Book Review: Christopher Browne – The Little Book of Value Investing
Introduction:
- This book was gifted to me by a family member around 5 years ago, and although I read it around 3 years ago, I only recently stumbled across my notes. Having this gap between reading the book and reviewing my notes was really interesting, as it provided me with the opportunity to understand what content from the book I’d naturally kept and what I’d forgotten, fortunately more was remembered than I expected!
- Whilst I am not currently investing in any individual stocks that doesn’t mean I won’t be in the future, and even if I don’t in the future a lot of the key lessons and points I took from the book are relevant to other investment strategies.
- Browne is part of the ‘Value Investing’ community, who focus on investing in companies who are currently trading at less than their ‘intrinsic value’. Value investors believe that there are greater returns in the long term identifying these stocks than from ‘Growth Investing’, which is focused more on capital appreciation and companies with above average growth even if their shares seem comparatively expensive. Other famous Value Investors include Benjamin Graham (the grand-father of Value Investing), Warren Buffett, Peter Lynch and William O’Neil.
- The categorisation of my notes on the book below are my own doing, not Browne’s, therefore the chronology of the below won’t necessarily follow the chronology of the book.
- My biggest concern with value investing, especially for beginners, is how can you really ascertain the ‘intrinsic value’ of a company? The key to be a successful value investor is identifying whether the cause of a stock decrease is superficial or detrimental to the long term health of the company, not an easy thing to do, especially when you are just starting out.
- Overall I think the book is a great introduction to value investing, it covers the core components and offers excellent rationale for why you should invest in the stock market with a value investor approach.
- If you are interested to find out more, here are 3 links to articles I’ve published on investment and personal finance that you might like:
Core Value Investment Principles
- Always look to buy stocks which are on ‘sale’, when their current value is lower than their ‘intrinsic value’. If possible aim to buy stocks selling at 2/3 or less of their ‘intrinsic value’.
- Don’t be scared by a downturn in the whole market, a solid company will always recover.
- If investing based on value, you’ll be selling when everyone is buying, this is something you’ll need to understand and come to terms with. There will be a reason the company is currently trading below it’s usual value, the power and skill of a good value investor is in understanding if the current problem is detrimental in the long term or just a short term blip.
- Don’t invest in companies with a lot of debt relative to net worth, companies with little or no debt are less volatile to outside factors, adding a ‘margin of safety’ to your investment. A company should own twice as much as it owes, following this rule stops you buying companies in too much debt.
- Look for companies with a stable record of earnings and degree of predictability.
- Conventional investing wisdom says that a portfolio should have 1/3 bonds, 2/3 stocks, Browne argues that this is rubbish wisdom because bonds get eroded by inflation, stocks don’t.
- However, that doesn’t mean that a diversified portfolio isn’t important, it fundamentally is. Ensure you have diversification across the number of industries and the number of companies you hold. To ensure diversification you should have a minimum of 10 stocks in your portfolio.
- You can absolutely make money in the long term from index funding investing, (Browne puts this figure at 10% a year, although I think in the current climate that is too optimistic). This is made up of 3% GDP growth, 3% Inflation and 4% from dividends. Browne’s argument is whilst this is good, you have to handle a number of years of lose in the cycle to achieve this, with value investing you can achieve as good if not better returns and don’t have to deal with the same peaks & troughs because you are clever about when you buy & sell.
Types of Companies to Invest in
- Browne recommends buying stocks in companies which are consumed daily, e.g. food, beverages and consumer staples. Focus on companies that people buy habitually and have loyalty to.
- Buy in companies who announce stock buy backs, company wouldn’t buy back if they didn’t feel stock was under-priced. Don’t read too much into Senior Management (insider) selling, but do look at insider buying. Insiders can sell for a large number of reasons; pay for a divorce, pay for a new holiday home etc. Insiders buying more of the stock suggest they have confidence in the short to medium term outlook of the company.
- Avoid companies with excessive pension liabilities or contentious labour environments.
- Avoid companies that are subject to technological obsolescence.
- Avoid companies who can’t control basic costs, e.g. Airlines controlling fuel costs.
Questions to Ask before Purchase
- 16 Questions to ask yourself to understand companies future potential:
- What is the outlook for pricing for the company’s product? Can they raise prices?
- Can company sell more?
- Can company increase profits on existing sales? Can increase gross profit margin?
- Can company control expenses?
- If company raises sales, how much will fall to bottom line?
- Can company be as profitable as it used to be/ more profitable than competitors?
- Does company have 1-time expenses that won’t have to be paid in future?
- Does company have unprofitable operations to be shed?
- Is company comfortable with Wall St earning estimates?…If company management think Wall St has it’s earning estimates too low it’s usually a good sign company is trading below ‘intrinsic value’
- How much can company grow over next 5 years? How will growth be achieved?
- What will company do with excess cash? Re-invested or given to shareholders?
- What does company expect competitors to do?
- How does the company compare financially with others in same business?
- What would company be worth if it was sold?
- Does the company plan to buy back stock?
- What are the insiders doing?
Play the Long Game
- ‘If your portfolio is well constructed, a bit of market turbulence is no reason to bail. You will reach your financial goals.’
- Don’t try to be a ‘Market timer’, much more likely to win by staying in the game all of the time.
- Most investors head for the hills during periods of market declines, thinking the decline will go on indefinitely. Once the market has rebounded, they return, having missed the best part of the rebound.
Important Technical Indicators
- Earnings are what a company has left after it has paid all it’s bills. Earnings are the principle factor driving stock prices:
- Price-to-Earnings ratio: companies stock price divided by its profit…Earnings Per Share (EPS)
- Earnings Yield: return you would receive if all earnings were paid out in cash as dividend….earnings per share (EPS) divided by stock price
- The lower the Price-to-Earnings (PE), the higher the Earnings Yield.
- Look for companies with a low PE because it means you are likely to be buying earnings cheaply
- Book Value = what company owns (Net Worth) – what company owes.
- Buy stocks selling at low multiples of Book Value, these are low price-to-book value companies
- Companies Balance Sheet
- Look for high liquidity, 2:1 Current Ratio (companies ability to pay short term debt/obligations – Current Assets > Current Liabilities.
- Also look at Long term Assets Vs. Long term Liabilities, ensure to look at trends over last few years
- Shareholder Equity (Book Value) – Subtract all company owes from all that it owns
- Debt-to-Equity Ratio = Total Debt divided by Shareholder Equity.
- If >1 is bad
- Always compare the company you are looking at with others in its industry
- Income Statement = Record of how much money the company took in over a period (sales/revenues) and how much it paid out in period (expenses). This is reported quarterly and annually by most companies
- Look for High Gross Profit Margin (% of gross profit divided by sales) and low Operating Expenses
- Top Line Earnings = Earnings Before Interest, Taxes, Depreciation and Amortisation (EBITDA)
Views on Professional Help
- Investment Portfolio managers are more likely to buy ‘popular’ shares, this is because if value falls they are less likely to be fired from there job because lots of their peers will also be impacted.
- Choosing best Money Manager for your portfolio:
- Does manager have an investment approach that they can explain in plain English which has been applied consistently over time?
- What does track record look like? Look over last 10 years.
- Whose record is it? Does the manager who got previous returns still run fund?
- What do managers do with their own money? Do they invest in own fund?
- Look for money managers who are also owners of the investment management firm.
- Only 15% of Money Managers will beat an Index over long periods of time
- Speed of trading is directly coordinated to investors level of confidence
- More confident people more likely to stick with what they have and trade less….You want to trade less!
- A company missing Wall St. Analysts targets isn’t necessarily a bad thing…those targets are notoriously incorrect, however if a company regularly misses targets then perhaps it’s time to consider selling.
Resources
- There are a number of good free stock search engines: Yahoo! Finance, Zacks and MSN. Alternatively you can pay for Bloomberg.
- Morningstar has an excellent mutual fund ranking service, although note that it doesn’t include hedge funds or private investors. Morningstar can also provide Companies’ EPS data.
- Barron’s publishes a list of the new weekly highs and lows in the stock market every Saturday, checking out the lows can be a good starting point for identifying companies currently trading below their ‘intrinsic value’. Check is out here: http://www.barrons.com/public/page/weeklyhighslows.html
- If you are interested in finding out more information on resources check out Jason Kelly ‘The neatest little guide to Stock Market Investing‘, much more detailed analysis of resources.
Parting Wisdom
- If worry you aren’t seeing results using Value Investing style then re-read Chapter 20 in Browne’s book, which provides a good succinct rationale for why it works and why you should stick with it.
- Maintaining a steady state of mind, whether we are in good times or bad, is the key to successful long-term investing.
- Owning a diversified portfolio of stocks that meets the standards of a margin of safety and are cheap, based on one or more valuation methods (low price-to-book value ratios & low price-to-earnings ratios & appraisal method), has proven to be a sound way to invest.
- Today’s worst stocks become tomorrow’s best, and the darlings of the day become spinsters of the next.