Warren Buffett likes to buy wonderful companies at fair prices.  Seth Klarman is happy to buy average companies at wonderful prices.  
Following are my notes on Klarman:     

• Speculating vs. Investing
  • No one knows what the market will do so trying to predict it is a waste of time
  • Market timing is speculating
  • Investors have a good chance of achieving long term success; speculators are likely to lose money over time
  • Investments throw of cash flow; speculations do not
  • Successful investors are unemotional and use greed and fear of others for their benefit
  • Prices move up and down for two reasons
    • Change in business reality (or perception of change)
    • Short term supply and demand
  • Greed leads people to seek shortcuts to success
• Defining Investment Goals
  • Avoiding loss is key
  • Focus on risk first and return second
  • A substantial loss can greatly impact standard of living while a comparable gain may not improve it commensurately
  • Consistent “good” returns over a long period of time are better than excellent returns followed by a meaningful decline
    • A 50% decline in one year requires a 100% increase to break even.  This could take twelve years in a low return world
    • 16% for a decade is worth more than 20% for nine years and a 15% loss in year ten
  • Focus on approach, not outcome. 
    • Having an annual return goal can encourage unreasonable risk taking
  • A significant ongoing commitment of time is a prerequisite for successful long term value investing
• Margin of Safety
  • Difficult to analyze Tech, commercial banks, and P&C insurance so many value investors avoid them
  • Value investing can work well with inflation
  • Look for overfunded pension fund or real estate carried on books below market value
  • Technical analysis is a waste of time
  • Large caps are much more efficient with more competition
    • Charlie Munger “Don’t try to figure out Merck’s pipeline vs. Pfizer’s, it’s too hard.  Go where there is less competition, where you have an edge”
• Key Elements
  • Bottom-up – not top down
  • Absolute performance – not relative
    • Hold cash if you can’t find anything
  • Focus more on risk than return
    • Risk is the probability and the potential amount of loss
    • Risk reduction
      • Adequate diversification
      • Hedges
      • Margin of safety
• Business Valuation
  • DCF
    • Best used in a high return business with stable cash flows
    • However - Very difficult to forecast the future
    • Contradiction – To calculate present value, you must predict the future, yet the future is not predictable
    • Only answer is be conservative
  • Liquidation Value
    • Best used for unprofitable business with price below book value
    • Cash worth 100% of book value
    • Investments worth market value
    • A/R very close to book value
    • Inventory more difficult
      • Raw material or finished product?
      • Risk of technological or other obsolescence?
    • Fixed Assets also difficult to estimate
    • Short cut is Ben Graham net nets
      • Current Assets less Total Liabilities
      • No value placed on Land, buildings, equipment, growth, patents, trademarks etc.
      • Need to also consider OBS items (underfunded pension)
  • Dividend discount model is not useful because dividends are only a small fraction of corporate cash flows
• Areas to look for potential investments
  • Filtering can be helpful for net nets – but still need to look more closely
    • Databases can be out of date or inaccurate
  • Daily stocks with large % declines
  • New 52 week low list
  • Elimination of a dividend
  • Stocks below $5 (Institutions unwilling to own)
  • Small with infrequent trading
  • Year-end tax selling can depress shares
  • Spinoffs
    • Analysts normally don’t cover them – low trading volume = low commissions
    • Info not readily available for a few months
    • Holders of the parent company don’t want to mess with a small cap
    • Temporary supply/demand imbalance with initial selling
  • Insider buying
    • Insiders know the company best
    • They sell for many reasons but only buy for one – they think the stock is going higher
  • Need to determine why a stock is undervalued
    • Pending litigation?
    • Off balance sheet liabilities?
    • Competition launching superior product?
• Portfolio Management
  • Appropriate diversification
    • 10-15 holdings in different industries
    • It’s not how many different things you own, but how different the things you do own are and the risks they entail
  • Hedging
    • Diversification does not protect you from market risk
    • Short entire S&P 500 against portfolio of large cap stocks
    • Not always smart to hedge
      • Should be willing to take on more risk if available return is sufficient
  • Liquidity
    • Opportunity cost of illiquidity is high
  • Staying in touch with the market
    • Problem with buy and hold is that the market can create good opportunities each day based on short term movements
    • Does not mean watching every market tick and doing short term trading
  • Buying
    • Must resist fear and greed
    • Buy partial position to leave room to average down
      • If you are not willing to average down, you are speculating instead of investing
  • Selling
    • Wrong way to sell
      • Setting target sell price at time of purchase
      • P/E ratio target or P/B
      • % gain target
      • Using stop loss prices limits downside risk but is crazy – you should be increasing the position!
    • Right way to sell
      • Based on business value which is always changing
      • Don’t sell an undervalued company and pay tax on a gain if there is nothing better to buy
  • Leverage is neither necessary nor appropriate for most investors

I still approach investing the old-fashioned way where you determine what something is worth and only buy at a discount to that value.  One of the benefits to this approach is increased conviction when the markets fall.  If I own stock in a company that I think is worth $100 and the price falls to $75, I do not panic and sell.  In fact, I might even buy more.  But if you own stock in a company that is worth $100, and it trades for $500 it’s hard to know when to sell if it starts falling.  Momentum is great on the way up, but unfortunately it works on the way down as well.
 
There are several ways to value a business but the three I use the most are:
 
1)Discounted cash flow – best used for a high-quality company with stable margins and cash flow
2)Liquidation value – best used for a struggling company that has gotten too cheap and people have totally given up on it.  Most of the time these companies survive and the returns can be excellent, if you buy them cheap enough.
3)Sum of the parts – best used for holding companies or companies in a diverse group of industries.  Think G.E. or Berkshire Hathaway.
 
At this point, people are probably thinking this is all great for a Finance guy but I’m not one so I will just invest in things that have gone up a lot or companies mentioned on CNBC or Twitter.  Even if you don’t follow one of the valuation approaches listed above, you can still determine if the price is reasonable for the company you are considering.  It only takes a few minutes to look up a company’s financials in Yahoo Finance or one of the other many sources.  They say most people spend more time researching a vacation or a new refrigerator than they do a stock.
 
If you look at the annual returns of the great investors, you expect to see several years of amazing outperformance.  In reality, their success normally comes from avoiding losses.  Keep in mind, if a stock drops 80%, you need a 400% return to break even.  This is very much a game of winning by not losing.  Therefore, following a simple checklist of what not to do can be beneficial.  For example:
 
1)Don’t invest in companies that are losing money
2)Don’t invest in companies that are burning through cash
3)Avoid IPOs
4)Never pay more than 30x earnings (I rarely pay more than 20x)
5)Avoid companies that recently made a large acquisition (most acquisitions destroy value)
6)Avoid companies that have heavy insider selling (you can find this at gurufocus.com)
7)Avoid commodity businesses like steel, mining, chemicals, energy etc. unless you are good at predicting economic cycles.
 
I’m not saying there are never opportunities in these types of companies, but the odds are stacked against you and may require a lot more research.  For example, as a rule I don’t like to invest in companies that recently made a major acquisition.  Studies show nearly 70% of all acquisitions either destroy value or add no value.  The easy approach is to just take a pass on acquisitive companies.  The alternative is to do a deep dive on the acquisition and determine if it really is a good idea and if the price being paid is reasonable.  Most acquisitions are driven by ego, not value creation.  I’m sure part of this is the fact that executive compensation is tied to the size of the company, not the value being created for shareholders.  There are exceptions and I would put Berkshire Hathaway in that category.  It’s highly unlikely Warren Buffett overpays for a company.
 
This is a very basic checklist designed to keep you out of trouble.  Ideally, you should be doing more research if you are investing in individual stocks, but this basic checklist should help you avoid the large blowups that can occur with stock picking.  With sites like Finance.yahoo.com and Gurufocus.com you should be able to work through this checklist in less than 10 minutes.  
 
   
 
 
 
Questions or comments, feel free to email me at askfinanceguy@gmail.com
 
Disclaimer: Askfinanceguy.com is not an investment advisor, brokerage firm, or investment company.  This blog is for educational and/or entertainment purposes only. Use this information at your own risk. Do not consider anything on this page to be legal, tax, or investment advice.

Although smoking has been on a steady decline for decades, Altria has delivered a 16% annual return over the past 30 years.  This compares to 9.5% for the overall stock market.  If you invested $10,000 in the S&P 500 30 years ago, you would have $152,200 today.  If instead you invested in Altria, you would have $858,500.
 
What I like about Altria:

• Industry leader with ~50%+ market share.
• Very impressive margins (2019 operating margin was 42.7%).
• 9% dividend yield – They have increased the dividend 54 times in the past 50 years.
• They own the Marlboro brand - #1 brand for 45 years.
• Significant pricing power – They have been able to offset roughly 80% of volume declines with higher prices.  Buffett will tell you if there is just one thing to look for in judging the quality of a business, it would be pricing power.  Very few companies have it.
• High returns on invested capital – Altria’s return is 36%.  The average company is closer to 9%
• Recession proof.  Some would argue people smoke more in a recession.
• Margin expansion.  They have increased their operating margin every year since 2014.  This is something that really impressed my when I looked at their historical financials.  Here are the historical operating margins:

 
2014    31.9%
2015    33.1
2016    35.5
2017    38.3
2018    41.7
2019    42.7
2020    43.0 (est.)
 
 
What I do not like about Altria:

• The industry is in a secular decline
• High legal risks
• High regulatory risks
• High excise taxes
• They overpaid for JUUL and Cronos (in my opinion).  Good news is they already took significant write downs for this.

 
What is Altria worth? 
 
Using a discounted cash flow approach with their current financials and assuming a 2.0% growth rate (conservative), Altria has an enterprise value of $138B.  This does not include the value of their investment in:
 
                              Est Value:
 
AB Inbev (BUD)     $12.0B
JUUL                           4.2B
Cronos                        1.0B
Total investments  $17.2B
 
If you add it all up:
 
Enterprise value                $138.0B
Equity Investments                17.2
Cash                                         5.2            
Less debt                              (30.0)                       
Less pension                           (0.5)
Fair value estimate            $130.0B
Divide by # of shares            1858
 
=Fair value estimate per share $70.00
Today’s price                              $38.60
% Undervalued                             45%                
 
 
 
Disclosure: Long MO
 
Questions or comments, feel free to email me at askfinanceguy@gmail.com
 
Disclaimer: Askfinanceguy.com is not an investment advisor, brokerage firm, or investment company.  This blog is for educational and/or entertainment purposes only. Use this information at your own risk. Do not consider anything on this page to be legal, tax, or investment advice.

The CAPE ratio is my preferred metric to determine whether the stock market is reasonably valued.  Other popular metrics like the Price/Earnings fall short because they are based on current earnings which could be depressed in a recession or inflated when profit margins are at peak levels in the business cycle.  For example, in 2009, the simple P/E ratio for the market was 71 which looked crazy expensive because earnings were depressed from the recession.  However, with the CAPE ratio at 13.3, you would have been convinced this may have been the buying opportunity of a lifetime.   It was one of the few times my equity exposure was over 80%.  In March 2009, the S&P 500 was trading at 666.  Today it is over 3,000.  I have found the CAPE ratio to be the most reliable metric for determining long term future returns in the market.
 
The experts say you cannot time the market.  In the short run, I agree.  Valuation does a lousy job of predicting short term market moves.  In 1999, I thought the NASDAQ (tech stocks) was extremely overvalued when it was at 3370.  I refused to cave and invest in these overvalued tech stocks.  I thought if I really felt this way, why not put real money behind it?  So, I did.  In 1999, I put on a short position on the NASDAQ (with shorting, you make money when stocks go down).  Day after day, week after week, the market continued to climb until it reached 5050 in March of 2000, which was an increase of 50% since I put on the short position.  It felt like every day we were losing money.  After several months of losing money, it was not fun anymore.  I just wanted out.  Once the market came down to my break even point, I covered the short position.  Eventually, I was right, but I did not profit from it.  In fact, by September 2002 the NASDAQ had fallen 66% from when I shorted it and it fell 77% from the peak.  There is a common phrase short sellers use; “Markets can remain irrational longer than I can remain solvent.” These days I still short stocks but only as a hedge against long positions.  If the market is very overvalued, its best to just avoid it vs trying to profit from a decline.

Back to the CAPE ratio….
 
Over the past 150 years, the low point for the CAPE ratio was 4.8 in 1920.  The record high was 44.2 in 1999 during the tech bubble.  The 150-year average is 16.7.  Today the CAPE ratio is 28.5 which is rich given the current economic climate.  As shown below, when the CAPE ratio is low, 10-year future returns are high.  When the CAPE is high, future returns are low.             
 
 
 
 

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At today’s CAPE ratio, the market is priced to deliver basically nothing over the next 10 years.  In my opinion, it could be even worse because today’s ratio goes back to 2010 therefore it does not include any recession earnings which was the original intent of the ratio.  Normally, 10 years is long enough to capture the peaks and valleys of the business cycle.  When I was in school, we were taught you can expect a recession every 4-5 years.  Today is unique because we are in the longest economic expansion in our history (until COVID hit us).  I deal with this issue by going back 11 years and including 2009 earnings in the calculation.  At the end of 2020, this won’t be necessary because the depressed earnings of 2020 will be baked into the numbers.
 
With my adjustment, The CAPE Ratio today is 31.
 
Ben Graham (Warren Buffett’s mentor) said you should never have more than 75% or less than 25% of your portfolio in stocks.  I think this is sound advice.  People often talk about being “in the market” or “out of the market.” It should not be a binary decision.  With few exceptions (like today), I am rarely 100% stocks or 0% stocks.  I like to adjust exposure based on valuation.  When stocks are cheap, future returns are high and downside risk is limited.  This is the time to increase exposure.  When stocks are expensive, future returns are low and downside risk is significant.  This is the time to lighten up on exposure. I realize this is easier said than done.  Very few people wanted to sell stocks in 1999 during the tech bubble or in 2007 during the housing bubble.  Nor could I find anyone excited about buying stocks in 2002 or 2009 after experiencing 50%+ declines.  Most can tolerate 20-30% declines like we just experienced in March of this year.  However, declines over 50% can be life changing, especially if you are over 50. 
 
So how can I use the CAPE Ratio to manage my portfolio?
 
When it comes to estimating future returns, I like to make things complicated and factor in future growth rates, inflation, dividend yields etc.  But for someone who does not want to make a career out of it, I found the following framework to be helpful: