Is Value Investing the “Holy Grail” of financial investing (update Nov 2017)?

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Value Investor
Is Value Investing the “Holy Grail” of finance investing ?
Few slides to explain because the value investing is working well vs fundamental analysis and
technical analysis
Some simple flowcharts to describe the Value Investing process on stocks and Bond-Stock
allocation, bond and Etf, because we are focusing only on process of value investment
Update November 2017, included new sections on:
more depth into financial statements, understanding the
business now & after

Value Investor
Because value investing works
Value investing process on stocks
Bond-Stock allocation in value investing
Value investing process on bonds
Value investing process on ETFs
Value Disinvesting on stocks and ETF stocks
Conclusion
Comment
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Value Investor
The idea is inside four books and …:
• Security Analysis, Graham & Dodd
• Intelligent Investor, Graham & Dodd
• Value Investing, Greenwald & …
• Stocks for the long run, Siegel
• Some my idea to make easier process
Introduction, always every investor is going to buy low and sell high, in
addition all of them admit to buy securities at low price than the
underlying real value

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Value Investor quote
“To invest successfully over a lifetime does require a stratospheric IQ,
unusual business insights, or inside information, it is enough. What's
needed is a sound intellectual framework for making decision and the
ability to keep emotion from corroding that framework.” Warren Buffet
In few words to be a Value Investor.
“Simplicity is the ultimate sophistication“. Leonardo Da Vinci

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Because fundamental analysis and
technical analysis do not work
1. Technical analysis: based on analysis of particular chart shape on
price and volume, to forecast the next price movement
• Do you buy an house only because its price or trade volume is rising ?
• Do you buy a particular car model only because its price chart has a
“special shape”
Any Intelligent Investor answers NO, so there isn’t any reason because
technical analysis works well

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2 a. Fundamental macro analysis: many economic factors
unemployment rate, GDP, inflation and interest rate to forecast
economic trend and so to decide what group of securities to buy or sell
2 b. Fundamental micro analysis: analyzes the economic fundamentals
of the company and predict the future price of securities estimating the
cash flow or earning for next 10 years (not much easy)

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• Do you think is possible to do a reliable revenue forecast or profit
forecast in next ten years ?
• Do you remember IMF forecast on emerging market (Brazil, Russia, …)
in 2010 ?
They was very brilliant but now in 2016 are in recession
Economic forecast in micro or macro area for long period (10 year) is
extremely difficult, even in 3/5 years, in fact it is impossible
Intelligent Investor answers NO, so there isn’t any reason because
fundamental analysis works well
However in each of these areas there are famous successful investor

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Because Value Investing works
1. Markets are not efficient and it is moody, swings between
depression and euphoria
2. Figure out balance sheet without extrapolation
3. Earning and revenue no forecast
4. Earnings Power value & Moat
5. There are not good or bad stocks, but there are good stocks where
there is good price
6. Value investing remains the best strategy over time, but it is poorly
described and divulged
Afterwards, the value investing process is simple

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Value Investing on stocks
“Simplicity is the ultimate sophistication” in the Value Investing
is to identify stocks whose value as a business is reliably calculable by you
HOWHOW
Moat
Strong financial
condition
Profit
Overtime
Earnings
Stability
Low debt
P/E
dividend
price book
Value
Investing
Value Investing is manly on stocks
Define business along some parameters
Low price book
Low P/E
Significant dividend yield and paid in last ten
years
Upward trend in profit in last ten years
Earnings Stability + Growth
Low value of debt
Strong financial condition
Durable competitive advantage (moat)

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Value Investing process on stocks
• Negative news on market
• Stock market in depression mood, least down 10%
• Cheap p/e market index compare 10y bond rate > 2% / 3%
(1/p/e) *100 - 10y A rate bond yield > 2% / 3%
or great two third than bond rate. Least a 30% of safety margin
Stocks
• Negative news on stocks or sector least down 20%
• Normally Ignored Unfashionable
Next step “Valuation Criteria”
Environment criteria
No extrapolation
No forecast

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• price book < 2
• How: use book value easy to get it
• Compare book with tangible book slight difference,
otherwise there is a huge goodwill
• p/e < 20
• How: use earning average five past years
• however price book * p/e < 30
• Significant dividend yield and always paid in last
ten years great than 1%
• Upward trend in profit and revenue in last ten
years at least grown 10%
• However earning stability over the time
Valuation criteria
No extrapolation
No forecast
Revenue > 500m
Public utility, asset > 1B
If p/e is upper bound near 20 or little
more, we need to get deep into
financial statements page 13
We can pay more only there is value
on capital employed and growth

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• Strong financial condition
• Debt / Equity < 2
• Current ratio > 1.5 with stable trend
• in public utility check only
Debt < 3 * Equity
Next step “financial statements in depth”
Valuation criteria
No extrapolation
No forecast

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more deep into financial statements
Valuation criteria
No extrapolation
No forecast
Operation income and free cash flow on capital employed
and enterprise value
Capital employed (CE) is total assets minus current liabilities
Enterprise Value (EV) = market value of common stock + market
value of preferred equity + market value of debt + minority interest -
cash and cash equivalents
Operating income (OI) is an accounting figure that measures the
amount of profit realized from a business's operations, after
deducting operating expenses such as cost of goods sold (COGS),
wages and depreciation
Free cash flow (FCF) is a measure of a company's financial
performance, calculated as operating cash flow minus capital
expenditures.
BV:= book value TBV:= tangible book value
FDS:= fully diluted share
ROCE (Return on capital employed) = OI/CE
ROCE > 12
FCFROCE () = FCF/CE
FCFROCE > 6
Profitability
Meaningful growths of delta year per year in last five (at least)
If it is in line with inflation then the business is flat, so I’d like a
growth 3% or more over inflation
∆OI / FDS ∆FCF / FDS
∆BV / FDS ∆TBV / FDS
Growth
EV / OI < 8
Cap / FCF < 9
Cheap

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understanding the business now
Valuation criteria
No extrapolation
No forecast
It is always desirable and meaningful to invest in understandable business
Because sometime the business is clearly difficult to understand or too complex to analyze together
Complexity and Incomprehensibility are a good way to lose money
Try to describe the business in five different
area
1. Product
2. Customer
3. Supply
4. Sector
5. Geography
NOW
Understanding where you invest NOW is in the
is a compulsory activity

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understanding the business, after in the future
Valuation criteria
Little extrapolation
Little forecast
Understanding where you invest, AFTER (in the
future) is tougher but in anyway is always a
compulsory activity
1. Force or weak analysis
a. customers power on prices and service (how it affects on sales)
b. suppliers power on prices and service (how it affects on sales and business process)
2. Customer Loyalty
a. Customer retention refers to the ability of a company or product to retain its customers over time
b. New entrants with same price or lower and same service
3. Moat (Economic moat describes a company's competitive advantage derived as a result of various
business tactics that allow it to earn above-average profits for a sustainable period of time)
a. Patents
b. Brand
c. License
d. New technologies
e. Low operating expenses
f. Switching costs
AFTER however earning stability over the time

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Earning Power Value
• Epv:= earning x 1/cost of capital
How: earning avg five past years
-cost of capital > A 10y bond + 3%
Compare Asset Value
and Earning Power
How: Asset Value book value
Epv < Book value
Value Lost to Poor
Management and/or Industry
Decline
Epv = Book value
Free Entry, Industry Balance
Epv > Book value
Consequence of Comp.
Advantage and/or
Superior Management
Epv > book value * 1.5
Competitive Advantage
Extrapolation
cost of capital := in simple way is the return that a an investor requires to decide if an investment
meets invested capital return requirements. So could be A rating 10y bond + 3% margin

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Competitive beyond EPS to ROIC
Sometimes, earning is distorted by many factor like stock-option, special situation, accounting rule
or accounting adjustments, extraordinary and unsustainable operation or a one-time source of
income unrelated to its core business
So an other way to determine whether or not a company has a moat is to measure its return on
invested capital (ROIC)
ROIC = (Net Operating Profit After Taxes) / (Invested Capital)
Net Operating Profit After Taxes = (Operating Profit) x (1 - Tax Rate)
There are a number of ways to calculate this value one is:
Invested Capital = the book value equity + the book value its debt - non-operating assets
ROIC is always calculated as a percentage and It should be compared to a company's cost of
capital (WACC) to determine whether the company is creating value.
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Compare Asset Value
and Earning Power
ROIC < WACC
Value Lost
Poor Management
and/or Industry
Decline
ROIC = WACC
Free Entry,
Industry Balance
ROIC > WACC
Competitive advantage

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Competitive beyond EPS to ROIC
Some rules of thumb
WACC = Ep * CoE + Dp * CoD (1 – T) 0.6*12 + 0.5*4*(1-0.35) ~ 9%
Ep is the percentage of financing that is equity
CoE is the cost of equity
Dp is the percentage of financing that is debt
CoD is the cost of debt
T is the tax rate
If ROIC is greater than the weighted average cost of capital (WACC), the most common cost of
capital metric, value is being created. If it is not, value is being destroyed
if a company has an ROIC in excess of 15% for a number of years, it most likely has a moat. That
said, whether a company is creating value depends on whether its ROIC exceeds its cost of
capital
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ROIC > WACC * 1.5
How
roic use average last 5 years
wacc based on rules of thumb
Competitive advantage
ROIC in Morningstar

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“Sustainability” over the time of the Moat
The stock returns throughout the world tend to revert toward a mean average return
over longer periods of time, i.e., more than one year. Current high investment returns
tend to be associated with lower investment returns in the future. Current low
investment returns tend to be associated with higher investment returns in the
future.
• Reasonable levels of executive compensation
• High Levels of Insider Ownership
• Clear Communication with Shareholders
• Share Repurchases
• Dividend Payments
Negative news is a good opportunity for value investor
More details
Little Extrapolation
Signs of a Shareholder Friendly

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Where is the margin of safety ?Where is the margin of safety ?
if selected stock meets all the criteria, then
you have chosen a cheap stock, hence you
are in a real safety margin
Market and stocks EnvironmentMarket and stocks Environment
AssetAsset
EarningEarning
Strong financial conditionStrong financial condition
Competitive AdvantageCompetitive Advantage
Safety MarginSafety Margin
Don’t forget diversification, about 30 stocks and patience
Only long (you have advantage of secular GDP growth), never short
importance

Bond-Stock allocation
There are a huge number of securities type, but we identify
only some securities where the value is reliable and easily
calculable by you.
Stocks
Bonds
In addition we use also ETF
on stocks and bonds
Investment
Fund
Cfd
Certificate
Stock
Currency
Commodity
Etc
Etf
Convertible
bond
Bond
Securities
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• Investor should never have less than 25% or more than 75% in
common stocks
• so inverse range between 75% and 25% of bond
• reduce stocks below 50% to 25% if the market is too high or too
expensive
• increase stocks upper 50% to 75% if the market is cheap or there are
many special bargains
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Stocks: 25% to 75%
Bond: (100 – stocks range )%
Reduce stocks range Increase stocks range
dividend yield below
two-third of bond yield
Cheap p/e market index compare
10y bond rate < 2%
(1/p/e) *100 - 10y A rate bond yield < 2% or 2/3
Mean reversion
on a diversified portfolio of stock is nearly 7%
annual real return the United States
Compare a expecting the stock market growth
with historical growth
No one criteria matches
with “reduce stocks range”
Huge number of IPO Few stocks meet value investing criteria
Market mood in euphoria
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There are two ways to compute anticipated long-term returns (LTR)
LTR:= Nominal World GDP + dividend yield
or
LTR:= E/P + inflation
based on Graham formula where g is the growth expected in next
seven to ten years and V is value
V= EPS * (8.5 + 2g)
we can make the converse of it and to determinate the growth rate
anticipate by current market price
g=(p/e)/2 - 4.25
So we compare g, LTR and mean reversion of historical stocks
yield
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Work out: measuring the US stock market (May 2017)
world GDP 4.0
S&P Value 2402
P/E 23.8
Dividend Y% 1.97
Inflation 2.2
A Bond Y% 2.73
Avg return 5Y 10.45
Avg return 10Y 5.33
trailing P/E 23.8 forward P/E 18.45
LTR (gdp) 5,97 5.97
LTR (e/p) 6.40 7.62
g Graham 7.65 4.97
Stock Y% 4.20 5.42
Using trailing or forward P/E
Few changes compared to last year
You may be taking on a little risk in
stocks today. Probably slightly less than
50% in stocks is better allocation
If you are used to using forward P/E, then increase the value of 20%, because it is always historically overvalued
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Value Investing process on bonds
Also here there are a huge number of bond type, but we identify
only some bonds where the value is reliable and easily calculable by
you. So we accept only plain vanilla bonds
Government Bonds
Corporate Bonds
Since the main emphasis must be placed on avoidance of loss,
bond selection is primarily a negative art. It is a process of exclusion
and rejection, rather than of search and acceptance. In first we get
only investment grade bond (minimum BBB rate), only in
exceptional situation we could invest also into speculative grade
bonds.
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Bond allocation
• Investor should never have less than 50% or more than 95% in
government bonds in relation with previous bond-stock allocation
• so inverse range between 50% and 5% of corporate bond
• reduce corporate bond below 50% to 5%, if exist very few corporate
bonds that match with criteria
• increase corporate bond upper 5% to 50%, if exist many corporate
bonds that match with criteria
So some criteria of value investing process on corporate bond is most
import task of bond allocation.
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Value Investing process on corporate bond
There four principles for the
selection of corporate bonds
I. Safety is measured not by
specific lien or other contractual
rights, but by the ability of the
issuer to meet all of its
obligations. Senior Liens Are
to Be Favored, Unless Junior
Obligations Offer a Substantial
Advantage
II. This ability should be
measured under conditions of
depression rather than
prosperity.
III. Deficient safety cannot be
compensated for by an
abnormally high coupon rate.
Risks of losing principal should
not be offset merely by a high
coupon rate
IV. The selection of all bonds for
investment should be subject to
rules of exclusion and to
specific quantitative tests
corresponding to those
prescribed by statute or sound
rules. Typically investment
grade bond
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• Bond market in depression mood, least down 10%
• Yield to maturity compare AA government bond > 1.5%
or great two third than AA government bond.
Least a 30% of safety margin
Next step “Valuation Criteria”
No extrapolation
No forecast
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Valuation criteria
No extrapolation
No forecast
Size of Enterprise and rating
•Revenue > 500m
•Public utility, asset > 1B
•Investment grade bond great
than BBB rate
Utility Industrial
Interest coverage > 2 Interest coverage > 3
Stock value ratio > 0.5 Stock value ratio > 1
Interest coverage = EBIT / Interest Expense
Stock value ratio = Market Cap / Bond long term debt
Unavailability of sound bonds is NOT EXCUSE for buying poor ones
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Value Investing on stocks ETF
ETF is really a disruptive instrument in the financial sector
ETFs are a true democratization of investment management and
capabilities. Now there is availability of once-exclusive investing techniques
to a wider range of investors. ETFs today represent a vibrant and diverse
array of investment strategies.
We can apply the same previous process of value investing on stocks
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Value Investing on stocks ETF
Since we would like to use the same process, we need independent and trusted data on the
same parameters (p/e, book value, dividend, …)
So far, only Morningstar into free area provides trusted and accurate data on ETF. The
Value Investing process on stocks ETF is to identify ETF whose value as a business is
reliably calculable by you. So we choose only between country ETF and sector ETF with
simple strategy, the new generation like smart, beta, high/super strategy, leveraged are not
eligible because they are too complex.
Price/Prospective Earnings*
Price/Book*
Dividend Yield %*
Long-Term Earnings %*
Historical Earnings %
Book-Value Growth %*
* Forward-looking based on historical data. Since the economist’s
address is always highly optimistic. They predict that corporate profits,
one of the major factors driving stock prices, will increase at double-digit
annual rates for at least the next three years. So we should increase
p/e, dividend yield and price/book at least 20%
and decrease at least 20% the other ones
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Value Investing process on stocks ETF
No extrapolation
No forecast
Environment criteria remain the same of value investing on stock,
like stock market in depression mood, cheap p/e market, …..
In EFT sector we have also the criteria normally ignored and
unfashionable
Valuation criteria
No extrapolation
No forecast
• price book < 2
• p/e < 20
• however price book * p/e < 25
• Dividend yield great than 1%
Long-Term Earnings % > 0
Historical Earnings % > 5%
However earning stability over the time
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• Strong financial condition for all selected stocks
• Debt / Equity < 2
• Current ratio > 1.5
in public utility only
• Debt < 3 * Equity
Next step “Competitive Advantage”
Valuation criteria
No extrapolation
No forecast
We do not have direct financial parameters, so we have to
compute them. We get the first ten stocks ranked by weight
inside the Etf and figure out debt/equity and current ratio for
each of them.
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Earning Power Value
• Epv:= earning x 1/cost of capital
Compare Asset Value
and Earning Power
Epv < Book value
Value Lost to Poor
Epv = Book value
Free Entry
Epv > Book value
Consequence of Comp.
Advantage
Country Etf
Epv > book value * 1
Sector Etf
Epv > book value * 1,5
Competitive Advantage
Extrapolation
We divide Etf in two groups, country Etf
and sector Etf. The competitive advantage
is more meaningful in etf sector.
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Value Disinvesting on stocks and
ETF stocks
When you have to say farewell to someone of your securities in
your portfolio (selling time)
In previous slide we have explained the criteria to get a good
value securities
However over the time, they can lack the label of value. Right
now we identify the criteria to exclude them from your portfolio.
When & Why
Every six month you have to check your securities portfolio
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Value Disinvesting on stocks and
ETF stocksValuation criteria
No extrapolation
No forecast
There are two different situation, however is enough that at least
one criteria is true to trigger the selling action
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Stock
too expensive
Price book > 3
p/e > 25
pb * p/e > 50
Stock
Quality is reducing
Debt / Equity > 3
Current ratio < 1
Utilities sector
Debt > 4 * Equity
Dividend cancelled for two years
Reduced competitive advantage
Epv < book value
There is not a trigger criteria on environment

Value Investor
Because value investing works
Value investing process on stocks
Bond-Stock allocation in value investing
Value investing process on corporate and government bond
Value investing process on stocks Etf
Value investing process on bond Etf
Workout on real stocks, bonds and Etfs
Conclusion
Comment
Next future slides
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But if Value Investing is so simple, why isn’t everyone a value investor ?
It is simple but not easy
Value stocks don’t tend to have big payoffs. Their success is incremental;
they are not a lottery tickets, so they do not promise a immediate wealth.
Sometimes the price stays low also for long time and to wait for long time
up to fair value
Stocks that are cheap are ugly stocks, with boring stories. People sell
them and buy expensive success story
People are over-confident, we think a growth stock will continue to grow
and a value ugly stock will only continue to go down.

40
Comment on competitive advantage
There is a competitive advantage if a company has some aspects like meaningful
management performance, product differentiation, customer captive, cheap cost, patent, …
However the “Sustainability” of it over the time depends on continuing protection barriers-to-
entry that create value.
Can I calculate if there is a real competitive advantage ?
There are many different ways, we choose the two of them easier
1. Based on Earning and Book value
Book Value (definition)
is in theory, what would be left over for shareholders if a company shut down its operations,
paid off all its creditors, collected from all its debtors, and liquidated itself. It refers to the
amount of net assets belonging to the owners of a business based on the balance sheet
values.
Yield% of book value [YBV] = (earning / book value) * 100
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If YBV is great than A 10y bond + 3% (cost of capital) then there is a real competitive
advantage, otherwise should be better to precede to shut down the company and to invest
the liquidated cash in bond market (less risk). A “great YBV” should be over the time at least
5/7 years. Here cost of capital is the return that a an investor requires to decide if an investment meets invested capital return requirements.
So could be A rating 10y bond + 3% margin
2. Based on ROIC and WACC
ROIC (definition)
Return on invested capital (ROIC) is a percentage that
ROIC = (Net Operating Profit After Taxes) / (Invested Capital)
If ROIC is great than WACC (cost of capital) then there is a real competitive advantage,
otherwise should be better to precede to shut down the company and to invest the Invested
capital in bond market (less risk). A “great ROIC” should be over the time at least 5/7 years.
Here cost of capital is the return that a an investor requires to decide if an investment meets invested capital return requirements. So could be A
rating 10y bond + 3% margin
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If the competitive advantage is verified over the time then we should wonder
is there a strategic position ?
what and where is the moat ?
where are the competitors if YBV is more then 3 times of cost of capital ?
why do customer pay more my products
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Value Investing
Is Value Investing the “Holy Grail” of finance investing ?
Yes it is.
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Fabio Michetti
michetti.fabio@gmail.com

Is Value Investing the “Holy Grail” of financial investing (update Nov 2017)?

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