“ Have as much good nature as good sense since they generally are companions. ”
— William Wycherly

My favorite excerpts from "Value Investing with the Masters" by Kirk Kazanjian

1) Dreman: We'll only raise cash in a market that's in free-fall. We don't run away from bear markets or volatility. We love it. These periods allow us to get 15, 20 or 30% growers at much lower prices.

2) Eveillard: Intrinsic value is what we think we would pay, expecting a reasonable return, if we were to buy the entire company. One of the reasons Buffett is such a genius is that he has figured out that there are only a tiny number of companies that you can have reasonable confidence will be as successful 10 years from now as they are today.

3) Fries: Numbers to determine basic value: Reference to historical levels of price-to-book and balance sheet strength are important. Earnings power potential and the PE using normalized earnings are important as well. Banks, financial services and insurance companies tend to have P/B as very useful. Each company is a unique situation. e.g. Utilities sell at low multiples always due to being regulated so rate of growth and return as not particularly high.

Of 10 ideas, I'd like to think six work out. If you're better than half on average, you're doing well. A lot of success came from owning stocks that didn't sell off too much.
We aim to sell in 12-18 months.

4) Gilligan : The best investments you can make are in growth companies that are being overly penalized by the market for a short-term problem. Its not a matter of buying dogs, but rather buying good companies that have fallen out of favor. That's where the huge opportunities lie. In the purely cyclical companies, its more of a trading game. But if you can find growth, your holding period may get extended dramatically.

For a cyclical company with normal margins, less than 1X EV/Sales may interest us.
However for good ROIC 20-30% companies, may pay even 3 times EV/Sales.

We really pay attention to the ROIC and net margin numbers over time and compare to competitors to know what realistic profitability numbers should be.
In many cyclical companies, we try estimate a normalized earnings level.We predict what sales should be, and then put a margin that the company has been able to generate over time.For many companies, history is a valid guide. For years, you could put an eight times multiple on peak earnings for any cyclical company to determine the price target, and it almost always worked. PE ratios are important, but only using normalized earnings.

Ideal company: My best company grows somewhere between 8-15% (both top and bottom line).Over 15% attracts growth people and they bid up too high. In addition, ROIC should exceed cost of capital. AN ROIC atleast in the teens. It generates free cash flow, spends no more than depreciation on capital spending, fairly clean balance sheet. If you can buy a company like this at a discount to the market (EV/FCF), it could be a good opportunity.

Annual reports: You want to focus on change year over year in the annual reports, trends in margins, SG&A, R&D, tax rate and shares outstanding.
On the balance sheet, look at receivables, days of sales outstanding, inventory turns, and any outsized growth in assets or liabilities.
You want to see that cash is coming in and that its growing atleast on par with income. If you find that income growth is heavier than the growth in cash flow, something is going on.

Over a long period of time, concentrated portflios should work as long as you're disciplined. However, on any given day, you can take enormous hits. If your investors are patient and understansing, thats fine. But I don't know too many of those.

We find that when you pick a stock that works, you often grossly underestimate how well it will do.

5) James Gipson: One thing that was particularly memorable is how we played the loser's game to avoid buying overvalued assets. In 1981, oil stocks were hot. We avoided oil stocks entirely.

There is large virtue to being a rational, disciplined buyer. In 1999 and early 2000 it was very difficult to remain patient. Easy to preach, difficult to practice.

Periods of superior returns come in unpredictable lumps. Its normally when you get impatient that you get into trouble.

From a psychological standpoint, many people have "avoiding criticism" as their major goal. One way to avoid criticism is to do what everyone else is doing. The real essence of what you're asking comes down to character. Do you have the patience to persist in doing what you believe is the rational thing, even though you're not being rewarded for it?

Be rational and value-oriented. Avoid buying stocks you don't really understand.

a) Easy to understand (how it works and prospects) b) good businesses c) sell at a sizable discount to what a rational private buyer would pay to be a partner in the business.

A good business has a competitive advantage, generates superior returns on capital or on equity, and generates cash apart from accounting earnings.
Different measures for different industries. P/B useful for insurance, useless for a media company. Atleast a 30% discount.

Mathematically, you get about 95% of the maximum theoretical benefits of diversification with just 13 stocks.

Before buying any stock, ask how much you can lose by owning it. If the answer is more than you can stomach, its a good sign the investment is not right for you.

John Goode: 1st leg is inflection points. 2nd leg is : Screen to identify companies with good long-term prospects such as ROIC versus cost of capital, free cash-flow generation. Identify a population of companies that represent good business franchises. May not be attractively valued today but we want to know businesses that consistently earn a premium to their cost of capitsl. When cisrcumstances cause the shares of these companies to reach levels we believe are attractive, we are prepared to move.

3rd leg is to analyze fundamentals in the 11 S&P sectors. understand prospects that can't be determined by looking just at income statements or balance sheets. 4th leg is technical: insider buying, selling, percentage difference between price and 90 day moving average. At extremes, it suggests that our fundamental research efforts should be increased to determine whether a particular stock should be bought or sold.

What you're really trying to do is to find something cheap relative to its future prospects.

We are usually willing to hold a stock for 6-9 months unless we get information that says we've made a mistake. For best results, we have found you need to be in a stock for 18-36 months because it takes that long for low expectations to become modest expectations.

Bill Miller:
Our ideas come from new-low lists, we screen a lot and look at anything that is statistically cheap. Spectacular blowups like Waste Management in 1999. Many times terrific companies with strong competitive advantages will not make it into our portfolio because they never hit our valuation metrics. We've missed many great companies like Microsoft.

Dell in 1996 was growing at 25-30% a year earning 30% on invested capital and trading at 5 times earnings. They had a superior business model, and excellent competitive advantages.
Our models are updated every quarter as we get more fundamental data. We're always trying to figure out the underlying business value.
You can value any asset using financial theory. The PV of future cash flows essentially. The value of a business is independent of how it is financed. But how it is financed determines who has access to that value. If a company is worth 1B and there is 1B debt, the equity holders don't have an asset worth anything. In case of Exodus, the debt is trading at 15c/dollar after default. The current value of senior debt is 300M and we value teh company at 1B so we think we'll make several times our money.

Value investors tend to overlook a lot of great ideas. e.g. MSFT and CSCO were great values in 1991. Even after its severe correction, CSCO is still valued at 120B, and it was valued at 1B 10 years ago.
There are a lot of companies that are great values that we miss. In the 1970s, walmart traded at 24 times earnings. Had one bought it and held on, one would have creamed the market. Difficult.

Ronald Muhlenkamp:

P/B and ROE are useful but you have to adjust for inflation and interest rates. Even Graham adjusted his values in 1974. I still use the Graham format but adjust for inflation and interest rates.
The key is "what return you can get versus your cost of capital".

I would argue that if inflation is less than 1%, interest rates are 4.5%, and the ROE is high enough to sustain a high growth rate, PEs should be 2.5 times the growth rate. On the flip side, I've never seen a reasoned argument as to why PEs shoudl be higher than 2.5 times the growth rate.

if you have a high return on shareholder equity and you sustain it, chances are you're doing a pretty good job as a company. We then look to buy those companies at resonable prices. The price we're willing to pay changes as inflation and interest rates change. In 1980s, we wanted PE below half of ROE, today we want PE less than ROE.

The usual way is to page through Value Line. First screen for good ROE.You then look for reaosnably priced. You follow that with research to find of ROE is sustainable. You want to make sure its not just a blip, and that its a business you want to be part of.

When the numbers look good, we typically call the company and ask 3 favorite questions:
1) Are there analysts on Wall street who do a good job on your company? Thats saves us time.
2) What criteria do you use to judge your own performance? All are valid, we just want to talk and measure in their terms.
3) At what point do your people start earning a bonus ? If bonuses kick in at 15% ROE Iam interested. If they kick in at 10% ROE Iam not interested. We at least want to know what they're shooting for and what they're trying to do.

I want an ROE over 14%, which is the average. I want an above-average company. In today's environment, I want a PE below ROE. I use Value Line and analyst data but not their conclusions.

Warning signs: If revenues slow down and margins deteriorate, we get nervous. We look in 4 ways: marketing and sales, cost control, balance sheet, labor relations.

Bill Nygren :
Liberty Media was trading at 30% of its value and was also growing over time. There were only going to be more cable subscribers.The last thing we look for is economic alignment of management team with the outside shareholders. We need to believe that the management approaches their job with the mindset of an owner. From 1991-1998, it appreciated 60-fold. Business value grew so rapidly that even though the stock price was increasing , it always still traded at a discount to intrinsic value.


Oakmark Select is concentrated. Not more than 20 stocks.

We don't shun technology. Our analysts start by looking at stocks that seem cheap, they come down a lot, low PEs relative to other companies in their industries, low P/S.

Kevin O'Boyle: invest in companies generating strong returns on equity that are market leaders and operate in markets experiencing rapid growth. if these companies have sustainable competitive advantages and are bought at a reasonable price, you can generate very good returns over time.

Meridian Value fund: We observed that companies with up to a year's worth of negative earnings growth or earnings decline then did very well when their operational performance improved.Two key assumptions in this trategy are that the market tends to be very myopic and extrapolates short-term trends into the future. The second is that underlying business value tends not to be as volatile as stock price.

We don't really care about the overall market environment. We have a mandate to keep less than 10% of the overall fund in cash.

We're looking for companies whose stock price has dropped 50% or more from its high. Most companies stumble occasionally. We focus on companies that are market leaders, that have a history of generating good ROIC, or that own an asset that cannot be easily replicated. Cash flows strong enough t o support the capital structure.

We feel that it takes at least two down quarters before the stock price declines dramatically and the problem that cropped up begins to be addressed. Its in the third quarter that problems are getting fixed.
Markets are fairly efficient. After a couple of down quarters, stocks get hammered and those who see value get in. Markets are more efficient for large companies. Hence we don't necessarily wait for 3 quarters.
Earnings misses monitor. Our average holding period is 18 months.

Robert Olstein: There are 5 of us working on a portfolio. We spend a lot of time reading all kinds of publications, including magazines and annual reports, looking for hot spots. We re looking for misperceptions-where we think the negativity on a stock is not backed by the numbers. Temporary problems. You've got to have a 2-3 year time horizon for value investing.

The numbers we most look at are the estimated cash flows for the next 3-5 years. We're saying this is what we think the earnings power is. We do misestimate cash flows, we are wrong 1/3 times but not very wrong.
If I read something phony starting to develop in the financial statements, I'll sell. e.g. unbilled receivables spiking up or deferred taxes. I never talk to management, everything one needs to know is in the statements. How conservative they are, how they solved problems in the past.

Very much bottoms-up. No attempt to call the general market, interest rates or economy. Just minimizing downside risk.Out of 10 investment decisions, 3-4 will be wrong. But should not be too wrong.
We love to look at new low list, out of favor industries.

When you are looking at a fallen sector, the best balance shet will have strength to weather the storm.

Been wrong? We bought 2-3 staffing companies that were 70-80% off highs. After Y2K, their earnings estimates had fallen. We felt Internet would take over the slack. We were right for a short amount of time, but that came to a screeching halt, the bottom fell out. We lost almost 25-30% of our invesment, Never happened to me before.

Is tehre a threshold where you refuse to hold on to a stock that has gone down by a certain percentage? There's no set formula, but whever something underperforms by 10-15% relative to its group, it necessitates an automatic review of what's going on.
We hold a stock for about 2 years.

Charles Royce: We g right to its heart and soul, which is return on assets, and try to understand this. Is it permanent? Is it sustainable? What's going on that will impact returns of the sector ? If you can capture a high-returning company, even if has cyclically growth or sporadic growth, you're capturing a better engine than a company with low returns.

Lets say there are 2 companies both selling at 10 times earnings. One has a ROIC of 25%, one has a return on capital of 7%. The company with high return is going to be a better investment, If it doesnt have capital opportunities inside its own firm, its going to generate excess cash. The excess cash will operate as a positive pressure point on the comany and stock. Over time that excess cash will build up, will be spent creatively, and will be used to retire stock. The company without excess cash is flat in the water. So we're looking for companies with higher returns that tend to generate excess cash.

What else to look at? Frankyly 70% of it is looking at returns on capital and understanding the sustainability of returns on capital. If you get that right, you've really got it right.
How to gauge sustainability? You think out loud with the comapny, otehr people, and compeittors. We go through a Socratic Q&A of trying to understand the company. We want to know how competitors and customers regard the company.

What about valuation? I don't wake up and say that the whole world should sell at 9 times earnings.
Valuation is one part of risk management, important but not the only part. If I can get a deep confidence in the qualitative part of the company, I will address valuation after that. I need to understand the qualitative dimensions of the company before I'm ready to talk valuation.

I never know exactly what will happen to a given stock. I buy lots of stocks to give a higher chance of lightning to strike often.
Risk: The closer you are to reality, the better you'll' be at making judgements about risk.
Bear markets are not the time to be conservative. Best to dollar-cost average in a bear market, start off slow and add more to your portfolio every couple of weeks.

What made you a value investor? Losing a lot of money in the 73-74 bear market. I lost most of my money by having speculative risk, not understanding the importance of balance sheets, not understanding diversification principles, and not understanding integrity principles as they relate to individual companies.
The biggest mistake investors make is not reading annual reports and understanding the risks involved in their investment. Do your homework.

You don't need to swing at every pitch. This is a game that goes on and on. You can stay out of the game for a while and come back. You don't need to be hyperactive to win.
I am more conservative as markets go up, and aggressive as markets go down. I always try to stay fully invested.

Kent Simons:

Value guys like me get into trouble by buying stocks at below market multiples, and the earnings turn out not to be there. When I buy a stock, I do have assumptions about earnings in a certain amount of time. If those earnings are not to be seen, I won't hold on.
I bought Bank of New England at $24 P/E 6. And sold it for $6 at 6 P/E. They eventually went bankrupt.
The final reason I'll sell is since Iam 99.8% invested, is to raise money for something that looks even better.

Bret stanley: Typical Day: Every morning starts off with going through overnight news on the portfolio and other things that come under the heading maintenance research. We listen to every management conference call on each of our holdings. Constantly reevaluationg our IV calculations and making sure the fundamentals are unfolding as expected. 20% time on maintenance and 80% on new ideas.

Wallace Weitz:
A solid business that has some control over its destiny, that generates discretionary cash. Ideally the company is growing at some moderate rate. If anything grows too fast, I get nervous since fast growth is unsustainable most of the time. The company must also have management I really trust, who treat me like a partner, whose motives and aspirations match up with mine as an investor.

Buffett says that if he cant put a proper value on the company in his head or if being off by a percentage point or two on the discount rate makes a difference, its not cheap enough. I use 15% discount rate since thats the return we'd like to generate.

Some kind of control over their destinies, like monopolies, e.g. cable companies. In contrast, cable equipment makers generally have multiple competitors so less control over their destiny.
Recurring revenue, insulation from competition, not particularly capital intensive.

We rarely go over 5-6% in a company. I worry about specific company risk.

There are an infinite number of facts you can learn about a company, but there are usually two or three very important variables that make the company succeed or fail. A lot of Wall street research gets so bogged down in the minutae and details that it misses these two or three big things that make or break an investment. its important to be able to distinguish what matters from what doesnt. That's one of Buffett's great gifts.

Martin Whitman:
An awful lot of managements are out to rape public stockholders. We try to avoid these people. We avoid incompetent looking management, overreaching management in stock options or compensation levels and other transactions as discolsed in SEC filings.

In general, all businesses that are good are involved in wealth creation. Away from Wall street, most intelligent people would prefer to create wealth by methods other than earnings (for tax reasons). Maximise cash flow rather than earnings.

Right now, we're buying huge portoflios of tech cmpnaies selling at under 8 times peak earnings. We feel it can take 3-5 year for a cycle to turn.
On the distressed side, I read the Daily Bankruptcy reporter.

10 Keys to successful Value Investing :

1) stick with the market. Mostly the masters stay invested at all times. "Research shows tht 80-90% of investment returns occur during just 2-7% of your holding time." Christopher Browne points out.
David Dreman says that he raises cash only when the market is in middle of a freefall. "Ive seen too many good managers get hurt trying to outsmart the market. They wind up missing rallies".

2) View yourself as a long-term partner of the business. Instead of constant attention to the company's stock price, concentrate on how well the business itself is progressing.

3) Price is important. Simple-minded computer screens like low PE or low PB do not tell you much about value.

4) Build portfolio bottom up. Little consideration to macros considerations. Masters seek out individual companies one by one. Sometimes bottom up approach leads you to a more general trend that you can latch to.

5) Dreman : "We found it pays to sell, not if there's a bad quarter, but if there is a major fundamental change in the longer-term outlook".

6) Have patience: Since you're buying what is currently out of favor, it can take months or even years to work out. Periods of superior performance come in unpredictable lumps.

7) On analyst reports: Such reports can provide many general insights into a company's overall operating environment. I want an analyst to tell me what's going on in the industry and company. Their job is to know their companies but not their values.

8) Get a firm grip on what makes a company tick. What is management like ? (Mine: Is it consistent with what I would do? )