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Large spenders, Large value

By Alex Lanoie. Originally published at ValueWalk.

Key lessons:

  • Non-traditional businesses may have hidden value as compared to traditional ones
  • Expenses, depending on their nature, can bring long-term value
  • Valuation methodology remains the same, but in-depth understanding is even more critical

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Seth Klarman

Since I’ve started to be interested in investing, I’ve always had a strong inclination towards value investing. This particular investment philosophy traditionally focuses on businesses generating an interesting cash flow, with a strong balance sheet, and which the investor understands well and can easily project its performance in the future. Obviously, there are a multitude of variances to the typical value investing approach, such as the deep-value approach, the net-net approach, etc. However, I’m more of the conventional type. The way I like to value companies is to consider how much the future stream of earnings of a firm is worth as of today – quite simple, not always easy.

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Such an approach, applied with consistency, have led me to consider companies which operate mainly in more traditional industries, such as utilities, retail, manufacturing, and others. However, I’ve recently started to feel that there were many companies and industries which I wasn’t considering and which had incredible value, even from a value investing point of view. I felt there was something I was missing. There was a need to grow my snowball further! (The SB effect in action!) As a constant learner, I’ve therefore become interested and curious to know how companies such as Amazon could grow so much in value (market value at least) and barely make any profit. The idea that investors were banking on the fact that, one day, the company would be hugely profitable seemed over simplistic. How can you project 10 or 20 years into the future when projecting even one year is challenging? So the real question is: how can you value a firm and therefore its future stream of earnings if it doesn’t even make any money as of today? (I’m obviously far from being a VC type of investor.) And so, I started reading about the subject, looking at the financials of some of these companies and believe I have found at least a partial answer to my question. There certainly is more to this but it’s a start!

Don’t get me wrong, I’m not saying it’s possible to understand every company in existence and this is not what I’m trying to achieve. And you should definitely stick to your circle of competence. That being said, there are several companies which their business can be understood but their financials are more challenging to get a grasp of as they don’t follow the “typical” model of good revenues, high profit margins and stable and predictable growth – which can be quite a clash when compared to traditional industries. Nowadays, these companies are often operating in the technology space (think Facebook, Alibaba, Amazon, Tencent, etc.). However, it’s important to note that many of these firms today are not necessarily offering or creating revolutionary technologies but instead use technology in a clever way to offer great products or services and they do this at on an incredible scale. These are the type of companies which attract my attention. I’m no scientist and far from having the capacity to judge and value companies offering new cutting hedge technologies. So, what makes these companies different? Where’s the value? How should we look at valuing these companies? Let’s first look at two important differentiating factors.


Nature of expenses

Warren Buffett once said that the valuation ratio Price-to-Earnings (P/E) did not have much importance when he conducted the analysis of a company. This can be rather controversial as so many investors rely heavily on this metric when making investment decisions. But why is that and why is it relevant in this case? The Oracle of Omaha has repeated several times over the years that the net profit of a company (the denominator of our P/E ratio) calculated following the accounting standards can be vastly different from what company owners can end up with in reality. When considering expenses and outflows of cash, this is largely due to the fact that some outflows are capitalized (capital expenditures in our case) and therefore not accounted as expenses but as purchases of assets, which are then depreciated over time. This allows for a lot of manipulations – whole books have been written on this topic. So, when looking at expenses on the income statement and capex on the cash flow statement, the first step is to make sure that, as an investor, you understand the items which are being expensed and the ones which are capitalized. It can be quite straightforward for traditional industries. For example, you buy a machine for your factory, which you will use for 10 years, you capitalize the purchase and depreciate it for 10 years – easy enough. However, it can get much more complex to make the difference between simple expenses and capital expenditures when considering, for example, companies using and/or selling software which are either produced in-house, outsourced, or bought from a third party, or a combination of these. There obviously are accounting standards which need to be followed such as GAAP and IFRS, however it is not always black or white. This is the more boring, accounting side of things and is the first step. The second part of the analysis should be kept clearly in mind while conducting this first step. Once you have a good understanding of what exactly is expensed and what is capitalized, it’s time to look at the business side of the equation.

This is honestly where I learned the most doing my research. Beyond the expense ratios and the trend of these over time, you want to look into the details and understand what exactly the company is spending money on. You want to find out if the cash outflows are in reality investments which will generate additional revenues for the firm in the future or if they are expenses which are necessary to run the business on a day-to-day basis, such as direct costs of sales or G&A expenses. Amazon is the perfect example. Over the years, Amazon has been generating a growing amount of cash out of its operating activities – about $6.8b in 2014 up to $16.4b in 2016. But the company is far from having high profit margins. Year after year, it’s the same story. So how is it that the company isn’t able to increase its margins? When looking into the details, you realize that, it certainly could, it just doesn’t “want” to. In terms of financials, Amazon is very focused on cash flow instead of income statement. And the main reason is that, every year, Amazon generates cash and takes most of that cash and reinvests it directly into the business, whether it is in the form of capex or other relevant expenses. You want to make sure though, that over time, the increasing capex and expenses are used to productively reinvest in the business to generate

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