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Value Investment Methodology

One question that everyone seems to ask is, "how do you invest?"

There is no short answer, but hopefully I will be able to summarize the thought process and methodology to clarify for readers and clients.

We like to think of Lodestone Capital Solutions (LCS) as value investors. When people think value investor, the names Buffet, Munger, Schloss, Graham, and a slew of other names all come to mind. The whole premise of value investing is to see buying investments as buying a piece of the company and that when you buy, you must have a margin of safety. (For value investors, they will know this comprises chapter 8 and 20 of "The Intelligent Investor" by Warren Buffet)

To put it in simple terms. If we take a stock such as Apple (NASDAQ:AAPL) and are considering the purchase of a share, the first question is not "is this a good price for AAPL", but is this a business I want to be a part of. Often people will see a stock increase in price, then want to get in "before it's too late." Or, they will see a well known stock drop in price, and then consider "getting in on a good price."

After deciding if it is a good business, we then evaluate the company, arrive at what is called an intrinsic value or what we think it is worth in a fair market. The thought process should be

  1. Is this a good business?
  2. If so, what do I think it is worth
  3. How safe do I feel with my analysis and how much of a margin of safety do I need.
  4. My resulting buy price, how does it compare to the current market price?

Looking at price before the business analysis is putting the cart before the horse. (As you will see, I love my analogies and lists.)

Using AAPL in the example using fictitious numbers.

  1. Yes, has solid operating margins, great growth, strong cash flow with a large moat.
  2. Based on a growth rate of 5% in domestic markets and 15% in foreign markets and a 2 dollar dividend, the intrinsic value of AAPL is 100 dollars.
  3. I am reasonably sure of my analysis, but AAPL is large with many moving parts so I would need a 50% margin of safety.
  4. My resulting buy price would be 50 dollars. AAPL currently trades at 80, so I would not purchase this investment even though it is above my intrinsic value estimate. If I do like the business, but just not the matching stock price, we will add it to our watch list and revisit it if the price drops into the 50-60 dollar range.

The investing community in general (excluding day traders, high frequency trades and option traders)applies mostly the same valuation tools. There are a few major differences that come to mind.

  1. Strong emphasis on growth. Value investors generally will not buy what is currently hot and trending. We like predictability, reliability and repeatability in our companies as far as producing earnings. Growth is great, but is generally mean reversionary, assuming large tech stocks on average, have 15% operating margins, AAPL with their strong branding and moat, may revert to 25% margins.
  2. Lack of Margin of Safety.
  3. Comparison to peers. One large cap fund may be compared to the S&P annually, and their salary and job security may be based on being in the top quartile of their peer group. So it is more important to do better than others, than to focus on overall long term return.
  4. Hot stocks sell, boring stocks don't. Facebook, Apple, new IPOs, generate buzz and lots of interest and can bring in the assets. But Target, Walmart, or Hanes do not. This may be a result of #1, as headline stocks that have amazing growth make the news and generate interest.
  5. Ability to hold cash. There is the idea that if the money is not invested, then it is being wasted. There is the benefit to being able to act when a good deal presents itself.

Lodestone Blog

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: No information presented should be considered advice.