šŸ”‘ Sieva's thoughts on value investing

November 2, 2022
Welcome to the 598 new readers of The Business Academy. The šŸ”‘ key to success is information.

šŸ”‘ Learn How to Value Investā€¦

This week I discovered the most comprehensive guide Iā€™ve ever seen on learning how to value invest (on reddit here).

Itā€™s fairly long and thorough, so I took the time to summarize it here for you.

Key Learnings:

Do not invest based on market comparisons

Your job as a value investor is to underwrite each company on its own merits.

Do not compare the market price of one company to another company. You will fall into the trap that comes with a bull market run.

Letā€™s look at a hypothetical example:

You wake up on a Tuesday morning to the sound of a leaf blower outside your window.

You roll over and check your Robinhood app.

You see that Salesforce stock is valued at 15x revenue and they are growing 20% per year.

Then you see a smaller software company valued at 12x revenue, growing at 20% per year.

Does this sound like a good investment opportunityā“

Maybe, if you invest in this smaller company, then one day the market will realize this company is undervalued and your stock will go up until it gets closer to 15x revenue, just like Salesforce. Right?

šŸš© Wrong.

I hate to admit, but invested like this for yearsā€¦

This strategy is problematic for a variety of reasons, and it is how most individuals invest.

Here are some potential issues with this strategy:

  1. The market may be ā€œhotā€ and Salesforce may be trading wayyyy above what its true long term value is. If Salesforce drops to be priced at 10x revenue (the way it is today), then your investment will get crushed as well.
  2. Salesforce is a huge company that makes $4Bn of cash flow per year, and it has $2.6Bn of long-term debt. It can easily service its expenses. But what if your smaller company has zero cash flow? ā­ļø When the market corrects, cash flow production is what investors care about. Our little companyā€™s stock will get destroyed.

How do we calculate a companyā€™s true value?

I recommend you follow the Warren Buffet strategy of value investing.

Find a company that is undervalued by the market. Invest in it.

If you do that enough times, over time the market will recognize the mispriced value and your investments will do well.

But how do you price the value of a company? šŸ‘‰ Start with intrinsic value.

What is intrinsic value, and why is it important?

Finding the intrinsic value of a company requires you to value the business based on specific characteristics.

These characteristics include:

  • cash flow
  • growth
  • risk

***Note, you can only apply this to cash flow-generating assets.

It does not apply to things like growth tech companies with no cash flow, and it also doesnā€™t apply to an asset like Gold, Silver or Bitcoin that doesnā€™t generate cash flow.

Using Discounted Cash Flow (DCF) is a good strategy for intrinsic value calculation.

Hereā€™s how DCF is calculated:

Take a company like Caterpillar Inc. Here are the steps to calculate a DCF:

  1. guess how much cash flow it will make in the coming years,
  2. apply a discount to each year of cash

We can guess the future cash flows by looking at last years cash flows, and building in some reasonable growth rate based on your analysis of the company (this caries some risk).

The discount is a bit of a harder number to understand but it basically is an attempt to compare the value of receiving cash in hand today, VS what an investor would need to earn in a couple of years to make waiting worth it.

Itā€™s most often based on another asset class in a similar category. So you can say ā€œI think I would earn 8% per year investing in the S&P500ā€. So 8% would be the discount rate you use.

(watch the video below for more on this)

When I buy a business, I donā€™t calculate the DCF but we are effectively making a similar calculation. If we want to buy a small business with $2 Million of cash flow, and it sells for $8M, then that business continues to produce $2M of cash flow. Thatā€™s a 25% return per year.

Thatā€™s considered a very high return in the investing world.

The Psychology of Investing

Even if one prices a stock correctly, and invests at the right time, itā€™s still incredibly hard to become a world-class investor. Iā€™m sorry but itā€™s true.

You will need to avoid four of the most common mistakes.

Even when I call them out, youā€™ll have trouble avoiding them (Iā€™m not superhuman, I have trouble with this too!).

  1. Momentum investing. People love to invest in things when theyā€™re going up (stocks, cryptoā€¦etc). When we see our friends making money, we want to join the party.
  2. Selling when things fall. Itā€™s a totally human response to want to ā€œprotectā€ your investments by selling it when you see a 20-30% drop. It feels devastating, gut-wrenching. Thatā€™s a good time to check our notes. Has anything changed about our assumptions of the underlying business? Do we still believe in it? If so, donā€™t sell. This is a good way to lose their money.
  3. Short-term investing or trading. This is gambling. I donā€™t do it. Weā€™re better off playing roulette at the casino. Either we invest because we believe in the long term underlying fundamentals of the business relative to its price. Or we donā€™t invest at all.
  4. Sitting on cash. When you have a lot of cash in your bank account, you fidget. Weā€™ve been taught to spend. Weā€™ve been taught to invest. People will tell you inflation is eating your cash. Forget those people. If you donā€™t see good prices for great companies, meditate, sit on your cash. Wait to pounce on the right opportunity.

Iā€™m a big believer inā€¦

Illiquidity is a feature, not a bug

90% of people canā€™t handle investing in stocks or crypto. They may say itā€™s great because ā€œyou can take you money out anytimeā€. Thatā€™s nice. Itā€™s also the biggest issue with these investments.

If I wake up in a panic, or my bank account feels tight for a day, I may just click ā€œsellā€.

I prefer to invest my money in:

  1. Illiquid investments (real estate + my private companies)
  2. Index + REITs.

I donā€™t want to manage my investments or check the stock market daily. I donā€™t plan to sell my index investments, and I simply canā€™t sell my illiquid investments when the market changes.

My main hope in this article is to help us all remember: when weā€™re investing, ā—ļøwe do not just look at the price of a share, the market cap, revenues or price-to-earnings ratio.

Itā€™s a big mistake. And most investors are making this mistake.

āœ… We review the financials (balance sheet, income statement, cash flow statement). Itā€™s a full time job to be good at this stuff!

Share this post with a friend if you liked it.

Share

Useful links

šŸ“œ Favorite Book on This Topic - The Little Book that Beats The Market

I love this book. I appreciate that it takes some of the key concepts I described above and gives you a simple formula you can follow to be successful in the market. There are a million traps you can step in investing in stocks. This may help you avoid some of those.

šŸŽ„ Good Videos To Watch

  • How to calculate intrinsic valuation
  • How to read an income statement (free). If you watch this pay attention to the explanation between cash accounting and accrual accounting. Most small businesses we consider investing in do cash accounting, but the more sophisticated (and better) strategy is accrual.
  • Avoid the lemming - understand why valuing a company is important. At 12 minutes he starts talking about the main valuation strategies.

šŸ“« Favorite Newsletter Article.

This week I particularly enjoyed Jack Reineā€™s post on 6-types of wealth.

Health / Relationships / Knowledge / Time / Experiences / Money

I went to a fancy business school. At this fancy school, I was surrounded by some incredibly bright people..

There was a lot of talk of money, salaries, bonusesā€¦etc

But it often felt like people were ignoring the other types of wealth in life.

With each life decision, youā€™re making a trade-off.

Make sure to use the right inputs in your decision to get the right output for your life.

For example, a lot of my brightest friends became consultants.

If you donā€™t know about it, consulting may require you to fly to a different city Monday morning to be on-site with a client, then fly home Friday. You repeat this process for months (or years).

In this case, youā€™re getting Money and some Knowledge.

But youā€™re losing Relationships and Time.

You donā€™t have control over your own time, and youā€™re never in your home city long enough to nurture community and personal relationships.

Alas, every pursuit comes with sacrifice.

My perspective of the 6 types of wealth.

Iā€™ve organized these from most to least important in my life.

Health - You need this. You donā€™t really know how badly you need this until you donā€™t have it.

If you get hurt, or sick, your life becomes limited by your health.

Thereā€™s no way around it. Itā€™s a core building block. Take care of your health and a lot of other types of wealth will follow.

Relationships - This includes family, community, and partnership.

Iā€™m a big believer that American cities and suburbs are harmful to our health. Imagine the classic European city. Itā€™s built around a central square or a church where people gather. You can walk there from just about anywhere.

American city design has separated families and communities from each other. Individuality is celebrated. Sharing is shunned.

But we are community-driven creatures. Thatā€™s why weā€™re obsessed with social media. We crave community.

Relationships are a meaningful measure of my personal wealth and I spend dozens of hours each week investing in this.

Knowledge - you compound this one like an investment.

You can gain it fast, or slow, but either way, nobody can take it away from you once you have it.

If you ever played Zelda the video game, the next reference will make sense to you.

As you go through the game and win, a Fairy will grant you a larger Magic Meter. You may die in the game, but when youā€™re reborn you still have the larger Magic Meter.

Thatā€™s how I feel about knowledge. You go through life collecting ways to enhance your knowledge. And even if you fail in a startup or a job doesnā€™t work out for you, then you get to take that knowledge with you.

Time - Have you heard of time billionaires?

Warren Buffett is a financial billionaire. He has all the money in the world. But heā€™s running out of time.

A 20-year-old has 2 Billion seconds left to live. Warren may have hundreds of millions of seconds if heā€™s lucky.

Would Warren trade all of his wealth to buy another billion seconds of life? I think the answer is yes.

Use your time wisely.

And when you have time, use it in a way that 80 year old you would be proud šŸ˜Š

Experiences - they make us happy.

Since the early 2000s Cornell Psychology researchers have proven again and again that experiential purchases are more satisfying than material purchases.

This happens for a couple of simple reasons:

Waiting in anticipation for an experience elicits more happiness and excitement than waiting in anticipation for material goods.

A good experience gone bad is better than a good material possession gone bad.

Think of people who went on a beach vacation, and it rains the whole time. You may hear them say ā€œit rained, but we got some nice family time togetherā€.

When someone buys a Porche, and the suspension breaks, we rarely hear the silver lining of that purchase

Money - This is the one thatā€™s most easily measured. And perhaps thatā€™s why itā€™s unilaterally pursued in capitalism.

But there is a limit. Somewhere around $100k per year, there is a meaningful reduction of the return on happiness you get on every extra dollar you earn.

As the weekend approaches, I think Iā€™ll be reinvesting my time in relationships, health and knowledgeā€¦unless thereā€™s fried chicken on the menu.

Have a fantastic week,

~ Sieva

Adult Disclaimer:
The information I provide here, and anywhere is not to be considered investing advice. Itā€™s informational and educational in nature. Do your own research. Please do not invest in things I talk about here without doing proper research.

ā€