Value investing insight pdf

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The state of 60 60 Michigan went after them over billing errors it discovered and the federal govern- 50 50 ment and 42 states sued them over some 40 40 irregularities in documenting the substitu- tion of generics. Both of these have recent- 30 30 ly been settled, and while the market has 20 20 tended to view these as potentially indica- tive of a larger problem, we generally con- sider these to be isolated situations that are THE BOTTOM LINE inevitable when operating in such a com- David Mandelbaum doesn't believe the recent events weighing on Omnicare shares plicated regulatory environment.

Once the market The third thing worrying the market is sees through all the clouds, he expects the shares to return to their historical 17x a pricing dispute with UnitedHealth. United covers about one-third of the dual- Sources: Company reports, other publicly available information eligibles now getting their prescriptions November 30, www.

Theyre getting higher margins on at the majors its actually declining. We see sub- spending in the sector, which particularly opment prospects are. Given that we stantial cost-saving opportunities from the benefits services firms like Transocean.

We estimate on the low end theyll around They town, and mousetraps are in short supply. Once the market Current Price vs. Price Dividend Yield 0. We Net Profit Margin Describe one of your favorites in the sec- 80 80 tor, Transocean [RIG]. Despite extremely high oil November 30, www. One is a medical issue and, knock on than in the stock. Another risk would be if the holes start LC: We have a position right now in Second is if I stopped delivering perform- coming up dry.

These rigs lease out for Japans Nikkei index. Japan has significantly lagged major ing with me unless Im delivering highly constraining factor. Third, Ill stop rency, which is very positive for the profit if I dont still enjoy it. Thats the only one At around What do policy, which is very positive for multiple you think theyre worth?

You have a growing economy Why? Im unusual in this business. I spent double-A companies and countries their improvement. Youre coming off a my career at one firm before setting out business is reasonably locked. Just getting credit for the cash flow Japan than into the U. Youve been at this for 40 years. Do you pay me if I do well and if I lose money, Ill Supporting the price is the fact that expect to keep it up for another 40? I cant bemoan the way theyre using some of their enormous free things are, the system has treated me very cash flow to buy back shares.

Theyve LC: I still enjoy the game, making bets on well. Market prove me right. Ive said since I started in the business make the money that we do. VII Looking for investment ideas that stand out from the crowd? Please visit www. Your investment philosophy has been In companies earning abnormal influenced as much by Warren Buffett the returns, theres something unique going on CEO as by Warren Buffett the investor.

Were trying to find businesses that have Charles Akre: I was fascinated by John great moats, which translates into great Trains The Money Masters in the mid- returns on capital. Moats are fairly rare s, the first chapter of which was on but come from a variety of things, such as Warren Buffett.

I became the best student regulation, intellectual property, sustain- of Buffett I could and first bought able cost advantages and superior man- Berkshire Hathaway shares when it had a agement. From that happy dence in projecting future performance. Charles Akre experience, it became clear to me that the We next focus on management. Im at best way to see if a business is adding a stage in my career where Id say human Long and Winding Road shareholder value is by the growth in its behavior is the most important determi- book value per share.

You have to make nant of a businesss long-term success. I Having earned an English Literature adjustments for different industries or for dont care how smart an analyst you are, degree from American University, Chuck issues with GAAP accounting, but Im you cant really know whats going on Akre took a practical approach to his inde- looking for growth in the companys true inside a business.

We want to invest not cision about a career: I took a series of economic value per share over time. I truly didn't know the difference other things growth in new stores or the Ive found that when a manager puts his between the two then. When I meet hands in shareholders pockets once, hes with management, I dont ask about much more likely to do so again. Few do. Do you ever buy a great business with a there became a shareholder in the firm, I look at it this way: The average annu- not-great management, expecting change?

When CA: We generally dont invest in broken sion. He started Akre Capital in to you clean up the accounting, the real businesses that need to be straightened out manage separate accounts and a hedge return on equity [ROE] of American busi- or bad people that need to be thrown out. So our con- Its just not what we do. This Middleburg, Virginia, not far from his farm was the case with Berkshire Hathaway, at the foothills of the Blue Ridge Historical returns obviously dont guaran- which created a compounding machine.

I had an atypical start in this tee future returns. How do you separate business and it's taken a long time to get the future winners from the has-beens? How does valuation come into play? Curiosity, hard work and more than a little luck goes CA: We focus on three things: business CA: On top of everything we apply our a long way. A workbench position gets built loans many from an American Express than that of the market, with what we into a core position only when we have lit- subsidiary against what turned out to be believe is a lower level of risk than the tle or no question about the business, peo- non-existent soybean-oil inventory.

When market. It the fraud was uncovered, American The opportunity to buy usually comes takes time to learn how the business Express suffered significant losses on the down to a significant diversity of opinion model really behaves and Ive also found loans, driving down its share price. A company We really dont pay that much atten- A company compounding capi- compounding capital at way above-aver- tion to why something is undervalued. The return over a reasonable time period and rationale is that simple.

How would you define your circle of that it usually takes a long time to under- competence? Theyre to produce revenue are smaller. Ive done that has been that way for some time is only in regional markets, with no position well over the years in recreation and enter- AmeriCredit [ACF], a sub-prime auto today in Las Vegas or Atlantic City.

We got into it also have racetrack licenses in West insurance, and banks and other financial after they had some credit problems and Virginia and Maine. We have larger investments they changed their accounting from gain- When we first got involved with the today in retail than weve had in the past on-sale to more cash-based, making their company ten years ago, it was mostly in theyre relatively easy to understand, GAAP earnings nearly disappear.

We the off-track betting business, which had which is key for me. Its a busi- Whats attractive about the business? CA: I like that they see their profits in cerned with how my portfolios are catego- cash, every day. Once venues are estab- rized. Why so from the strict licensing issues surround- fund, then it was a core fund and now concentrated? On the demand side, its driv- it shows up sometimes as a growth fund. You know as three or four hours of entertainment, that growth is a creator of value is an how much of Warren Buffetts partnership for which theyre more than willing to pay important part of how we invest.

Theres a lot of activity, November 30, www. I could see a pretty good food. Thats an attractive Cincinnati, theyre adding a new riverboat few things right away, including that he value proposition for many people. His background was in return business. In the ten years weve finite, though, so theyll have to acquire real estate development, so I knew his owned Penn stock, book value has com- more.

But one thing that stuck see several public companies that would with me from that conversation was how Whats driving future growth? If the in all his real-estate deals, hed never had opportunities dont materialize, theyll his wife on a note. Thats almost impossi- CA: With existing assets, they continue to have a tremendous amount of capital to ble to do as a small developer the banks do a great job of expanding when they shrink the share base.

It told me he had an can. In Charles Town, West Virginia, they This is a perfect example of where my acute sensitivity to risk. Over time, as he started with a racetrack and slot confidence about reinvestment potential made acquisitions and built the company, machines and now have 4, slots, with has a lot to do with management. I remem- that sensitivity has translated into very approval to go to 6, In ber meeting Peter Carlino, who is still the high standards for the returns he requires for the risks he takes.

It doesnt take away Price In some cases, five years. New jurisdictions will also open up, Sources: Company reports, other publicly available information bringing some new competition to existing venues. I just assume there will always be November 30, www. You past 10 years. If you put underwriting profits on top of [of Terra Nova, a European insurer that which theyve achieved in all but acquired in ], theres some risk in Why is Markel Corp.

I think its long-time holding, still attractive? Do you still see great upside at risks that arent included in the standard, CA: They may have to acquire premiums this price? TTM : Business: Underwriter and marketer of ditions and premium pricing. Rowe Price 3. Given such growth prospects, he says, the shares are very ance sheet. So owners. We think this type of think- 11x what we would call this years eco- of towers to the independent companies ing by competitors plays into American nomic earnings, which we expect to com- like American.

Thats not to say American Towers hands. As with Penn National, well get ket theyve been very smart in making Are there key technology risks here? Crown Castle recently agreed to buy CA: Clearly, if some way is developed that Global Signal, another big player in the allows the wireless exchange of voice and American Tower [AMT] is also up strong- market, and will now be the largest inde- data without the use of ground antennae, ly this year.

Why are you still high on it? Americans that would be a disruptive event. Once a tower is up and Current Price vs. Rowe Price 8. Net Profit Margin Youve had the recent sale of a tremendous amount of 35 35 wireless spectrum and companies like 30 30 Craig McCaws Clearwire building a nationwide wireless broadband network. Customers the current 25x multiple of free cash flow will pay off handsomely, he says. OReilly serv- number of cars on the road and miles driv- inquiry at the company.

Heres a case ices stores from a distribution center at en, which continue to grow. It can be where we have to make judgments about least five times a week, as opposed to affected by gas prices or a slowing econo- the people. That gives them a growth trend is up. It will take its course, but I expect and-pops who are willing to sell for net ultimately that the biggest downside for Is such a system much more expensive?

Even a bigger company like theyve stopped an aggressive stock-buy- CA: It works well for them their returns CSK Auto [CAO], with 1, stores in the back program until this is sorted out. He believes such growth prospects are not all adequately Because of that mix, the company has a built into the shares, which trade at 15x his estimate of free cash flow.

OReilly actually has the better bal- CA: Despite all the problems, the business ance sheet to do so and I believe theyre Where does a competitive moat come is modestly profitable and producing much better, more-focused operators. Same-store sales are pos- The company is opening new itive, so customers are still attracted. If you Cents Only offers good value and some end infrastructure, both of which are sta- combine that with mid-single-digit growth treasure-hunt excitement.

Within the bilized and showing signs of progress. We in same-store sales, growing buying power dollar-store market, we think it offers a believe the people running the business and the prospect of a large acquisition one more attractive product mix, with fewer are smart retailers and we see no reason day, it's pretty easy to see how they can get knick-knacks and novelty items and more why they can't get return on equity at to high-teens annual earnings growth.

Again, thats Current Price vs. They entered the Texas market a few years ago, 20 20 didnt get it right and have been losing 15 15 money there. The management transition between the founder, David Gold, and his 10 10 son-in-law, Eric Schiffer, hasn't gone well. They have underinvested in systems and 5 5 technology, gone through more than one CFO and changed auditing firms twice in recent years, with the result that they THE BOTTOM LINE haven't filed audited financial reports yet The company is poised for a turnaround after a series of operational and administrative this year.

This was a case returns. So where the upside just didnt ever arrive, so them around this issue. Its sold almost annual returns are likely to be around money from the current price. For 13 years, the hedge fund has averaged around How patient do you expect to have to be? If they can't get it right, there's likely With shorts, we take a lot of little bites, to be some sort of catalyst to get it right.

Were looking for bad business models, bad accounting, bad In general, how do you approach the people or bad valuations. Our short book decision to sell? In , it was the reason we our sell decisions. We sell when something well do extremely well from here. We recently sold Citigroup, for exam- CA: Yes, even though its return character- The market turning south was when you ple, which originally came from a big istics are now lower than what were typ- seem to have really hit your stride.

I see it as sort of a low- after its Treasury-bond scandal. We had a fine, but management didnt produce, they were nary purchases in an adverse time. We then had pos- history. On one hand, that type of thing is itive results across all our businesses dur- music to my ears, but the other side of it You mentioned the potential of activism ing the period, a time when was that it didnt exactly matter to Weill with 99 Cents Only.

We sold, activist do you tend to be? This may be the then, for a couple of reasons. First, the most significant achievement of my invest- driver at the top demanding high rates of CA: We want to have a regular and in- ing career. When we then also had home- return from individual businesses was depth dialogue with management. Ive run years in and , we really gone. Second, the unwinding of all the owned shares in International Speedway started to get noticed. Its an amazing What I particularly enjoy is when you to judge with confidence how attractive business model: the barriers to entry are can help change the choices people have the returns would be going forward.

We had the they own, but they get the biggest portion still has them. For years it has ence of all. VII November 30, www. Buffett Heres to You, Mr. Robertson At the time legendary investor Julian Robertson closed his hedge fund, I described his portfolio as a lame col- lection of companies. Mea culpa, Mr. By Whitney Tilson Six and a half years ago, at what see how all of these stocks had per- page, despite two bankruptcies, Tigers turned out to be the very peak of the formed.

Did Buffetts high-quality busi- portfolio did far better than Berkshire's Internet bubble, famed hedge-fund man- nesses trading at not-so-cheap stock though both handily beat the market. In ager Julian Robertson closed his fund prices outperform Robertsons lower- just six and a half years, an investor put- with the following prophetic words: quality, but much cheaper, businesses?

The current technology, Internet and telecom craze, fueled by the performance desires of investors, Stretching In a comparison of his disclosed holdings with those of Warren Buffetts Berkshire Hathaway, it appeared in early that Julian Robertson had fall- money managers and even financial for Value? As things turned out see table, p. Growth frankly do not understand. Buffett of the Berkshire holdings. Says a former Tiger employee companies such as eToys, Priceline. The Weak Shall Tiger Management's motley band of disclosed portfolio holdings in have handily beaten the gilt-edged holdings in Berkshire So, mea culpa, Mr.

You Be Strong Hathaway's portfolio from that time. Not surprisingly, both the were undone not by your own mistakes, Tiger and Berkshire portfolios have trounced the overall market. First, buying beaten-down, out-of-favor companies can be hairy Coca-Cola The corollary is Gillette While Robertsons investors Bowater Pittston Brink's Starwood Hotels During times like UnumProvident Sometimes the XTRA Some people call that GARP growth at a were doing it as much for all the share- reasonable price , Id call it value.

I think holders as we were for ourselves. It had a thats just semantics. Thats their job country club. We brought in a few outside based on the business and the companys directors, including an investment banker, position in it, how fast is the company a consultant from Booz Allen and a going to grow?

Its pretty hard to lose if female professor from Yale. We thought youre right on the growth rates when the our actions would be appreciated, but the growth rates are high. You were a pioneer in hedge funds before Tiger was well known for the quality of its they became trendy.

Is it a good thing that analysts, many of whom now run some of Editors Note: Tiger Managements Julian hedge funds have become so popular? What was the secret to your find- ing that There is no point in subjecting JR: I think its an inevitable thing. Its the ing and developing investing superstars?

It was an thing, so it does attract the best managers. JR: : I really think that we benefited from unhappy end to one of the most successful From the point of view of the investor, he starting with good young people, who careers on Wall Street: At its peak, Tiger gets a partner in the manager who, in begat more good young people. Thats a huge advantage.

It is part years for his investors. Charming as ever at department guy who calls you up reading aptitude, but also psychological. It sort of 74, Robertson recently spoke with Co- from a script. You want the guy working emanated from our having a few people Editors Whitney Tilson and John Heins at for you to have the most to lose and the over time who just didn't have the fire- his Park Avenue office.

Hes not going to go overboard happens, because it's not their fault. So we Has your definition of what constitutes wild, because he has the most to lose. The fact that so many new people go The test was also designed to show into this business does makes it tougher on what kind of team player the person was Julian Robertson: When I started in the those already in it. For example, you used and their competitiveness. Ive found that business and for a long time, my concept to get a rebate on credit balances when you most good managers are great competi- of value was absolute value in terms of a were short now borrowing stocks costs tors.

I think that all helped us pick good price-earnings ratio. But I would say my you money overall. That alone makes a big people. These changes include: 1 a shift toward a service- and knowledge-based economy focused on intangible assets, and 2 the emergence of internet-based businesses that have strong network economics and winner-take-most or winner-take-all competitive dynamics. An Evolving Global Economy In the past several decades, we have seen a notable evolution in how value is created across the global economy, particularly in the U.

Today, much more value is created from investments in intangible assets, like research and development, brand building or customer acquisition. The theory behind using book value as a proxy for value is that it represents all the investments a company has made in the past to create future value. Historically, these investments were largely tangible assets, which are accounted for on the balance sheet and are thus included in book value.

That is not the case for most intangible assets, the cost of which is often expensed through the income statement. For example, the assets of a company like Facebook are largely intangible, i. Employee compensation is expensed through the income statement, but the assets they create do not show up on the balance sheet. This shift is happening across the economy—Exhibit 3 illustrates the increasing rate at which intangible assets have been responsible for value creation.

For certain areas of the economy, this clearly calls into question the usefulness of book value as a value proxy. Alphabet currently trades at approximately 5X book value—certainly not low enough to be considered a value stock by the standard of many investors—but what if the value of its intangible assets could be included on its balance sheet?

Book value would go up and its price-to-book multiple would come down. It might even come down enough to be widely accepted as a value stock. It is not that the philosophy of value investing has become less valuable; rather, the way we have historically measured value has perhaps become less insightful than it has been in the past. The Emergence of Internet-Based Businesses Businesses like Amazon, Alphabet, Netflix or Facebook are prime examples of businesses creating value from intangible assets and benefitting from powerful network effects, where their products become more valuable as users and suppliers are added to their platforms.

This dynamic often results in a winner-take-most competitive structure, which is different than the environment historically encountered in industries focused on physical assets. Once a company gains a lead online, it can grow very rapidly and expand its competitive advantage over peers, leading to more persistently high returns on capital and larger market shares than the market leaders of the past.

Intrinsic Value Investing Despite the shifts in the economy and competitive landscapes, we do not believe value investing in its broadest, philosophical sense has been undermined. Buying an ownership interest in a business for less than what it is worth and patiently waiting for value to be realized is still a very logical strategy that should continue to work. But it requires an intellectual evolution in understanding how value is created as the economy changes, along with diligent work analyzing competitive dynamics.

Simply buying stocks with low price-to-book or price-to-earnings ratios is not sufficient. At Diamond Hill, we prefer to call ourselves intrinsic value investors. This is more specific about where we believe value comes from: the core competencies of a business and the future cash flows those competencies allow it to produce.

This process results in a wider universe of businesses to consider for investment—beyond just stocks trading at low multiples—and positions us very well to adapt to, and capitalize on, changes in the global economy. We sometimes find value in slow-growing, undervalued businesses with stable competitive positions that happen to trade at low multiples of earnings or book value.

In other cases, our search for value leads us toward high-quality, growing businesses whose future prospects are underappreciated. In other words, our portfolios are composed not only of what most investors consider value stocks, but also some that are typically considered growth stocks.

To us, every position represents value. In fact, we believe the distinction between the two is a false one—growth is a component of value. Take Alphabet—it has never traded at an optically low multiple of earnings or book value, which has likely made it off-limits for many value investors. While the market was focused on the potential near-term negative impact, we viewed it as an opportunity to start a position at an attractive price.

We looked at the quality of the business and the predictability of its long-term growth, and we became confident we were getting more value in the form of that growing cash flow stream than what we had to pay to acquire the shares. Alphabet was a growth company that offered a lot of value. Our purchase of Facebook in early was similar, when the shares traded at an unusually low valuation due to concerns around the Cambridge Analytica scandal.

We had been following the business for several years and liked it very much, but never had the opportunity to buy shares at an attractive enough valuation. After spending a significant amount of time evaluating the potential impact of privacy concerns on user engagement, we believed the long-term impact would be limited.