Motley Fool Hidden Gems Investing - Value Hunting

Episode Date: February 25, 2023

Motley Fool Senior Analyst Rich Greifner joins Ricky Mulvey for a primer on value investing, or trying to find out how much a company is worth, and buying them for less than that amount. They discuss:  - If there’s even a difference between growth and value investing. - Signs that a business is mispriced. - How investors can find mispriced businesses. - Why companies trade below their accounting-based worth. - If there even needs to be a distinction between growth and value investing. - Unpopular companies that may be worth your attention. Companies discussed: META, WCC Host: Ricky Mulvey Guest:Rich Greifner Engineer: Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

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Because we have your number. It goes back to the definition of value investing, right? I want to figure out what I think an asset is worth and then buy it for less than that amount. And that is your margin of safety, the difference between your estimate of intrinsic value and the amount that you're paying for a company. And ideally, you want that margin of safety to be as wide as possible and that it protects you on your downside in case your investment thesis doesn't pan out the way you expect.

And it gives you a little boost to your upside potential if things do go as you expect. I'm Dylan Lewis, and that's Motley Fool senior analyst, Rich Griefner. He joined Ricky Mulvey to talk about the fundamentals of value investing. In this episode, they break down if we should even draw a line between growth and value investing, how to look for mispricings in the market, and a couple of stinky feedstocks that might be worth your attention. This is a simple question, but possibly difficult to answer, Rich. What does it mean to be a value investor? Yeah. The term value investor means different things to different people. I think to many people, it conjures up the image of this shabbily

dressed guy scouring the street, searching for discarded cigar butts in hopes of getting one last puff of value for free. That's not an image that's really resonated with me. not a style of investing that has worked well for me historically. I much prefer Joel Greenblatt's definition of value investing. And that is, I'm trying to figure out what an asset is worth and then buy that asset for much less than that amount. And I really like that definition because it means any asset can be a value investment. It's just really a matter of how much you pay and what you get in return. I think the cigar butt type of investing, That's the Benjamin Graham, right? So that might have worked more. My guess is that probably worked

better when there was just less information available and markets were maybe a little less efficient. No, for sure. You're absolutely right. It used to be, back in Graham's day, back in the early Buffett days, he would literally go to the Library of Congress and check out a company's financial statements, analyze them in the library, and then return them to the desk. You could be the only person in possession of that type of information. But due to the proliferation of technology, that is no longer the case. Makes sense. So, what kind of temperament do you...

Because value investing maybe isn't for anyone. You've got different styles of investing for different folks. What temperament do you need to be a value investor? What's the type of person who makes a good value investor? I think there's a couple qualities that you really ought to have if you're going to be a value investor. First, I think you need to be an independent thinker. That's because the companies that you choose to invest in are probably going to be out

of favor, and often they're going to be unpopular and wildly unpopular. You need to be OK with that. You need to be patient. That's probably true for just about any type of investor. But for these types of value investments, it can take a long time for your investment thesis to play out. And last but not least, you need to be disciplined. could be long stretches where it's difficult to find an attractive value investment. During

those times, it's really important to maintain your high standards and not chase after mediocre opportunities. What's it mean for a business to be wildly unpopular but attractive to a value investor? Dan Loeb has a concept that I really like. I think he called it Stinky Feet Stocks, which is hard to say, but it's easy to understand, which is when you mention the name of a company to someone, they give you that stink face, like they just smelled some horrible stinky socks. Nice. For a value investor, is this the kind of person who's more concerned about not losing money or more eager to outperform the market? I think most value investors would probably say they're more concerned about not losing money. But truth be told, it's hard not to play

that relative comparison game when the scoreboard is updated every second. It's interesting the way that you posed that question, though, because I don't think those two things are necessarily mutually exclusive. I think if you're primarily concerned with not losing money, that means you're probably going to focus on buying strong companies with sustainable competitive advantages, high returns on invested capital, good management teams, strong balance sheet, and buy them at a reasonable valuation. If you do that consistently, not only will you not lose money, but I think you're also probably likely to outperform over time. You didn't mention momentum.

No, no, not a factor. Value investors are sometimes at odds with growth investors. And I think there's two parts to this question. But the first is, what do you think growth investors can learn from the value side? I know you bring me on here as the value guy. I don't really think it's helpful to draw such a distinction between growth and value investors. I think investors do themselves a great disservice by labeling themselves and by thinking of themselves as, I'm only a growth investor or I'm only a value investor. You're shutting yourself off from a universe of potentially attractive investments. And I think everyone's portfolio should have a mix of companies that might be defined as traditional growth or traditional value.

Let's move on to some of the principles, because there are some fundamentals that I don't want to gloss over. Is book value important to you as a value investor? And what's that mean? It can be important. It used to be a lot more important, as you noted during the days of Ben Graham in his heyday. It was a lot more important. So, taking a step back. So, book value is an accounting concept. And it's simply the value of a company's assets minus its liabilities. And you can think of this, you know, for listeners who might own their home, you can take the value of your house, subtract the outstanding principal amount on your mortgage. So the value of your home, your assets, the principal amount in your mortgage, your liabilities, the net of that,

that's your equity. That's your book value in your house. It's the same concept when you apply to companies. And then what would be the intrinsic value of a company? How's that different than that simple net worth calculation? Sure. So book value is an accounting concept. intrinsic value is really a theoretical concept. As the investor, that is your estimate of what a company is worth. It's important to note, there's no such thing as a true intrinsic value. It's just your estimation of, if I were to buy this entire business outright, what might be a fair price for that? I still think that accounting concept of book value is important because occasionally, businesses will trade below their book value. What are some reasons that a

business could trade below that accounting calculation for the value of a business. Yeah, sure. I mean, it's a strong signal if a business is trading below book value. That's basically the market telling you, we don't think this company is going to generate high returns on equity going forward. Or maybe they're saying, okay, fine, maybe it will generate high returns on equity, but we don't trust this management team to take the capital and deploy it in a manner that creates value for shareholders. And book value, as I mentioned, it can be a useful metric, but only for a certain type of company. So, that'd be for a financial firm or a manufacturing company that has a lot of physical assets. Then book value could be a really important

valuation indicator. But for a lot of the companies that are driving today's economy, like, um, you know, alphabet or meta or any, any software business, like the real value is being created by their engineers and their code and like their brands. And those factors are just not, um, accounted for in the book value calculation. Do you, so if you see a company trading at a discount to its accounted, it's, it's accounting value. Is that more of a red flag or is that more of a, let me check this for a potential mispricing opportunity? It depends on the industry. For a software company, it's a non-factor. For a financial, it could be interesting, but it's also probably the market's referendum on the quality of that

business. But yeah, it's certainly something worth investigating. And maybe not a full breakdown, but how do you find a company's range of intrinsic values? Sure. Yeah, there's many ways, and a full breakdown could be its own podcast. The way that I tend to do it, to calculate a company's intrinsic value, is you run a discounted cash flow analysis, a DCF model. That's basically what you're doing, is you're projecting the company's financials. You're estimating the amount of free cash flow it will generate each year from here into perpetuity. Then you're discounting those future free cash flows back at some required rate of return. And that sounds like quite a mouthful,

but you're basically figuring out how much cash is this company going to generate over its lifetime and how much is that worth to me as an investor today? And then when you're looking for companies, do you have any valuation guardrails? For example, I don't buy companies above a 10X price-to-sales ratio, that kind of thing? No, no. Those types of relative multiples are useful, but they're really just a snapshot in time. So, like I said, what I really care about is the company's ability to generate free cash flow in the future. So, looking at a multiple over any arbitrary one-year period, it doesn't really inform you about that company's future prospects. So those multiples can be useful, but I think you need to go beyond them. They're not

the end-all and be-all. And it could be a company with an enterprise value to sales ratio of 10 is cheap, and a company with an enterprise value to sales ratio of 1 is actually expensive. I want to expand on that. So what would be a case, maybe a hypothetical case where that... So enterprise value, just real quick, this is fun, but unlike book value, enterprise value includes debt into the value of the company. What could be an example where an enterprise value to sales ratio of 10 would be cheap? Well, it's all about the future. It's all about the free cash flow that the company is going to generate in the future. If I'm buying young Microsoft in year one or year two, it really doesn't matter what kind of multiple

you're paying to the sales back in the 70s, because we know the sales for the next three, four, or five decades are just going to grow exponentially. The free cash flow the company generates is going to be monstrous. You could pay, I don't know, 1,000 times, 10,000 times sales. That's not relevant for the amount of free cash flow we know this company is going to generate in the future. Markets are supposed to be efficient. We talked about earlier how it's a little bit more difficult to find those mispricing opportunities, and that's something that value investors still look for. What are some ways you've seen, let's say, the efficient market hypothesis break down? I've never really seen the efficient

market hypothesis work. I was learning about this concept in 1999. I was in college taking my econ classes. I was in class and the professor would say, these guys won the Nobel Prize this efficient markets hypothesis." And I thought, okay, it's probably correct then. And then, at the same time, you'd see these companies change their name to such-and-such internet company, and the stock would triple in a week. I was like, these two things can't both be true. The efficient market hypothesis can't be true and coexist with this type of stock market behavior. So, I concluded at that time, the efficient market hypothesis wasn't all it was cracked up to be.

What are some signs then? Actually, I'm going to go back on that because I think that's the dot-com era. I wonder if we're seeing it today. I mean, I think I am, where you also see markets maybe overpriced or overpriced bad news, where you're seeing these, in some cases, strong businesses where their price stocks declined by 30% to 40% in a day if they miss expectations, or there's a little bit of bad news, especially for the more thinly traded businesses. Yeah, and that could be efficient. Theoretically, that could be efficient if the piece of news comes out and that does adversely impact the company's ability to generate future free cash flow, or it makes it less certain, so you would increase your discount rate, making those future

free cash flows worth less. In theory, a 30% price swing could be justified, but in reality, you know, intrinsic value is not really changing that much day-to-day. And stock prices are much more volatile than fundamental business changes. Fair enough. So, then, what are some signs, because we can't go to the Library of Congress looking at income statements that no one else can, what are some signs that a business is mispriced? Yeah. So, we talked about multiples before. Here's where I think they're really useful, where if something sticks out, you know, if every other company in the industry is trading at a multiple of five and this company is trading in a multiple of 10 or two, that's interesting. There's something going on there and maybe it's

warranted, maybe it's not, but it's a sign to dig in. Another sign that a business might be mispriced is, we talked about Dan Loeb's stinky feet stocks before. If everyone's reaction to a company is universally negative or flip side, universally positive, it's like, well, that's, that's probably not right. Like there's, you know, the, the, the real answer is probably somewhere in between the two extremes. We may get to one of those businesses in a moment. Um, and then I, I often associate dividends, like looking for companies paying large dividends with value investing. Are dividends important to you or important to value investors? I think they're important to value investors. They're not very important to me. This, this is,

someplace where I may differ. I don't want dividends. If the company wants to give me money, I will take it. But dividends are really my least favorite form of capital allocation. And that's because when I'm investing in a company, I'm investing with the assumption that the company has lots of high return opportunities into which it can invest capital and then reinvest capital for years and years and years. That's paving the path for much higher free cash flow generation in the future. When a company pays a dividend, it's basically saying, no, I don't have any better use for this money here. You take it back. That's not really of interest to me. If high return investments aren't available, I'd much rather have the company keep

that cash and just stay patient with it. Markets can turn, opportunities pop up. Maybe you could reinvest in the business. Maybe you could acquire a competitor that's in trouble. Maybe the stock price drops and you can buy back shares that really attract the price. Or, if you have to pay a dividend, pay it to me as a special one-time dividend. I don't like this imposed quarterly cadence where these companies just put handcuffs on their capital allocation. They feel obligated to make this payment every single quarter, year after year after year. I think the argument against that, though, is that obligation to make those payments makes management teams better at capital allocation because it restricts their resources

and they can't just go after any opportunity that they want to. Yeah, people will say that, but I'd rather invest in a management team that doesn't need those constraints imposed upon it. They're just good at allocating capital. They don't need those false boundaries. And then, I guess with buying back shares, though, historically, many management teams are not so good at that because they often buy back shares at a relatively high price and then don't have the ability to buy back shares when they actually should. Yeah, for sure. Share repurchases can be a really powerful tool, but most companies, I agree with you, most companies don't really use them well. When they're flush with cash and

everything's going great, then they'll step up the repurchases. And then when inevitably the market turns, business conditions turn, and the stock is cheap, then they husband their cash away. It's like, you should be doing the exact opposite. I think this question goes beyond metrics, but what are some signs to you that a management team is good at capital allocation? I like to see a management team that acts strategically and opportunistically. I always want that management team putting capital towards its highest and best use. That could be reinvesting the business, making an acquisition, repurchasing shares. It could be issuing shares. If they think the stock is really high, you could raise capital by issuing shares. It works both ways. You don't

see that too often. But I want them making savvy capital allocation decisions consistently. Let's move on to some application stuff. In October, you were on with Alison Southwick Robert Brokamp, and you pitched Meta as a value stock. I think you could categorize that company as a stinky feet stock. A lot of people want to stay away from that. Meta has done pretty well since then. Has your thesis on Meta changed at all since October? My thesis hasn't changed. The stock price has changed. It was probably about $130 per share when I mentioned it. I thought there was a nice, attractive margin of safety there. And immediately after I pitched it, the stock dropped to like $90. But the business hadn't

really, as we mentioned before, the intrinsic value of the company hadn't really changed that much. It was the stock price that had really fallen off a cliff. So, I thought that was an exceptionally attractive opportunity. And sure enough, now the stock has more or less doubled from that low. As we speak, it's currently about $170. So, I think it's still attractively priced. But the margin of safety isn't quite what it was. So, it definitely was a stinky feedstock when I pitched it back in October. Whenever you mentioned meta to someone, all they would do is mention the risk factors. And there were legitimate risk factors, and there still are very legitimate risk factors.

They're spending very aggressively on the metaverse with no certain payoff in sight. The iOS tracking changes have impacted their ability to deliver targeted ads. TikTok, at that time, was a big concern. It feels like a bit less of a competitive concern now. But there are still very real risk factors. But this is still a world-class business. It's among the best businesses in the world, if you're being objective about it, with a leader who I consider one of the best executives in the world. At the time, in October, it was trading at just a very, very cheap valuation. Now, I think it's still attractively priced, but not as attractively priced as it was. You mentioned margin of safety there.

I want to dig in on that concept. Why is finding a margin of safety so important to you? Yeah, it goes back to the definition of value investing. I want to figure out what I think an asset is worth and then buy it for less than that amount. That is your margin of safety, the difference between your estimate of intrinsic value and the amount that you're paying for a company. Ideally, you want that margin of safety to be as wide as possible. It protects you on your downside in case your investment thesis doesn't pan out the way you expect. It gives you a little boost to your upside potential if things do go as you expect. I can imagine, if you're listening, there's a chance you may have wrinkled your nose a bit

hearing that Mark Zuckerberg is one of the greatest executives in the world. I guess that would be, by definition, a stinky feedstock. And I think that's been a concern for many, though, which is that historically, he has bought back shares at extraordinarily high prices. And he doesn't have a board to keep him in check, to rein him in on those capital allocation decisions that are so important to investors. Yeah, for sure. If you're investing in Facebook, you're betting on Zuck. I mean, the guy's all in on the metaverse. He's got this grand vision for what the future of computing is going to look like. And he feels he needs to pivot the company there aggressively in order to benefit from that, or even maybe in order to participate

in that. I'm not a tech visionary. I don't know. But he is. He's been very right about a lot of changes. It was not popular when he pivoted the company towards mobile. That was the right decision. It was not popular when he bought Instagram. People laughed. He spent like a billion dollars on Instagram and everyone laughed. And that's one of, it's on the short list of the greatest acquisitions of all time. Like he knows what he's doing. He's completely invested in every sense of the term in the company. And he's exposed to trends and technology and thinkers that are living years ahead of what we've experienced. So if I had to bet on someone to figure out what the future of technology was going to look like, Zuckerberg would be on the short list of

candidates. You work on a service at The Motley Fool called Value Hunters. And I don't want to necessarily give away a pick, but are there any other value opportunities without Mark Zuckerberg that you want to discuss? Maybe one on your radar. Yeah, sure. And I'm happy to give away a pick. This is a pick in the Value Hunters service. It's called Wesco International, ticker WCC. Wesco is a really well-run distributor. It helps deliver electrical, industrial, and communication products from 45,000 suppliers to 140,000 customers. I know it might be hard to visualize what that might look like, but a typical customer might be a data center or an electric utility or a manufacturer. And Wesco provides them with all the things they need to run their

facilities, wire, cable, lighting, electrical equipment, power, safety, security. It goes on and on. It's just tens of thousands of products. I mean, that's a company that many people don't have a lot of touch with, but when you described it, it kind of sounds like a CentOS, but from a more industrial level. Yeah. I think that's a really good analogy. I think that might help people get more comfortable with it. And I should point out, it's not just about distributing the products. They obviously do that. They're a distributor. But Wesco also provides value-added services to those customers, like warehousing, inventory management, and equipment assembly, where they will make all the pieces of equipment that you

might need on a construction site, on a job site, and then they will actually lay them out. They will kit them out in the order that the workers need to pick them up and assemble them. So it saves you labor as a company. It saves you labor. It makes things more efficient for your operations and the inventory is being kept off your balance sheet. So it's very attractive. 70% of Westco's revenue has some sort of service attached. So they're really tightly integrated with their customers. If it's got such a great business model, though, why do you think it's trading at such a discount to some of its competitors? Yeah, it's a bit of a head-scratcher. I think, historically, the business was a bit more

cyclical. If we go back a bit, Wesco has always been a really well-run distributor. But the thing that's really attractive here is, in 2020, they merged with another equally-sized, really well-run distributor called Anixter. That basically doubled the size of the business overnight. This has been a case where one plus one equals three, where the value that has been created from this merger, just every single quarter, they're just producing more and more value, and they make their initial estimates at the time of the merger look laughable in retrospect. What's been really successful is, Wesco can cross-sell its products and services into to Anixter's customer base and vice versa, and they're just creating so much value.

I mentioned, it doubled the size of the business. Distribution is a business where scale is really important, and this combined entity, they're now the largest player in a very fragmented industry, so they get volume purchasing discounts. So, basically, they can buy cheaper and distribute more effectively than competitors. it's hard to determine why a customer would go with someone other than Wesco. Rich Griefner, appreciate your time and your insight. Learned quite a bit about value investing in this conversation. Thank you, Ricky. As always, people on the program may own stocks discussed on the show and The Motley Fool may

have formal recommendations for or against, so don't buy or sell anything based solely on what I'm Dylan Lewis. We'll see you tomorrow.