My Favorite Investing Book: Value Investing From Graham to Buffett and Beyond, 2nd ed.

by Bruce Greenwald, Judd Kahn, et al.

This is far and away the best book on investing I have read. It’s regrettable that I found it so late. Often investing books will get lost in formulas, provide too narrow examples or not consider the business within economic terms. This book walks a perfect balance between context and case studies. For example, it breaks down concepts like the time value of money in a simple way (Ben Graham never explicitly talks about this), which is essential to understanding investing. It covers different value investing models, but is still able to distill these to a few useful principles and a few useful case studies.

While there are a few pages that are fairly economic formula heavy, Greenwald does an excellent job of breaking these down equations into their parts which helps you walk away with applicable insights into valuation.

Overall, the book is great because of its ideas, so let me share a few key ideas from the book that I found valuable.

You can and should value a business in 3 ways: net asset replacement value, normalized earnings power, future earnings (growth).

In most other investing books, typically only one method of valuation (most often discounted future cash flows) is discussed. Greenwald is wise to evaluate a business on 3 levels, and most accurately value the firm.

Greenwald’s first model is net asset replacement value. Essentially asking, “How much would it cost me to replicate all the assets of this business right now?” This value is similar to Graham’s liquidation value.

Greenwald’s second model is durable earnings power. Essentially “How much cash will this asset produce for owners in its current state?” Or “What is the cash return of this business?”

Greenwald explains that a business with an adjusted earnings power higher than it’s asset replacement value may be a franchise business with good prospects for growth. A business without advantages and protection should not expect to maintain a earnings power greater than its net asset replacement value in the long run. That is if this business truly possesses durable competitive advantages and a resulting moat against market entrants. With no moat, entrants can recreate the firm at its net asset replacement value and reduce expected earnings rates closer to the cost of capital.

Moat can be measured

Measuring moat was never clear to me. Greenwald provides the best measurement for moat that I have found.

1. Start with the required market share that a competitor would need in order to earn anything above its cost of capital (be a profitable investment). Greenwald does this by taking a businesses in one industry and finding the minimum market share needed to be profitable. Observing the soft drink market we can say that must be at least 20%.

2. Now for a new entrant to get to that market share they need to take it from competitors, so we next look at how much of the soft drink market changes hands each year (how captive is the customer to existing brands). For example in soft drinks we would find that change in market share to be 0.2% per year.

3. So it would take 100 years for a new market participant to reach its minimum viable market. That is a wide moat.

Very simple, and very true.

We can also calculate minimum viable market

1. Identify Fixed Costs: List the company’s annual fixed costs, such as administrative expenses, rent, and equipment maintenance.

2. Estimate Contribution Margin: Calculate the margin per unit of product/service after covering variable costs (e.g., price per unit – variable cost per unit).

3. Determine Required Sales Volume: Divide the fixed costs by the contribution margin to find the minimum number of units that must be sold.

Required Sales Volume=Fixed Costs/ Contribution Margin

4. Translate Sales Volume to Market Size: Using the estimated market share and pricing, calculate the minimum size of the market needed to reach the required sales volume.

An advantageous investment is based on advantageous unit economics. He illustrates this idea perfectly. I always learn the most from theories applied to real life situations, so I appreciate the chapters dedicated to specific firms like Intel and WD-40.

The best investors are economists at heart

Greenwald makes it clear that understanding the economics of a business and competitive pressures is key to investing success. Buffett and Munger excelled at this where many others failed.

Greenwald differs from Michael Porter’s definition of competitive forces in sensible ways

Porter laid out 5 competitive forces:

1. Threat of new entrants.

2. Bargaining power of suppliers.

3. Bargaining power of buyers.

4. Threat of substitutes.

5. Competitive rivalry.

And seems to weigh them roughly equally.

Greenwald on the other hand sees new entrants as the key competitive force that far outweighs the others.

Porter finds 3 sources of competitive advantage

1. Cost Leadership: Being the lowest-cost producer.

2. Differentiation: Offering unique products or services.

3. Focus: Targeting a specific market niche.

While Greenwald identifies

1. Supply-Side Advantages: Cost advantages due to unique processes, patents, or proprietary technologies.

2. Demand-Side Advantages: Customer captivity and brand recognition that creates barriers to entry.

3. Economies of Scale: Cost efficiencies that deter competitors from entering the market due to the high initial investment required.

4. Focus: Firms should focus on building local monopolies and market dominance as the key source of competitive advantage and wise capital allocation. Basically “Does this firm understand competitive advantage and is it using its competitive advantages?”

Coca-Cola for example rose to dominance by using advantages 1 and 4, but maintains its dominance with advantages 2 and 3.

Use of discounted cash flow models is common, but can be perilous

DCF models are very sensitive to assumptions and can produce unreliable long-term projections. Greenwald takes issue with:

1. An overemphasis on Terminal Value: Most of the valuation in DCF models often comes from the terminal value, which is highly speculative and prone to error.

2. Uncertainty in Cash Flow Forecasts: Predicting cash flows far into the future is inherently uncertain.

3. Discount Rate Challenges: Small changes in the discount rate can lead to significant valuation swings. A 1% change in discount rate can impact your valuation by 12% or more.

4. False Precision: A DCF model can give you a false sense of security.

These insights were paradigm shifts for me in terms of how I value a business. I highly recommend you read this book as a premier on value investing, I have not read one quite like it.

You can buy it here: https://www.amazon.com/Value-Investing-Graham-Buffett-Finance/dp/0470116730