THREE KEY IDEAS

1.

Investor should look at stocks as part ownership of a business;

1.Underneath every stock and bond is a business! 2.Think like a businessman - think you are buying the whole company! 3.If it does not make sense to buy the whole company at the current price then it also does not make sense to buy a 100 shares in that company.! 4.People dont do the basic math of guring out how much is the total company selling for.! 5.Example of the $500 billion company

2.

Investors should look at market uctuations in terms of Grahams Mr. Market example and make them your !iend rather than your enemy by essentia"y proting !om fo"y rather than participating in it.

Bargains do appear in the stock market recurrently. However, it cannot be said with certainty that a clear#cut bargain investment wi" produce excess investment returns, and it is impossible to predict the pattern, sequence or consistency of investment returns for a particular bargain investment...

It can only be stated with certainty that repeated investment in numerous groups of bargain securities over very long multi#year periods has produced excess returns. # The Partners of Tweedy, Browne

Noise and Signal

3.

The three most important words in investing are margin of safety, which means always building a 15,000 pound bridge if youre going to be driving 10,000 pound trucks across it.

An investment operation is one which upon thorough analysis promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.
Why did he use the phrase Investment Operation?

1.Its the act of buying and selling a security! 2.Infy in March 2000 and Infy today! 3.Cannot say that a good company is a good investment.

An investment operation is one which upon thorough analysis promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.
Why did he use the word promises?

1.Investing is a probabilistic activity. There are winners and losers. No commitment is made when there is an expectancy of a loss - e.g. you dont BUY lottery tickets or play in the casino.! 2.There are no sure things.!

An investment operation is one which upon thorough analysis promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.
Why did he put safety of principal before satisfactory return?

Pavlovian Mis-association
Associating Investment with Long term Bonds Income Own funds Associating Speculation with Short term Stocks Prot Leverage

The correct association is between investment and the presence of a margin of safety and speculation and the absence of a margin of safety.

Margin of Safety

When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000#pound trucks across it. And that same principle works in investing.

We insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying. We believe this margin#of#safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.

The Idea of Margin of Safety is based on the idea of Redundancy in Engineering!

!

http://en.wikipedia.org/wiki/ Redundancy_"engineering#

Redundancy in Engineering!
!

Duplication of critical components of a system with the intention of increasing reliability of the system, usua"y in the case of a backup or fail# safe...

In many safety#critical systems, such as y#by#wire aircra$, some parts of the control system may be triplicated. An error in one component may then be out#voted by the other two.

In a triply redundant system, the system has three sub components, a" three of which must fail before the system fails. Since each one rarely fails, and the sub components are expected to fail independently, the probability of a" three failing is calculated to be extremely sma".

Margin of Safety in Business Models! "Bu$ett approach#

Pricing power! Low cost advantage!

Margin of Safety in Capital Structures

Aversion to debt

Margin of Safety in Managerial Practices

For example, having slack!

Taking calculated risks! not backing up the truck

Margin of Safety in Accounting!

!

Optimism has no place in accounting. % Charlie Munger!

!

Bad accounting encourages bad behavior

Margin of Safety in Price

Scene from Movie Casino

Las Vegas has been built upon the wealth transfers that occur when people engage in seemingly#sma" disadvantageous capital transactions.

In American roulette there are 38 slots numbered 1#36, 0, and 00. Pay#out is 35:1

If you bet Re 1 on your lucky # 8 and if the ba" lands on # 8, you win Rs 35, otherwise you lose Re 1.

You wager Rs 1,000 on a single number, say number 7.% Probability of ba" landing on 7 = 1/38 = 2.63&. Probability of not landing on 7 = 37/38 = 97.37&%

Event Ball lands on 7 Ball does not land on 7

Payoff 36,000 0

Probability Expected Value 2.63% 97.37% Amount Bet NPV 947.37 0 947.37 -1,000 -52.63

What happens when Margin of Safety is %ve and you practice wide diversication?!
!

Suppose you bet Rs 1000/38 or Rs 26.32 on each of the 38 numbers to spread your risk

Event Ball will land on one of your numbers

Payoff

Probability Expected Value

947.37

100%

947.37

Amount Bet

-1,000

NPV

-52.63

Lesson: Diversication does not work when Margin of Safety is absent.

In fact diversication hurts you when margin of safety is negative!

In the earlier case when you bet Rs 1,000 on a single number, at least you had a small chance of getting lucky and winning Rs 35,000. In the fully diversied strategy, you will ALWAYS lose.

The Casino is a value investor.!

!

Why?

Each bet has an expectancy of a prot even though some will inevitably result in a loss!
!

Wide diversication!
!

Cap on Max Bet

In order to take proper advantage of the margin#of#safety principle in investment operations, its almost always essential that the investor practices adequate diversication...

A margin of safety does not guarantee an investment against loss; it merely guarantees that that probabilities are against loss # and in case of common stocks, that the probabilities favor an ultimate prot...

The individual probabilities may be turned into a reasonable approximation of certainty by the we"#known practice of spreading the risk.

Look for high base rates strategies - this does NOT mean look for high probability of success in every bet.! Talebs bleed - frequency magnitude.!

Avoid low base rate strategies i.e. where margin of safety is negative.!

This is the cornerstone of the insurance business, and it should be the cornerstone of sound investment.

Why is value investing akin to sensible underwriting?

What counts in 'insurance( business is underwriting discipline. The winners are those that unfailingly stick to three key principles:

1. They accept only those risks that they are able to properly evaluate )staying within their circle of*competence+ and that, a$er they have evaluated a" relevant factors including remote loss*scenarios, carry the expectancy of prot.* These insurers ignore market#share considerations and*are sanguine about losing business to competitors that are o,ering foolish prices or policy*conditions.

2. They limit the business they accept in a manner that guarantees they wi" su,er no a-regation of*losses !om a single event or !om related events that wi" threaten their solvency.* They*ceaselessly search for possible correlation among seemingly# unrelated risks.

3. They avoid business involving moral risk: No matter what the rate, trying to write good contracts*with bad people doesnt work.* While most policyholders and clients are honorable and ethical,*doing business with the few exceptions is usua"y expensive, sometimes extraordinarily so.*

Margin of Safety

For Graham: Low Price and Diversication! For Bu$ett: Business rst, People second, Price third.

One of the things that value investors have to struggle with when they are contemplating a transition from pure Graham & Dodd approach to value investing to Bu"ett/Munger/Fisher style is to understand that margin of safety can come from multiple sources. Graham focused primarily on only two such sources: a low price and wide diversication.!

! ! ! ! ! ! !

For a Bu"ett/Munger/Fisher style investor, margin of safety could come from many other sources as well:! First, margin of safety could come in the form of a superior business model one which has a sustainable moat which makes life di#cult for competitors and which enables the business to earn a high return on invested capital over a long time period (competitive advantaged period).! The businesses I talked about in the OctoberQuest conference have solid business models which have proven to be extremely resilient and have enjoyed long CAPs.! A superior business model makes it a low risk business to be in the rst place (leaving the question of price aside lets ignore that for now as I will address it later.) Agreed till now? Good.! Second, margin of safety comes from a bullet proof capital structure. Notice, the companies I referred to favorably in my talk all had debt-free balance sheets (except Shriram Transport Finance which has a leveraged balance sheet as its a nance company but nevertheless its hgot one of the strongest balance sheets in that business) with plenty of liquidity on the asset side of those balance sheets. How can this not be a source of margin of safety?! Third, margin of safety comes from high quality management one with very good operating skills, capital allocation skills, and integrity.! And nally, margin of safety comes from a low price.! For a pure Graham & Dodd Style investor, who primarily focuses on low price, its important to not only get the margin of safety from the large di"erence between intrinsic value and market price. Its also important to practice wide diversication- as an additional source of margin of safety. A Graham & Dodd investor has only two friends a low price, and wide diversication.!

Investing vs. Gambling

While our process does a"ow us to unearth undervalued stocks, we usua"y do not know how or when a gain !om a particular stock wi" occur.

In fact sometimes we lose money on a particular stock even though it appears to be undervalued.

However, we do know that there are prot producing occurrences in a diversied portfolio of undervalued securities such as the general rise in market prices, special dividends, tender o,ers, mergers, recapitalizations, spino,s, purchases of shares by raiders, and corporate share repurchases.

Steven Penman

Modern finance has given us ways to measure risk and ways to reduce it-diversification and hedging, for example-but modern finance does not deal with a primary source of risk: the risk of paying too much for an investment.

Steven Penman

To deliver efficient prices, modern investment theory requires investors to mentally visualize a myriad of covariances, risk factors, risk premiums, and expected returns, all of which vary randomly through time according to some stochastic process. Quite demanding; my head hurts. Sorry, I failed the rational man test.

Steven Penman

Architects and engineers well know, safe and effective design rests on firm underlying principles (of the physical sciences). Otherwise, the house or bridge falls down.

When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000#pound trucks across it. And that same principle works in investing.

What are the principles of Valuation Architecture?

1.One does not buy a stock, one buys a business 2.When buying a business, know the business 3.Price is what you pay, value is what you get 4.Part of the risk in investing is the risk of paying too much 5.Ignore information at your peril 6.Understand what you know and don't mix what you know with speculation 7.Anchor a valuation on what you know rather than on speculation 8.Beware of paying too much for growth 9.When calculating value to challenge price, beware of using price in the calculation 10.Return to fundamentals; prices gravitate to fundamentals (but that can take some time)

Principle # 1: ONE DOES NOT BUY A STOCK, ONE BUYS A BUSINESS

!

Efficient market investors buy paper, without investigation of the business. Day traders buy paper, or even just a ticker symbol. But fundamental investors buy a business.

Principle # 2:WHEN BUYING A BUSINESS, KNOW THE BUSINESS

!

To value a business one has to understand the business. That amounts to understanding the idea behind the business-the business model-and managements execution of the idea.
! !

VALUATION ARCHITECTURE

How do they make their money?! DO they make any money?!

Valuation, in turn, is a matter of translating one's knowledge of the business model and its execution into a price for the business. One observes factories, mines, farmers elds, inventories, customers, suppliers, sales and purchase prices, and the many transactions in which a business engages. What to make of it? !

! Valuation Architecture pulls these many features together to make sense out of them for the investor.! ! ! !

Principle # 3: PRICE IS WHAT YOU PAY, VALUE IS WHAT YOU GET

!

Unlike the efficient market investor, fundamental investors do not accept price as necessarily equal to value. Price is what the market is asking the buyer to pay, value is what the share is worth.
!

But
!

DISCARD THE IDEA OF INTRINSIC VALUE

! ! ! ! !

A Valuation model should not be employed as a method of determining a value but rather as a way of understanding uncertainty about value.

Principle # 4: PART OF THE RISK IN INVESTING IS THE RISK OF PAYING TOO MUCH

Modern finance supplies models, like the CAPM, to help us understand the risk of holding a stock. Business school students are drilled on beta, in an exercise they refer to as "beta bashing." Beta measures the investor's susceptibility to price movements. The fundamentalist sees it differently. As a matter of first order, the risk is in buying a stock rather than holding it, and that risk is the risk of paying too much. To fundamentalists, knowing a firm's beta ranks rather low on the list of things they would want to know. They are buying value, so, although they are concerned with fundamental risk-the risk from competition, poor management, and too much debt that can damage value-they are less focused on the price fluctuations that are the concern of those who buy just on price alone. Indeed, they may see a price drop as presenting an opportunity rather than inflicting damage. Buying at less than value is low risk, in fact providing a "margin of safety."' They emphasize the need for a model to detect the risk of paying too much rather than a beta model.

Principle # 5: IGNORE INFORMATION AT YOUR PERIL

Equity investing at its core is a matter of dealing with uncertainty. Information reduces uncertainty, so this principle is indeed pure common sense, to be dismissed only if one is persuaded that efficient prices already contain all the information required. However, the point begs the questions "What information is relevant?" and "How do I pull that information together?"

Principle # 6:UNDERSTAND WHAT YOU KNOW AND DON'T MIX WHAT YOU KNOW WITH SPECULATION

Don't contaminate what you know-your reliable information-with conjecture. Knowing a firm had sales of $150 million this year is different from a forecast that sales three years hence will be $250 million. Don't mix them. Focus on "value justified by the facts," and so be better prepared to challenge speculation. If current sales are $150 million, what would cause them to climb to $250 million in just three years?

! ! ! !

We want solid, conservative accounting. We understand that some estimation is required-to discount receivables for the uncertainty about bad debts or to estimate pension liabilities-but keep it within bounds and based on solid evidence. Estimating the market risk premium is a very speculative task. Implementing the CAPM is largely playing with mirrors. The fundamentalist is at once on guard: When challenging speculative prices, separate what you know from speculation. Inserting a CAPM estimate of the required return into a valuation model (like the dividend discount model), is building speculation into the valuation. The discount rate in these models is supposed to accommodate our uncertainty, not to compound it. Plugging a CAPM estimate of cost of capital into a valuation formula is simply adding speculation to the valuation. The fundamentalist will not participate: Separate what you know from speculation.. As buy side investors, we must be honest about our ignorance of cost of capital. Those on the sell side, pushing stocks, might play with mirrors to justify the price of a stock offering, but not us.

Principle # 7: ANCHOR A VALUATION ON WHAT YOU KNOW RATHER THAN ON SPECULATION

! !

Value = Anchoring accounting value + Speculative value

! ! ! !

Having separated what is known from speculation, the fundamentalist anchors on what is known. the investor identifies value implied by the accounting and then thinks of adding extra value for speculation. What did Graham did with Debt-capacity bargains - he said value CANT BE LESS THAN DEBT CAPACITY. What happened when we added 75% on top of Debt Capacity? We need a system, outside of our mental schemes, intuition, and self-delusions to bring us to the level of rationality that is assumed for the rational man with "all available information." Our mental accounting is just not up to the task. Fundamentalists embark on a disciplined, detached analysis of the information. Our system must be built on a rational foundation and governed by principles and rules that are immutable, invariant to fashion or fad and other aspects of human behavior (including management manipulation).

Principle # 8:BEWARE OF PAYING TOO MUCH FOR GROWTH

Markets love growth and tend to get overexcited about it, particularly in boom times. Visions of growth stimulate all sorts of fortune-telling. Fundamentalists are aware that growth is the most speculative part of any valuation, so they are disciplined about buying growth. Graham saw growth as not worth paying for.!

! ! !

DCF: The student is told to forecast FCFs up to a "forecast horizon" (here, ve years ahead), calculate a "continuing value" (or "terminal value") with a growth rate, and discount the FCF forecasts and the continuing value to present values The value is for a going concern, so the continuing value is an estimate of the value of the FCFs that continue after the forecast horizon. This model has been a standard for valuation for a long time. It preserves the notion that value is based on expected cash ows.. But is this good accounting for value? Note, rst, that the valuation does not anchor on anything in the present (unless one counts the net debt!); the value is based entirely of expectations of the future. Second, the valuation involves the daunting task of estimating a continuing value, and that estimation rides on a growth rate for the long term. That is a speculative task indeed, one that confounds the student: "What long-term growth rate do I assume, professor?" Practitioners know how sensitive their valuations are to the growth rate but often feel they don't have much of a grasp on it. This is uncertain valuation, so much so that investment bankers carrying out due diligence on a valuation for an IPO can use the model to rationalize just about any price for the offering! Benjamin Graham's words echo once again: The concept of future prospects and particularly of continued growth in the future invites the application of formulas out of higher mathematics to establish the present value of the favored issue. But the combination of precise formulas with highly imprecise assumptions can be used to establish, or rather justify, practically any value one wishes, however high, for a really outstanding issue.! Graham was skeptical of the "formulas out of higher mathematics" that modernists defer to. He saw a valuation model like the DCF model as speculative because it puts too much weight on speculation rather that what we know. Just as the CAPM is based on speculative inputs, so is this model.! Graham did not like valuations that depend on long-term growth rates (as the quote above indicates). Growth in a continuing value is speculative. Indeed, Graham and his fellow fundamentalists were apprehensive about paying for growth at all. It is a guess; growth can be competed away unless there is a clear protected franchise. A valuation that rides on estimated growth is a risky valuation.6 It is better to anchor a valuation on something we can observe now or can predict fairly condently in the short term. We want value justied by the facts.

St. Petersburg Paradox

!

I toss a fair coin If it lands heads, you receive $2 and the game ends. If it lands tails, I toss the coin again. If it lands heads again, you get $4; if it lands tails, the game continues.
!

For each successive round, the payoff for landing heads doubles (i.e., $2, $4, $8, $16, etc.) and you progress to the next round until the coin lands heads.
!

How much would you pay to play this game?

Daniel Bernoullis St. Petersburg Paradox says that you should be willing to pay a very large sum of money to play this game because its expected value of this game is innite. Each round has a payoff of $1 (probability of 1/2n and a payoff of $2n, or " x $2, # x $4, $ x $8, etc.) So, Expected value = 1 + 1 +1 + 1 . . . = $

When the [long-term] growth rate is higher than the discount rate, then [mathematically] the value is innity. This is the St. Petersburg Paradox, written about by Durant 30 years ago. Some managements think this [that the value of their company is innite]. It gets very dangerous to assume high growth rates to innity thats where people get into a lot of trouble. The idea of projecting extremely high growth rates for a long period of time has cost investors an awful lot of money. Go look at top companies 50 years ago: how many have grown at 10% for a long time? And [those that have grown] 15% is very raried. Charlie and I are rarely willing to project high growth rates. Maybe were wrong sometimes and that costs us, but we like to be conservative.

Consequences of projecting perpetual growth rates more than growth rate of world economy?!

! ! !

An Absurdity!! The man in the hot state is delusional - he wants to believe in a story of unparalleled success. However, elementary reductionism which reduced the problem to a physics one, pours cold water over his dreams.!

Principle # 9: WHEN CALCULATING VALUE TO CHALLENGE PRICE, BEWARE OF USING PRICE IN THE CALCULATION
!

Price is not value, so do not refer to price in calculating value.

!

Be wary of:
!

P/E of past; P/E of Comparable firms; Increasing earnings forecast because price has gone up; Marking to market
!

But:
!

One should learn from the information contained in price (e.g. recognize information asymmetry)
!

INFORMATION IN THE PRICE

! !

! ! ! ! !

If one seeks to challenge price, one must refer to information that is independent of price.! Do not accept that the expectations of others that go into the price are necessarily those of a rational accounting. Deferring to price for one's "rational expectations" can be like joining a chain letter: A feedback loop sets prices on the basis of prices, so bubbles form.! Fundamentalists will not anchor on prices, as efcient market theory would have them do, but rather seek an autonomous accounting for value.! Fundamentalists rst understand the information in market prices and then challenge that information with their own pricing. If market prices are efcient, they so conrm; if prices are inefcient, they see a trading opportunity. In conrming that prices are efcient, they are behaving like the defensive investor doing due diligence, kicking the tires. If their investigation indicates prices are inefcient, fundamentalists have an opportunity as an active investor. In either case, they stay grounded to the notion that they are playing against the information in price.! The spectacle of IPO (initial public offering) bubbles tells the tale. Investment bankers base oatation prices on the price of other rms in recent IPOs. Firms oat at an opportune time, when they view stocks prices as high. Basing price on other prices in a hot IPO market is akin to joining a chain letter. Bubbles form and burst, just as a chain letter ultimately collapses. Witness the Internet IPOs of the late 199os and the earlier theme-restaurant and teleservicing IPOs. As a tool for the investment banker trying to get the best price for an offering, the method is appropriate. But investment bankers are on the sell side, pushing stocks; investors are on the buy side and caveat emptor applies.

Principle # 10:RETURN TO FUNDAMENTALS: PRICES GRAVITATE TO FUNDAMENTALS (BUT THAT CAN TAKE SOME TIME).

Earnings drive stock prices, so the fundamentalist focuses on "long-run earnings power" with the recognition that prices will adjust to earnings information as it arrives. Thus one can think of valuation as asking, "What will the nancial reports look like in three, four, or more years?"!

Thank You