.AsBenGrahamsaid:‘Irecall...the
emphasis that the bridge experts place on playing a hand right rather than
playingitsuccessfully.Because,asyouknow,ifyouplayitrightyouaregoing
tomakemoneyandifyouplayitwrongyoulosemoney-inthelongrun.’


PartIV:Theempiricalevidence
NassimTalebtalksabouttheneedforempiricalscepticism.This,ineffect,isa
desire to check your beliefs against the evidence. The two chapters in Part IV
provide a very brief look attheevidenceonvalueinvesting.Thefirstlooks at
the proposition that an unconstrained global approach to value investing can
createreturns.Thesecondconsidersadeepvaluetechnique,muchlovedbyBen
Graham,andshowsthatitstillworkstoday(adirectresponsetothosewhoargue
that Graham’s approach is outdated or outmoded). I could have included
additional chapters in Part IV, but many excellent surveys on the evidence
supporting value investing are easily available to the interested reader. The
ultimateproofofthevalueapproachisthatalmostall(ifnotall)oftheworld’s
mostsuccessfulinvestorstakeavalueapproach.AsWarrenBuffettopined:
Iwouldlikeyoutoimagineanationalcoin-flippingcontest.Let’sassumeweget
225 million Americans up tomorrow morning and we ask them all to wager a
dollar.Theygooutinthemorningatsunrise,andtheyallcalltheflipofacoin.
Iftheycallcorrectly,theywinadollarfromthosewhocalledwrong.Eachday
the losers drop out, and on the subsequent day the stakes build as all previous
winnings are put on the line. After ten flips on ten mornings, there will be
approximately220,000peopleintheUnitedStateswhohavecorrectlycalledten
flipsinarow.Theyeachwillhavewonalittleover$1,000.
Nowthisgroupwillprobablystartgettingalittlepuffedupaboutthis,human
naturebeingwhatitis.Theymaytrytobemodest,butatcocktailpartiesthey
will occasionally admit to attractive members of the opposite sex what their
techniqueis,andwhatmarvellousinsightstheybringtothefieldofflipping.

Assumingthatthewinnersaregettingtheappropriaterewardsfromthelosers,
inanothertendayswewillhave215peoplewhohavesuccessfullycalledtheir
coin flips 20 times in a row and who, by this exercise, each have turned one
dollar into a little over $1 million. $225 million would have been lost, $225
millionwouldhavebeenwon.
By then, this group will really lose their heads. They will probably write
bookson‘HowITurnedaDollarintoaMillioninTwentyDaysWorkingThirty
SecondsaMorning.’Worseyet,they’llprobablystartjettingaroundthecountry


attending seminars on efficient coin-flipping and tackling skeptical professors
with,‘Ifitcan’tbedone,whyarethere215ofus?’
Bythensomebusinessschoolprofessorwillprobablyberudeenoughtobring
upthefactthatif225millionorangutanshadengagedinasimilarexercise,the
results would be much the same - 215 egotistical orangutans with 20 straight
winningflips.
I would argue, however, that there are some important differences in the
examplesIamgoingtopresent.Foronething,if(a)youhadtaken225million
orangutansdistributedroughlyastheUSpopulationis,if(b)215winnerswere
left after 20 days, and if (c) you found that 40 came from a particular zoo in
Omaha, you would be pretty sure you were on to something. So you would
probably go out and ask the zookeeper about what he’s feeding them, whether
theyhadspecialexercises,whatbookstheyread,andwhoknowswhatelse.That
is, if you found any really extraordinary concentrations of success, you might
want to see if you could identify concentrations of unusual characteristics that
mightbecausalfactors.
Scientific inquiry naturally follows such a pattern. If you were trying to
analysepossiblecausesofararetypeofcancer-with,say,1,500casesayearin
the United States - and you found that 400 of them occurred in some little
miningtowninMontana,youwouldgetveryinterestedinthewaterthere,orthe

occupation of those afflicted, or other variables. You know it’s not random
chance that 400 come from a small area. You would not necessarily know the
causalfactors,butyouwouldknowwheretosearch.
Isubmittoyouthattherearewaysofdefininganoriginotherthangeography.
Inadditiontogeographicalorigins,therecanbewhatIcallanintellectualorigin.
Ithinkyouwillfindthatadisproportionatenumberofsuccessfulcoin-flippersin
the investment world came from a very small intellectual village that could be
called Graham-and-Doddsville. A concentration of winners that simply cannot
beexplainedbychancecanbetracedtothisparticularintellectualvillage.


PartV:The‘DarkSide’ofvalueinvesting:Shortselling
Therecentmarketwoeshaveledtotheall-too-predictablebacklashagainstshort
sellers. Indeed this pattern seems to have existed since time immemorial. As
statedintheNewYorkTimes:
Inthedayswhensquare-riggedgalleonspliedthespiceroutetotheEast,
theDutchoutlawedabandofrebelsthattheyfearedmightplundertheir
new-foundriches.
ThetroublemakerswereneitherBarbarypiratesnorSpanishspies—
they were certain traders on the stock exchange in Amsterdam. Their
offence: shorting the shares of the Dutch East India Company,
purportedlythefirstcompanyintheworldtoissuestock.
Shortsellers,whosellassetslikestocksinthehopethatthepricewill
fall,havebeenreviledeversince.Englandbannedthemformuchofthe
18th and 19th centuries. Napoleon deemed them enemies of the state.
AndGermany’slastKaiserenlistedthemtoattackAmericanmarkets(or
sosomeAmericansfeared).
JennyAnderson,NewYarkTimes,30April2008
However,farfrombeingtheSithlords,theshortsellersIhavemetareamong
themostfundamental-orientedanalystsIhavecomeacross.Theseguys,byand

large, really take their analysis seriously (and so they should since their
downside is effectively unlimited). So the continued backlash against short
sellersasrumourmongersandconspiratorssimplyleavesmeshakingmyhead
in bewilderment. I can only assume that the people making these claims are
either policy-makers pandering to shorted companies, or shorted companies
themselves.Ratherthanbeingseenassomemalignantforcewithinthemarkets,
in my experience short sellers are closer to accounting police - a job that the
SECatonetimeconsidereditsremit.
ThisviewpointwasconfirmedbyaninsightfulstudybyOwenLamont(2003)
(then at Chicago University). He wrote a paper in 2003 examining the battles
betweenshortsellersandthecompaniestheyshorted.Heexaminedsuchbattles
between 1977 and 2002 in the USA. He focused on situations where the
companiesbeingshortedprotestedtheirinnocencebysuggestingthattheywere


thesubjectofabearraid,oraconspiracy,orallegedthattheshortsellerswere
lying.Healsoexploredfirmsthatrequestedinvestigationbytheauthoritiesinto
the shorts, urged the stockholders not to lend shares out, or even set up
repurchaseplans(presumablytocreateashortsqueeze).IfImayparaphrasethe
immortalwordsoftheBard:‘Methinkshedothprotesttoomuch’!
Lehmanprovidesaclassicexample.AstheWallStreetJournalnoted:
‘What were they thinking? Lehman Brothers documents released
MondayshowedthatinJune,whentheinvestmentbankwasnegotiating
to raise about $5 billion from the Korea Development Bank, senior
Lehman executive David Goldfarb emailed Lehman Chief Executive
Richard Fuld with a suggestion. The firm should ‘aggressively’ go into
the stock market and use $2 billion of the proceeds to buy back stock,
thereby ‘hurting Einhorn bad!!’. He was referring to hedge fund short
seller David Einhorn, a critic of Lehman. Mr. Fuld, who was testifying
before Congress Monday, wrote back in agreement. Lehman didn’t get

themoneyandfiledforbankruptcyprotectioninstead.’
David Einhorn’s response to such matters is a lovely line: ‘I’m not critical
becauseIamshort,IamshortbecauseIamcritical.’
The results Lamont uncovered in his study show the useful role played by
shortsellers.Figure1showstheaveragecumulativereturntotheshortedstock.
In the 12monthsafter thebattlestarted,the averagestock underperformed the
market by 24%. In the three years after the battle started, these stocks
underperformed the market by 42% cumulatively! The shorts were right - too
oftenitwasthecompaniesthatwerelyingandconspiringtodefraudinvestors,
notthereverse!
The chapters in Part V section explore how to hunt for potential short
opportunities, or if you never want to short, they provide you with some
thoughts about the characteristics of stocks in which you don’t what to be
invested.
Figure1Lamont’sshorts:cumulativemarket-adjustedreturns(%)
Source:Lamont(2003).SGEquityresearch