Liquidation Valuation (Ch. 2 Deep Value)

Time-out: How to Think and How to read a book        Worth reviewing.

As a supplement to Chapter 2, Contrarians at the Gate in DEEP VALUE, please read the highlighted paragraphs on liquidation value in Seth Klarman’s chapter on Valuation (Chapter 8 in Margin of Safety and emailed to the Deep Value Group at Google).

You will understand

  1. how wide the range of valuations can become
  2. how uncertain valuation is.

Therefore, a value investor passes on what he or she can’t understand or uses CONSERVATIVE assumptions to build-in a margin of safety.

Take your time and read the above chapter carefully, especially his case study on Esco Electronics.  He makes a compelling case. The difference between price and intrinsic value (determined several ways) is ASTOUNDING.  A great investment should slap you in the face–it should be obvious, but then you might say what am I missing? You can’t believe the opportunity.

To reveal one of the secrets of this course (shh..) by the time we have journeyed through the readings, examples, videos, and cases, you will realize that if you are buying assets like net/nets, then you must buy them VERY cheaply to allow REVERSION to the MEAN to work.

Or if you go the Munger/Buffett (in his later years) route and buy franchises with moats around them (the companies have high returns on invested capital and they either grow profitability or return excess cash to shareholders) those companies are RARELY on sale.  The franchise moat (barrier to entry) slows the reversion to the mean process while high profitability allows for compounding of capital–an investor’s nirvana.

Great investments are FEW and FAR BETWEEN unless markets are in a huge dislocation.  Keep waiting and waiting until the money is just lying there for you to safely pick it up.  In other words wait for:


Can any pretty women taking this course teach the others:say no

Certainly we need to do better than this:

I will be posting a lesson index shortly.   We will tackle Chapter 1, The Paradox of Dumb Money, of Quantitative Value next before we move back to Chapter 3 in Deep Value and read Buffett’s Partnership letters (to be posted).

7 responses to “Liquidation Valuation (Ch. 2 Deep Value)

  1. Just a couple fo comments about the discount rate …

    Investors shouldn’t really “choose” a discount rate, it should be calculated by the CAPM. It is a function of the risk-free rate, equity risk premium, and beta. As Domodaran says, the discount rate is not a place to stuff risk and uncertainty in; you can “punish” the company and handle uncertainty in other ways.

    One thing you can do, for example, is make a range of assumptions about growth rates, and so on, and therefore come up with a distribution of values. You can then say something about how probable you think the company is undervalued.

    The dividend-discount method is likely to be problematical in most cases. A better approach is likely to be to perform a discounted cashflow at the firm level rather than the equity level, and then adjust for debt. If you calculate discounted cashflows at the firm level, then you must remember to use unlevered betas.

  2. Not to go off on a tangent too much, but your notes in the Vault on Robert Bruce are very intriguing. He has evolved from a deep value investor into a buyer of a diversified portfolio of great businesses. He did this despite saying his fund size doesn’t mean he HAS to buy in this way. He also appears to have a tilt towards the quantitative side of analysis by allowing the historical numbers to speak to him when identifying a franchise business.

    My interest has always been in the Schloss-style of investment. However as a private investor with limited capital, the Schloss style seems difficult to implement as my individual purchases to create a diversified basket of cheap assets would be too small to justify the fees. I have only been able to implement the style by buying funds/etfs of undervalued assets (gold miners).

    For individual stock selection for the private investor with a small pot of money, the Bob Bruce method seems to make more sense. Waiting at the side-lines for excellent businesses to become cheap during distressed market periods or bad news announcements. In your notes, Bob Bruce seems to emphasize that his competitive advantage in this method comes from focusing on valuation and being strict on his prices. I would love to hear people’s thoughts/experiences on this problem for the small investor wishing to implement a deep value style.

    • I am fortunate to know the great Robert Bruce (Hired by Buffett to run Fireman’s fund). He initially bought deeply-out-of-favor cyclical businesses like oil services company Lonestar Technologies that sold steel tubing to the drilling industry.

      The problem was that the cyclical price movements were often too much for the clients to bear. Moves of 50% in a week, up and down.
      Instead he developed a broadly diversified 30 to 40 stock portfolio with STRONG financial characteristics. They didn’t all have to be GREAT businesses, but they had to be STABLE through various business cycles.

      He focused on a behavioral approach looking at how the company had been valued in the market over time. The portfolio tends to outperform in weak markets and underperform in strong markets, but, since declines are less, then compounding takes place at a higher equity level. (poor writing!).

      Again, it comes down to understanding how the particular approach works and being comfortable with it. One isn’t necessarily “better” than the other.
      As Buffett says, the best investment is the one at the largest discount to intrinsic value (whether growing or not). Buffett even bought Korean companies in a basket a decade ago when they traded at three times earnings.

      Back to this course, our goals (well, mine anyway) are to thoroughly explore “deep” value investing, read original sources especially from the great investors, and think for ourselves to learn and apply investing principles. So far I am amazed to learn that the best net/nets are the money losing companies. I certainly want to dig deeper on that. While others will have different interests.

      • Buffett’s returns seemed better when he was buying the weird stuff, not the IBMs. So I think Deep Value is the way to go.

        If you’re going to go for the nice compounders, then I think one would be better off with smaller companies. You’re trying to find the Walmarts in the 70s. Interesting, UK investor Lord John Lee did this kind of steady, compounding type company, holding them for decades. He obviously made a few mistakes. I don’t recognise most of his companies, but I did notice PZ Cussons, which he had held for a few decades. That one share alone must have made him a fortune.

        Spotting these compounders is hard, and I think a lot depends on your temperament. If you’re really patient, and you can really understand the business, then it is certainly one way of going.

        Deep Value is likely to appeal to the more quantitative types, like me. Reading Carlisle’s book is certainly having an impact on me. Dare I say it, but I think it might be the most important investing book in a decade. If I really wanted to be like anyone, it would be Greenblatt.

        There are some great minds out there, like what Einhorn did with Apple. Damodaran was dismissive of Einhorn’s approach, arguing that it could not in itself create value. However, I think history favours Einhorn.

        Icahn might be another interesting character to follow. I took a look at Dell a couple of days ago; obviously before it was bought out. I have to say, I couldn’t understand Icahn’s logic in saying that the takeover price was undervalued. He and Dell obviously saw value in the company, which I couldn’t fathom.

        If I could even begin to approach the level of insight of Greenblatt, Einhorn or Icahn, I’d be a very happy, and very wealthy, man.

  3. Guys, please don’t read “How to Read a Book”. Everyone keeps saying how good a book it is, but I’m going to offer a contrarian opinion. At over 400 pages, they use too many words. Remember, we’re not trying to critique works of literature like the academics are.

    My advice: be selective. Extract the information you need to extract, then move on. This, straight out of Greenblatt’s Genius book, page 78: “Frankly, reruns of Gilligan’s Island hold more appeal than a page-by-page read-through of an entire proxy or Form 10 – so selectivity is key.”

    We’re not Mike Berry or Buffett, so unless you have Aspbergers, it’s going to pay to read smarter, not harder.

    Now, what would be useful is something along the lines of “How to read a 10-12B”.

  4. I saw you talke about the Margin of Safety.

    Recently I am reading in details of this book as I find Seth actually had something in depth about the value investing although I’ve been reading Buffett’s materials for some years.

    About the Chapter 8 Esco’s valuation.

    I find easy in how to get the figure about $5.87 per share under the discount rate of 12%.

    But I find it difficult to get the number of $14.76 per share valuation for Esco.

    Seth said the $14.76 valuation was made by assuming discount rate of 12% and additional $0.20 cents cash flow on top of the previous situation in which $0.45 for the first five years and $0.90 from Year 6 till forever.

    I think the problem arises because I don’t quite understand Seth’s words “twenty cents per share, for the next ten years, after which it leveled off”

    Can you please share the details in calculating the $14.76 valuation if you have any idea?


    • Dear Medici715 are you part of the deep-value group at Google Groups. Join and ask the question there since most folks there are a hell of a lot smarter.

      But, I will get back to you by this Saturday. Post again if you don’t get the answer by Sunday EST in the USA.

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