Enhanced Value InvestingTM

--Beyond Graham, Buffett and Greenwald

C.T. WU, PhD TAITA MONTHLY SEMINAR 9/29/2011

Contents and Trademarks are intellectual property of the author and thus proprietary in nature

Outline

Long-term Behaviors of Stock Market Short-term Behaviors of Stock Market A Holistic Framework for Stock Valuations A Unified Model for Value Investing Business Model Analysis for Value Investing

Ben Grahams Value Investing Principle

Pay 50 Cents for a Dollar A Dollars Intrinsic Value is always a Dollar! Pay 50 Cents for a stock whose Intrinsic Value is a

Dollar (i.e., a Margin of Safety at 50%)

How to determine the Intrinsic Value is a Dollar? (Valuation) When the Market will offer you 50 Cents for a share whose Intrinsic Value is a Dollar? (Patience)

The Holy Grail of Value Investing

Price Earning* (Price/Earning)

P E* PE
(Gee! Any 7th Grader can be the Next Buffett!)

Components of Expected Returns

P(t 2) E (t 2) PE (t 2) R [ ] *[ ] P(t 1) E (t1) PE (t1)

Company Dependent Reward (Intrinsic Reward) Market Dependent Reward (Emotional Reward)

A Superior Investment Strategy should be both Economically and Statistically sensible!

A Pictorial View of Expected Stock Returns

Cruise Speed

Head/Tail Wind

Long Term Stock Return Patterns

Mid and Long-term Stock Returns

Robert Haugen-- Guru of Stock Market Behaviors

Studied 35 years of stock market behaviors via vigorous Regression

Analysis tracking 70+ parameters per company

Good News

You can predict the stock price change 30 days from today with the companys past financial and price information

Bad News

Accuracy: 10%; Noise: 90%

Robert Haugen Short-term Stock Price Volatility

Three types of Price Volatility (Standard Deviation)

--Event-Driven Volatility (fast reaction to company news) --Error-Driven Volatility (residual reaction to company news) --Price-Driven Volatility (purely driven by market sentiment) Price-Driven Volatility contributes to 80% of the total Volatility Price-Driven Volatility is unpredictable and thus indivertible Historically the yearly S&P 500Price Volatility has been around +/- 20% from the yearly average price; thus maintaining a Margin of Safety >20% helps minimize the chance of having near-term losses due to short-term volatility

How to Determine the Market is Overvalued?

Fair PE Ratio Valuation Formula

Ben Grahams 1934 Formula Fair PE = 8.5 + 2 * G (EPS Growth Rate)

C.T. Wus 2010 Formula Fair PE = 8.5 + 1.5 * G (based on Post WW II Regression Data)

Current PE Implied EPS Growth Rate

= (Current PE 8.5) / 1.5

The CJPR Holistic Valuation Framework* Reference from Chuck Carnevale (Mr. Valuation)
Fair P/E= 8.5 + G/2 Fair P/E = 8.5 + G Fair P/E = 8.5 + G/2 +D G=10-15% Fair P/E = 8.5 + G/2 +D

G<= 15%

G>=20%

G<5%

IRDM TSYS CKSW

F5 JNPR ARUN

CSCO MSFT WMT

Emergent Growth

Fast Growth

Stable Growth

Mature

(Courtesy of C.T, Jane, Peter and Roger, in alphabetical order)

Don Yachtmans Investing in Stocks like Bonds

Bond Investing Criteria Company Credit Rating (AAA, AA, , CCC) for Risk Assessment Promised Annual Interest Rate by the Issuer Stock Investing Criteria Company Quality Rating for Risk Assessment Expected Annual Return Rate (IRR)

A Unified Reward/Risk Investment

Framework for All Classes of Assets!

Investment Vector = (Expected IRR in N Years, Risk Level)

A Unified Model for Value Investing

1. 2. 3. 1. 2. 3.

Investment Vector = (Expected IRR in N Years, Risk Level) or IV= (IRR-N, Risk Level) (Risk is the most undefined and ambiguous term in Finance!) Enhanced Investment Vector (EIV) =(IRR-N, 1- Risk Level) or EIV = (IRR-N, Confidence Level) where Risk Level + Confidence level = 1 Risk Level: (0 ~ 1) Confidence Level: (0~1) Why the Efficient Market Hypothesis is Erred? Its Key Assumptions: The higher the Risk Level, the higher the Reward. The market is always efficient. You can not outperform the market, use full diversification to mitigate the risk. Fact: Only the market mechanism is efficient. The market results are often inefficient because the majority of market participants are inefficient.

Why Buffett Advocates Concentrated Portfolio?

Its all about Confidence Level establishment

--Personal understanding of the industry --Personal understanding of the business model --Personal understanding of the management team --Personal understanding of the balance sheet quality --Personal understanding of the potential technological substitute threats
Buffett: I have 2 views on diversification. If you are a professional and

have confidence, then I would advocate lots of concentration. For everyone else, if it is not your game, participate in total diversificationCharlie and I normally operate with 5 positions

(Source: Buffetts 2/15/2008 speech at the Business School of UT Austin)

Why True Value Investors Have an Edge?

Employ Margin of Safety >= 20% of Fair Price Discipline

* Minimize the chance of having near-term losses due to Price Volatility * Create long-term gain when the Margin of Safety gap is closed by the market (e.g., from 20% undervalued to 20% overvalued in PE Ratio)
Concentrate on a few well studied stocks that have superior

EIV= (IRR-5, Confidence Level) profile based on the investors Circle of Competence * Buffett: Investment is all about Compounding!
* Alice Schroeder*: Buffett requires each investment to have at least

15% IRR.

(* Author of The Snowball: Warren Buffett and the Business of Life)

Enhanced Value InvestingTM Framework

Follow the EIV = (IRR-5, Confidence Level)

Unified Model Consider making an investment bet when --IRR-5 >= 20% --Confidence Level >=80% (via Business Model Analysis) --Current PE <= (1 Beta * 20%) * Fair PE Ratio Consider selling when Current PE >= (1 + Beta*20%) * Fair PE Ratio Focus on 3-5 solid investment targets a year

Enhanced Value InvestingTM Illustrated

Sell

>=20% long-term compounding goal

$
portfolio setup (researched) buy/sell decisions (systematic) trade size decisions (systematic) timing (systematic)

Buy

A Pictorial View of Expected Stock Returns

Cruise Speed (Intrinsic IRR)

Head/Tail Wind (Emotional IRR)

Sources for Superior Stock Returns

Valuation Premium

Current PE much lower than Fair PE (The difference is the Margin of Safety) Wide Moat Quality Premium Wide Moat Quality stocks consistently outperformed No Moat stocks by an average IRR of 3% historically Small Cap Growth Premium Double-counting effect (Price= EPS * PE): 3-6% IRR extra gain Business Model Optimization (BMO) Premium* 2-3% IRR per year (IBM is the most viable case-in-point)
(* Courtesy of the Author)

Business Models Core--Buffetts Wide Moat

Wide Moat = High Entry Barriers

Business Model- A Systemic Perspective

Financial Performance Tracks CEOs Business Model Optimization Paths

CEOs Key Decisions

Competitors Moves

Financial Outcomes (ROE, Earning Growth Rate, Asset Quality, Debt Ratio)

Blueprint for Business Model Optimization

Goal for Business Model Optimization Creating sustainable and growing EPS (excluding stock buy-back effect) Adopt a Growth Strategy that is continuously leveraging the business CORE possessing high entry barriers --The most critical part of Business Model Optimization --Most public companies failed at adopting the right Core-Centric Growth Strategy; 3 in 4 acquisitions turned out to be big failures

(Chris Zooks Focus Expand Redefine Cycle)

Align business Internal Organizational Economies with the evolving Core-centric Growth Strategy --Most public companies are nave about Internal Organizational Economy; especially not aware of Economy of Scope only applies to the same customer group which is the major cause for acquisition failures (Russ Ackoffs Multi-dimensional Organization)

Conclusion
Enhanced Value InvestingTM is a systematic way of achieving superior long-term

investment returns via a thorough integration of

1. Stock Market System Behaviors --Long-term Predictability vs. Short-term Volatility (i.e., Complex Adaptive System characteristics) 2. Competitive Business System Behaviors --Business Model Analysis and Optimization 3. The CJPR Holistic Valuation Framework 4. A Unified Model for Asset Investment: EIV= (IRR-N, Confidence Level)

A Chronological Evolution of Value InvestingGeneration 1: Ben Graham (1934) Generation 2: Warren Buffett (1980) Generation 2.5: Bruce Greenwald (2001) Generation 3: Enhanced Value InvestingTM (2011)

Contents and Trademarks are intellectual property of the author and thus proprietary in nature

Case Studies
Visa

IBM
Apple Juniper

Altria
Aruba

VISA

IBM

APPLE

JUNIPER

ALTRIA

ARUBA