Value Investing and Risk Management

Value Investing and Risk Management

Adib Motiwala

Motiwala Capital LLCwww.motiwalacapital.com

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Disclaimer• Any material here is for education purposes only. I may have a position in some of the securities

mentioned as examples. Please do your own research or consult your financial advisor. Do not take it as investment advice. This is not an offer to buy or sell securities or investment advice.

Motiwala Capital LLC 2

Outline

• Introduction• What is value investing?• Why does value investing work?• An approach to Risk Management


About me

• Education– MBA in Finance @UTD - 2010– MS in Comp Sc. @Texas A&M –2001

• Motiwala Capital LLC– Registered Investment Advisor (RIA) in Texas– Founded in 2010– Managing clients capital since April 2011.– AUM : ~ $800k (as of 10/25/2011)

4Motiwala Capital LLC

Motiwala Capital – Investment Philosophy

• Value oriented, bottom up investing style• Long Only (except in Arbitrage)• Investing = Business Analysis + Financial Analysis + Behavioral aspects• Buy good business at a bargain price• Prefer companies with strong balance sheets, generating high ROIC and consistent

FCF• Don’t use leverage• Focus on Absolute returns• Always insist on a margin of safety• Practice discipline and patience.


Motiwala Capital – 3 Strategies

• Typical long equity investments ( Good quality business at cheap valuation)

• Special Situations– Merger Arbitrage– Closed end fund tender offers– Dual Share Class arbitrage– Spin offs

• Option enhancement via Covered Calls and Cash Covered Puts


Investment v/s Speculation

• “An investment operation is one which, upon thorough analysispromises safety of principal and an adequate return. Operations not meeting these requirements are speculative”

- Graham and Dodd in Security Analysis (1934)


What is Value Investing?

• Hunting for bargains.– Buying a dollar for 50 cents.– Buying debt at 20c on the dollar– Buying security at prices WELL below their intrinsic value.

• Companies that are neglected, unloved, obscure are typically cheap [ and not necessarily low – quality ]

• Contrarian / Go against the crowd.

• Reversion to the Mean

• Ben Graham – Father of Security analysis– The Intelligent Investor– Security Analysis.


Presenter

Presentation Notes

What do you do when shopping for clothes? Do you like to buy on sale? Or pay full price? Do you look for coupons?

Central Concepts

• Investing in a stock is part ownership in a business

• Mr. Market and Intrinsic Value

• Margin of Safety

• Circle of Competence


Mr. Market

• “Manic-depressive”

• Metaphor that explains how stocks can become mispriced.

• He Buys High and Sells Low!!!


Intrinsic Value

• The underlying value of the business.• Not an absolute number but a range.• Various methods

– Asset based approach– Earnings / Cash flow based approach– Private market value / Prior transactions– Relative valuation

• “It is better to be roughly right than precisely wrong”


Circle of Competence

• Buy what you know. Do your own research.

• Don’t feel compelled to invest in an area just because every one is investing there.

• Over time increase your circle of competence.

• Investors get better as they age ( unlike sports or some other professions)


Margin of Safety

What is Margin of Safety ? A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck or extreme volatility –Seth Klarman

Why is having a margin of safety important?

•Valuation is an imprecise art

•The future is inherently unpredictable

•Having a margin of safety provides protection against bad luck, bad timing, or error in judgment.


2 Rules of Investing

• Rule #1: DON’T LOSE MONEY


2 Rules of Investing

• Rule#2: Don’t forget Rule#1

– Warren E. Buffett


Importance of downside protection

Initial Percentage Loss Required gain to break even

10% 11%

20% 25%

33% 50%

50% 100%


Magic of Compounding

Years of Investment 7% return 12% return 18% return

20 4 times 10 times 27 times

40 15 times 93 times 750 times

60 58 times 898 times 20,555 times

Example : $100,000 investment made today will be $1 million in 20 years if investments compound annually at 12% and $9.3 million if invested for 40 years. A ‘meager’ rate of 7% turns $100,000 into $1.5 million in 40 years.

Keys: • Invest for the long term. • Stay healthy and Live Longer!!!• Start EARLY! Invest in your 20s and 30s regularly. • Save money!!! 10$ could turn into $930 in 40 years!!! (@12%)


Areas of Value Investing

• Net – Nets• Special situation stocks (Spin-offs, Mergers, Bankruptcy)• Out of favor blue chips• Distressed industries• Turnarounds• Overlooked small caps.• Fallen Growth Angels• GARP• Sum of the parts• Discounts to cash• Activist Opportunities• Post bankruptcy

– Source: Value Investor Insight


Why do stocks become cheap?

• Missing quarterly guidance/analyst expectations. • Neglect from investors. (eg: Microsoft has been dead money for decade)• Prior history of losses/ fraud/ accounting issues.• Management issues (resignation, poor execution. eg: HPQ)• Complicated business or unloved business (eg: Waste Management)• Unrelated business in large conglomerate (eg: Loews)• Hated company (eg: British Petroleum)• Operates in an out of favor industry (Housing, Defense, For Profit Education)• Painted by a common brush (eg: Ensco during BP spill.)• Small cap with no analyst coverage • Cyclical at the bottom of the cycle. (eg: Valero)• Forced, non-economic selling ( Removal from an index )


Advantages of Value stocks

• Bad news usually don’t hurt as much (did not work in 2008 and recently)

• Value stocks tend to do well on slightly good news.

• Value to private owners.

• Downside protection. – Think dividend yield


What has worked in investing?

• Low price in relation to asset value• Low price in relation to earnings/cash flows • High dividend yield.• Significant pattern of purchase by one or more insiders.• Significant decline in the stocks price• Small market capitalization

– Taken from Tweedy Browne classic research paper.


http://adibmotiwala.wordpress.com/2010/06/27/what-has-worked-in-investing-a-paper-by-tweedy-browne/

Investment Process

– Idea generation

– Fundamental research

– Portfolio construction and position sizing

– Portfolio maintenance

– Risk management


Idea generation

• 52 week low list• Low P/E, P/B, P/FCF, P/S, high dividend yield• Screeners (Magic Formula, FinViz)• Fund manager 13F filings• Magazines/newspapers/ ValueLine• Blogs / Investment Clubs (SumZero, VIC)http://motiwalacapital.com/blog/search-strategy/


http://motiwalacapital.com/blog/search-strategy/

Valuation

“Price is what you pay, Value is what you get” – Buffett.

- Arrive at normalized earnings for the business operating in “normal” conditions (normalized margins etc)

- Check what Mr. Market is offering the business to you for ? ( Market Cap and Enterprise Value)

- P/FCF, P/E, EV/FCF, EV/Sales, EV/EBIT are some of the measures used.

- What is the business worth? Other businesses, past valuations, Private market value. Depends on the nature of the business.

- Inverse DCF


Management Evaluation

• This is more qualitative than quantitative. • Past Capital allocation• Skills to run the business and grow it• Compensation levels.• Duration of management• Past decision making and results• Past mistakes. Past promises.• Dividend policy and record.• Share buyback.• Insider holding level.• Insider buyback• Cluster selling


Why does Value Investing work?

• Focus on short term results– Traders / Momentum / High frequency trading– Funds that need to report performance monthly/quarterly

• Liquidity concerns (daily/weekly)

• Mandates to be fully invested at all times

• Closet Indexers , Managing to an index

• Participants view volatility as risk

• Greed, Fear and lack of discipline

• Value Investing does not always work – People give up!


Types of Risk

• Business risk– Risk that investment does not work from a business perspective

• Valuation / Investment risk– Buying at a high price in relation to value

• Financial leverage risk– Risk of default, bankruptcy, share holder dilution

• Portfolio risk

• Market Risk


Presenter

Presentation Notes

investment risk is buying at too high a price business risk is the risk of things not working out as you expect from a business perspective.. margin compression.. operating deleverage Examples for investment risk.. you can use example of cisco from 2000 2) for business risk... you can show toyota unexpected developments in a great business

Cisco in 2000 – example of Valuation risk


Since 2000• Earnings up 4x• Sales up • ROE in mid 20s• Bought back stock• But stock is 75% lower from peak

WHY ??

Stock was over valued in 2000 and has never been really cheap.

Financial Leverage Risk

• Enough examples from 2008-2009 such as Lehman, AIG, Bear Stearns and so on.

• Combination of operating and financial leverage can work wonders. It can also be an absolute disaster. We avoid this combination.

• We look at LT Debt / Equity, Interest Coverage. The ability to service debt via cash flows.

• Graham recommended Equity > Liabilities.


How to mitigate these risks?

• Know the business intimately

• Buy with a margin of safety. Use conservative estimates

• Avoid highly levered business especially one that is capital intensive

• Sector and position limits, avoid extreme concentration– Sector limit: 25% max, Position limit 10% max, 15-25 long positions

• Beta is not risk.


Final thoughts

• Do your own homework. There are no shortcuts in investing. Ignore the noise.• Understand the business. If its too difficult, move to the next company.• Financials – understand them and know how to value the firm. • Evaluate management capital allocation, shareholder friendly decisions• Know the thesis on the opposite side.• Always invest with a margin of Safety.• Consider Risks before Returns.• Invest for the longer term. Compounding works very well over many, many years.• Patience is the toughest part of Value Investing.• Learn from your mistakes and of others.• Stick to your style. No style works day in and day out.


Resources

• Books for value investors– Intelligent Investor by Ben Graham– Security Analysis by Graham and Dodd.– Margin of Safety by Seth Klarman– You can be a stock market genius by Joel GreenBlatt.– Beat the street by Peter Lynch– One up on Wall Street by Peter Lynch– Common stocks and uncommon profits by Philip Fisher– The little book on Value Investing– The little book that beats the street.

• Resources for learning – Letters by Buffett and Munger, Berkshire letters.– Letters by great hedge fund and mutual fund managers. – Value investors club, SumZero, GuruFocus– http://motiwalacapital.com/blog/favorite‐blogswebsites/


http://motiwalacapital.com/blog/favorite-blogswebsites/

Documents

Value Investing and Risk Management