Value Investors are realists who buy shares from pessimists and sell them to optimists

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Ricco Friedrich 1 October 2007
A pragmatic approach to Value Investing
Value Investors are realists who buy shares from
pessimists and sell them to optimists
Warren Buffet
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Agenda

• What is pragmatic value investing?
• In search of value
• A few great examples
• Summary

Doubt is not a pleasant condition, but certainty
is absurd.
Voltaire François Marie Arouet (1694-1778)
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What is pragmatic value investing?

• Pragmatic simply means finding a practical
  approach to problems or affairs, by making
  reference to historical events with the emphasis
  on the practical lessons to be learnt from them
• Value means buying R1 worth of a business for 85
  c or less. While this may sound obvious it is
  often not a principle which is consistently
  applied.

Charles Pierce in reference to philosophical
school of thought
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Key investment tenets

• Mean Reversion
• Ultimately the rate of return on investment
  tends towards equality in all industries.
  Entrepreneurs will leave unprofitable industries
  and seek out profitable ones (Stigler, 1963).
• Normalised operating conditions
• What are the likely profits a business will
  generate under conditions which are neither
  inflated nor depressed.

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Key investment tenets

• Focus on long term, not just the next 3 years!
• The next 3 years worth of cash flows only account
  for 15 of the value of a business
• Emphasis on fact and less on forecasts
• Analysts errors in forecasting are high (error
  is as high as 70 in year 3)

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Understanding the value of a business
Aggressive high risk
Significant value attributed to future growth
Replacement VALUE
Continuing Value
True Benjamin Graham Students
GROWTH

• Future earnings potential

• Historic info and facts
• Book Value (Div Yield,
• Low PE)

Conservative low risk
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Annualized Returns(1979 2003)
Russell 1000
S P 500/Barra
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The SA experience of Value vs Growth
This study done by CSSS highlights some
interesting points about Value and Growth
Value has shown - a lower frequency of negative
returns - average out performance per annum is
greater - to be more defensive (more losses
likely from growth strategy)
Value defined as low PE stocks and vice versa
for growth
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Annual excess returns from Value and Growth
strategies
Shaded area (Growth out performs value)
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Cumulative capital appreciation from Value and
Growth strategies
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Warren Buffets view
Market commentators and investment managers who
glibly refer to growth and value styles as
contrasting approaches to investment are
displaying their ignorance, not their
sophistication. Growth is simply a component
usually a plus, sometimes a minus in the value
equation
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In Search of Value
The best time to buy markets and companies is
when earnings are below normal operating
conditions
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Growth in real earnings in the All share is well
above trend
Source Inet, Sim
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Where is the value or is it different this time?
Took 20 years to maintain the value of your money
in real terms
Cycle 1 Took 20 years for Allshare to recover in
real terms
Source INet, SIM
This is the single largest, uninterrupted rise we
have had in the markets (up 225 in real terms)
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Graham Dodd PE ratio JSE all Share
15 yr avg. 20 X
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Rolling 3 year returns will normalise
Source Inet, Sim
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The best time to buy equities is when earnings
are depressed
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5
6
3
1
4
Average subsequent 3yr return at top of earnings
cycle18 Average subsequent 3yr return at bottom
of earnings cycle 87
Source Inet, Sim
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Conclusion on the market

• Real earnings growth has been well above trend
  for the past 5 years and is slowing. Ultimately a
  reversal of profit growth to the long term trend
  will occur!
• Look for companies
• whose earnings are depressed and/or
• more defensive and can be sustained and/or
• higher in quality
• As Warren Buffet said No one can predict when
  the floods are going to come, but when they do
  you want to make sure you have an ark
• More recently, new highs are being driven by
  fewer stocks going up
• The increase in listings supports the view that
  markets are fully priced

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A few (great) Egs applying our investment
tenets
Eventually valuation trumps sentiment
sometimes it just takes longer
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1. The commodity cycle is already extended
3 yrs
2.5yrs
4 yrs
3 yrs
1 yr
6 yrs
Commodities are cyclical we prefer to buy low
and sell high (not always possible)
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Resource earnings have trumped Industrials and
Financials
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2. Banks are offering great value

• Exposure to capacity expansion in South Africa
• We still expect a benign interest rate cycle
• Valuations now over-discount
• Worsening bad debts
• Slowing advances growth (NCA) retail only
  accounts for 39 of bank profits
• SA Banks still cheap (taking into account much
  higher ROEs) when compared to other emerging
  markets
• Sub-prime concerns

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Standard Bankan awesome track record!
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3. Buffet Rembrandt Long-term focus the
difference
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4. Focus on NAV, not just earnings.
PSG has been a great success story, based on
sound investment principles!
Source PSG
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5. Where is the margin of safety?
Share Price is up almost 6x in real terms while
historic earnings have been flat!
Source Inet
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6. Implied growth expectations
The following 10 stocks have very HIGH annualised
growth expectations priced in
Assume mean reversion to Average Market PE of
13x and Required Capital Return of 15
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Implied growth expectations
The following 10 stocks have very LOW annualised
growth expectations priced in
Assume mean reversion to Average Market PE of
13x and Required Capital Return of 15
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Combining the best of both styles (simply)
Source Inet Forecasts, Sim
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7. Apply logical thinking
Great expectations from Raubex!
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In Summary

• There is only 1 type of investing buying a
  business below its value under normalised
  conditions. Anything else is speculation. This
  involves an assessment of long term growth.
• Traditional Value Investing (low P/E, Low P/BV)
  strategy has out performed growth globally and in
  South Africa.
• Apply logic and common sense (a pragmatic
  approach) to all investment decisions
• Recognise and avoid serious risks!
• Intelligent capital allocators take a long term
  view.

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The END