3. Value Point

I summarized value point as asking three questions and getting four answers, as shown in Figure 3.1. On the surface, this is very similar to traditional value investing (such as buying a good company cheap). However, significant extra detail is included within the treatment of the margin of safety (Question 3 in the figure) to deal with all the mentioned problems when “going global.” The previous chapter’s focus on the mechanics of Graham’s Method and on building uncertainty analysis into the language of value investing was in order to address the added complexities of Question 3.

Figure 3.1. Value point

For all effective purposes, I am laying out a value approach for the opposite extreme of what is generally considered global value investing. Instead of stretching out somewhat to moderately more uncertain markets (such as short-term listed equities in Hong Kong), I am jumping to the furthest extreme (such as buying and holding minority shares in private Russian companies). If a long-term value strategy can work with these assets, it can work anywhere. If you can do emerging markets, you can do developed markets. If you can do China and Russia, you can do India and Brazil. If you can do negotiated private deals, you can do public purchases. If you can do small companies, you can do big companies. If you can do buy and hold, you can do buy to sell.

But the real key to overcoming the five “going global” challenges (limited access, increased current uncertainty, increased long-term uncertainty, weakened claims, and foreigner disadvantages) is Graham’s Method.

Looking again at Graham’s approach, but with a global worldview (see Figure 3.2), we can see that the first and second laws hold true for most companies in most environments around the world. Market price and intrinsic value are independent in most cases. And more importantly, market price returns to intrinsic value in the long term in most private assets and public equities. I am simply asserting this from experience. It has always seemed somewhat mysterious as to why this happens.

Figure 3.2. Derivation of value investing

However, you do see Soros-type reflexive relationships fairly frequently, particularly in real estate, infrastructure development, and other sectors where government credit is very active. I will argue later that this is inherent to many systems where government policies and credit are used to drive large-scale domestic development.

It is Graham’s Third Law that becomes the biggest problem when we leave the developed world (see Figure 3.3). It greatly depends on intrinsic value staying relatively stable—or at least not decreasing. However, in developing and colliding markets, this just doesn’t hold. Companies and markets are rising (and falling) rapidly. Governments are actively involved and frequently change the rules. Most of the assumptions about stability and the separation of government and private sectors are not there. These things are all considered exceptions in developed economies (and usually are avoided in practice). But in much of the multipolar world, they are now the norm.

Figure 3.3. Graham’s Laws in a colliding world

Because there are many cases when we cannot assume long-term stability, we need to actively eliminate the long-term downside uncertainty at the time of investment. The best way I know to do this is through a combination of a large margin of safety and a negotiated deal structure. This can include negotiating a lower price and adding value at the time of investment (see Figure 3.4), thereby increasing the margin of safety. But negotiated value-added deals can also impact the stability of the intrinsic value in the near and long term. So I expand Graham’s Third Law in this way: “In the long term, intrinsic value is stable for many companies, and it can be actively stabilized in many others.”

Figure 3.4. Value point in a colliding world

Note that this is an expansion of traditional value investing into value-added deal-making. In the best-case scenario, adding value supercharges the margin of safety. But the most important impact is that it minimizes and often eliminates the downside long-term uncertainty, which effectively opens the door to value-based investing in many more situations. There is no set approach for doing this across all deals. The common element is that we are introducing additional variables and tools into the deal process by which we can construct deals that eliminate the current and long-term downside uncertainty.

Looking at Graham’s Method, we can start going through its steps for various companies in various types of environments. The “mispriced value + added value” (MP + AV) approach basically greatly expands Graham’s Net Nets trick. We cannot say what the future value will be, but in many carefully constructed deals we can very accurately say what it will not be. As soon as the current margin of safety is known and the long-term downside is eliminated, we can invest surgically and big. Graphically, the approach looks like Figure 3.5.

In both value investing and value point, the central problem is the downside uncertainty in the future intrinsic value. An accurate and healthy margin of safety does not help us if the intrinsic value can decrease over time. The main thrust of both value investing and value point is eliminating this possibility. But where value investing does this by choosing stable companies in stable environments, value point does this by constructing value-added deals.

Figure 3.5. Mispriced value + added value

And when going global, we discover we have tools that investors in developed economies do not. We are not limited to either being passive investors or adding value long term through active management. We can surgically add capabilities and other types of value at the time of investment. Capability migration, political partnerships, weak management environments, and many other uniquely global situations give us a lot of tools with which to do this. Most of the rest of this book is about deal structures that achieve this. But all deals follow Graham’s Method:

1. Postulate a price-to-value thesis for a specific company.
2. Eliminate the uncertainty.
3. Quantify the risk.
4. Invest surgically.

In terms of quantifying risk and for those who think better with equations (yes, I am one of those who tried to adapt quantum mechanics to investing—it doesn’t work but it’s great fun), the standard value investing calculation is as follows:

(1 / risk_VI) ≈ margin of safety = IV_t=0 – δ_1- – MP_t=0

where MP is market price and delta(1) is the downside uncertainty in the intrinsic value at time zero. Note that per the earlier discussion, I am including only the downside uncertainty of the intrinsic value. Investors often require that:

margin of safety > 30%

and we assume/hope that:

IV_t=0 – δ_1- < IV_t=LT

For value point, the calculation is similar:

(1 / risk_VP) ≈ margin of safety = (IV_t=0 – δ_1-) + (AV_t=NT – δ_2-) – NP_t=0

where NP is the negotiated price and AV is added value in the near term. And I am including the downside uncertainties for both the intrinsic value and the added value.

The key uncertainties are the minimum values of the intrinsic value and the added value (again, we are proving what it is not). However, bracketing the final terms shows an important difference with value investing.

margin of safety = (IV_t=0 – δ_1-) + [(AV_t=NT – δ_2-) – NP_t=0]

In value point, the investor’s key skill is crafting an investment that maximizes the added value and pushes down the negotiated price (the bracketed term in the equation). Compare this to value investors who typically spend their time trying to calculate the intrinsic value with the greatest accuracy (the first term in the equation). Value point investors are both investors and deal-makers. We calculate the intrinsic value, and we structure deals that drop the negotiated price, maximize the added value, and eliminate the long-term downside uncertainty.

Putting it all together, we have a clear price-to-market thesis, we can eliminate the uncertainties, and we can quantify the risk. And the approach is very surgical (see Figure 3.6). We make our money at the time of the investment and avoid any long-term operating or management requirements. It is more hands-on than typical value investing but is still surgical investing.

Figure 3.6. Value point versus value investing versus private equity

B2B: Back to the Balance Sheet

Value-added investing, particularly within unstable markets, depends heavily on balance sheet analysis

Graham wrote about the transition he witnessed during his career from a focus on the balance sheet to an increased focus on the income statement—particularly future earnings. This transition followed from both changes in the interests of the investment community and from changes in the American economy. During this period, the American economy transitioned from a heavy reliance on industries with extensive fixed assets (railroads, factories, natural resources) to more service-type industries. It also entered a period of much more stablity and with somewhat predictable growth.

“Going global” for many means rediscovering this earlier period of the U.S. economy, focusing on fixed-asset type businesses (manufacturing in China, natural resources in Africa), and returning to the balance sheet. And it’s fairly obvious that if you are looking at environments with greater uncertainty and instability, relying heavily on earnings power values or discounted future cash flows becomes problematic. Additionally, “adding value” often means changing the assets and the asset value in the short term (and hopefully the earnings power value in the near term). So in terms of understanding an enterprise, the starting point is most often the changes in the balance sheet over time and the balance sheet’s relationship to the income statement.

My intention is not to reiterate ideas that are well known and well presented elsewhere (and balance sheet analysis fits in that category). So I’ll note just a few things in passing on the increased importance of balance sheet analysis when “going global.”

Point #1: The Relationship Between Assets and Earnings Is a More Stable Starting Point

In traditional value approaches, this is a good check on reported earnings per share (and management performance) and enables you to discern the real relationship between resources and earnings. But in value-added deal-making, this relationship becomes the key to deal structures. Tangible assets, intangible assets, and replacement value (sometimes liquidation value, but rarely) are the primary initial targets in the analysis.

The instability in both the intrinsic value and the environment are the key problems. So forward projections of earnings aren’t particularly useful. The balance sheet will give you a more stable assessment in the near term.

Point #2: The Relationship Between the Asset Value and Earnings Power Value Over Time Is Critical

When people talk about “developing economies,” they are usually referring to geographies where assets are being deployed at a fairly rapid rate—a more accurate term would be “developing assets economies.” Buildings, factories, and infrastructure are being thrown up, often at astonishing speeds. Intangible assets (such as brands, franchises, and licenses) are similarly being created and deployed. If markets are described as “emerging,” economies are “developing assets.” And when a mismatch occurs in the market emergence versus asset development rates, the results can be interesting. In 2007, Dubai was clogged with traffic as the market surged ahead of the infrastructure. In 2009, Dubai was a ghost town as the market pulled back and the assets remained.

Given the predominance of asset development, the current replacement value of an enterprise is one of the most measurable and meaningful values in most environments. The market and the competition may be changing rapidly, but we can know a particular company’s position in the industry based on its existing intangible and tangible assets. And we know what it would cost for a competitor to build the same asset base, even in a rapidly changing situation. The balance sheet and the current replacement value of an enterprise are usually fairly solid starting points for changing environments.

Per standard security analysis, we can tell a lot about a company by the relationship between its asset value and its earning power value. Columbia Business School professor and “guru to Wall Street gurus” Bruce Greenwald describes three basic cases:

• AV > EPV normally implies ineffective management or some other problem that has the company producing lower earnings than such an asset base should. Typically this means that an investor needs to think about a catalyst or a management change.

However, in developing economies this is a much more common and important case, because we can have an outsized impact on the effectiveness of management. As will be discussed, the migration of management ability around the world is an important trend and something a deal-maker can use in a deal. In many of these cases, by bringing foreign management to a management-weak situation, we can rapidly pull the EPV up to the AV. Changes in management can be a fairly powerful way to surgically add value in these AV > EPV cases.

• AV = EPV is the most common case, indicating that reasonable management is in place and is driving for continual operating and asset improvements without any significant protection from competition. It’s pretty common and a pretty tough way to make a living.

But as will be shown, this is actually a fairly attractive place to do value-added deals. If we can significantly increase the asset value of an enterprise at the time of investment (say, by bringing in capabilities or other assets to increase replacement value), the earnings power value should naturally follow over time, assuming no degradation in management ability.

• AV < EPV usually is evidence of a franchise or some other type of significant barrier to entry. In developed economies, this tends to be the most attractive target for value investors (everyone looks for a sustainable competitive advantage, but they are much rarer than people think). In developing environments, the other two cases can often be as attractive.

Looking at the relationship between earnings power value and replacement value over time is important. Having an impact on the replacement value is an important strategy, and how this affects earnings power value or discounted cash flow over time is critical. Looking at the current time, near term, and long term, there are actually nine cases to consider, six of which can be attractive opportunities. Note that these six cases graphically create an arrowhead or “point,” as shown in Figure 3.7—hence the term value point.

Figure 3.7. Six attractive EPV versus AV cases over time

Point #3: “Added Value” Often Shows Up on the Balance Sheet in the Near Term and on the Income Statement in the Long Term

If we improve a company’s management in Case 3 of Figure 3.7 (EPV < AV at time 0), we can move it rapidly to Case 5 (EPV = AV in the near term). If we add significant value to a company’s balance sheet in Case 1 or 2 (EPV > AV or EPV = AV at time 0), this should lead to an increase in the EPV (Case 4 or 5). If we add capabilities such as unique brands or technology to a company in Case 2 (EPV = AV at time 0), we can sometimes create a competitive advantage result in Case 4 or 5 (EPV > AV in the near or long term).

Types of added value vary by industry and company but generally can be placed into five categories:

• Tangible assets such as buildings and factories

• Intangible assets such as goodwill, trade names, and patents

• Earnings such as additional businesses with existing profits

• Management

• Value perceived by the seller or partner (reputation, political access)

Point #4: The Balance Sheet Sits at the Intersection of Competition, Management, Earnings, Assets, and Capabilities

This book began with a mild rant about how global investing is frequently viewed as Western investing with lots of additional problems. However, with the right worldview, you can see that global investing offers a host of advantages that developed markets do not have. Competition, assets, earnings, management, and capabilities all interact within changing environments (see Figure 3.8). This creates endless opportunities for value-added deal-making. And at the center is the most stable point in this interaction—the balance sheet.

Figure 3.8. The intersection of competition, assets, management, earnings, and capabilities

Putting It All Together

Value point is a value strategy for a colliding, multipolar world

I stated that value point is about asking three questions and getting four answers:

1. Is it a good, potentially great, or great company?
2. Is it cheap? (Is there a market inefficiency?)
3. Is the margin of safety capturable and sustainable?

If the answer to all three is yes, we consider the company attractive, and we can purchase with a healthy margin of safety. The downside has been eliminated/minimized and the upside maximized. Time becomes our ally in the capture of the company’s economic value.

Looking again at the summary chart, a lot of the details should now make more sense (see Figure 3.9).

Figure 3.9. Value point: the search for opportunity to add value

Note on the left of the chart that the market inefficiencies we are targeting include both those we are familiar with in developed economies (change in value, investor bias, crazy Mr. Market) and new ones more characteristic of developing markets and cross-border situations. But the principle is the same: Get it cheap.

Note also Question 3 in the middle, which brings in all the deal-making and adding value aspects of the approach. We need to structure deals to truly capture the margin of safety, both now and in the long term. And that means adding value with various tools, which I call value keys. Also note that with this value-added approach, the number of companies and situations (the six presented EPV versus AV cases), we can target increases dramatically. Adding value in Question 3 increases the number of companies in Question 1.

On the right side, you see the end result of a smart value investment or deal. A good or great company has been purchased at a cheap price. The better the company and the cheaper the price, generally the better the investment.

Value investing’s “search for value” is actually a subset of this broader approach, which makes sense (see Figure 3.10). As we expand to more types of landscapes, we are also expanding our value methodology and adding some tools to the tool kit. In practice, they are often used in combination. We do both standard acquisitions and value-added deal-making. We search for both value and the opportunity to add value. We target both the standard market inefficiencies and a list of new ones. If you look at articles about Prince Waleed, you will see he is often referred to as either the “Arabian Warren Buffett” (implying traditional value investing) or the “Prince of Deals.” Many don’t recognize that it is really one coherent value strategy.

Figure 3.10. Negotiated deal-making’s impact on the value approach

Hunting for deals and investments with the objective of adding value has several other important effects. As shown in Figure 3.10, it can do the following:

1. Increase access to deals. As mentioned, private companies tend to be particularly tightly held in developing markets. You almost always need to bring more to the table than just capital. A strong value-add can open the door to investments.
2. Decrease the negotiated price. Depending on the investment, a strong value-add such as a Starbucks brand, political connections, or a highly reputable investment name can enable you to decrease the negotiated price. This is particularly true of deals with multiple parts.
3. Increase the intrinsic value of the asset or company. As discussed, this can be very large in smaller companies, although I have also seen investors turn $400 million investments into $800 million at the time of purchase.
4. Create an advantage when competing for deals. If there are multiple bidders at the table, a value-add almost always beats no value-add.
5. Create a long-term partnership with the company (strengthen your claim to the enterprise). A strong value-add creates a true partnership between the company and the investor, and you are less dependent on contracts, board seats, or proper governance to protect your interests.
6. Eliminate the future downside uncertainty (stabilize the margin of safety). As discussed, deal structuring plus a margin of safety is the best approach to eliminating the long-term downside uncertainty. This is also achieved by creating a long-term partnership with the company.
7. Eliminate some nonmarket risks (defensibility). In many particularly difficult environments, nonmarket forces such as regulators and state-backed competitors can be significant threats. Defensibility will be discussed later, but value-add is a big part of this.

Adding value also enables value-focused investors to target many situations in the relationship between earnings and assets/resources, as shown in Figure 3.11.

Figure 3.11. Multiple situations can be targeted

This approach solves most of the problems and limitations previously outlined: limited access to investments; uncertainty in current intrinsic value; long-term uncertainty, including worries about instability; the availability of only weak or impractical claims against the target enterprise; and foreigner disadvantages (see Figures 3.12 and 3.13). It solves value investing’s upper atmosphere problem.

Figure 3.12. From Buffett to Waleed: From the search for value to the search for the opportunity to add value

Figure 3.13. Value investing versus value point economics

Value Keys

Value keys are the building blocks of value point

Searching for value in practice is mostly about estimating an external and independent variable (intrinsic value). However, searching for the opportunity to add value in practice muddies this. You mix objective and perceived factors as well as independent and dependent ones. What is the company’s value? How do you add value so that the downside uncertainty is removed and the margin of safety is stabilized? How do you add value so that the company or owner gives you access to the investment—and so that you create a strong, long-term partnership? The quantitative and qualitative factors that are involved can sometimes be independent of the observer and other times are dependent.

Therefore, we break “added value” into smaller component parts. I call them value keys because they both open the door to the investment and add value. The five main keys are political access, reputable capital, foreign capabilities, local capabilities, and management. Some of them are purely quantitative and independent of the observer, and others are more qualitative and perceptional. Adding value to an investment or deal becomes a matter of assembling the right combination of value keys, as shown in Figure 3.14.

Figure 3.14. Value keys can both open the door and add value to investments

Subsequent chapters will detail the uses of various combinations of value keys in deals; the following is just a summary.

Political access is the value key that requires the largest break with a Western “unipolar” worldview. Active government involvement in both markets and companies is common in many parts of the world. Dealing with the government is the norm, not the exception. And it should not be perceived as a risk or problem, but as an opportunity.

Reputable capital is about the value of an investor’s reputation in specific types of deals. Clearly in the West, reputation matters for investors. If you have to sell, Warren Buffett is everyone’s buyer of choice. However, in a colliding world, reputation can have a much more powerful effect. Not only does it often gain you preferential access to investments, but it can also overcome inefficiencies in the capital markets, regulatory grayness, weak rule of law, and many of the other problems discussed. A partner with a strong reputation can be seen as the solution to all these problems. Deals between Africa and the Middle East are often done only if a reputable, trusted partner is involved.

The next two value keys are capability keys. Bringing a Four Seasons management contract to a hotel in Egypt adds value by adding capabilities—the brand, the operating system, the increased access to foreign customers, and so on.

We separate the capability keys into foreign and local types. The hotel’s improved operating system is, by and large, a local capability. It is something you bring into Egypt and build there. The brand and access to foreign customers is a foreign key. If the deal is dissolved, the Four Seasons name and its reservations system (the foreign key) disappear. But likely the improved operating system (the local key) stays. One resides locally and the other at a distance. This difference between foreign and local capability keys becomes important in environments such as China and Russia.

The final value key is management, which could be considered a capability key. Private equity firms have long focused on adding value to an investment over time through their operational and management expertise, sometimes referred to as “solution capital.” However, in developing economies, the impact of management can be much greater and faster, particularly in parts of the world with very limited professional management.

As a simple check, note that Figures 3.15 and 3.16 show that value point reduces to both traditional value investing and common private equity structures (absent the debt plays). Value investing can be seen as the use of some reputable capital and some management—particularly capital allocation, but very little. Private equity of the leveraged buyout (LBO) type can be seen as the use of some reputable capital and, some might say, political access. Private equity of the management-intensive type, such as Cerberus, is the use of reputable capital and long-term management.

Figure 3.15. Value investing: the search for value

Figure 3.16. Private equity: buy-to-sell

The More Things Change...

Value point is an expansion of the value investing methodology

If traditional value investing is mostly about searching for opportunities in a fairly efficient market, value point is mostly about getting access to opportunities in overwhelmingly inefficient markets and then coming up with clever ways to eliminate the uncertainties. Our problems, as detailed, are mostly access, uncertainty, control, and foreigner disadvantages. Inefficiencies can be found virtually everywhere.

A broader value tool kit can capture a wider spectrum of inefficiencies and reach both unrecognized and inaccessible value. As you would expect, many of the familiar value investing terms and concepts are similarly expanded in this approach:

• The bipolar Mr. Market is joined by his giant cousin, Mr. Government. With the mixing of commercial and government activities in many markets, Mr. Market’s chaotic pricing is also impacted by Mr. Government. And Mr. Government has the additional ability to impact intrinsic value.

• To the margin of safety, defined as the difference between the market price and intrinsic value, we add another term—added value. How “cheap” a company is can depend heavily on this other term.

• The focus on competitive advantage (hopefully sustainable) in value investing is joined by a focus on defensibility. A competitive advantage is your profit’s protection from competitors, your moat around the castle. But in many environments, your profits face threats from more than just competitors. Partners, employees, customers, government regulators, and state-backed competitors can all be direct threats to your profits. Defensibility can be as important as competitive advantage.

• Instead of searching for value by screening lots of investments, you search for the opportunity to add value mostly by networking. This means spending more time traveling and meeting people and less time reading annual reports.

• Instead of positioning yourself in the market as the buyer of choice for investments, you focus on becoming the partner of choice or the value-added partner of choice. You are the person everyone approaches when entering a geography or expanding their capabilities in an industry. You bring more to the table than just capital.

...the More They Stay the Same

Value investing’s core principles are good advice everywhere

I have found that when operating in more developing-type environments, a lot of the quieter principles of value investing become more pronounced. Chief among them is the value of reputation. I have briefly discussed reputation as a way to help deals happen. But over many years of doing this, I have found that reputation is, as Buffett has always said, your most valuable asset. And when you are operating in the global Wild West, this becomes even more true. Absent the rule of law, clear contracts, regulations, and such, reputation is everything.

I have hardwired this into the center of the presented strategy. Searching for the opportunity to add value means that you are always striving to become a more valuable and reputable partner. By the very definition of the investment thesis, we invest only when we bring value to the project and to our partners. Reputation and a strict adherence to principles-based capitalism is central to the strategy.

Some of the other value investing principles that I keep at the front of my brain as I hunt for investments around the world are:

• An investor’s wealth is still created by capturing and growing economic value per share. Wealth follows from economic value, not speculation. Fortunately, a colliding world can be described as a time of historic growth in economic value.

• 80% of value investing still involves picking the right strategy and the right location to hunt for investments. The remaining 20% is waiting for the right pitch to swing at.

• Always choose your own area, do your own research, and find your own opportunities.

• Avoid crowds. Whether value investors are contrarian by personality or strategy is a matter of debate, but I do tend to quickly move to more remote areas as soon as crowds show up.

• Focus on good to great returns on a relatively small number of investments.

This last point is why it is so easy to be excited these days. You ultimately need to find only 20 to 30 really good investments in an investment world that just got a lot larger and a lot more inefficient. These are easy times for value investors.