My Favorite Investing Book:  Value Investing From Graham to Buffett and Beyond, 2nd ed.

by Bruce Greenwald, Judd Kahn, et al. 

Regrettably I found this book late in my investing journey. This is far and away the best book on investing I have yet read. Often investing books will get lost in formulas, specific examples or not contextualize the ideas with economics well. With a focus on valuation and the associated competitive advantage this books remains focused and walks a perfect balance between context and case studies. For example, it breaks down concepts like the time value of money in a simple way (Ben Graham never explicitly talks about this), which essential for understanding investing. It covers an array of value investing models, but is still able to distill these to a few useful principles and a few useful case studies.  

While there are a few pages that are fairly economic formula heavy, Greenwald does an excellent job of breaking these down equations into their parts which helps you walk away with applicable insights into valuation.

Overall, the books is great because of it’s ideas, so let me share a few key ideas from the book that I found valuable. 

You can and should value a business in 3 ways : net asset replacement value, normalized earnings power, future earnings (growth). 

In most other investing books, the author emphasized only one methods of valuation (most often discounted future cash flows). Greenwald is wise to evaluate a business on 3 levels. By doing so we gain the most accurate picture of the value of a firm. Also by comparing these different models you gain important insights into the business. 

Greenwald’s first model is net asset replacement value. Essentially asking, “How much would it cost me to replicate all the assets of this business right now?” This value is similar to Graham’s focus on a firm’s liquidation value. Greenwald’s second model is durable earning power. Essentially “How much cash will this asset produce for owners in it’s current state?” Or “What is the cash return of this business?”

Greenwald further explains that a business with an adjusted earnings power higher than it’s asset replacement value may be a franchise business with good prospects for growth. A business without advantages and protection should not expect to maintain a earnings power greater than its net asset replacement value in the long run. That is if this business truly possesses durable competitive advantages and a resulting moat against market entrants. That is because if a firm can not prevent barriers to entry, then a competitor will recreate the firm at it’s net asset replacement value and reduce expected earnings rates closer to the cost of capital.

Moat can be measured

What was always unclear to me in previous books was what is a moat, how is it defined and how is it measured. Greenwald provides the best answer to this that I have found. 

1. Start with the required market share that a competitor would need in order to earn anything above its cost of capital (be a profitable investment). Greenwald does this by taking a businesses in one industry and finding the minimum market share needed to be profitable. Observing the soft drink market we can say that must be at least 20%. 

2. Now (as a new entrant) in order to get to that market share we need to take it from competitors, so we next look at how much of the soft drink market changes hands each year (how captive is the customer to existing brands). For example in soft drinks we would find that change in market share to be 0.2% per year. 

3. So it would take 100 years for a new market participant to reach its minimum viable market. That is a wide moat. 

Very simple, and very true. 

We can also calculate minimum viable market

1. Identify Fixed Costs: List the business’s annual fixed costs, such as administrative expenses, rent, and equipment maintenance.

2. Estimate Contribution Margin: Calculate the margin per unit of product/service after covering variable costs (e.g., price per unit – variable cost per unit).

3. Determine Required Sales Volume: Divide the fixed costs by the contribution margin to find the minimum number of units that must be sold. 

Required Sales Volume=Fixed Costs/ Contribution Margin

4. Translate Sales Volume to Market Size: Using the estimated market share and pricing, calculate the minimum size of the market needed to reach the required sales volume.

This was another way of looking at it that an advantageous investment is based on adventageous unit economics. I appreciated the further explanation. He does this with a few case examples that illustrate this idea perfectly. I always learn the most from theories applied to real life situations, so I appreciate the chapters dedicated to specific firms like Intel and WD-40.

The best investors are economists at heart 

Greenwald makes it clear that understanding the economics of a business and competitive pressures is key to investing success. Buffett and Munger excelled at this where many others failed. 

Greenwald differs from Michael Porter’s definition of competitive forces in sensible ways

Porter laid out 5 competitive forces:

1.  Threat of new entrants

2.  Bargaining power of suppliers and 

3. Bargaining power of buyers

4.  Threat of substitutes, 

5. Competitive rivalry.

And seems to weigh them roughly equally. 

Greenwald on the other hand sees the threat of new entrants as the key competitive force that far outweighs the others. 

Porter finds 3 sources of competitive advantage

1. Cost Leadership: Being the lowest-cost producer.

2. Differentiation: Offering unique products or services.

3. Focus: Targeting a specific market niche.

While Greenwald identifies

1. Supply-Side Advantages: Cost advantages due to unique processes, patents, or proprietary technologies.

2. Demand-Side Advantages: Customer captivity and brand recognition that creates barriers to entry.

3. Economies of Scale: Cost efficiencies that deter competitors from entering the market due to the high initial investment required.

4. Focus: Firms should focus on building local monopolies and market dominance as the key source of competitive advantage and wise capital allocation. Basically “Does this firm understand competitive advantage and is it using its competitive advantages?”

Coca-Cola for example rose to dominance by using advantages 1 and 4, but maintains its dominance with advantages 2 and 3. 

Use of Discounted Cash Flow Models is common, but perilous 

DCF models are very sensitive to assumptions and can produce unreliable long-term projections. Greenwald takes issue with:

1. An overemphasis on Terminal Value: Most of the valuation in DCF models often comes from the terminal value, which is highly speculative and prone to error.
2. Uncertainty in Cash Flow Forecasts: Predicting cash flows far into the future is inherently uncertain.
3. Discount Rate Challenges: Small changes in the discount rate can lead to significant valuation swings. A 1% change in discount rate can impact your valuation by 12% or more.
4. False Precision: A DCF model can give you a false sense of security. 

These insights were paradigm shifts for me in terms of how I value a business. I highly recommend you read this book as a premier on value investing, I have not seen one quite like it.