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Value Investing

Tuesday, November 28, 2006
The investment strategy that most fits my personality is value investing. The style is made famous by Warren Buffett who tries to buy companies that the stock market does not value high enough. This strategy avoids the pitfalls such as unrealized growth that is a major risk of speculation. It also ties into the theory that you make money when you buy, and not when you sell.

An example of value investing is buying a stock that you value at $100,000 based on current cash flows, growth, stability, etc. and the stock is priced at $80,000 you saved $20,000. Now assuming you did not miss a material reason why the stock was undervalued in your research, the wisdom of Warren Buffett would suggest that eventually the market will realize the underlying economics of the company and the value should rise at least to the $100,000 point. He considers this a “margin of safety.” Now also, assuming you picked a company that has the ability to grow year over year, the value of the stock may actually go above $100,000.

The concept is not any more complex than buying products from the store when they are on sale. Though uncovering a “sale” on the stock market requires a lot more due diligence and long term strategy. Strategy is important in that it will allow you to take advantage of conditions that might scare away institutional investors because they have to make a profit in the short term. However, with value investing, you just basically have to buy and wait for the market to get back in favor of the stock which is a lot easier to predict than figuring out what company is going to have the next revolutionary product.

Applying Value Investing Elsewhere
Now you probably thought that this was all about Warren Buffett, and stocks. It was actually a long intro to how I look at other assets, such as real estate, domain names, and websites.

Real Estate
With real estate, value investing is a lot more common than other fields. I am interested in areas that have a good probability of rents going up year over year in the long term. Then I tend to look for properties that are undervalued. Typically an undervalued house will have something wrong with it.

Being an investor my job is to look at the problem with complete neutrality and try to decide the exact dollar amount it will cost to fix the problem, and any risk that it might not go as planned. Then I do the valuation based on projected cash flows of the place in the condition after repairs and hopefully there is a positive discrepancy between the price I can get the property for and how much it will be worth after repairs. Large problems with houses such as termites, electric, water damage, etc. will scare off homebuyers and could cause the price to be significantly less than the valuation.

There are often smaller problems with a property that may make it look less desirable. Sometimes a building just needs a fresh coat of paint, some drywall work, and new carpet and it will be in much better appearance. This may only cost a few thousand dollars to do, but might raise the property value significantly.

Then there is the option of buying a shell of a house. Either a place that needs a complete overhaul and is possibly not even livable at the moment, or better yet: a property that had a previous investor who ran out of funds, time, or whatever before they could complete the job. This strategy works best for the serial investor that has a network of employees or contractors who they can trust to do quality work for a good price.

Domain Names
Value investing in domain names would be investing in “traffic names,” or domains that generate traffic and revenue intuitively. Speculation would be buying domains you think have a name that someone else will want to buy to brand. I would avoid names that have a limited life span such as current game console names. These domains might lose traffic over time and not achieve the proper payback you were looking for.

Financing on domain names might be a little trickier than getting financing on real estate. It might be possible to get a business loan of some type for domain names. For real estate I am finding that a lot of the properties will return around 10-20 percent on the financing I can get (investment non-owner occupied with limited credit history) with conservative expense estimates. Of course most domains will get a return of 10-20 percent without leverage, and some will even get closer to 50-100 percent return on investment.

Web Sites
If you have a system in place to maintain, and grow websites it is possible to look at acquiring websites as a value investor. The current market has a much simpler valuation method for websites that I think is quite flawed. They simply value it on 10-20 months gross revenue typically. Sometimes hosting and advertising costs are taken out of the price valuation. However, rarely is the cost of time factored into sales.

As a true investor you should look into how much it will cost to maintain the site, and make it grow maybe 10-20% per year. Then subtract that from the revenue, and if you can get a decent cash on cash return, it can be compared side by side with these other investment types. Typically I would think that the payoff period for a site, after paying for labor would be under three years. That is not to say that you will actually be hiring someone else, you might end up “hiring” yourself, but at least you will have looked into the cost of your time involved in the site.


Synergies
With stock investing you often get diversification with purchasing more stock, but with these other investments you get synergies: The relationship of 2 + 2 = 5. For instance with real estate, owning one property might be very costly to maintain, but owning 5-10 might make it so you can hire someone at a much better rate because they know your giving them a steady stream of business. There is also the possibility of raising the value of the neighborhood if you improve the value of a few houses on the same street.

With websites, synergies exist beyond just linking strategies. With enough sites on similar subjects, you should be able to create a network of sites that can basically be used to launch new sites, products, or services.

Conclusion
The topic of value investing is very intriguing to me. I think it works very well with the way my mind is wired, and I can take it to heart. Some people have different strategies and can identify profitable activities with other methods of evaluation etc. Speculation and other methods of investing are not really what I can think through and evaluate though, so I am sticking to value investing. I have outlined how I will use essentially the same strategy and the same fundamentals to evaluate all types of assets I am thinking about acquiring, or even creating. This is not necessarily the best strategy for everyone, but it is a good idea to have a comprehensive investment strategy that you can understand and hold yourself to as time progresses.

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