Tag Archives: Chapter 4

A Reader Shares Good News; Finishing up Ch. 4


I couldn’t repair your brakes, so I made your horn louder. –Steven Wright

A Reader shares good news.

Hi John,

Partly motivated by your blog and lectures on value investing, I decided to quit my dead-end Hedge Fund job, and open my own investment management firm, Apatheia Capital. Think Schloss, and early Greenblatt special situations.I intend to use the best from quant and value investing in terms of buying cheap special situation stocks consistently.

So far it has been fun, exciting and anxiety-ridden process, and few friends and family have been misguided to be infected by my optimism. Please keep up the good work!  I cannot stop thinking about my ideas (about ever-present fat tails in special situation value stocks). So far in the process, I have filed for state registrations etc. and finalized a mission document for the firm.

I wish you a great journey. Be flexible and patient. Use your small size to your advantage by going anywhere there is value. Keep good records of your investment journey and keep in touch!

Toby Carlisle Talk:

Recording of Webinar: Portfolio Construction, Concentration and Diversification for Value Investors

Footnotes for Chapter 4 (Deep Value)

Success-equation.com (Mauboussin’s Web-site)

The Relation Between The Enterprise Multiple and Avg Stock Returns 2010 more research on the efficacy of using the enterprise multiple as an indicator of value.  Remember to adjust for normalization because at the top of a cycle you will see low EV to EBITDA (like in housing circa 2005/06) or high EV/EBITDA (11 x) BTU VL Dec 2014 near a depressed cycle. Coal reserves are priced low and production doesn’t generate high enough cash flows for the industry to generate a normal return, so mines are being closed, production shuttered, mines consolidated. The cure for low prices is low prices.

Berkshire 1992 Letter on What is an attractive investment.

This post wraps up Chapter 4 in Deep Value so don’t hesitate to comment or ask questions.

My first date did not go well

Questions on Chapter 4

ABOOK-Feb-2015-Buybacks (1)

The Acquirer’s Multiple Ch 4 in DEEP VALUE  is where we left off in discussing Chapter 4.

Imagine diligently watching those stocks each day as they do worse than the market average over the course of many months or even years….The magic formula portfolio fared poorly relative to the market average in five out of every 12 months tested. For full-year period…failed to beat the market average once every four years. Joel Greenblatt discusses the role that loss aversion plays in deterring investors from following his ‘magic formula’. (Montier)

A Summary

Greenblatt reinterpreted Buffett’s return on equity capital measure as RETURN ON CAPITAL, which he construed as the ratio of pre-tax operating earnings (earnings before interest and taxes, or EBIT or EBITDA-MCX or operating earnings that are sustainable) to tangible capital employed in the business (Net Working Capital + Net Fixed Assets) defined as:

Return on Capital = EBIT divided by (Net Working Capital (NWC) + Net Fixed Assets)

The use of EBIT makes the return on capital ratio comparable across different capital structures. EBIT makes an apples-to-apples comparison possible.

For tangible capital Greenblatt uses NWC + Net Fixed Assets rather than total assets to determine the amount of capital each company actually requires to conduct its business.

The higher the return on capital ratio, the more wonderful the company.

To determine a fair price, Greenblatt uses earnings yield, which he defines as follows:

Earnings Yield = EBIT divided by Enterprise Value (EV).

EV gives a more full picture of the actual price an acquirer must pay than market capitalization alone.  EBIT is agnostic to capital structure so we can compare companies on a like-for-like basis.

The higher operating earnings are in relation to enterprise value, the higher the earning yield, and the better the value.

Greenblatt has quantified Buffett’s wonderful company at a fair price strategy.

Enterprise Multiple (EV) = EBITDA divided by EV or (EBITDA – Maintenance Capital Expenditures) divided by EV.


The EV to EBITDA ratio is useless without a discussion on asset lives, capital intensity, technological progress or revenue recognition.

EBITDA, or any of its derivatives (EBDIT, EBITDAR, etc.) is simply a crude measure of gross cash flow.

The gross cash flow margin is simply a measure of the capital intensity of the business.   A manufacturing business will have a significantly higher gross cash margin than, say, a retailer, because it needs to pay for the capital (via in the accounting sense the depreciation charge) of all its plant and equipment which consumes more of it than a superstore.

What matters is not gross cash flow but net of free cash flow, which is the amount of cash available after reinvestment.

Case Study:

In the heyday of the technology bubble, the EV to EBITDA ratio was a favorite among telecom analysts.   Sadly, as new entrants came into the system and pushed up the price of the UMTS licenses (the third generation of mobile networks) to insane levels, the cost of replacement went sky-rocketing; expected free cash flow plummeted, and the telecom shares got more and more ‘attractive’ on an EBITDA basis, which could not capture any of this.   Eventually, some went bankrupt, some had to undergo a debt rescheduling exercise or issue new capital, and all saw their share price collapse.

James Murray Wells, a 21-year-old law student in Bristol, UK, needed a pair of glasses, and was faced with a bill of 150 stg.   He found that the manufacturing cost off standard spectacles (frame and glasses) was less than 10 stg.   This prompted Mr. Murray Wells to set up an Internet-based company to challenge what he claimed was a lack of price competition among the four major high street opticians in England.  Three months into his venture, he was selling hundreds of pairs for as little as 15 stg to apparently delighted customers.

The replacement value of the asset, ‘making spectacles and selling them’ is rather low.   A 21-year old student with no expertise in the field is apparently able to replicate it from his student room, with a few thousand pounds borrowed from his father.   On the other hand, the market value is enormous because, as previously discussed, it equals the net present value of free cash flow discounted to infinity.

The market value is a direct function of the economic profitability of the asset in question and, in this example with a cost of goods sold at 10 and sales at $150, it is plain that economic value added is truly staggering.   Making spectacles and selling them has a high ROIC, and an equally impressive asset multiple—the ratio of market value to the replacement value of invested capital.

If the entrepreneur is successful in his venture, he will collapse the marginal return on capital invested of the industry by accepting a lower margin than his competitors.   The entrepreneur made an arbitrage between the market value of existing capacity and the replacement value of new capacity, which he found cheaper to create.

Investors in incumbent firms my find out that they have paid too much for the economic value of their asset in the belief that a very high economic return on capital invested was sustainable.   Investors who ignore the workings of the capital cycle, the ultimate driver of share prices, do so to their disadvantage.

Investment should just be a replication of the process of arbitrage between market value and replacement value. Good stock pickers are brilliant strategy analysts.   They understand the business case for the company. (TATOO that to your forehead!)


Why is the EV so good at identifying undervalued stocks?

What drives the returns of the magic formula? What Metric?  What does this mean for us as Deep Value Investors?

Assuming you read the entire chapter, what two main points about investing did you learn?  Anything surprise you?

Supplementary Readings:

What Has Worked in Investing by Tweedy Browne   Why do low price-to-book, low price to cash flows, etc tend to generate higher returns than a market average?  What is the principle behind the returns?  Also, note the Richard Thaler link below for a hint.

When an investor turns to the research on regression to the mean and investors overreacting to poor company performance/bad news in Richard Thaler research, he or she sees that prices of the winner and loser portfolios take three-to-seven years to revert.  See also The New Finance: The Case Against Efficient Markets by Robert A. Haugen and Inefficient Markets by Andrei Schleifer.

Next, we will focus on Mean Reversion and ROIC.

Death Taxes and Reversion To The Mean (Mauboussin)


Dale Wettlaufer on ROIC and MROIC  a series of Fool.com articles

EconomicModel of DFC_ROIC The author uses NOPAT (after-taxes). I placed this here for those who wanted to see how others determine value.

We will review the second half of the chapter next.





Let’s Move Forward

ExpectationsA Hermit has no peer pressure–Robin Wright


Thanks for all the comments. A student from Germany kindly offered to host a discussion board for anybody who wants to analyze investment ideas, cases and/or investment subjects in more detail. The infamous Dr. K has also offered to moderate the board. If he upsets too many people, I will referee. As long as differing views are respected then we will be fine.

My overall goals for this course are to study deep value investing while encouraging independent and skeptical thinking. We will try to read original sources and apply principles to our own situations.

I don’t “like” deep value investing or mechanical investing but I was curious why investing in business disasters is so profitable (Preface in Deep Value). I also find it odd at first glance that Ben Graham the father of detailed security analysis gravitated to rule-based (my substitute for “mechanical”) investing. Joel Greenblatt who was the master of special situation, heavily concentrated investing also moved towards the “magic formula” style of investing. Another great investor I know used to visit companies and be highly concentrated into 8 or so businesses. Now he buys a diversified group of STABLE franchises when they go on sale. He also has a rules-based valuation method. What is going on?

Also, as more time passes, you realize that our human flaws are tough to overcome. Toby in Deep Value mentions that experts often DEGRADE mechanical systems. In other words, human tendencies hurt investment performance. Perhaps “mechanical” investing is worth exploring further without preconceived notions.

I often feel investing is like this situation:

Killing a child is wrong. Those soldiers acted, but then the unexpected happened. What now? Morally you know what is right but can you face the consequences?

It isn’t hard to find cheap companies in this pile (but many worth $0), but there is every reason not to act. Can you endure the ridicule?

TSX Gold

Gold mining is a tough business–when wasn’t it a bad business? Managements are bad (true, but note how US tech firms are buying back stocks near their all-time highs—their managements are no better than the miners yet their stock prices are stratospheric), and on and on.


Altucher writes of Buffett’s early career. Even in the 1990’s Buffett was buying net/nets and companies in Korea trading at 2 to 3xs earnings.

So I chose Deep Value as a guide/textbook to pursue these topics with this group.

The direction of the course will be easy to follow:

We will go chapter-by-chapter in DEEP VALUE by Toby Carlisle while reading the footnotes and original sources as best we can. Let’s understand terms in the book like enterprise value and EBITDA, for example, before moving on to the next chapter.

We just finished Chapter 3, Warren Buffett: Liquidator to Operator where we had the case study of See’s Candies. Buffett moved from investing in deeply discounted tangible assets like Dempster Mills to a franchise like See’s Candies. Buffett was willing to pay a premium over book value because the assets of the business generated returns far in excess of its cost of capital. See’s takes commodities like sugar, milk and chocolate and turns them into boxed chocolates that customers are happy to pay a premium for. Why? The company has a brand built through the customer’s experiences with the product.  As a deep value guy, I gave a second-hand box of chocolates to my EX.  I said, “Here, ignore the half-eaten chocolates, the rest look OK. I got this on a 95% off sale!” Tense!

So what can WE learn from the case that we can apply in our investments? So rather than try to be like Buffett let’s take his principles and find applications which we can apply going forward. Why is See’s a great business? Taking commodities and turning them into a product that consumers pay a premium for seems like a business to buy. Note that Bicardi was the best business in Cuba and still is going strong. Bicardi takes sugar and water and turns it into premium Rum. I see similarities—brand name built upon quality and good distribution within its geographical boundaries. See’s is strong in southern California, for example. Perhaps, Sherwin-Williams is a bit like See’s Candies. People are willing to pay a premium for paint because 98% of the cost of a painting job is the labor while you want the job to last and look good. Good distribution coupled with service (color tinting/application advice) is also critical. I could go on but the point is to take the general concepts and apply them in your own way. Don’t be Buffett, but be yourself in applying Buffett’s lessons.

Chapter 4: The Acquirer’s Multiple: Fair Companies at Wonderful Prices in Deep Value

is the next assignment. As a supplement: Placing EBITDA into Perspective