1

Value Investing the Approach

Value

Review

Manage Risk

Search(Look systematically for undervaluation)

2

Review

• Key Issues -- EPV BUY (Growth Buy)– Franchise– Asset Buy– Management

•Collateral Evidence– Insiders, Other Investors•Personal Biases

3

Earning Power and Entry - Exit

Asset Value EP Value

Case B: Free EntryIndustry Balance

Case A:

Asset Value EP Value

Value Lost to Poor Management and/or Industry Decline

Asset Value EP Value

Case C: Consequence of Comp. Advantage and/or Superior Management

“Sustainability” depends on Continuing Barriers-to-Entry

4

Summary of ValuationStrategic vs. Traditional Approach

Market Size Estimate

Market Share

Operation Margin

Investment

Cost of Capital

Value

Traditional

Revenue

Oper Income (EBIT)

Cash Flow

NVP

National Income,Growth, Consumer Trends

Competitive Responses; Entry/Exit

Technology, Costs;Prices; Input Costs

Technology, Growth

Financial Market Conditions; Risks

Strategic: Is this the South Bronx of the Investment World?

5

Basic Strategy FrameworkPorter Five Forces – Probability Determinants

Four Forces too many

Substitutes

CustomerSuppliers

Entrants

Industry Competition

6

Strategic Investment Forces

• Entry-Expansion – Barriers-to-Entry“Incumbent Competitive Advantage”

Does this company enjoy competitive advantage that is significant?

Yes – Being industry creates valueNo – Efficient Operation may create valueOthers enjoy advantage – stay out. (Being in industry destroys value)

What about entrant advantages? No good – after entry you become incumbent.

• Existing Competitor Dynamics ≡ Degree of Competition (Phillip Morris)

• Share the Wealth (Workers, Customers) ≡ Value Chain Dynamics

7

Consequences of Free EntryCommodity Markets (Steel)

$/Q

QFirm Position

Price

AC “Economic Profit”

ROE (20%) > Cost of Capital

Entry/Expansion

Supply Up, Price Down

$/Q

QFirm Position

Price

AC

(Efficient Producers)

ROE = 12%

No Entry

No Profit

8

Consequences of Free EntryDifferentiated Markets (Luxury Cars)

$/Q

QFirm Position

Demand Curve

AC“Economic Profit”

ROE (20%) > Cost of Capital

Entry/Expansion

Demand for Firm shifts left (Fewer sales at each Price)

$/Q

QFirm Position

Demand Curve

AC

ROE = 12%

No Entry

No Profit

9

Barriers to EntryIncumbent Cost Advantage

Entrant Incumbent SourcesNo “Economic”Profit

ROE = 12%

No Entry

“Economic” Profit

ROE = 20%

Proprietary Tech(Patent, Process)

Learning Curve

Special Resources

• Not Access to Capital

• Not Just Smarter

$/Q

QFirm Position

Demand (Entrant, Incumbent)

ACEntrant

ACIncumbent

10

Barriers to EntryIncumbent Demand Advantage

Entrant Incumbent SourcesNo “Economic” Profit

ROE = 12%

No Entry

Higher Profit, Sales

ROE = 20%

Habit (Coca-Cola)• High Frequency

PurchaseSearch Cost (MD’s)

• High Complex Quality

Switching Cost (Banks, Computer Systems)

• Broad Embedded Applications

DemandIncumbent

DemandEntrant

AC (Entrant, Incumbent)$/Q

Firm Position Q

11

Barriers to EntryEconomies of Scale

• Require Significant Fixed Cost (Internet)

• Require “Temporary” Demand Advantage

• Not the Same as Large Size (Auto + Health Care Co)

$/Q

Firm PositionEntrant Incumbent

Q

AC

Demand

Firm Position Q

AC

Demand (Entrant, Incumbent)$/Q

No advantageNo advantage

12

Barriers to Entry

Economies of Scale

• Advantages are Dynamic and Must be Defended

• Fixed Costs By:• Geographic Region (Coors, Nebraska Furniture Mart,

Wal-Mart)• Product Line (Eye Surgery, HMO’s)• National (Oreos, Coke, Nike, Autos)• Global (Boeing, Intel, Microsoft)

Q

$/Q

AC

Price (Both)

Sales Entrant

Sales Incumbent

D-Entrant

Profit

D-Incumbent

Loss

13

Barriers to Entry - Sustainability

Static Demand Advantages

•Tied Customers

Exploitation

•Pricing, focus on “Own” Customers

•No advantage with Virgin customers

•Shrinkage over time as base changes

•Cost efficiency in “Own” technology

•No advantage with virgin technology

•Shrinkage with technology change

Static Cost Advantages

Economies-of-Scale + Dynamic Demand Advantage

• Principal sustainable advantage

• Constant vigilance

14

Sources of Franchises

• Proprietary Technologies/ LearningJapanese as the futureRCADuPontCiscoPharmaceuticalsBubble Wrap (Sealed Air)

•Captive CustomersMercedes-BenzIBMCoorsPhillip Morris (Marlboro)Coca ColaTideMicrosoftAmazonLocal Doctor

•Economies-of-scaleNebraska Furniture MartOxford (HMO)Winn-DixieKmartWal-MartMicrosoftDellBoeingIntel

15

Other Barriers-to-Entry

• Government, Regulatory, Public(Lead based Gas Additives; Cigarettes)

• Informational (Who Knows What)(Banks, Financial Services, HMO’s)

16

Performing Strategic Analysis

Industry Map

Do barriers Exist?

What Competitive

Advantages?

Future Strategy, Profitability

(1)

(2)

(3)

(4)

Identify Industry

Industry History

Demand? Cost? Economies-of-Scale?

17

Performing Strategic AnalysisApple Computer - Industry Map

Industry:

• Identify SegmentsStep 1:

For Apple Segment Are:• Chips• Hardware• Software

Step 2:

Step 3:

Chips

Components

Hardware Software NetworksIntel, AMD, Motorola, Apple

Dell, HP, Gateway, IBM, Compaq, Apple

Microsoft, Apple, Oracle, Netscape

AOL

Power Supply Co.’s, etc.

• Identify firms in each segments

• If firms are the same, treat segments as Single Industry

•If firms are different, treat segments as Separate industry

•If in doubt, treat segments as separate industries

18

Performing Strategic AnalysisDo Barriers/Competitive Advantage Exist?

Profitability • Above Cost of Capital (12%) for sustained periods – Especially for dominant firms

Chips: • Intel – (Y)Hardware: • Compaq, Dell, Gateway, IBM (Maybe)Software: • Microsoft (Y)

Share Stability • Do market shares change hands?• Does Dominant competitor change?• Is there significant entry?

Year: 1990 Share 1998 Share Change

Compaq 28 39 30 39 0

IBM 18 25 12 16 9

Apple 22 31 14 18 13

Dell 4 6 20 26 20

Total 72 100 76 100 10.5

Chips, SoftwareHardwareSoftware, Chips

• High Stability, Low Entry• Low Barriers• High Barriers

19

Performing Strategic AnalysisNature of Barriers-to-Entry Competitive Advantage

Chips (Strong) Hardware (Weak)

Software (Strong)

Demand Yes No Yes (Very Strong)

Cost Yes/Maybe No No

Economies-of-Scale

Yes Maybe Yes

Apple Disadvantage Level (?) Disadvantage (Some

advantage)

• Where is Apple Going?• Is integrated Strategy

Appropriate?• Is Steve Jobs going to save

Apple in the Long run?

20

Other Strategic Considerations

Cooperation within Barriers

–Coke – Pepsi

–Cigarette Makers

Division of Spoils in Value Chain

–Strategic alliances

–You can not take home, if you don’t bring (NuKote)

–Employee Power (unions, Prof. Services firms)

21

Summary of Strategic Investment

Without Competitive Advantage –no Value in Franchise

Competitive Advantage must be identifiable and sustainable

In particular, Are existing Competitive Advantages Sustainable or are they likely to erode?

If in doubt, do not pay for franchise

Ideally look for ‘hidden’ franchise–Unused pricing power (Coke, Cereals)

–Poorly performing divisions

22

Franchise Value Calculation

(A1) Cost of Capital = 10%(A2) Asset Value “AV” = 1200M(A3) Earnings Power Value = 2400M = 240M X (1 / 10%)

“Earnings”

• Competitive “Free Entry Earnings” = 120M = Cost of Cap. X Asset V= 10% x 1200

• Franchise Earnings = “Earnings” – “Free Entry Earnings”

= 240 - 120

= 120

(A4) Sales = 2000M (Tax Rate = 40%) Power Value = 2400M = 240M X (1 / 10%)

• Franchise Margin = 120M ÷2000M = 6% after tax

• Franchise Margin (pre-tax) = 10%= (10% - 40% X 10% = 6%)

Tax

EP Value Implies Sustainable 10% Cost and/or Pricing Advantage

23

Summary of Basic Valuation

Compute: Asset Value (Most reliable)EP Value (Second most reliable)

Case A: Asset Value ≥ EP Value Value = EP Value(500M) (300M) + Catalyst Value

Case B: Asset Value = EP Value Value = 500M(500M) (500M)

Case C: Asset Value ≤ EP Value Value = Asset Value(500M) (1000M) + Sustainable

Fractionof Franchise Value (1000M-500M)

24

“Real” Earning Power Value

“Real” Earnings = “Earnings” – Inflation driven Investment

“Real” Cost of Capital = WACC – Inflation Rate

Inflation Driven Adjustment = Net Assets (Not including ‘goodwill’ items) * Rate of Inflation

Example:(A1) EP Value = 2400M = 240M * 10%(A2) Net Assets (not including goodwill) =

Cash + AR + Inv. + PPE – A/P – AL – AT = 800M(A3) Inflation rate = 2%

• Inflation Driven Adjustment = 2% * 800M = 16M• “Real” Earnings = 240M – 16M = 224M• “Real” Earnings Power = 224 = 224 = 2800M

10% - 2% 8%