Professor Bruce C N Greenwald, pro-fessor of fi nance and asset manage-ment at Columbia Business School, is the academic Director of the Heilbrunn Center for Graham & Dodd Investing. Described by the New York Times as “a guru to Wall Street’s gurus,” Greenwald is an authority on value investing.

Greenwald has been recognised for his outstanding teaching abilities. He has been the recipient of numerous awards, including the Columbia Uni-versity Presidential Teaching Award which honors the best of Columbia’s teachers. His classes are consistently oversubscribed, with more than 650 students taking his courses every year in subjects such as Value Investing, Economics of Strategic Behavior, Glo-balization of Markets, and Strategic Management of Media. He has co-au-thored the hugely popular “Value In-vesting: From Graham to Buffett and Beyond” (2001) and “Competition De-mystifi ed: A Radically Simplifi ed Ap-proach to Business Strategy” (2005).

In an interaction with Outlook Profi t, Greenwald talks about, among other things, how a valuation model used by value investors is far more re-liable than the traditional discounted cash-fl ow model used by most analysts. Excerpts:

Can you tell us why value investing can result in out performance? Value investing, developed by Benja-min Graham and David Dodd at Co-lumbia University, and practised by Warren Buffett and Gabelli among oth-ers has historically outperformed the market by 3-5 per cent. Value investing is all about buying bargains.

The effi cient market theory says that investors can’t really do better than the market, so it’s best to diversify, mini-mise your transaction cost and not try to guess which stocks are going to go up. What people have discovered is that there are, in fact, ways of statisti-cally picking stocks that can outper-form the market.

But when you go in the investment business, notwithstanding the statisti-cal evidence, there is an unavoidable

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TAKING STOCKProfessor Bruce Greenwald believes that value investing is all about buying bargains as it’s diffi cult for investors to outperform the market

PHOTOS: SANJIT KUNDU

13 June 2008 Outlook PROFIT

way in which markets are effi cient, and it is this there are two sides to ev-ery trade and one of us is always wrong. Therefore, one way to think of effi cien-cy is to see what it is that makes your portfolio decisions better the market.

Basically, what Ben Graham recog-nised is that there were ways to look at cheap stocks, many of which were practically obscure. Statistics shows these kinds of stocks ultimately out-perform the market.

In every society, people buy lottery tickets which have always been a crap-py investment. People will overpay for the dream and the reverse side of that is something that looks ugly, so people will irrationally sell off or shy away from it. If, I am a fund manag-er, I’m going to lose the funds under management if I under-perform in a signifi cant way. So I copy everybody and buy the same lottery-ticket stocks which are going to get bid up more and more. It is an echo chamber that am-plifi es these behavioral irrationalities and people never learn.

Can you tell us about the method you use to arrive at the correct value of a stock? When you buy a stock, when you think you have found an opportunity, it’s cheap, it’s ignored, and it’s a small-cap stock. If you want to decide whether to buy it or not, the conventional way to go about it would be to do a discount-ed cash fl ow for 6-7 years, by getting a terminal value and calculating the net present value of all future infl ows. Now in theory, if you know the right numbers, this will give you the right answers. In practice it is an incredibly stupid way to value stocks. And I think there three reasons for that -- two are quite obvious and one, a little subtle.

The most obvious reason why it’s a

bad way to value a stock is that to take the sum of discounted cash fl ows, you have to fi rst estimate near-term cash fl ows which is very good information; then estimate the distant-year cash fl ow; fi nally, you have to fi nd out the terminal value, which is very bad in-formation because you don’t really know what that value is. And when you add bad information to good informa-tion, you end up with bad information. So what you want is a different proce-dure where you can say ‘this is value that I’m confi dent of’; the second piece is intermediate quality information that I have semi-confi dence in; and the third piece where there are mistakes and on which I’m not going to rely on that much. Discounted models don’t do that.

The second thing is that there is one very important piece of information that this model throws away is the bal-ance sheet information. The balance sheet describes the company and any asset it has. These are very important elements to think about when you are buying assets, yet DCF models ignore the balance sheet.

The third reason is a little more sub-tle and I will explain it in the context of Tata Motors and their 1 lakh rupee car. If you wanted to value that enter-prise, you would have to estimate sales over the next 15 years, estimate mar-gins which is a number, estimate capi-tal intensity which is a ratio, estimate the cost of capital which you may not be able to do accurately especially as you go deep into the future.

A valuation procedure is a machine

into which you take assumptions like that, put them and crank it up and wait for it to throw out a valuation. Now if the assumptions are bad, you won’t get a good answer. If it was the best you could do, that would be fi ne because you got to put a number to it.

So how do you deal with it?There are assumptions that we can make with confi dence about the future of the Tata Motors’ car. For example, will there be a market for the 1 lakh ru-pee car 15 years from now? We think there will be; this is an economically viable market. The second question is do we think that Tata Motors is the only one who can do this? Bajaj just announced that they are going to do it as well, so has Honda. So Tata Motors is going to have no competitive advan-tage in that market and 15 years from now everybody is going to be mak-ing these cars. Those are strategic as-sumptions we like to use.

So what Graham and Dodd devel-oped although they were never explicit about it is to organise the information by way of a ‘reliability class’. You start with the most reliable information that is the balance sheet. For instance, in the case of Tata Motors which is in a viable industry, sooner or later those assets will have to be reproduced or replaced in the most effi cient manner. Just work down the balance sheet and you can look at the reproduction value. If the company is in a viable industry, compute the asset value and if it’s in an unviable industry, look at the liqui-dation value.

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Then what you look at is the near-term earnings power of the business. Let’s forget growth altogether and we average out for the business cycle and we undo all accounting fallacies, we get what is the real distributable cash fl ow. Rather than using accounting depreci-ation we ask, what will we have to pay in investment to return the company at the end of the year to the state at which it was in the beginning of the year? That is a much better number because that is what you need to really re-invest.

So you get a good idea of what the after-tax earnings power of the business is and if it went on forever, what would the busi-ness be worth? This is your second piece of most reliable infor-mation. Two things can happen: one is the day the earning power is 10 billion rupees (say for Tata Motors) and the assets are worth 5 bil-lion rupees. Since there are no barriers to entry in this industry, people could create 10 billion in earnings for 5 bil-lion rupees in investments and that’s when the Bajaj and the other foreign car companies are going to come in.

If you saw that and if there was a discrepancy between earnings power value and asset value and the earnings power are higher, then Tata Motors better do something that other people

can’t copy. That is a barrier to entry, so the key research question is looking at the structure of competitive advantage in the market and fi nding out whether that gap is sustainable.

The other possibility is that the as-set reproduction value is 5 billion ru-pees and the business earns 5 billion rupees. That’s exactly what you would

expect to see if there were no barriers to entry and Tata Motors didn’t enjoy any com-petitive advantages. Now you have two independent obser-vations on what that company is worth and that is going to be far more reliable than DCF.

The third possibil-ity is the assets are worth 10 billion ru-pees and earnings are 5 billion rupees. Well, assuming that it is not a dying industry and you have not over-es-

timated the value of the assets, that’s got to be crappy management because they are taking 10 bn of assets and pro-ducing 5 bn of earnings. In this case, what you care about is whether you can get rid of these guys. And so you’re going to study the proxy statements; the activist investor will focus on that. Notice that in each case, it ties the ulti-mate valuation to a critical single ques-tion.

How do you value growth?

What I told you is our basic framework. We haven’t talked about growth at all because it a complicated question. What you have to understand about growth is while everybody says growth is good, it is not. It is a two-edged sword. A growing income stream is worth a lot more than a fl at income stream. But usually to get the grow-ing income stream you have to invest. And the more you invest, the smaller the distributable income is. Growth, in cases where the asset value is greater than the earnings power value, is ac-tually bad. I don’t care if I’m in India or China. If it is a crappy management investing money in a stupid way or at a competitive disadvantage, growth is your enemy.

Let us take the case of Tata Motors, where there are no barriers to entry. I am going to invest 10 billion rupees and I have to pay 10 per cent to the peo-ple who provided it. If competition is out there, then basically it is not going to earn two billion a year because com-petition will enter and eliminate that. So I am going to earn a billion rupees a year and I pay a billion to the people who provided that capital. Growth has no value here. That’s the situation in companies like Mittal Steel which are expanding capacity in India while de-mand is expected to grow by 12 per cent or so, which means they will not make much money. So when you look at growth in India, you have to be very selective. There is also a lot of stuff that Reliance Industries is doing by setting up retail all over India and this is also going to destroy value.

The growth that creates value is only where you are protected by barriers to entry - where you pay 10 per cent and get 20 per cent, where earnings pow-er value is decisively greater than as-

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If you want to decide whether to buy a stock or not, the conventional way to go about it would be to do a discounted cash flow for 6-7 years, by getting a terminal value and calculating the net present value

58Outlook PROFIT 13 June 2008

set value. Take Hindustan Unilever which enjoys economies of scale and also commands the loyalty of custom-ers. If you are 50 per cent of the mar-ket and competition has only 10 per cent of the market, you could kill them and still make a ton of money. Unile-ver India has got all powerful competi-tive advantages and they are going to make money out of the growing mar-ket whereas Mittal Steel is a very dif-ferent story.

Two prime drivers for Indian soft-ware service companies have been a depreciating currency and cheap labour. Would you call these competitive advantages?Ask yourself what elements consti-tute as barriers to entry and these are the competitive advantages that an in-cumbent enjoys. There are three types of competitive advantage: custom-er captivity; proprietary technology; and economies of scale. The strength or weakness of a currency cannot be a competitive advantage. If a currency is undervalued or overvalued, the sit-uation will soon correct itself and the advantage will go away. The low cost you described is not an advantage. You have to differentiate between what is good for the country and an individual company. Besides, competitive advan-tage has to be measured against your strongest competitors, not your weak-est ones.

They do not have proprietary technol-ogy or a cost advantage over the rest of the Indian players. But what they do have is customer captivity which is a relatively useful competitive advan-

tage. These companies have long-term customer relationships which are go-ing to be hard to displace. But over time, their customers would look to source the same services more cheaply from other service providers.

If you look at the top 10 Chinese companies by market value (remem-ber they all have got cheap labour and great manufacturing capabilities) none of them are manufacturing com-panies – instead, they are natural re-sources companies. There are only two manufacturing companies in the top 25: Shanghai Motors and China FAW and they make 2-4 per cent on equity. They are not profi table as they have to compete with other Chinese com-panies. So China is doing great, wages are rising and output is expanding but are companies profi table? No, because they have to compete.

Despite boasting powerful brands, some consumer goods companies compete fi ercely in the market place. Does that not destroy value? Look at their margins and return on capital -- it has been going up. People tell that story because in some indus-tries it matters but when it comes to consumer goods, people are fanatically loyal, for example, to their detergents. P&G can work like crazy but they are going to see stable market shares at best. So for these companies, you have to look at each product segments and consumer behaviour in that segment, not the company as a whole. By the way, consumer behaviour is surpris-ingly uniform across the world. In ev-

ery country, the toothpaste segment has a single dominant competitor, and that’s because people use the same toothpaste forever and ever. They don’t switch their colas easily either: look at Coca Cola – people have been drinking it for a hundred years now.

Similarly, people don’t switch cig-arettes easily. But shampoos, they switch all the time. The shampoo busi-ness is, therefore, more like steel!

The point here is that people who try to compete without a competitive ad-vantage will usually lose their shirts. The famous example of that is AT&T, which decided in 1982 to go after IBM in the information processing busi-ness. IBM had captive customers in the business and enjoyed big economies of scale. AT&T did not have either but still it was considered a ‘strong com-petitor’ because it had tons of money. In the next fi fteen years or so, AT&T lost about $100 billion and it’s no lon-ger even there.

So do you mean new companies can’t challenge established players? They can but they need to act smart. The challenger has to attack the incumbent where the latter is the weakest. So if P&G was smart, they would look at markets where Unilever has the smallest share geographically and would set up base there.

When Pepsi went up against Coke, they targeted the new generation – who had not taken to the drink yet. They targeted the north-east and the mid-west where Coke was the weak-est. They targeted grocery stores where Coke did not have a distri-bution network. Smart companies don’t run head-on with a competitive disadvantage.

So these dominant companies are safer bets?It depends on what multiples they trade at. But they are safer because they have competitive advantages and their growth is valuable. For the sec-ondary companies trying to fi ght their way in, growth, more often, has nega-tive value because they are competing with a disadvantage.

How do you factor in liquidity into stock valuations? We don’t! We ignore it completely. Li-quidity gets built into the price, it doesn’t get built into the value. Value is concerned with what is this thing going to earn? What does it cost to reproduce the assets? These are the fundamentals. For value investors, li-quidity is not a concern and macro is not a concern. p

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The Heilbrunn Center for Graham & Dodd Investing has a page on profi les on various value investors at www.gsb.columbia.edu/valueinvesting/schlossarchives/public

www.gsb.columbia.edu/students/or-ganizations/cima/newsletter.html for the Graham and Doddsville news-letters

www.gannononinvesting.com Val-ue investing blog and value invest-ing podcast infl uenced by Benjamin Graham, Joel Greenblatt, and Warren Buffett’s value investing model.

www.stocksbelowncav.blogspot.com - Cheap stocks: Below net current as-set value, real estate, and other value strategies

www.grahaminvestor.com Value In-vesting Benjamin Graham style

http://valueinvestingresource.blogspot.com Value investing re-sources

www.moderngraham.com Devoted to the study and modernisation of the theories of Graham and Buffett.

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The Intelligent Investor –Ben-jamin Graham’s The Intelligent Investor still con-sidered the Bible of value investing – a book no value investor can start without.

Security Analysis – Comprises Ben-jamin Graham’s courses in Columbia University. Originally part of Dodd’s notes that he transcribed during Gra-ham’s classes.

Interpretation of Financial State-ments – Graham’s fi rst book for the non- fi nance people. It instructs how

to read the balance sheet and the in-come statement.

Janet Lowe’s The Rediscovered Benjamin Graham – Treasure trove of Graham’s articles, lectures and in-terviews that he gave. Straight from the Master. Must Have!

The Memoirs of the Dean of Wall Street by Benjamin Graham– Again straight from the Master himself. Con-tains his memoirs as he traces back his life through all its ups and downs.

Benjamin Graham on Value Invest-ing: Lessons from the Dean of Wall Street by Janet Lowe – A concise yet comprehensive coverage of Graham’s life, his strategies and his key lessons.

GRAHAM’S DISCIPLES – VALUE INVESTORS’ HALL OF FAMEWarren Buffett – The Undis-puted succes-sor and most successful val-ue investor ev-eryone knows about. Read the Berkshire Ha-thaway Annu-al Letters if you want to learn from the most successful in-vestor of all times, straight from War-ren at www.berkshirehathaway.com/letters/letters.html

Christopher H Browne author of “The Little Book of Value Invest-ing”. Read the Tweedy, Browne Let-ters and Articles resources avail-able at www.tweedy.com/content.asp?pageref=reports

Martin J Whit-man – Legendary value investor. Read his letters to shareholders of Third Avenue Funds to gain profi table insight into value invest-ing at www.thir-davenuefunds.com/taf/aboutus-

shareholder-letters.html

Other famous value investors that you must read up on include:William Ruane of the Sequoia Fund, Jean-Marie Eveillard of First Eagle Funds, Walter and Edwin Schloss

WEB RESOURCES AND BLOGS

The Original Graham and New-man Letters brings alive the Graham Newman Corporation, the stocks that they bought, the times they operated in and their performances.

Benjamin Graham: The Father of Fi-nancial Analysis by Irving Kahn and Robert D. Milne, 1977.

What has worked in Investing: Stud-ies of Investment Approaches and Characteristics Associated with Ex-ceptional Returns by Tweedy, Browne Company LLC – A study of various approaches to investing and their re-spective performances.

Testing Benjamin Graham’s Net Current Asset Value Strategy in London by Ying Xiao and Glen C Arnold –Their study done for the pe-

riod 1981 to 2005 on stocks trading with net current assets/market value greater than 1.5 found them giving an-nualised return up to 19.7 per cent per year over fi ve holding years.

The Superinvestors of Graham-and-Doddsville by Warren Buffett – Based on his 1984 presentation to the Columbia University – challenges the Effi cient market hypothesis and Gra-ham’s contribution to making money through market ineffi ciencies.

Grahams lectures from the series en-titled Current Problems in Security Analysis that Graham presented at the New York Institute of Finance from September 1946 to February 1947 available at www.wiley.com/legacy/products/subject/fi nance/bgraham/index.html

Valuable resourcesBOOKS

PAPERS AND LETTERS