The Fundamentals of Value Investing

In this podcast, Motley Fool senior analyst Rich Greifner and Motley Fool producer Ricky Mulvey 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.
• Unpopular companies that may be worth your attention.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on Feb. 24, 2023.

Rich Greifner: It goes back to the definition of value investing. I want to figure out what I think an asset is worth and 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. Ideally you want that margin of safety to be as wide as possible. It protects you and your downside in case your investment thesis doesn't pan out the way you expect. It gives you a little boost, your upside potential if things do go as you expect.

Dylan Lewis: I'm Dylan Lewis and that's Motley Fool Senior Analyst Rich Greifner. 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.

Ricky Mulvey: This is a simple question, but possibly difficult to answer Rich. What does it mean to be a value investor?

Rich Greifner: The term value investor means different things to different people. I think too many people wait, conjures up the image. This shavelly dressed guy scouring the street searching for discarded cigar butts and hopes of getting one last puff of value for free. That's not an image that's really resonated with me. That's not a style of investing that has worked well for me historically. I much prefer Joel Greenblatt's definition of value investing. That is, I'm trying to figure out what an asset is worth and then buy that asset for much less than that amount. I really liked 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.

Ricky Mulvey: I think the cigar butt type of investing, that's the Benjamin Graham. My guess is that probably worked better when there was just less information available and markets were baby a little less efficient.

Rich Greifner: No, for sure you're absolutely right. It used to be like, back in Grahams' day, back in the early Buffet days, he would literally like 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. Or 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.

Ricky Mulvey: Makes sense. What temperament? Because value investing maybe isn't for anyone. You 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?

Rich Greifner: I think there's a couple of 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 company is that you choose to invest in are probably going to be out of favor. Often they're going to be unpopular and like 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, they can take a long time for your investment thesis to play out. Last but not least, you need to be disciplined. There 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.

Ricky Mulvey: What's it mean for business to be wildly unpopular but attractive to a value investor?

Rich Greifner: Dan Loeb has a concept that I really like. I think you called it stinky feet stocks. Which is hard to say what it's easy to understand, which is when you mentioned the name of accompany to someone they become that stink face like they just smelled some horrible stinky socks.

Ricky Mulvey: Nice. For a value investor. Is this the person who's more concerned about not losing money or more eager to outperform the market?

Rich Greifner: I think most investors would probably say they're more concerned about not losing money. But the truth be told, it's hard not to play that relative comparison game when the scoreboard is updated every second. But it's interesting the way that you pose 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.

Ricky Mulvey: You didn't mention momentum.

Rich Greifner: No, not a factor.

Ricky Mulvey: Value investors are sometimes at odds with growth investors. 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?

Rich Greifner: 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 in 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. I think everyone's portfolio should have a mix of companies that might be defined as traditional growth or traditional value.

Ricky Mulvey: 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? What's that mean?

Rich Greifner: It can be important. It used to be a lot more important as you noted, during the days of Ben Graham and his heyday, it was a lot more important. Taking a step back. Book value is and accounting concept. It's simply the value of the company's assets minus its liabilities. You can think of this. For listeners who might own their home, you can take the value of your house, subtract the outstanding principal amount on your mortgage. 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.

Ricky Mulvey: Then what would be the intrinsic value of accompany? How's that? How's that different than that simple net worth calculation?

Rich Greifner: Sure. Book value isn't 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?

Ricky Mulvey: 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?

Rich Greifner: Yeah, sure. 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, OK, 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. Book value as I mentioned, it can be a useful metric, but it only for a certain type of company. That'd be for like 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 Alphabet or Meta, or any software business like the real value is being created by their engineers and their code and their brands. Those factors are just not accounted for in the book value calculation.

Ricky Mulvey: If you see a company trading at a discount to its accounting value, is that more of a red flag or is that more of a let me check this for a potential mispricing opportunity.

Rich Greifner: Depends on the industry. For a software company, it's a non-factor. For financial it could be interesting, but it's also probably like the markets referendum on the quality of that business. But it's certainly something worth investigating.

Ricky Mulvey: Maybe not a full breakdown. But how do you find a company's range of intrinsic values?

Rich Greifner: Sure. Yeah, there's many ways than a full breakdown could be its own podcast. The way that I tend to do it to calculate 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. 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?

Ricky Mulvey: 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 thing?

Rich Greifner: No. Those types of relative multiples are useful, but they're really just a snapshot in time. Like I said, what I really care about is the company's ability to generate free cash flow in the future, so looking at multiple over any arbitrary one-year period, it doesn't really inform you about the company's future prospects. Those multiples can be useful, but I think you need to go beyond them, they're not the end-all and be-all. 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 one is actually expensive.

Ricky Mulvey: I want to expand on that. What would be a case like maybe a hypothetical case where that matters? Enterprise value just real quick, is, this 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?

Rich Greifner: 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 1 or year 2, 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 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.

Ricky Mulvey: Markets are supposed to be efficient and 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?

Rich Greifner: 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, and I was in class and the professor would say, these guys won the Nobel Prize for this efficient market's hypothesis. I thought, it's probably correct then. At the same time you'd see these companies changed their name to such and such Internet company and the stock would triple in a week. I was like, these two things can be true. The efficient market hypothesis can't be true and coexist with this type of stock market behavior. I concluded at that time the efficient market hypothesis wasn't all it was cracked up to be.

Ricky Mulvey: 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, think I am, where you also see markets may be overpriced or overpriced bad news where you're seeing, in some cases, strong businesses where their priced stocks declined by like 30%-40% in a day if they miss expectations or there's a little bit of bad news, especially for the more thinly traded businesses.

Rich Greifner: Theoretically, that could be efficient if the if the piece of news comes out and 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 and making those future free cash flows worth less. In theory, a 30% price swing could be justified. But in reality, no. Intrinsic value is not really changing that much day-to-day and stock prices are much more volatile than fundamental business changes.

Ricky Mulvey: Fair enough. Then what 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?

Rich Greifner: We talked about multiples before. Here's where I think they're really useful. Where if something sticks out, if every other company in the industry is trading at a multiple of five and this company is trading at a multiple of 10 or 2. That's interesting. There's something going on there. 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 when we talked about Dunlop's stinky feet stocks before. If everyone's reaction to a company is universally negative or flipside universally positive. It's like, well, that's probably not right. There's the real answer is probably somewhere in between the two extremes.

Ricky Mulvey: We may get to one of those businesses in a moment and then I often associate dividends, like looking for companies paying large dividends, with value investing. Are dividends important to you or important to value investors?

Rich Greifner: I think they're important to value investors. They're not very important to me. This is someplace where I may differ. I don't want dividends. If a company wants to give me money, I will take it, but dividends are really my least favorite form of capital allocation. 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. 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 are 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 at really attractive 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.

Ricky Mulvey: I think the argument against those, 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.

Rich Greifner: People will say that, but I'd rather invest in a management team that doesn't need those constraints imposed upon it. Like they're just good at allocating capital, they don't need those false boundaries.

Ricky Mulvey: 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.

Rich Greifner: For sure. Share repurchases can be a really powerful tool but most companies, I agree with you, that most companies don't really use them well. When they're flushed 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 when it's like you should be doing the exact opposite.

Ricky Mulvey: I think this question goes beyond metrics, but what are some signs to you that a management team is good at capital allocation?

Rich Greifner: I like to see a management team that acts strategically and opportunistically. I always want that management team putting capital toward its highest and best use. That can be reinvesting in 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.

Ricky Mulvey: Let's move on to some application stuff because in October, you're on with Alison Southwick and Robert Brokamp and you pitched Meta as a value stock. I think you could categorize that company as a stinky feedstock 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?

Rich Greifner: 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 then immediately after I pitched it, the stock drops to 90. But as we mentioned before, the intrinsic value of the company hadn't really changed that much. It was the stock price that has really fallen off a cliff. I thought that was an exceptionally attractive opportunity and sure enough, now the stock has more or less doubled from that lower, 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. It definitely was a stinky feedstock when I pitched it back on 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 and TikTok at that time was a big concerns, 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 cheap valuation. Now I think it's still attractively priced, but not as attractively priced as it was.

Ricky Mulvey: 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?

Rich Greifner: 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 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.

Ricky Mulvey: 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 sticky feedstock. 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 rain him in on those capital allocation decisions that are so important to investors.

Rich Greifner: Yeah, for sure. If you're investing in Facebook, you're betting on Zuck. The guy is 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 toward mobile, that was the right decision.

It was not popular when he bought Instagram, people laughed, he spent a billion dollars on Instagram and everyone laughed and it's on the shortlist of the greatest acquisitions of all time. 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. If I had to bet on someone to figure out what the future of technology was going to look like Zuckerberg would be on, again on the shortlist of candidates.

Ricky Mulvey: You work on a service of 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?

Rich Greifner: 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 that's, 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.

Ricky Mulvey: That's a company that many people don't have a lot of touch with. But when you described it, it sounds like a Cintas, but from a more industrial level.

Rich Greifner: 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 keep them out in the order that the workers need to pick them up and assemble them. It saves you labor as a company. It makes things more efficient for your operations and the inventory is being capped off your balance sheet. It's very attractive, 70% of Wesco's revenue has some service attached, so they're really tightly integrated with their customers.

Ricky Mulvey: 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?

Rich Greifner: 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, and that basically doubled the size of the business overnight and this has been a case where one plus one equals three, where the value that has been created from this merger, it 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 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 are now the largest player in a very fragmented industry. 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.

Ricky Mulvey: Rich Greifner, I appreciate your time and your insights. Learned quite a bit about value investing in this conversation.

Rich Greifner: Thank you, Ricky.

Dylan Lewis: 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 you hear. I'm Dylan Lewis. We'll see you tomorrow.