Talk At The Diamond Hat Part 2/2

I had a nice chat with a fellow value investor in London who recorded his thoughts on the conversation, and kindly allowed me to reproduce it.

Lesson 4: “Mean Reversion”


Prices, in long-term, will return to their mean. This is also John Bogle’s way of looking at the market from a general picture point of view. Moreover, mean reversion will help the investor to identify possible bubbles-wild fluctuations of prices that tend to sky-rocket and then plummet back to earth to reflect a number closer to the real value of the company.

This does not mean that markets are rational.

It means that in long-term, it is the business value that wins and not the short-term market vicissitudes.

Lesson 5: “Free cash flow”

As a new and enthusiastic value investment scholar, I read most of the books on Warren Buffett. Consequently, I heard of a concept called ‘owner’s earning’. Mathematically, this concept is translated into net reported income plus depreciation, amortization and depletion (DAD) charges minus capital expenditure (that is capital that the company needs to stay in business).

Mr. Buffett explained that he uses this measure instead of free cash flow (FCF) because FCF is measured as net income plus DAD charges. However, this is non-sense as one must also account for the costs of doing business. However,

I knew that the free cash flow was defined as cash flow from operating activities minus capital expenditure. Peter Lynch, one of Fidelity’s star managers and a legendary value investor, also uses FCF as operating cash flow less capex. Therefore, confusing hit my mind and I asked Jun Hao if he can clarify this for me. He suggested to use Peter’s Lynch measure for simplicity’s sake.

However, he strongly recommended to measure the FCF for a period of at least 5 years in order to get a sense of how a business is doing: remember free cash flow is the amount of money you as a business owner are left with at the end of the financial year – you cannot pay your bills or buy new business with reported net income but with cash only!

Lesson 6: “Enterprise Value”

Jun Hao suggests that a more accurate way of ascertain the market value of a business is to look at its enterprise value (EV) instead of looking at its market capitalization. Market capitalization is the result of number of shares outstanding times the share price.

However, EV is calculated by adding the net debt to the market capitalization and subtracting the cash and cash equivalents from that number. EV is not to be used on its own: most investors use EV to EBITDA to compare firms with different degrees of financial leverage and to value capital-intensive businesses with high levels of depreciation and amortization.

Jun Hao also cautioned me that EV/EBITDA is not to be used alone but together with P/B, ROIC and FCF.

Lesson 7: “Recommended reading”

Of course, Jun Hao is a very well read individual and he was kind enough to suggest some of his most important books with me. The reading list is as follows: anything Howard Marks from Oaktree Capital Management writes, Bull by Maggie Mahar, Deep Value and Quantitative Value both by Tobias E. Carlisle and There’s Always Something to Do: The Peter Cundill Investment Approach by C. Risso-Gill.

Finally, Security Analysis by B. Graham is outdated. What? Yes, the Bible of investment is outdated: the principles within it were very, very relevant to a particular moment in time and were of immense help in a period of corporate governance and disclosure were a rare thing.

Nowadays, it is nearly impossible to find a company that ticks the boxes of Ben Graham. However, I recommend that the book is still relevant from a historical perspective: learn from history even if we, psychologically, are not programmed to do so – this is another key to long-term success.

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