2. Rethinking Value in a Global Age

The world’s tallest building is now in Dubai, its largest phone company is in China, and its richest person is in Mexico. The twenty-first century—the first global century—has arrived much faster than anticipated and in a fairly stunning fashion. And it has caught many smart investors flat-footed. Confident, experienced investors and deal-makers have found themselves on rapidly changing and increasingly unfamiliar terrain. Did Macau really surpass Las Vegas in revenues in just five years? Is Volkswagen really selling more cars in the BRIC countries (Brazil, Russia, India, and China) than in the United States? Have a million Chinese really moved to Africa to develop natural resources? The new global investment landscape is thrilling but, for many, increasingly uncomfortable.

Within this general chaos are real challenges for the traditional value methodology. In the previous chapter, I described the typical problems and concerns of Western-based value investors looking at global investments. Most of these “going global” problems can be classified as one of five types:

• Limited access to investments

• Increased uncertainty in the current intrinsic value

• Increased long-term uncertainty, including worries about instability

• The availability of only weak or impractical claims against the target enterprise

• Foreigner disadvantages

I also asserted that none of these problems is getting smaller. They are in fact inherent characteristics of many rising economic systems—and, therefore, of a colliding global world, which Mohamed El-Erian called “the new destination.”

Ben Graham’s core concept of intrinsic value is the anchor for understanding and investing in this new destination. It offers the one stable point in a sea of changing actors and dynamics. In the last century, Graham’s value concept and methodology made a confusing Western investment world understandable. It is also the key to understanding the next century.

Having come to the end of almost ten years of investing between the developed and developing markets, I have found myself repeatedly returning to Graham’s writings. It is impressive to see how easily his concepts can be reapplied to very different politico-economic environments. At the same time, I am an avid student of the global investment deals of the last 10 to 15 years, and I was fortunate enough to have worked for one of the leading practitioners. The presented investment strategies were built theoretically from Graham on one side and reverse-engineered from practitioners on the other. The point in the middle where these two approaches meet and, thankfully, agree is the investment strategy presented in this book, value point.

Essentially, value point asks three questions about potential investments and generates 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, the investment has all the characteristics we hope to see with a value approach. We consider the company attractive. We can purchase at a good price and secure a healthy margin of safety. The resulting four answers are as follows:

1. A margin of safety is captured.
2. The investment downside is minimized.
3. The potential upside is maintained.
4. The investment is made surgically, and returns are effectively captured at the time of investment.

Overall, the investor captures significant value at the time of investment and can benefit from the growth of the company’s economic value over time. You win big over time by not losing.

These questions on the surface are almost identical to those posed by traditional value investors in developed economies when considering a public or private company, except for Question 3, which is usually just assumed. But as you move to different environments, additional factors are introduced, so the details of how you answer these questions become more complicated, as shown in Figure 2.1.

Figure 2.1. Value point: the search for the opportunity to add value

The main difference is an expansion of the traditional search for value philosophy to a search for the opportunity to add value. Buying a $10 million company for $5 million is good. Buying it for $5 million and increasing its value to $12 million at the same time is better. Instead of just pushing down the price relative to the intrinsic value, the margin of safety can also be expanded upward by surgically adding value at the time of investment. This has several other important effects, which will be discussed. But the goal is to capture and stabilize the current and future margin of safety with structured deal-making. In short, we are combining value investing with active deal-making.

In many ways, this is a classic value approach for coping with increased uncertainty or instability in an investment or environment. You compensate for uncertainty by expanding the margin of safety.

However, this is also a departure from and a rejection of the classic global value approach. In that approach, you compensate for additional perceived risks (currency fluctuations, governance problems, limited reporting, increased instability) by limiting your investments to those that are identified as having an exceptional margin of safety. The problem with demanding an exceptional margin of safety is that it is impractical. Too few investments reach this level of extreme precaution, and it is in many ways a denial of the fundamental characteristics of many increasingly important economic systems.

And as will be shown, a “search for the opportunity to add value” approach effectively solves the five primary going-global problems listed at the beginning of this chapter. You increase access. You eliminate uncertainty in both the current and future intrinsic values. You strengthen your claims to the enterprise, and you overcome the foreigner disadvantages. However, it is important to stress that the primary objective of adding value is to reduce the longer-term downside uncertainty (and “stabilize” the margin of safety). The big payoff is to be able to hold to a longer-term value approach in unstable and uncertain environments, which enables you to capture the growth in economic value of the enterprise.

This, hopefully, makes somewhat intuitive sense. As you leave the developed democracies, you start to lose stability, information accuracy, governance relationships, minority shareholder rights, and many other things. But you also start to gain an ability to significantly impact the value of companies that, like their economies, are rapidly developing. Both of these factors push you into a closer and more hands-on deal-making posture with the investment. If successful, you can take a rising sea of new companies with exceptionally large market inefficiencies and transform them into capturable value opportunities.

This chapter presents two important prerequisites for this approach. The first is a value-based worldview—a way to see global markets through the lens of a value investor and deal-maker. The second is a recasting of Graham’s value concepts within this worldview. This lays the groundwork for the next chapter, which details the investment strategy.

A Value-Based Worldview

The Microfundamentalists Strike Back

A value worldview bears little resemblance to most of the globalization talk

“Globalization” as a subject (particularly for books) has long been the realm of economists, macro-traders, policy wonks, and portfolio managers. Their language is that of interest rates, government policy, capital flows, gross domestic product (GDP), and employment rates.

We value-focused microfundamentalists find little utility in this approach. Our language is that of management, customers, competitive advantage, intrinsic value, margin of safety, economic goodwill, and return on invested capital (ROIC). In a large and growing investment world, our favorite approach is to go very small. We do real estate investments in China, develop hospitals in India, and structure cross-border mergers and acquisitions (M&A) deals between the U.S. and the Middle East. And the only “globalization” theories we espouse are a sort of hazy aggregate of all this bottom-up fundamental analysis. My own experience has been that after a decade on the ground on three continents and in more than 15 industries, a fuzzy but consistent macro picture does emerge from lots of time spent at the micro level.

What we value-focused investors do see is a world that is full of new companies that are wildly mispriced. It is a place in which rising economies and colliding systems are creating huge gaps between price and value. For us, the global investment world looks like one big value opportunity.

The key question is how to capture it. The strategy presented is based on combining fundamental security analysis with uncertainty analysis and deal-making. The first has long been the domain and primary language of value investors. The second is the key to transporting fundamental analysis out of relatively stable developed economies and into more uncertain and unstable terrains. The third lets you remove the long-term uncertainty. The melding of uncertainty analysis and deal-making lets you do long-term fundamental investing in uncertain places.

Unsurprisingly, the value worldview conflicts with most of the current globalization talk. The world is flat. Its financial system is precarious. Foreign policy power and regional stability follow from wealth and trade relationships. If it’s not a direct conflict, it’s a situation of talking past each other. I can’t see how the world is flat in any meaningful way, and I generally don’t care what the trade policies or World Trade Organization (WTO) commitments are. I also find economic or multivariable macro analysis not particularly usable at the company and asset level. Globalization theorists and macroeconomists tend to be top-down analysts. We are bottom-up analysts. Or bottom and “we don’t really care about up” analysts. But value investors and economists disagreeing is nothing new. Twentieth-century value investors had the Efficient Market Theory promoters to butt heads with. Global value investors have the globalization theorists to contend with.

In this vein, I thought it appropriate to make a clear declaration of fundamentalist principles at the start. I am presenting a worldview and investment strategy based on fundamental value that is staunchly micro. And I will probably not resist the urge to fire some gratuitous broadsides at the globalization crowd as I pass by.

The Unsexy Reality of Globalization

The global investment world is overwhelmingly local

I proffer the very exciting worldview that globalization is nothing new. It’s fascinating, intellectually challenging, and very profitable. But it doesn’t appear to be anything really new in terms of investing. The number of sizeable markets and economies is certainly increasing. The markets and economies of the U.S., Europe, and Japan have already been joined by established emerging markets such as China, India, Brazil, Russia, and the Gulf Cooperation Council (GCC). For investors, this means a lot more companies and assets to buy. And certainly some of these economic systems are fundamentally different from the developed Western economies. China and Russia, in particular, are completely different animals. But investment is still mostly about profits, and profits are still mostly about competition in local markets.

I assert that the global investment world is multipolar, colliding, and overwhelmingly local.

Let me immediately backtrack this big assertion with a big qualifier. I am terrible at economics, which implies that I am an order of magnitude worse at global economics. I am a mathematician and physicist by training, and I can pretty confidently model the radiation scatter from an electron-positron collider (a nano-fundamentalist). I can also tell you the laser penetration rates needed to remove tattoos from LA gang members and the biophysics of Swedish fighter pilots in high-speed turns. (Because Sweden has been officially neutral for almost 200 years, flying around Sweden as a fighter pilot is about the most fun you can have in a career.)

But I have no real idea what the GDP of Argentina will be in a few years. I have no idea why foreign exchange rates move the way they do. I am strictly micro and would go nano if I could. So the presented worldview (multipolar, colliding, and local) is mostly descriptive and limited to factors relevant to direct investing. It has about the same analytical rigor as cloud naming. (“That cloud looks like a castle, that one a bunny.”)

The World Is Multipolar

The investment world has seen an increase in both the number of sizeable markets and the types of economic systems. If the last century was Western and unipolar, this century is global and multipolar. I have given various examples, but it’s really just cloud naming and hopefully is self-evident. China and Russia are alternative economic models with little in common with the U.S. or UK. And despite being called developing economies, most are not developing toward the developed economies. They are something new and different. State-managed (and mismanaged) economies in Asia, Africa, and the Middle East come in various shades, just as Western capitalism varies between historically free-market America and more tightly regulated France and Germany. Brazil and India are also different entities, offering an almost nineteenth-century version of large population, low income, international capitalism. And the majority of the other countries that are often grouped illogically but conveniently into the “emerging markets” bucket show significant variation as well.

But overall, many more types of investment landscapes exist today, and avoiding them is getting harder and harder for Western investors. The world is multipolar.

The World Is Colliding

Mohamed El-Erian’s book When Markets Collide describes the collision of these fundamentally different types of systems—the increasing interactions of a multipolar world. That book was written mostly at the macroeconomic and policy level, whereas I am viewing the same topic at the company and asset level. If When Markets Collide is at 30,000 feet, this book is in the trenches. But the conclusion is the same. The collision is dramatic and increasingly intense—although it is debatable at what level the collision is more interesting to watch. I get to see it in the unusual interactions between companies, investors, and partners from around the world. But people at the macro level get to watch the interconnected financial system and all its precarious chaos.

A quick scan of the Wall Street Journal or Financial Times on any given day shows the collision at the company level. United Arab Emirates (UAE) investors buy UK soccer teams. Indian industrial companies buy European steel makers. Chinese state-owned enterprises try (mostly unsuccessfully) to acquire U.S. assets. Besides producing frequent headlines, the increasing collision of companies, markets, and investors is creating interesting investment dynamics. The multipolar world is colliding.

Again, I am simply stating these first two observations without much support. (“That cloud looks like an elephant.”)

The World Is Local

The key difference in how microfundamentalists (particularly fundamentalist microfundamentalists) view global investing is the primacy of competition and competitive advantage. Profits and investment returns are overwhelmingly a function of competition, and this drives most market participants’ activity and behavior. Most of the activity that can be seen on the ground in Mumbai, Shanghai, and Dubai is about competitive dynamics. So I am far more interested in how local real estate companies in India compete with foreign entrants than with what the trade policies are. The fight for customers on the ground in local markets is the sharp end of the investing spear.

This mostly local competitive fight is creating a strong push toward an increasing localization of services, products, and capabilities. To win customers in a local market, you likely need to tailor your products and services to their tastes. If your competitor has achieved local economies of scale in, say, distribution in Bangalore, you need to build the same or risk being pushed out.

If the past decade was mostly about the emergence of a colliding, multipolar world, the next decade will be about the arrival of a multilocal world. Service industries such as banking, healthcare, insurance, and hospitality will all be local. Private clinics in Brazil are not terribly worried about competition from Germany. Even large multinational companies can be viewed as mostly multilocal in practice. Standardized products, such as Coca-Cola, are marketed, bottled, and distributed mostly domestically. Certainly, many industries (cars, manufacturing) have global value chains with different functions in different regions, but markets, customers, and competition tend to be mostly local, and that is the primary concern for direct-value investors.

This raises a conundrum that sits at the center of much of the presented investment strategy. Business and competition are increasingly local. But investing and capital are increasingly global. How do increasingly globally active investors engage with increasingly local businesses?

An important aspect of the competitive dynamics of most developing economies is also worth noting—the impact of foreign capabilities. The coffee shop in Abu Dhabi that first franchised with Starbucks suddenly acquired a significant advantage over its local competitors. The acquisition of Starbucks’ capabilities (brand, operating systems, supply chain, management) quickly manifested itself in the local market share, earnings, growth prospects, intangible and tangible assets, and many other quantitative and qualitative parameters that value-concerned investors look at. The migration of capabilities across borders is a significant aspect of competition and therefore investment returns.

In fact, driving through Abu Dhabi, it is fairly hard to find any business that is not a combination of local operations and foreign capabilities. Competing in the developing economies has a lot to do with assembling best-of-breed combinations of global capabilities (brands, supplies, technology) and deploying them locally. U.S.-based companies usually assume that all their needed capabilities (and customers and capital) can be found domestically. In contrast, Middle Eastern companies, a fairly shallow market in terms of customers, skills, and technology, start virtually every project by looking for new foreign capabilities to bring into the market.

Most often this migration of capabilities between markets is a natural part of the never-ending race for operational efficiencies. Absent a competitive advantage, local companies are continually adding and refining capabilities, assets, and performance to stay competitive and make a moderate profit. Migrating capabilities typically appear first on the balance sheets of local companies (brands, factories) and then are translated over time to the income statement, depending on management ability. It is important to note the degree to which global value investing is about the interaction between competition, capabilities, management, asset value, and earnings power value.

That markets are becoming more local and that capabilities can be advantages should not be surprising. Developing markets are by definition developing. Moneylenders are being replaced by banks. Hutongs are being replaced by modern apartment buildings. Bicycles are being replaced by scooters and scooters by cars. As will be discussed, the migration of developed-market capabilities into rising economies is a big part of the direct investing worldview.

The World Is Uncertain and Unstable—But This Is Somewhat a Matter of Perspective

A final note on an issue that cuts across much of the “going global” discussion. The developed economies feel—and, for the most part, are—relatively stable. The public and private markets are large, have grown fairly predictably for 50 years, have relatively clear regulations, and are subject to only rare political risks. They are also deep and offer frequent mispricing opportunities. When going global, Western-based investors are confronted with much shallower markets that are constantly changing. They are less stable and predictable—and feel even more so. Regulations can change suddenly and dramatically (five years is a very long time in India in terms of new regulations). This decreased “stability” (both real and perceived) will play out repeatedly in strategy discussions, particularly because many value investors tend to think longer-term when stability really matters. However, it should also be noted that investors in the Middle East, Russia, India, and China don’t feel things are unstable. They long ago acquired their sea legs and consider this all very normal.

An increasingly uncertain and unstable world (both real and perceived) raises a core challenge to the value methodology. Value investing has most often been described as a long-term approach, buying and holding relatively stable companies in a stable environment. The focus on sustainable competitive advantage is mainly about targeting companies that have the most stable (protected) profits. Yet, the worldview I have presented is overwhelmingly unstable, or at least uncertain. The markets are developing. The companies are young and growing in real economic value. The competition is constantly shifting. Capabilities are migrating. The regulatory grayness, lack of rule of law, active involvement of the government, and other factors all create additional uncertainties, especially in the long term.

This uncertainty question has always been central to a value approach. In Security Analysis, uncertainty as a topic runs through every chapter. And certainly the 1930s time period in which Ben Graham and David Dodd wrote it was much less stable and more volatile than most of the 70 years that have followed. Graham and Dodd discuss this uncertainty and instability question within the 1930s shift in the American economy from asset-heavy industries such as resources, manufacturing, and transportation to more asset-light service industries.

Uncertainty discussions take up most of this chapter, but I wanted to make a couple of key points early on:

• Because global investing is rife with a mixture of perceived and real uncertainties and instabilities, separating out the perceived uncertainties is both the first step and an opportunity.

• Dealing with the increase in real uncertainties and instabilities is the central challenge, particularly with a long-term approach. Warren Buffett has said that he puts companies into one of three buckets: “good,” “bad,” or “too hard.” But “too hard” can be a mix of real complexity, the limitations of your strategy, and investor perception. This investment strategy is mostly focused on putting back into play many of the companies that are frequently placed in the “too hard” category.

On a purely gratuitous side note, this perceived lack of stability also makes the global investing landscape largely free of what some would call questionable Western investment thought. There is not much talk about efficient markets or random walks in India. Nobody assumes Gaussian distributions in China.

The Inefficient Century

The global landscape is brimming with companies that are wildly mispriced

In 2002–2003, Warren Buffett purchased $488 million worth of Petro-China. Within five years he sold this stake for $4 billion, an eight-fold increase. In 2008, he purchased 9.89% of Shenzhen-based battery maker BYD for $230 million. Less than 24 months later, that investment had increased six-fold to $1.45 billion. When was the last time value investors made these types of returns? Not only are the returns in the six to eight times range, but this is also for some of China’s largest companies. The number of mispriced companies increases dramatically as one moves to medium and smaller-sized companies.

The takeaway is that we are witnessing massive gaps between price and value in many of the world’s new markets. The first global century may turn out to be the most inefficient.

Going global is still mostly about getting a cheap price. A $10 million company trading at $5 million is a 100% return, but if it’s trading near $1 million, the returns jump to 900% to 1,000%. Value investors’ number-one objective is to find such market inefficiencies—gaps between intrinsic value and market price—and the bigger they are, the better.

Cheap prices can result from a range of factors such as a real change in value, a change in company size, investor neglect and other biases, an economic downturn, management problems, or just crazy Mr. Market. But as you leave the developed economies and move to a larger, multipolar, colliding, and less stable playing field, all these inefficiencies get larger.

This is great news for investors. A host of new markets contain not only a sea of new companies but also much greater inefficiencies.

Three particularly global phenomena can also significantly impact price. They are not market inefficiencies as typically defined but can have the same effect. They are large trends, cross-border inefficiencies, and capability gaps.

Large Trends Swing Price Away from Value

In The Age of Turbulence, Alan Greenspan argued that rapid dislocations in markets and economic systems seem to be increasing in frequency. Financial crises regularly emerge in developing (and now developed) economies and ripple rapidly through the interconnected financial systems. Earthquakes in Ecuador can spike the price of copper, resulting in an increase in Chinese manufacturing costs and causing a rise in prices at Walmart. Far from diversifying risks and stabilizing the system, the connections between the world’s financial systems seem to almost amplify the daily swings and periodic booms and busts.

But these crashing waves on the surface of the global economy can sometimes obscure deeper currents underneath. Within the past ten years, 1 million Chinese have moved into Africa and started over 500 Chinese companies (Mandarin has become the number-two language in many places). This is a result of Chinese manufacturing’s growing demand for natural resources. In a few short years, Indian call centers and IT companies became a standard service for many Fortune 500 companies. This has fueled the rise of large Indian companies such as Infosys and has resulted in the migration of hundreds of thousands of people within India. The opening of Macau’s casino market in 2002 led to a massive influx of Western, Asian, and Chinese businesses into a small territory. And in the GCC, the rising price of oil in the late 2000s led to a development and real estate boom across the region that gave rise to the world’s tallest building.

Such larger and deeper trends appear to be increasing. And they are creating value opportunities.

I am not talking about normal growth. By large trends, I mean large and sudden changes in real economic value (or both companies and environments) that result in a lag between true value and market price. The subsequent growth can also increase returns, but the gap between current value and price is the starting point for the investment. Such trends are often the result of a new connection between two previously separate economies, such as Africa and China in natural resources. Buying office space in Macau in 2005 could have been done with a good margin of safety. The same thing was true of crane leasing in Dubai in 2007.

The key to distinguishing between turbulence on the surface and the deeper economic currents underneath is usually the size of the trend (either positive or negative) versus the size of the local economy. Capturing these large trends is one of the fastest paths to wealth in developing economies and explains many of the large investors emerging from these regions.

Colliding Cultures Are Creating New Biases

Behavioral finance issues seem inherent to colliding economic systems. Joint ventures between Mexican and Russian companies, for example, are rife with psychology. There are lots of biases. There are cultural and language gaps. There is an unfamiliarity with distant geographies and fundamentally different politicoeconomic systems. All this impacts price.

In the U.S., you can similarly see such cross-border inefficiencies when investment committees (of private equity firms, for example) are asked to approve, say, an investment in Bangalore. As experienced as the senior partners are, most have never invested outside the U.S. or Europe and are hesitant to approve large, particularly illiquid investments internationally. This lack of comfort and often strong bias (if the investment is in Africa, for example) show up in the discussion. Compare this to the price a local Indian private equity firm would pay for the same company. Whether it’s private equity partners in the U.S. or business development executives in Moscow involved, cross-border deals are often as much about behavioral finance as business or investment strategy.

For investors, these cross-border inefficiencies are value opportunities. Mexico–China natural resources deals are underserved today, as are Middle East–India infrastructure deals. Large Chinese and GCC investment dollars are struggling to move into Western opportunities, while Western investment dollars are struggling to move into the developing economies. There are opportunities at both the company and capital level.

Gaps in Capabilities Are a Type of Inefficiency

The discussed movement of capabilities into developing economies creates another type of inefficiency. If bringing the Starbucks franchise to a coffee shop business in Abu Dhabi will significantly increase the economic value of that enterprise, I can capture part of that change in value. If it will increase the value from $10 million to $12 million, there is no way I can be told that my buy-in price is $12 million. It’s partly about negotiation, but it’s also a situation with a real gap between price and value. Another way to think about such a capability gap is that it is event-driven investing, but you are creating the event.

The following chapters expand on this by looking at how capabilities are moving between the world’s economic hubs. This is overwhelmingly done by global investors and deal-makers. Someone had to bring Starbucks into Abu Dhabi. Someone struck a deal that put a 7-Eleven on what seems like every street corner in Hong Kong and Singapore. Capability gaps at both the industry and company level are capturable value opportunities.

Rederiving Graham’s Method

Value Investing’s Upper-Atmosphere Problem

Traditional value methodologies are failing to capture the really big opportunities

The power of value as a concept is that it isolates an independent and measurable variable from the general chaos of the market and its participants. The gaps between this variable and the market price (and between reality and perception) are value investors’ primary targets. The presented worldview, with its colliding markets, companies, actors, and biases, is overflowing with these types of gaps. Going global, we are not looking for investments with a 15% internal rate of return (IRR); we are looking for 50%, 75%, 100%, 200%, and so on.

So why, in a period of massive market inefficiencies, are the value experts so hesitant? If the world is littered with dollars selling for 50 cents, why aren’t they rushing about in a frenzy, grabbing them?

I suggest that this mostly Western hesitancy is the result of three factors. The first is an unclear worldview, as just discussed. The terrain is unfamiliar, and seeing the opportunities is half the battle. The second factor is the mentioned paradox of how to invest globally when most businesses are local. The third is that value investing’s most common methodology has limited applicability outside of developed economies. At the edges of developed economies, the standard value approach begins to break down. This is what I call value investing’s “upper-atmosphere problem.”

Per my favorite Richard Feynman trick, I continually translate business and investing problems into physics problems, work through them, and then translate the result back. Feynman was famous for doing this when meeting with professionals in other fields such as biology or anthropology. He would translate their field’s problems into physics, figure them out, and then startle the biologists or anthropologists by giving them the answers. Of course, he wouldn’t tell them how he was doing it, so they thought he was mystically smart.

With this approach, value investing’s limited applicability outside developed economies looks a lot like an upper-atmosphere problem. The Earth’s upper atmosphere is where many of the physical laws start to fall apart. It’s where a lot of our assumptions about life and our sense of the world start to break down (a gap between perception and reality). The world is not actually three-dimensional, as it seems to be when you’re walking around on the ground. The shortest distance between two points is not a straight line. And as accurate as Newtonian mechanics is on the ground (objects falling, pendulums swinging), it starts to give the wrong answer when you reach the upper atmosphere and light and time begin to bend. Even international flights can show small changes in time. Value point is a lot about investing in situations where traditional value investing starts to break down.

But it’s in situations where the established concepts begin to break down that we can learn something new and something old. We find new laws and rules, and we rediscover some of the hidden assumptions we have been relying on. Going to the extremes or to where the models break down is when things get interesting.

Value investing was invented to explain stocks in the American economy. It was a theory put forth to solve a practical problem, and it involves many unstated assumptions. George Soros caught one of them when he noticed that intrinsic value and market price are not always independent. In financial products, particularly with credit, they can form reflexive relationships with positive and negative feedback loops.

Working across the Middle Eastern and Asian markets, and observing their increasing interactions with the U.S. and Europe, I began to notice that lots of the value assumptions were breaking down (see Figure 2.2). Neither the companies nor environments were very stable. Continually involved government actors actively influenced both market value and intrinsic value. Governance and legal structures were often too underdeveloped to invest in a hands-off reader-of-annual-reports sort of way. As you go step by step through the standard value investing methodology, you discover problems and questions at virtually every point.

Figure 2.2. Value investing’s upper-atmosphere problem

Unsurprisingly, prudent investors following this approach have avoided most developing markets. Or they have adopted the posture that global investing is U.S. investing with lots of additional problems. This is a common red flag that your framework is breaking down. The applicability becomes narrower and narrower, and the qualifiers become more and more numerous.

In the sixth edition of Security Analysis, Thomas Russo wrote an introduction for the chapter on global value investing. His introduction, titled “Globetrotting with Graham and Dodd,” lists additional precautions to be aware of when going global. Avoid illiquid assets. Beware of high trading costs and currency risks. Note that disclosure is less transparent. That management practices are problematic. That capital movement is restricted. And that there are language, cultural, and political stability problems. The net conclusion is that extra protection is required when going global. The margin of safety must be much larger.

Value investing’s upper-atmosphere problem manifests itself as a posture of extreme precaution. This is impractical for most investors, particularly those who lack Mr. Russo’s ability and specialization. And beyond this, it results in investors avoiding the areas that have the largest market inefficiencies and offer some of the greatest opportunities for wealth creation.

I am arguing for an abandonment of this contorted stretching out from comfortable methodologies—and for a de novo targeting of the largest opportunities. In my experience, the largest value opportunities in a colliding world are in exactly the areas that this extreme prudence avoids: in the long-term growth in per-share economic value of mostly private companies. I am trying to go private and illiquid. I am trying to go long-term. And I am trying to go deep into the hunting grounds that everyone else avoids.

First, Eliminate Uncertainty

Graham’s most important lesson is his treatment of uncertainty

Many of the key principles of Graham’s Method are ironically unstated in his books. He talks about Mr. Market, intrinsic value, margin of safety, and circle of competence, but these are conclusions and a usable methodology. He states the end equation without showing the actual derivation. This is a shame, because I think some of his most impressive insights are in how he got there.

Given that the method is somewhat unstated, I am taking some large liberties and inferring it. Please cut me a lot of slack in this exercise if you can.

I think Graham had three steps in his derivation of value investing, as shown in Figure 2.3.

Figure 2.3. Derivation of value investing

In the first part, Graham postulated a series of “physical laws” for certain types of companies, which I will refer to as Graham’s Laws. Similar to Newton’s Law of Gravity, Graham’s Laws serve as a theory to explain how the world works outside and independent of any observers. And similar to the physical laws of the sciences, his laws, by virtue of being independent, can be tested with measurable data.

Graham’s Laws

1. Certain types of companies have an intrinsic value that is independent of the market.
2. The market price returns to this intrinsic value in the long term.
3. Intrinsic value is relatively stable in some types of companies.

This is a very simplistic summary and is just for discussion purposes. The point is that these physical laws for the investment world turn out to be true for a fairly large number of companies. There are many additional qualifiers related to the company’s size, the degree to which the company is followed by the investment community, the actions of management, and so on, but I believe this is a fair summary of one of Graham’s most common approaches. It can be represented graphically over time as shown in Figure 2.4.

Figure 2.4. Graham’s Laws

In the second part, Graham adopted an investing method that I call Graham’s Method (see Figure 2.5). It is analogous to the scientific method and sets out a systematic process for investing. If it works, you make money—and if it fails, you gain valuable feedback on the accuracy of Graham’s Laws. It is as much about organizing your thinking and putting in a process for systematic measurement and evaluation as it is about stating any inherent truth about the investing world.

Figure 2.5. Graham’s Method

Here are the key steps in Graham’s Method, which are complete speculation on my part:

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

Graham’s Method starts with postulating a relationship between the price and value of a specific company. If the company’s value is $10 million but the market price is $5 million, it is likely the type of company that fits Graham’s Laws. This is how many investors generally see value investing. It is intrinsic value and Mr. Market. But I think the next three steps are the really clever insights.

Step 2 is the elimination of uncertainty. Any theory about how the world works (such as Graham’s or Newton’s Laws) requires prediction and direct measurement. For Graham, this means measuring companies’ intrinsic value relative to price. But because intrinsic value cannot be measured directly, other factors are measured, and intrinsic value is then calculated. And doing this while eliminating uncertainty is most of the challenge.

This is one of those areas where coming from a physics background is a bit of an advantage. Physicists are used to spending 10% of the time calculating the answer and 90% calculating the uncertainty in the answer (which is always much harder). It’s not really how fast the rocket flies but under what conditions it blows up that concerns you. It’s also why so many of us detest Excel, which seems designed to do calculations without any consideration of uncertainties. There is an additional advantage if you did your training before computers took over, and you were forced to derive things empirically and without resorting to quantitative solutions.

Uncertainty runs through virtually every section of Security Analysis, but it lacks a coherent framework or clear language. Rather, it is discussed as a long list of fairly ambiguous terms such as “range of approximate value,” “indistinctness,” “adequate,” “thorough analysis,” “safety of principal,” and “satisfactory return.” There is almost a tangible struggle by Graham and Dodd over how to discuss uncertainty. This can especially be seen in the discussion about the inherent disconnect between intrinsic value and true value (which physicists would describe as definitional uncertainty). Based on what appear to be mostly uncertainty concerns, Graham is clearly at odds with the increasing reliance of the investor community on only future income to determine value, instead of using past and current balance sheets and income statements. Even the margin of safety concept itself is, at its core, a tool for dealing with uncertainty, although it is vaguely described as “a dependable conclusion for the relationship between price and value.” Uncertainty analysis runs through the center of Graham’s work, but in a somewhat vague way.

It is worth quickly noting the standard types of uncertainties. This exercise is tedious, but understanding the differences becomes important when we move to developing economies, where the uncertainties start exploding in every direction.

• Definitional uncertainty. The concept does not have an exact meaning, like height or weight. A president’s favorability rating has definitional uncertainty because it is not exactly clear what favorable means. Intangible assets similarly have significant definitional uncertainty. And intrinsic value has big definitional uncertainties.

• Measurement process error. Random errors always occur in the measurement process. If you measure your weight on a scale multiple times, you will get multiple results. Similarly, measuring the resale or liquidation value of a fixed asset introduces significant measurement process error.

• Variance in events. Counting the number of babies born each day in a hospital will get you different daily results. Although the definition is certain and the measurement process is accurate, the measured event is continually changing. Similarly, assessing a company’s cash balance can have significant variance depending on the company and on what days you check.

• Reading scale uncertainty. A digital clock can tell you the time only to the minute. So a reading of “6:55 p.m.” is actually a reading of “6:55.00 p.m. to 6:55.59 p.m.”

• Systematic error. Repeated measurements and frequent calibrations are needed to make sure that there are no systematic errors. Scientists routinely check to make certain that their scales are balanced. Financiers, not so much.

To go from direct measurements with various uncertainties, such as cash balance, assets, and revenue, to a calculated value such as intrinsic value, you need an appropriate definition of intrinsic value. And, unfortunately, you have to propagate the errors. A direct measurement with a 10% uncertainty multiplied by another direct measurement with 20% uncertainty gives you a calculated answer with 30% uncertainty. This is why most financial projections are nonsense. Not only are you guessing at future revenue and costs (the uncertainties increase dramatically going forward), but when you start adding and multiplying them, the uncertainties propagate so fast that the projection is meaningless. However, this has not stopped an entire generation of PowerPoint-wielding MBAs from creating linear projections for earnings five years into the future.

A few comments on definitional uncertainties versus calculated uncertainties for intrinsic value, and then I promise I will make my point and move off this somewhat tedious subject.

Significant attention is paid to what definition to use for intrinsic value. Graham famously used Net Nets. Many use the present value of the expected cash distributions over the lifetime of an enterprise. Some just look at last year’s earnings. Or at net asset value (liquidation or reproducible), earnings power value, free cash flow, and so on. I raise this question: Is it more important to have an accurate definition of the intrinsic value or an accurately calculated value?

In Figure 2.6, I have mocked up three calculated intrinsic values—net asset value (NAV) on the left, earnings power value (EPV) in the center, and free cash flow (FCF) on the right—and put them against a theoretical “true value.” Assume that the true value is the company’s real economic value (which is, by definition, unknowable as it usually depends on future events, but is assumed here) and that all three estimates of intrinsic value capture it within their confidence intervals.

Figure 2.6. Intrinsic value uncertainties

Note that for EPV, in the center, the uncertainty is not too bad, but the calculated value is significantly above the true value (we’ve likely overestimated the margin of safety). Compare this to FCF, on the right, where the calculated value is closest to the true value but the uncertainties are the largest. Then look at NAV, on the left, in which the calculated value is the farthest from the true value and the uncertainty is very large and asymmetrical. Which is the best intrinsic value?

Note that the net asset value (IV_nav0) has a very different shape from the other intrinsic value calculations. It has a small calculated uncertainty (you know the value of the liquid assets) but a large asymmetrical definitional uncertainty. (Nobody really thinks the true value of Coca-Cola is the value of its assets at liquidation.) But all the uncertainty is on one side. The negative uncertainty is very small because we know the company’s intrinsic value is not less than its net liquidation value. Graham’s Net Nets are a terribly inaccurate calculation for what the intrinsic value is. But they are a very accurate calculation of what it is not.

This is an old physics trick. Calculating what something is with great accuracy is very difficult. Calculating what something is not, with great accuracy, is much easier. I can calculate with great accuracy that the value of Coca-Cola is not less than $1 billion.

Underneath the catchy terms Mr. Market and intrinsic value, Graham’s Net Nets were a clever way to eliminate all the uncertainty in the direct company measurements and on one side of the calculated intrinsic value. And it was on the side that mattered, because we ultimately don’t care about intrinsic value. We care about intrinsic value minus market price. It is an exact calculation of the company’s minimum margin of safety.

The takeaway is that the critical second step in Graham’s Method is eliminating the uncertainty. But this does not necessarily mean eliminating the uncertainty in the intrinsic value, or in every direct measurement, or in both the upside and downside uncertainties. It’s about eliminating the downside uncertainty in the margin of safety, both at the time of purchase and in the longer term. Graham refers to this indirectly in multiple ways throughout Security Analysis. In particular, he emphasizes that an investor’s duties include both buying the asset and owning it. I would change the language to say that eliminating the downside uncertainty at the time of the investment and over the long term are the real duties. As we move to developing and more uncertain environments, value investing becomes figuring out clever, wily ways, like Net Nets, to eliminate downside uncertainty at the time of purchase and in the long term.

But as I will show, when going global, we also have many additional ways to do this that Western investors lack. We can add capabilities and impact a company’s replacement value quickly. We can structure deals to eliminate long-term uncertainty. We can impact management and change the relationship between asset value and earnings power value. We can structure political partnerships that limit entrants by competitors. Buying below liquidation value is even frequently possible (note real estate in Dubai in 2010). And absent high tax rates in many cases, we can sometimes do short-term balance sheet strategies, similar to those in Graham’s time.

Quantify Risk and Invest Surgically

Graham’s Method is not about eliminating risk, but about quantifying it

In the third step of Graham’s Method (we’re in the home stretch now), he quantified the risk. Risk is the investors’ catchall concept for both a wide spectrum of human emotions (perceptions, biases, fears) and actual potential financial losses (margin of safety, value at risk, volatility). But by quantifying the risk, Graham removed the former and kept the latter. He accomplished the same thing physicists did using quantum mechanics and what pilots did using VPR instruments. He removed the brain from the process when it could not be trusted (or could no longer understand what was going on). When Richard Feynman could no longer conceptualize what he was seeing at the quantum level, he just did the linear algebra and accepted the results. When pilots are flying in snowy weather and they lose their sense of the horizon and of level flight, they ignore their eyes and look at their instruments.

Quantifying risk (the margin of safety) takes the investor’s brain out of this step of the investment process. I don’t care how much I like the company or how I’m feeling today. I invest only when there is a calculated >30% difference between the intrinsic value and the market price.

This approach also enables consistency over long periods of time, which is critical for accumulating wealth. It is one thing to be rational and level-headed most of the time. It’s quite another to be that way all the time. This takes a quantitative system. Quantifying also has the benefit of standardizing risk, so one can cleanly compare investments across industries and years. This lets you slowly focus on the most profitable investment types over time. You get both richer and smarter as time passes.

Finally, Graham invested surgically. If the uncertainty is eliminated and the risk has been clearly quantified (hopefully low), you go in surgically by buying shares in one targeted move and making the returns at the time of the investment. There is no dependence on event-driven changes in the future. Or working with management over time to improve performance. Post-investment, the only requirement is to check that the intrinsic value is stable (or increasing), per Graham’s Third Law.

If these can be considered Graham’s Laws and Graham’s Method, we should also note two Buffett “Great Company” Corollaries (yes, I’m making all this up). Within this approach (see Figure 2.7), the biggest weakness is the third law, which requires that the intrinsic value be stable (or increasing) over the long term. The risk of the investment is the risk of intrinsic value decreasing over time (the long-term downside uncertainty).

Figure 2.7. Buffett “great company” corollaries

This is discussed in the section “Rethinking from Good to Great” in Chapter 10, but it is worth mentioning how “great companies” look in terms of uncertainty analysis. Great companies are those that have an economic value (per share) that is the least likely to decrease over time—the first corollary. Companies with a sustainable competitive advantage (among many other things) meet this criterion. Companies with protected profits have lower long-term downside uncertainties.

The second Buffett “Great Company” Corollary is that companies with a low cost of growth in addition to a sustainable competitive advantage are even better over the long term. They are less likely to decrease and the most likely to increase in economic value.

We finally reach the last step of my fabricated rederivation of Graham’s approach, Simplify to a Usable Methodology (see Figure 2.8). The familiar Mr. Market, intrinsic value, and margin of safety concepts fall out.

Figure 2.8. Simplify to a usable methodology

This chapter, admittedly dry for those who don’t live their lives according to various frameworks (most everyone I suspect), presented both a value woldview and a logical method for approaching it. Graham’s Method in particular turns out to be the key to opening the door to value investing in fundamentally different environments. In the next chapter, we reapply Graham’s Method to the colliding, multipolar world described and generate a broader investment strategy for it.