VALUE INVESTING

Benjamin Graham

This site discusses value investing concepts and principles, mainly from Benjamin Graham and Warren Buffett. Graham looked for companies that were undervalued and reasonably safe, with consistent, growing earnings, a history of dividends, and solid balance sheets. He recommended larger companies for more conservative investors.

In terms of metrics, Graham liked companies with a low trailing 12 month PE, preferably 10 or less. He used three year average earnings to make sure the trailing PE wasn't artificially depressed by blockbuster, one time earnings results. He also looked at the company's hard assets and possible liquidation value, trying to find stocks trading close to their tangible book value (preferring a price to tangible book ratio of 1.5 or less). Tangible book equals total assets minus goodwill minus total debt minus preferred stock. Multiplying the trailing PE by the price to tangible book, Graham liked the product of this figure to be 22.5 or less.

To reduce the odds of investing in cheap companies heading toward bankruptcy, Graham also liked stocks with less total debt than tangible book value, or with less long term debt than working capital. Working capital equals current assets minus current liabilities. Additionally, Graham preferred companies with lots of money to pay short term bills, so he recommended a current ratio of 1.5 or higher for aggressive investors and 2.0 or higher for conservative investors. The current ratio equals current assets divided by current liabilities.

Graham recommended holding a diversified portfolio of stocks to reduce risk.

 

Warren Buffett

Warren Buffett has said he values companies based on the discounted, present value of future “owner earnings.” He defines owner earnings as net income plus depreciation and other non-cash expenses, plus non-cash changes to the balance sheet, less the average capital expenditures and extra working capital needed to stay competitive and keep up unit sales.

 

CLAYTON CHRISTENSEN

Disruption Theory

Disruption theory has two branches: new market disruption and low end disruption. In The Innovator's Solution Christensen talks about new market disruption in the context of non-consumers who can't afford or use existing products. Existing incumbent products typically emphasize traditional performance measures/attributes like speed, quality, and reliability, and have an entire "value network," or market and operating context, tailored to the common needs of customers who prioritize traditional performance attributes. This value network is comprised of suppliers, distributors, cost structures, and internal processes.

A market entrant then introduces a new product that solves a job-to-be-done that incumbents have ignored, and that emphasizes different performance measures/attributes, like simplicity, convenience, portability, and accessibility. New performance attributes, and a new solution to an unmet job, lead to a "new market" of consumption -- or new market of consumers -- where none previously existed. New market consumers buy the entrant's product because it's more affordable and easier to use than incumbent offerings, or because it can be used in previously non-consuming situations (or on previously non-consuming occasions). The entrant's product has a value network tailored to the common needs of customers who prioritize non-traditional performance attributes/measures. Because incumbents have a value network tailored to customers who prioritize traditional performance attributes, it's difficult for incumbents to compete with the disruptive new entrant.

With low end disruption, a market entrant uses a new, low cost business model to profitably offer low end consumers -- who are overserved by existing offerings -- a simpler, more affordable, "good enough" option. Unlike new market disruption, which occurs in a new value network tailored to the common needs of customers who prioritize non-traditional performance attributes, low end disruption occurs at the low end of the existing mainstream value network. These low end customers still prioritize traditional performance attributes -- it's just that existing offerings which they currently use overshoot their needs. These customers want a simpler, more affordable option that still emphasizes traditional performance attributes.

Some products, like the PC, are new market and low end disruptions. The PC was a new market disruption in creating a new market of PC buyers who couldn't afford or use a mainframe or minicomputer but could afford, use, and access a PC. These new market buyers prioritized convenient, affordable access to a simple computing device over traditional performance attributes/measures like computing power and speed.

The PC was a low end disruption with respect to businesses that bought and used mainframes or minicomputers, and prioritized traditional performance attributes like computing power and speed, but only needed the power and speed of a more affordable, "good enough" PC.

Although entrants start with a new market or low end offering that prioritizes different product attributes and may be functionally inferior to competing products, these entrants gradually make technical improvements and move upmarket, taking more and more market share from incumbents. Incumbents are late to respond because they serve a different set of high margin customers who value better functionality or different product attributes. Incumbents aren't interested in trying to make low margin sales to new or low end markets that are small or of uncertain size, and therefore fail to make early, needed investments in the more affordable technology, the new business model, or the new cost structure. Incumbents typically retreat upmarket but eventually get displaced by the new entrants.

To avoid this kind of new market or low end disruption, when a product becomes highly reliable, and is becoming more than functionally "good enough" for the average customer, the incumbent seller needs to focus on making the product simpler, more affordable, more customizable, more convenient, and more accessible. The incumbent needs to adopt more affordable, accessible technologies that may be inferior to what the incumbent currently uses.

Most sellers don't do this because they don't want to move downmarket and cannibalize existing high margin products, and because they don't want to walk away from their most demanding high margin customers. But that's exactly what incumbents must do to avoid leaving a low end or new market opportunity for entrants -- when products start to overserve, incumbents must look for new ways to attract the average customer, or the non-consuming new user, with a simpler, more accessible, more affordable offering.

To get around the motivation problem inherent to cannibalizing existing products and abandoning high margin customers, incumbents should consider starting a separate organization or division to pursue the disruptive opportunity, or should possibly acquire/co-opt the disruptive new entrant.

For incumbents willing to simplify and move downmarket, or for new market or low end entrants, Christensen recommends focusing on a specific job that needs done. Existing good enough products often overshoot the simple, less glamorous job that many new market or low end customers really need accomplished. Customers in emerging markets, for example, may just need a phone with talk capabilities and great battery life (due to limited power and network availability) -- a smartphone badly overshoots the job they need done.

Companies that work in a cross-functional, multi-disciplinary way, across company functions, product divisions, and specific areas of expertise, are often the best at coming up with innovative new solutions to unmet jobs that need done. And effective CEO's are usually direct participants in the innovation process. They drive innovative ideas through associational thinking, which they foster through a corporate environment that encourages questioning, observing, networking, and experimenting to come up with new associations across disciplines and functions. Start-up and corporate entrepreneurs tend to have the best associating skills, followed by product innovators, process innovators, and finally non-innovators.

New market or low end jobs that need done are the best opportunities for new entrants to break into a market, and are the hardest for incumbents accustomed to high margins to respond to. By focusing on a simple low end job for a limited market, the new entrant avoids early, direct competition with incumbents that might otherwise put the entrant out of business. The entrant can then slowly move upmarket, improving margins and taking more and more market share.

The initial market for a disruptive product is usually small and then grows slowly over time. Christensen says new entrants should be patient for growth and impatient for profits. A new entrant should demand early profits to test the viability of its new market or low end strategy. Without the test of early profits, a new entrant can pursue the wrong strategy for a long time, continuing to invest time and money in initiatives that will never provide a meaningful return.

In pursuing early profits, Christensen says a new entrant should pursue the lowest cost structure possible, since this allows the entrant to capture a broader customer range as it slowly moves upmarket, and is a strategic weapon when the new entrant start displacing incumbents with higher cost structures.

A new entrant that tries competing in existing large markets for the incumbent's existing customers, often through a functionally impressive, high margin product, usually fails.  That's because: (1) the new entrant's offer must be markedly better to convince the incumbent's satisfied customers to take a chance and try something new; (2) when new entrants compete by trying to offer a functionally superior product to an existing large market, they must adopt and budget a high cost structure before revenues start coming in, making profitable sales more difficult; and (3) incumbents have the resources and motivation to fight hard for existing customers. Incumbents have the money, talent, and experience needed to make ongoing, sustaining product improvements that new entrants normally can't match (unless the new entrant brings superior and relevant resources, talent, and experience from work in a related or adjacent product category).

For all these reasons, it's very difficult for a new entrant to displace an incumbent by offering a high margin, functionally superior version of some product the incumbent already sells. As a general rule, disruptive products are functionally inferior to what's already available in the market.

Until a product becomes functionally good enough, vertically integrated sellers/manufacturers generally have an advantage over sellers who just assemble standardized, modular components made by different suppliers. Vertical integration permits rapid, innovative product improvement. When products start overserving and becoming commodities, vertically integrated sellers can improve profitability by entering adjacent businesses that aren't yet good enough, like component supply/manufacturing, retail distribution, or product service.

So What's Good Enough? 

In The Innovator’s Solution, Christensen notes that occasionally the customer's expectation of what's good enough can suddenly shift upwards. In the tech world, this happens when innovative new technology creates device capabilities and functionality that never existed before. Devices that were good enough before may suddenly be considered inadequate or obsolete. This may be the biggest question with Christensen's disruption theory: when what's good enough can suddenly change, as in the tech field, how can you really assess whether a product is overserving? What's overserving one day may be underserving the next.

In industries where what's good enough can rapidly change, vertically integrated sellers should have an advantage because they're better positioned to consistently make breakthrough innovations that change customer expectations of what's good enough. And vertical integration doesn't just facilitate breakthrough product improvements that change expectations -- it facilitates the creation of innovative new products that change expectations. A non-integrated company assembling modular components isn't pushing the next big innovation -- it's driving down component costs and trying to assemble the final product as cheaply as possible.

Non-integrated companies typically compete based on product customization, choice, and affordability rather than cutting edge product functionality. A non-integrated approach makes sense when: a product becomes functionally good enough; product components, and component interfaces, have standardized (permitting easy, "snap-together" assembly); and customer expectations of what's good enough don't change much over time.

Skate to Where the Puck is Going to Be

Wayne Gretzky famously said he tried to "skate to where the puck is going to be, not where it has been." This was one of Steve Jobs's favorite quotes. It's a concept that's never really discussed by Christensen, but it seems highly relevant in analyzing how a company should address unmet jobs that need done, whether those jobs entail improving affordability and moving downmarket, improving functionality and moving upmarket, or starting a whole new product category.

When looking at unmet jobs that need done, companies should focus on where the market is going to be, and what future markets will need or demand, not on where the market is or has been, and what the current market needs or demands. What looks functionally good enough for today's needs may not be functionally good enough to satisfy future needs. What looks unaffordable for today's market may be affordable for future markets.

John Gruber at daringfireball.net writes a very insightful blog about Apple. When the iPhone 5c was introduced, many people thought Apple failed to make the product affordable enough for the Chinese market. Gruber wrote the following in response:

"When the iPhone 5c came out last month and was not 'low cost,' many took it as a sign that Apple was somehow ignoring China. I would say it's just the opposite: they're skating to where the puck is heading, not where it is, and positioning their products to thrive as China's upper class grows."

When looking at unmet jobs that need done, whether it relates to improved affordability or improved functionality, companies should look at future markets and future needs. A product that seems too expensive today may become more affordable as living standards improve. A product feature or component that functionally overserves today may be essential next year.

In Cubed podcast #2 with Ben Bajarin, Benedict Evans, and Ben Thompson (released September 25, 2013), the moderators raise the point that Apple, as an integrated hardware/software maker, can start designing, engineering, and making a complex future product years ahead of time, slowly and patiently putting the pieces together, whereas more modular, specialized companies that work with partners -- such as Google or the pre-Microsoft version of Nokia -- often lack the in-house range of capabilities needed to do this. See cubed.fm. It's an interesting point because it means integrated companies may have an advantage in addressing future markets and future needs, and skating to where the puck is going to be. Integrated companies are also well-positioned to keep long term plans secret (versus more modular companies), giving them a bigger head start when they finally do release a breakthrough product.

Good Product Design May Prevent Overserving

Although not addressed by Christensen, good product design may help sharpen focus on the specific job that needs done, preventing functionally overserving products. Dieter Rams, the former product designer for Braun, is famous for stating that: product design should develop in unison with better technology; products should be designed to enhance usefulness while avoiding features and window dressing that detract from usefulness; usefulness encompasses aesthetic qualities like look and feel; and good design makes the product simpler and easier to use.

Tom and David Kelley (of the design firm IDEO) say that companies should encourage innovation and creative design ideas across all divisions, not just the R&D division. And companies can improve learning by observing how customers use the product and by increasing the rate of experimentation, often through rapid, iterative prototyping. Expectations for initial prototypes should be kept low to encourage employees to come forward with new ideas.

Consumer Markets

Ben Thompson at stratechery.com has noted that with pure consumer markets user experience and ease of use are the priorities, and these qualities are never really "good enough." Business customers, by contrast, care less about the subjective user experience and are more focused on the measurable benefits of product improvements versus the costs of these improvements.

Ben Bajarin at techpinions.com says that mass market consumers often choose products based on personal preference, not based on a pure, rational weighing of costs and benefits and what's good enough, and that disruption theory is less applicable to these kinds of markets. Consumers often buy appliances based on what's good enough, but they often buy items like cars, clothes, jewelry, purses, and shoes based on personal preference. And the greater the role of personal preference, the less that disruption concepts like good enough apply.

The corollary of all this is that with business markets, overserving is a greater risk because subjective, unmeasurable elements like user experience, ease of use, personal preference, and product aesthetics (look, feel, and quality) are less relevant. A consumer will pay for a BMW as his own personal car based on user experience, personal preference, and product aesthetics -- a business buying company cars for its salesmen will not. Consumer markets also tend to be larger than business to business markets, so there's usually a sizable market segment willing to pay up for aesthetics and a superior user experience.

All this raises an interesting question. If user experience, ease of use, and product aesthetics in consumer markets are never good enough, then can a company with a business model that targets the consumer market but compromises these subjective elements ever disrupt a consumer-focused company with a business model that doesn't make these compromises? A company may be able to stave off disruption by squarely focusing on a superior user experience, ease of use, and product aesthetics for large consumer markets.

Functional vs. Divisional Organizations

Horace Dediu at asymco.com has written extensively on the idea that companies organized by function (such as design, engineering, operations, marketing, etc.) may do better than companies organized by product division when it comes to moving downmarket with new, cannibalizing products. This is because product division managers typically have P&L accountability for their respective products, which make them unwilling to pursue anything that might jeopardize the sales and profits of their product divisions. With a functional organization, there’s only one P&L — which covers the entire company — so functional managers are more willing to invest in new disruptive products, even if it results in cannibalization.

Dediu has noted that product divisions may be best suited to maximizing short term profits, while functional divisions may be best suited to maximizing innovation (and possibly long term profits).

Ben Thompson at stratechery.com has noted that a functional structure is more difficult to maintain when a company has several products, since the CEO and the rest of the leadership team must coordinate functions across all these products (versus a single product manager for each product division). A functional structure may work best with just a few products, while a product division structure may work best with a wide range of products.

 

MICHAEL PORTER

Activities and “Fit”

Michael Porter says that companies create a competitive barrier, and gain a competitive advantage, by combining activities that “fit” well together and are difficult for competitors to match. The odds of matching activities goes down as the number of activities goes up, so the greater the number of activities, and the better the fit across these activities, the greater the barrier to new entrants.

Porter also says that tradeoffs, in terms of focusing on one strategy instead of many, can increase fit and further raise entry barriers. New entrants may be unwilling or unable to make these tradeoffs, instead trying to “straddle” two or more strategies.

When companies try more than one strategy at a time, the activities or processes required to support multiple approaches often conflict, creating process and cost inefficiencies, confusing employees and customers, and making it difficult to achieve fit across activities. These problems often leave straddlers unable to compete with more focused competitors.

Generic Strategies

Porter recommends that companies focus on one of four generic strategies: (1) target a broad market with a differentiated product; (2) target a narrow/niche market with a differentiated product; (3) target a broad market with a low cost product; or (4) target a narrow/niche market with a low cost product. The place you don't want to be is "stuck in the middle," with an undifferentiated product that's not low cost. Companies that get stuck in the middle typically lose market share to low cost competitors from below and high end, differentiated competitors from above. The goal in adopting just one of the four generic strategies is to create, over time, a set of complementary activities with great fit and clear tradeoffs which competitors are unwilling or unable to match.

In Understanding Michael Porter, by Joan Magretta, Porter says there are different kinds of disruption. He says that while low end, Christensen-style disruption can occur, high end companies sometimes disrupt low end companies by simplifying a sophisticated product/approach to reduce manufacturing costs and make the product more affordable.

The Five Forces

Porter says five forces influence the profitability of an industry: (1) buyer power; (2) supplier power; (3) rivalry/competition within the industry; (4) the threat of new entrants; and (5) substitute products. It’s striking how Porter’s five forces theory dovetails so well with Clayton Christensen’s disruption theory (see discussion of Christensen above).

Savvy, well-informed buyers can force down prices by making rivals compete with each other. Buyers are more powerful when: there are few buyers and many suppliers; the product is a big percentage of the buyer's costs/budget (which also leads to greater price sensitivity); the industry’s products are all similar; the switching costs for changing suppliers are low; or buyers can make the product themselves, entering the supplier's business. Similarly, Christensen says vendors of good enough, commoditized products should enter component supply businesses that aren't yet good enough and are therefore more profitable (see discussion above).

Suppliers are powerful and can limit industry profitability if: there are few suppliers and many buyers; the switching costs for changing suppliers are high; suppliers sell a unique or differentiated product; or there is nothing to substitute for the suppliers’ product.

Industry competition/rivalry limits profits and is strongest when: there are several competitors; competitors are similar in size and power; the industry is growing slowly (leading to market share battles); or a competitor wants to dominate the industry. Price driven competition hurts industry profitability, while competition on non-price factors like functionality, quality, or ease of use improves industry profitability.

Industry incumbents may have to keep prices low -- or increase capital investment -- to reduce the threat of low end, Christensen-style disruption via a new entrant. When a new entrant does arrive, the entrant typically pursues market share and adds product capacity/choices. This puts industry-wide pressure on prices, costs, and the investment needed to compete. New entrants may also come from other industries, using external cash flows and different ways of doing business to fundamentally change the industry they’re entering (possibly through a disruptive, low end business model).

Substitutes perform a function similar to the industry’s product, but often in a way that’s cheaper, simpler, and more convenient (applying Christensen’s concepts). Online courses are cheaper and more convenient than full time college. If the industry’s product doesn’t differentiate itself from the substitute, then industry profitability and growth will suffer.

 

SOURCES AND RECOMMENDED READING

A review of the concepts discussed on this website is no substitute for reading the original sources, which include:

The Intelligent Investor, by Benjamin Graham (Harper & Row, Fourth Revised Edition, 1973)

Security Analysis, by Benjamin Graham and David Dodd (McGraw-Hill, Sixth Edition, 2009)

The Rediscovered Benjamin Graham, edited by Janet Lowe (John Wiley & Sons, Inc., 1999)

The Essays of Warren Buffett, edited by Lawrence Cunningham (Carolina Academic Press, Second Edition, 2008)

The Innovator’s Dilemma, by Clayton Christensen (Harvard Business Review Press, 1997)

The Innovator’s Solution, by Clayton Christensen and Michael Raynor (Harvard Business School Publishing Corporation, 2003)

Seeing What’s Next, by Clayton Christensen, Scott Anthony, and Erik Roth (Harvard Business School Publishing Corporation, 2004)

The Innovator's DNA, by Jeff Dyer, Hal Gregersen, and Clayton Christensen (Harvard Business Review Press, 2011)

How Will You Measure Your Life?, by Clayton Christensen, James Allworth, and Karen Dillon (HarperCollins Publishers Inc., 2012)

Competitive Strategy, by Michael Porter (The Free Press, 1980)

Competitive Advantage, by Michael Porter (The Free Press, 1985)

Understanding Michael Porter, by Joan Magretta (Harvard Business Review Press, 2012)

HBR's 10 Must Reads on Strategy, "What is Strategy?" by Michael Porter (Harvard Business School Publishing Corporation, 2011; article originally published in November, 1996)

Creative Confidence, by Tom Kelley and David Kelley (Crown Business, 2013)

The Art of Innovation, by Tom Kelley (Doubleday, 2001)

Jony Ive, The Genius Behind Apple's Greatest Products, by Leander Kahney (Penguin Group, 2013)

Harvard Business Review, "The New M&A Playbook," by Clayton Christensen, Richard Alton, Curtis Rising, and Andrew Waldeck (March, 2011)

The Outsiders, by William N. Thorndike, Jr. (Harvard Business Review Press, 2012)

High Flyers, by Morgan W. McCall, Jr. (Harvard Business School Press, 1998)

Creativity, Inc., by Ed Catmull (Random House, 2014)

One More Time: How Do You Motivate Employees?, by Frederick Herzberg (Harvard Business School Publishing Corporation, 2008; article originally published in the Harvard Business Review in January, 2003)

Dieter Rams: As Little Design as Possible, edited by Sophie Lovell (Phaidon Press Limited, 2011)

Becoming Steve Jobs, by Brent Schlender and Rick Tetzeli (Random House, 2015)

Blockbusters, by Anita Elberse (Henry Holt and Company, 2013)

Blog and Podcast Sites

asymco.com

stratechery.com

ben-evans.com

barnetttalks.com

aswathdamodaran.blogspot.com

praxtime.wordpress.com

techpinions.com

stevecheney.com

daringfireball.net

5by5.tv/criticalpath/

exponent.fm

cubed.fm