Defining Value

The simple answer is that value is hard to define, but you know it when you see it. Basically, all great investments start with buying something for less than it's worth. Conventionally, value is measured in quantitative terms—by price-to-earnings, price-to-book and price-to-some other accounting metric—but there are problems with defining it that way, and one is the accounting numbers themselves. I have found, as have many investors before me, that accounting numbers are not a useful way to value a business. They are usually manipulated because they are subject to the opinions and whims of the person preparing the statements. Plus, instinct and creativity can't be measured that way. There's some judgment involved that goes beyond the math. I'm called a value investor, but was Google a growth stock or a value stock at $480 per share when I bought it? What I know is that it's a great opportunity for my shareholders and I'll let someone else define it.

The second reason why those numbers aren't useful is the market itself. For example, Lehman Brothers went bankrupt with all-time record earnings, a high P/E and a high price-to-book ratio. When the market is doing well, everyone justifies a high P/E, and when it's not, the metrics become more conservative. There is a lot of market exuberance in terms of what's the right P/E for a business, and I don't like that.

When I think about value, I keep it simple. I ask, 'What would I pay if I bought the whole business myself?' I usually come up with a much more conservative and durable number. I take the market's mood and accountants' whims out of the equation, because the real number is based on cash flow. Operating cash flow is a direct window into the heart and soul of a business, and if you know what to look for, you can get a good sense of whether good things are happening or not.

And then from there, you have to make some allowance for whether the balance sheet is good enough and from there you go to the four questions that I think are the four most important questions and maybe even the only four questions that matter to any potential investment.

Most people focus on knowing every little detail, fact and number, but they fail to distinguish which ones matter and which ones don't. There are just a few key things that matter to the outcome of any investment, big or small, in any sector and anywhere in the world. Over time I've boiled them down to four simple questions.

The first is, 'Is this business worth looking at?' If it's a commodity, the barriers to entry are low, or it's sliding towards obsolescence say, by the Internet, it's just a bad business, and we take a pass. If it is a business that is growing, earning more than its cost of capital, has a great product and a large and growing demand, with sound economics, and the barriers to entry are very high, you have a business that's worth your time.

The second question is, 'What is the right price?' If you're buying a dollar bill and paying a dollar, you're not going to do very well as an investor. The key is to find a dollar bill and pay 50 cents. The valuation techniques are what get me on the page, and there's as much art as there is science in valuing a business. You have to understand its assets in the context of the competitive landscape, and you have to understand its advantage. What is it? Is it size or scale? Is there a scarcity premium? Does it have better management? Answering these questions helps to evaluate whether or not the business can maintain it.

The third question is, 'Does management know what it's doing?' You might think that getting promoted to CEO or CFO would indicate that you knew what you were doing, but there are a lot of stories about bad management. I look at CEOs' track records as capital allocators to figure out two things: what's in their heads and what's in their hearts. Both are important. You can learn a lot about what people believe and how they're going to act based on what they've done in the past, so evaluating their financial decisions is a good indicator of what's coming to you as a shareholder.

The fourth thing that matters is, 'Do they treat you like an owner of the business?' You have to make sure you're first in line for returns. Sometimes you're not, and the money goes out the side door instead of the front door. I do not want to be third in line for returns. I want to be first.

I have the whole world to look at. I'm looking just for the best 50 or 60 ideas, and I can find plenty of things that are attractively mispriced. Good ideas happen where they happen. Looking broadly, Europe turned the corner last year when the banks started to raise capital, and it has become a fairly attractive market. I've been watching for that for three years. There's always opportunity in the U.S. It's an innovative, dynamic market, and in general, you get great corporate governance and shareholder focus. For the first time in the last several years, I think emerging markets offer some opportunity. People tend to think of emerging markets as Brazil, Russia, India and China, and I can't think of four more different markets, but you can find some global, quality, blue-chip companies that are great businesses in each of those countries. The question is, can you find them at the right price? Given the under performance of the last 12 months, I'd say there are some interesting opportunities.

We spend a lot of time thinking about what's going on in the world: Who's going to benefit, and who's not, making sure we're on the right side of that trend and finding where the investment attachment points are. E-commerce is a good example. Ten to 15 years ago, you could see if people were willing to put their credit card information online, e-commerce was just better. At only 7 percent of total retail currently, it's going to continue growing for the next 20 years, and nothing will derail that. Another is media content—what you watch on TV, online and at the movies. The beauty of that is there are only 10 companies in the world that control 95 percent of what the entire world watches. These businesses generate more cash than they need, there are huge barriers to entry, great economics, great product and growing demand. The seed industry is a similar story. It takes more than two decades to get a seed to market and there are only seven companies that do it. The world needs more food. The only way to produce more in our overbuilt world is to increase yield—with better seeds. The financial services sector looks good too. Not too long ago, no one wanted to own a money-center bank in the single digits. But I think that the breakup value alone for the major ones is many times that. Regulatory changes forced the sector to improve. Also, all of these companies have turned over their executive suites—in some cases two and three times. They wanted to put the problems behind them, which they have largely done.

Conventional risk management is based on the capital asset pricing model and measuring price change. As an investor who is trying to grow people's money, price change—beta, alpha—is not the risk I'm worried about. I'm worried about value change, and no quantitative model can predict that. The way you protect yourself against value change is to know what you own and pay the right price for it. I always go back to 'The Four Questions:' making sure you own a good business, paying the right price for it, knowing that it's run by decent people who are going to treat you like an owner. There's no amount of modern risk management that's going to save you from getting those four things wrong.

OFI has some of the best and most senior people in the asset management industry. One of the unique things about how our global team works is that a portfolio manager is just a really good analyst. I consider myself an analyst, and I do most of my own analytical work. I also put a lot of effort into communications and closing the gap between portfolio managers and our clients. I'm hopeful that all of the investors in my strategy feel like they really understand what's being done with it.