There are many valuation metrics and Technics investors use to try to estimate a company’s worth. Still, essentially, the strongest approaches, in our view, boil down to trying to come up with the “best guess” of the present value of the net cash flow the company will generate in the future. We are talking about net cash flow because the cash the company receives from its sales (minus what pays its employees and after it covers all its other cash costs and expenses) needs to be adjusted for the outlays needed to reinvest back in the business to generate even more cash in future years.

Companies also often receive cash from banks and other creditors (such as the holders of their bonds), so the net cash we use to calculate the value of the stock also needs to be adjusted for the claims that creditors have on the company. We will learn more about the accounting details in other sections, but for now let’s just remember that enterprise or firm value is what “belongs” to shareholders and creditors of a company. After we subtract the net debt from the enterprise value, we come up with the equity value, which is what stockholders of a company own. The equity value of a company is also known as its market capitalization, and when you divide this by the company’s shares of stock outstanding, you come up with the stock price.

A simpler, better known metric, to estimate a company’s valuation is its price-to-earnings (P/E) ratio. For companies with relatively stable earnings prospects, the P/E provides a reasonable approximation the discounted value of its future earnings, as it tells the investor how many times one year’s earnings the stock price is currently discounting. Thus, the P/E is a reasonable yardstick for a stock’s valuation. Everything else being equal, the lower the P/E, the more attractively valued the stock is said to be. However, there are many caveats to this statement. Different industries have different P/E ranges, the more stable the industry (and the company’s earnings streams), and the higher the P/E can be without necessarily making the investment “expensive.” Very cyclical industries tend to present additional challenges. Some investors prefer to buy stocks of highly cyclical companies when they have a high P/E (or even one with a negative number, as when the company is losing money instead of generating positive earnings). The argument for that is that investors believe they have a better chance to be buying the cyclical company near the bottom of its cycle (when the company is earning least or even generating net losses), and thus when market expectations for the stock tend to be at their lowest.

There are value investors who prefer to focus more on “balance sheet” related ratios, such as the price-to-book (P/B) value of a firm. The P/B compares the stock price to the value of company’s assets minus its liabilities. More on this on a section of the nitty-gritty of accounting.


Businesses know they need to start with a Mission Statement.  Marriages begin with the exchange of vows.  As a stock analyst, we are also trained to always begin with our Investment Objectives.  Invariably, if someone walked into my office to ask for financial advice, I would begin with two questions: When do you need to get your money back (investment horizon)?  And how much risk are you willing to stomach (potential loss)?   Only afterward, do we even begin the conversation about return expectations or what to invest in.

In this sense, the value of any particular investment is a genuinely personal decision.  If our job is to find out what a particular stock is worth, its intrinsic value, then what we are really asking is “what is it worth to you”?  A horse is worth more to a farmer than a sailor.   A McDonalds happy meal is worth more to my kids than, well, any other rational human being.   Value is always in the eye of the beholder.  That is why our first task is to understand the “beholder”, and what this “beholder” really wants.

Similarly, with the even harder questions, I have found we need to be specific and make it personal.  We should not so much be asking ‘what is the meaning of life?’ but rather ‘what is the meaning of my life?’ It is not nearly as useful to question ‘why do bad things happen to good people?’ as ‘why did those bad things happen to me?’


Before I invest in a company, I also need to have a carefully thought out Investment Thesis.   The Investment Thesis is a basically a simple and clear description of:

Why I own the company?

What I expect to happen?

What I see that the market doesn’t give them credit for.

My experience has been there is hardly anything as valuable in keeping me focused and intellectually honest as this simple exercise.  Remember that the principles to successful investing are simple, but the hard part is adhering to them through the ups and downs of the market.  In this sense, the investment thesis becomes our anchor, even when the waters get rough or (the even more difficult) when the waters stay calm for a deceivingly long time.  If the thesis is still valid, nothing else matters.  If the thesis may be at risk, nothing matters more.

Successful value investor Martin Whitman concluded “Based on my own personal experience – both as an investor in recent years and an expert witness in years past – rarely do more than three or four variables really count. Everything else is noise.”

Let’s walk through an example using Apple.  If we were going to buy the stock, we would begin by understanding the competitive landscape.  We would analyze their smartphone, PC and software peers.  We would look at the company’s strengths, weaknesses, opportunities and threats (SWOT analysis).  We would analyze the financial statements and historical returns to shareholders.  We would speak to the company, speak with their suppliers, speak with customers, and speak with competitors.  Now suppose after all of that, we determine that Apple, 1) has a sustainable competitive advantage, 2) generates and allocates cash well, and 3) trades at a substantial discount to what they are worth (The Investment Formula).  We determine that we have found a high quality business trading at a relative bargain.

A “Buy” case Investment Thesis for Apple may look something like this:

Apple’s strong brand power will enable the company to sell their products at premium prices.

Apple’s ecosystem of inter-connected aps, videos and music fuels a loyal and sticky user base.

Smartphone and tablets are in their early stages of adoption globally offering significant growth potential.

Apple’s management promotes a culture of innovation and design for consumer electronics, creating a platform for future product launches.

In contrast, maybe our research uncovers some concerns about that company so that we feel that Apple’s current position may not be sustainable going forward.

A “Sell” Investment Thesis may look something like this:

Apple competes in the highly competitive industries of PC and smartphones.  History has proven that commoditization is inevitable, which makes Apple’s premium prices and margins unsustainable.

After the death of Steve Jobs, Apple’s product innovation has noticeably deteriorated.

Apple is heavily reliant on their supply chain of components which they do not control, which will limit future innovation.

Which thesis do you agree with?  I would argue that even more important than being right, is the mere fact that you are making a choice, writing it down, and constantly keeping yourself honest by referring back to it.   Of course, that being said, it is also good to be right.

Let’s assume that you believe the first scenario, and you go ahead and buy shares in Apple.  You sit happy knowing that every time someone in the world that goes out and buys and iPhone, they are earning you a small share of that profit.  You even go out and buy yourself a new iPhone using that same argument, fantastic!  But then the news starts pouring in:  Samsung is launching a fancy newfangled smartphone next month.  Apple’s quarterly earnings were 10% below expectations and the stock price tanks.   CEO Tim Cook is having a bad hair day.  What is going on?! Every day we wake up to either panic or euphoria in the news – how do we keep it all straight?

One simple trick, I constantly ask myself the same question: “Is the investment thesis still intact?”

For example:

Does Samsung’s new smartphone have any impact on Apple’s 1) brand power, 2) ecosystem, 3) growth, or 4) culture of innovation?  No, then it’s just noise.

Does Apple’s earnings for the quarter indicate anything about the company’s 1) brand power, 2) ecosystem, 3) growth, or 4) culture of innovation?  No, then it’s just noise.

Does Tim Cook’s hairdo present any risk to the company’s 1) brand power, 2) ecosystem, 3) growth, or 4) culture of innovation?  Possibly, then for heaven sakes, get the man a comb!  If not, then it’s just noise.

When we develop the habit of constantly checking new information against the Investment Thesis, we learn to effectively filter out the noise.

But then let’s say that through conversations with second-hand resellers of Apple products, we find out that a one-year old used iPhone that used to sell for $400 is now only selling for $300.  We inquire as to why, and we are told that customers are saying that other phones out there nearly as good and aren’t willing to pay such a higher price for an iPhone.  We find that carriers are saying the same things.  Now, we can legitimately begin to worry.  There may be a crack forming in Point #1 (“Apple’s strong brand power will enable the company to sell their products at premium prices”).     If we find we can no longer defend the investment thesis, we sell the company.  Period.  It is simply not worth the time and the risk.

I learned the power of the investment thesis early in my investment career.  In 2007, we came across a company from South Korea that made online video games.  Their existing games had a remarkably sticky user base paying subscription fees every month. The games had two powerful things that we look for in companies: 1) a network effect – the more kids that played the game the more attractive the game become and 2) high switching costs – when someone had invested seven years levelling up a character and amassing virtual items, they were unlikely to switch to another game.  Maintenance costs on existing games was minimal, so the cash generation from their existing portfolio was substantial and sustainable.  The company had a rare competitive moat that was both wide and deep.  The company hadn’t had a hit game in a while, so the market was rather gloomy on the company despite what was considered to be a top-notch development team.  As any parent who has had to try and pick a video game for their kids, the video game industry is an unpredictable “hit or miss” industry.   Trying to forecast whether a game will be a hit is about as likely as forecasting who will win the World Series next year or which of my kids will spill their drink at dinner tonight.  It’s a roll of the dice.  However, we took a long-term approach and built our investment thesis on three pillars: 1) the existing games would continue to retain their loyal user base and pay handsome returns, 2) despite being a “hit-or-miss” industry, the development team would eventually get a hit, and 3) the current stock price implied no probability to a new game success.

Shortly after buying the stock, the company launched a new flagship game.  Here it was.  The game had all the makings of a blockbuster: substantial buzz in the gaming community, a legendary lead-developer, and three full years of development, a huge marketing budget, and positive reviews.  The game hit the shelves, and then… it miraculously flopped!  It just simply didn’t sell.   And I watched the stock price fall for the company by nearly 50% in a month.  Did I feel sick to my stomach? Absolutely.   I stumbled back to the drawing board – the Investment Thesis.  Was the original investment premise intact?

  1. Did the company still have a sticky, loyal user base on existing games? Yes.
  2. Was the development team still likely to have a hit game in the future? Yes.
  3. Was the stock undervalued? Yes, even more so.

This meant that all of the despair in the market was actually just noise.  Feeling a bit more comforted after reviewing the Investment Thesis, we continued to hold the stock.  In 2008, the company launched another game.  This time expectations were even higher.  The launch was timed to the holiday season, the game was a mix between car racings and online fighting, which every industry expert believed was a sure formula for success.  The game hit the shelves and low and behold… another flop!  The game mostly sat on the shelves and everyone that bought the game ended up returning it because there was no one online to play it with.  Investors were exasperated and the stock plummeted by another 40%.  Our clients began to notice poor performance.  At this point, to my knowledge, we remained the only international shareholders to continue to own the stock, which by default made us both stupid and oblivious.  We even had the audacity to add to our position.   Not one thing had changed from the original Investment Thesis, except for the fact that the stock price looked a whole lot more attractive now than it ever had.

Some may call this sticking to your guns.  Some may call this being just flat-out stubborn.  Investors like to refer to this as “high conviction”.  Despite what you call it, however, our conviction came from having a clearly defined investment thesis, giving us the ability to strip out the noise.

The following year the company launched another game that was largely ignored by the market because it was more of a niche game for an Asian audience.  Everyone’s expectations were rock bottom after the previous failures.  The game was released and turned out to be one of the bestselling video game of all-time in Korea, and then later a blockbuster hit in China. The stock price shot through the roof.  Two years later the company followed it up with another successful game launch, and the stock re-rated yet even higher.  From our initial investment, we had now made over 400% return.  Our clients were dancing in the aisles.

I have no doubt that if we hadn’t written those three simple bullet points from the very beginning, we would have sold our shares when times got rough.  Without the rock-solid conviction of why we owned it, we would have followed the herd and cut our losses.  Thank heavens we didn’t.

Lessons Learned:

  1. Know the stocks you own, and know why you own them.
  2. Creating and constantly re-evaluating an Investment Thesis is the most crucial tool to keep investors on-track and disciplined.

If news doesn’t impact the investment thesis than it is just noise.  If new data gives us either higher conviction or higher concerns in our investment thesis, nothing matters more.


When we say a stock is mispriced, we mean the current market price either over- or under-estimates its value.   If you do your homework in valuing a company, you will come up with a valuation based on the assumptions you make for the company’s future growth and profitability.   Assuming everyone has access to the same public information that you have, and markets are efficient, why would the market price be higher or lower than the price you came up with?  There are several possible explanations.

First of all, stock valuation is not an exact science.  It involves making educated guesses as to what the future holds for a company.  Your assumptions, based on your research and analysis, will be different from those of a Wall Street analyst who publishes reports and financial forecasts that are read and acted upon by other investors.  So the first point is that we may all have different ideas of what the logical “correct” price should be.

Even so, markets – and stocks – do not always move logically.  The whole market may react to negative economic data, such as interest rate movements; or to global concerns, such as the collapse in oil prices, Greek debt repayment, or rising tensions in the Middle East.  And a perfectly good stock could be dragged down with the market.  Alternatively, when something negatively impacts one company, say an Avian flu case is discovered at a poultry company, all poultry companies – i.e., each one in the industry – may see their stock price decline.  This is known as the neighborhood effect, or guilt by association.

Another reason for mispricing and volatility is an overreaction to company earnings reports.  If the market is expecting “x”, and the company misses that number by 20%, the stock is likely to sell off.  It is important for a good analyst to find out why earnings were lower:  Is it due to a one-time event, such as a regulatory fine?  Or is it recurring?  How serious is the problem?  and can it be fixed?  How much does it impact future growth and profit expectations?   A sell-off of a high quality company could represent a good buying opportunity for a value investor.

Investor sentiment can also play a role in stock price movements leading to mispricing.  This is especially true today, where we all have access to market-moving information, many times even as it occurs.  Fear and greed drive the market.  When fear dominates, as it did in 2008, when the S&P 500 dropped XX%, investors were afraid of further declines and desperately tried to get out, no matter what the price, no matter what it meant in terms of losses.  It became a self-fulfilling prophecy, as more and more joined in, pushing stock prices even lower.

Stock prices can also experience major swings when large investment firms – with billions of dollars in assets under management – are liquidating a position.  And many times the decision to sell has nothing to do with company fundamentals.  A decision may have been made at the investment committee level to reallocate investments to other sectors/industries.  Or the firm may be facing redemptions and needs to raise cash.  There could also be forced selling when a firm has leveraged bets, and needs cash to meet margin calls.   Each of these may cause the stock price to fall, even though nothing has fundamentally changed for the company.  Which again potentially presents a good buying opportunity for a value investor.

Warren Buffett says, “Look at market fluctuation as your friend rather than your enemy.  Profit from folly rather than participate in it”.


Participating in the stock market can be the equivalent of an emotional roller coaster.  Investors often buy stocks of companies they frequent with little consideration to the fundamentals.  Leaving the probability of success to a game of chance, sometimes you win and sometimes you lose.  Let’s take a closer look.

People by nature tend to exhibit overconfidence in their own abilities as it relates to normal tasks.  For example, if you asked a group of 10 people if they have above average, average, or below average skill driving a car?  The majority of the group believe they have above average skill and no one will lay claim to having below average skill.  However, by definition some will be above average, average and below average, thus some people in the group are overconfident in their driving ability.  Closely linked to this phenomenon is the Self-attribution bias.  Self-attribution bias would associate a positive outcome with the actions the individual has taken, but when there is a negative outcome, they attribute it to bad lack or external forces beyond their control.  If you buy stock X today for $100 and one year later stock X is trading at $110, did you make a great call?  What if the broader equity markets return 15% over the same period?

Loss Aversion is another interesting consideration in behavioral finance.  Understanding your risk seeking behavior will change depending if you are in the black (making money) or in the red (losing money)!  Investors tend to exhibit risk-averse behavior when confronting gains and risk-seeking behavior when confronting losses.  People feel the pain of loss more acutely than the pleasure of gain.  In an investment context, loss aversion can lead people to hold onto investments that have lost money longer than they should.  Pop Quiz!

You purchased 2 stocks, Stock A and Stock B, both trading at $50 per share.  Stock A has just announced earnings and came up just short of analysts expectations but display strong fundamentals in a growing sector.  Stock B also announced earnings in line with expectations, however, the CEO resigns over a potential accounting scandal.  Both stocks are trading at $40 per share.  Which one do you sell, Stock A or B?  Would you buy more of either?

Another challenge for investors, they typically ignore information that conflicts with their existing beliefs, a phenomenon called belief perseverance.  Who remembers losing their first tooth?  Even more exciting was the idea of the Tooth Fairy.  Leaving that first tooth under your pillow and waking up to see it has vanished and been replaced with MONEY!  Excited, you tell everyone you know about the good fortune, the Tooth Fairy is for real and you know it.  Then your older sibling informs you there is no Tooth Fairy, this information conflicts with your existing beliefs.  You decide that your older brother Peter has no idea what he is talking about and you insist the treasure that was left behind under your pillow was from the Tooth Fairy himself.  Keep an open mind when reviewing your portfolio, when new information is presented on a stock you own don’t be quick to dismiss its credibility, unless you hear it from your older brother Peter.

Benjamin Graham, once said, “The investor’s chief problem – even his worst enemy – is likely to be himself”.  When is it comes to investing people often buy what they know, in many cases the investor simply invest in things that are familiar to them, a behavior called familiarity bias.  It could be a company close to your home or a doctor buying a health care company as he understands the business.  Most U.S. investors tend to hold stocks or mutual funds that own companies based in the U.S.  With only a small allocation to non-U.S. stocks.  Pop Quiz!  Approximately what percentage of publicly traded stocks worldwide are based in the U.S.?

  1. 5%
  2. 30%
  3. 50%
  4. 75%

Approximately 70% of publicly traded stocks are domiciled outside of the United States, did you know the answer?


In my 20+ years of working with international portfolio managers and analysts, I’ve found that the best ones weren’t necessarily the absolute smartest.  They didn’t always have off-the-charts IQs.  But they did have several key characteristics.

First and foremost, they have a passion for learning.  And I don’t just mean academic learning, although a good grasp of math concepts and principles of accounting and finance are certainly necessary.  But maybe even more important is natural curiosity.  Do you like to read?  Do you like learning about new trends?  Do you tend to dig deeper when you discover something you’re interested in?  A good investor will study a company from different angles, and will gather facts, then critically evaluate them.  She will ask questions and search for answers in the quest for deeper knowledge and understanding.  She will read everything she can get her hands on that could give her additional insights.

So let’s suppose you’ve done your homework, you’ve done a thorough analysis of a company and its industry, and you’ve bought that jewel of a stock for your portfolio.  You are sitting pretty, ready for the price to rise.  And you’re waiting . . . . and waiting . . . . and waiting.  And the stock is trading sideways.  That leads us to a second important trait of a value investor:  he/she is patient.  A value investor has a multi-year time horizon, and is prepared to wait when he/she knows there’s upside to come.   Paul Samuelson, the first American to win the Nobel Prize in Economics, said, “Investing should be more like watching paint dry or watching grass grow.  If you want excitement . . . go to Las Vegas.”    We live in a world obsessed with instant gratification, and you will have to fight the impulse to sell if you don’t see results right away.  If your analysis was correct, your patience will be rewarded.

That leads me to the next characteristic, which goes hand-in-hand with patience.  It goes by many names:  Guts; courage of conviction; independent thinking.  We all have the tendency to want to go with the flow, to be part of the popular trend, to be where the action is.  But in investing, more times than not, that is not where the true value is.  In fact, many times the most popular stocks – the ones every Wall Street analyst rates as a Buy – are priced to perfection, and the smallest bump in the road will cause them to fall.  If the stock you love has fallen out of favor, and you’ve done your homework, analyzed the criticism and still find it compelling, go for it!  And if you already own it, and bought at a higher price, you can show the courage of your conviction by buying even more.  Presumably if you liked it when the price was higher, you will like it even more now that it is cheaper.  But it takes guts to ride out a storm, and to buy when everyone else is selling.

A final characteristic is the ability to admit you are wrong and to learn from your mistakes.  In the example above, if everyone is selling your stock because something has fundamentally changed, you will need to reevaluate.  Maybe there is a new technology coming that you weren’t aware of.   Or maybe as you’re digging deeper you uncover flaws in your reasoning.  Everyone makes mistakes, that is part of the learning process.  The most important thing is to learn from your mistakes.  Don’t get discouraged, but make sure you learn from the experience.  It is humbling, but it will make you a better investor.

So to recap, the key to value investing is doing the work, digging in, learning everything you can about the company and its industry, then making an investment decision for the long term, based on fundamental analysis and logic, not letting your emotions take charge, not buying into what’s popular.  In summary, a good value investor has:

– Passion for learning and a natural curiosity.

– Patience, and a long term time horizon.

– Guts, and the courage of conviction.

– The ability to admit mistakes and learn from them.


When a stock goes into free fall, your decision as an investor to hold, sell or even buy more, should depend on WHY it is falling.  Peter Lynch, the legendary former portfolio manager of the Fidelity Magellan Fund, once said, “Know what you own, and know why you own it.”   We assume you’ve done your homework on the company before you bought the stock.  Now it’s up to you to keep on top of it, to make sure you’re aware of news affecting the company, press releases from management, and any changes that materially impact the company.  In other words, you can’t just buy a stock and leave it in your portfolio.  You must continue researching it, updating on a timely basis, and making sure you’re aware of changes that affect expected future growth and returns.

Suppose you have done your homework and have been following a stock closely.  So what do you do when the price begins to fall?   Before you can decide, you need to know WHY it is falling.  Sometimes a stock price will decline, for reasons not related to the company itself.  Some such reasons were explained in the section on stock price volatility (INCLUDE LINK HERE), and may have more to do with market particulars or sentiment.  For example, a large institutional investor who holds this stock may be selling down a position because it needs the cash to meet redemptions or to use for other investment ideas.  Or maybe the whole market declined because of a major geopolitical event, such as the outbreak of war.  In both of these examples, nothing has changed fundamentally with the company.

But when the issues are company-specific, it is important to figure out:
– whether the impact will be temporary or permanent,
– if it is something the company can eventually correct, and
– how the company’s profitability and risk perception will be affected.

Let me give you a couple of examples of company-specific problems that can cause a stock price to fall.  One is natural disasters.  Imagine there is a flood or an earthquake near a large Coca Cola bottling plant, resulting in work stoppages and destruction of inventory.    How extensive is the damage?  How quickly can it be repaired?  How big is the damaged plant’s production compared with the what Coca Cola produces worldwide?  Given the size of Coca Cola globally, this is likely to have a small overall impact.  Any fall in price might just be an overreaction to the negative news, and not necessarily a reason to sell.    On the other hand, if the United States were to impose a 25% surcharge or tax on all sugary beverages, this could qualify as a permanent structural change.  Assuming the Coca Cola Company passes the tax on by raising prices, this would discourage consumption of Coke and likely lead to lower profits.  In that case, it could make sense to sell.
Another reason a stock may sell off is because of poor earnings results, i.e., the company fails to meet analysts’ earnings expectations.  Typically companies provide profit guidance, based on their expectations of growth in unit sales, prices, costs, etc.  When they miss their guidance, it is important to find out why.  Was it a one-off event, like a one-time fine?  Or something more permanent, like a margin squeeze as the cost of material inputs rises?

What happens when a company’s highly-respected CEO quits?  Or when a company announces an acquisition or a sale of one of its assets?  In both cases the stock price may fall, but your decision as an investor to hold, sell, or even buy more will require more research and more information.  Warren Buffet said, “The best thing that happens to us is when a great company gets into temporary trouble . . . we want to buy them when they’re on the operating table.”   In other words, if you’ve done your homework, you know the company is a good one and the problem will be fixed in the short term, you will have an opportunity to buy more at this lower price.  This is known as “averaging down”:  bringing down the average price by buying more shares when the price falls.

One more word of caution:  don’t get too emotionally attached to a stock.  No one likes to sell at a price that is less than what they paid.  But if you know the problem isn’t minor or easily resolved, it’s important that you don’t hang on in the hopes that the price will go back up.  You may be stuck with an even bigger loss for a long time.


You all probably heard the advice about not putting all your eggs in one basket. We already referred to this concept in the brief preliminary discussion of rule # 3. The saying comes from the fact that, if you literally put all the eggs you have in the same basket, if that basket falls, you are likely to lose most if not all of the eggs that were in it. On the other hand, if you had divided the eggs among different baskets to be transported somewhere, even if one of the baskets fell, you would still be left with at least some eggs after the accident. Diversification works in a similar way when it comes to a stock portfolio. Despite the fact that we have argued that there is no such thing as a “stock market,” it is still true that different groups of stocks tend to move together over time. This is what is called correlation. The correlation among stocks in the same industry group (or even country) tend to move relatively closely together, particularly over short periods of time.

That is why it is so important to diversify your stock portfolio, and do the homework on and own more than a single stock. That way, even if a part of your stock portfolio is suffering from some temporary setback, the rest may be holding up or even rising. There is some debate among the experts as to how many stocks you might need for an equity portfolio to be well diversified. There is not a simple answer, but the number depends on how different the stocks in question are from one another when it comes to company size, industry group, geographic location or focus of their business, etc. We do not claim to know the exact “right” number. Still, if you try to choose among companies that are quite different from each other when it comes to the characteristics just mentioned, ten or even fewer companies may be enough for you to have an adequately diversified stock portfolio. This is particularly likely to be the case if you followed rule # 1 and your stock portfolio is truly long-term oriented. Keeping your stock portfolio at ten or fewer holdings will probably mean it will be easier for you to do a good job at rule # 2 (doing your homework) on each of them.