Archive for October, 2013

Measures of Value

Friday, October 25th, 2013

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In previous posts I’ve shown you a measure of market valuation, the Shiller P/E, that indicates the stock market is at the upper end of the valuation range. I don’t want to beat that horse again, so I thought it might be interesting for you to look at some companies that are undervalued based upon two of my favorite measures.

The image above is a partial list of companies sorted by the ratio of Price-to-Book multiplied by its Forward P/E ratio, sorted from lowest to highest. This ratio is one of the rules of thumb that the father of Value Investing, Benjamin Graham, used to identify companies that were undervalued. In essence, Graham liked to buy companies when the product of these two ratios equaled less than 22.5.

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My other favorite measure of value is the ratio of a company’s Enterprise Value divided by its EBITDA. This ratio is a good measure of a company’s attractiveness for a takeover because it tells you how many years a company’s cashflow will take to breakeven on the overall market cap of a company in a takeover. If the ratio is below 7, then an acquirer knows that it should be reimbursed for the purchase of a target company within seven years through that acquisition candidates own cashflow.

The chart above sorts a partial list of companies by this ratio, from lowest to highest. The two companies that have that ratio blocked with a black box show should be ignored from this calculation.

When I am researching companies for a value investment (researching growth companies is a completely different exercise, one we’ve discussed here in the distant past), these two ratios are key components for me to look at. It is rare that you find a company that has both ratios under their threshold levels.

However, these ratios are just a starting point – there can be excellent reasons for a company to have a low ratio that should keep you from owning it. Value investing is an exercise in finding companies that other investors are shunning and buying them because you see some catalyst that will drive the valuation higher once other investors see it. If you can buy a company for less than its book value, you are buying it for less than the value of the sum of its assets – and if its competitors are selling for some value above book value, you only need to move to parity with its competitors valuations in order to make money.

The complete list above contains 104 companies out of our research database of 6,000 companies. Many of these 104 would not be candidates for us to buy for various reasons – too small, too illiquid, too much debt, too little cashflow, etc. However, I thought you’d like to see a sample of those 104 in case you wanted to use it as a starting point for some research of your own.

We have discussed several examples of this over the years – I believe that Dell Computer was the most recent one where we purchased it for about $8 per share (because we saw significant cashflow generation and a price well below book value) then sold it after the take-over was announced at $13.50.

Today, in client portfolios, we have several other companies in similar positions, selling below book value with either current cashflow being significant or some catalyst in place that we believe will cause cashflow to increase in coming quarters.

If you were to review the complete list of 104 companies, you would see the following companies that we already own in various client portfolio: Statoil, Marathon Oil, Hewlette Packard, Royal Dutch Shell, Apache, Wells Fargo, Tesoro, Agrium, Vale, and Xerox. We have different equity strategies based upon the different goals/objective/needs of our clients – Growth, Core, Blue Chip, Dividend Income, and Fully Diversified. These companies appear in one or more of those strategies depending upon their specific investment characteristics.

Let’s take a look at one of those companies that we hold: Xerox. This graph is the price chart from our initial purchase in May 2012 through today. We have a couple of purchases of this company at an average price of $7.12 compared to today’s price of $9.63, for an average gain of a bit over 35% – individual accounts may vary a few percentage depending upon the price they individually paid.

xrx-price

You can see that yesterday, Xerox reported earnings that were below expectations and it dropped 10%. One of the issues you have when buying companies based upon value fundamentals is you have no idea when the catalyst you identify will be recognized by the broader market, nor how long that catalyst might last. The higher the price goes, the more investors jump onto the bandwagon – ones that might not be in it for the same thesis you have and who are less willing to live through earnings misses that are inevitable in a turnaround.

In looking at the graph, you can see that after we made our purchases, investors still were punishing the company driving the price to about $1 below our average cost basis. However, based upon the cashflow Xerox was generating based upon its turnaround strategy of moving from a copier company to a business process company we believed that ultimately our return would be big and that we could not get hurt by buying the company under the book value of its assets as long as it was generating a significant amount of cash from its operations.

Finally, about six months after we purchased our shares, the stock price bottomed and investors began to realize the value in this company based upon the significant and reliable cashflow it was generating compared to its price below the book value of its assets. We have seen steady growth in the stock price, with a return of 43% year-to-date compared to 19% for the broader S&P 500.

However, not all value investments work out as well or as quickly as Dell and Xerox. Sometimes, that catalyst you see (like the turnaround/business transformation strategy at Xerox) takes a long time to make an impact and you may give up holding onto the company thinking its dead money long before other investors begin to see the value in it and drive the stock price higher.

It is really a balancing act – clearly Xerox has been a good investment for our clients, but if you compare its return during that initial six months we owned it to the S&P 500 Index, you might question whether we were on the right track:

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You can see that our Xerox investment was actually down 9% (the red line on the graph above) over the same period of time that the S&P 500 was up 5% (the green line on the graph above). This represents a 14% under-performance and honestly can shake your confidence in your investment thesis. However, the power of Xerox’s cashflow was convincing and we believed investors would spot it sooner rather than later – and fortunately that happened.

This is also a perfect example of why the monthly, quarterly, or annual comparison of a portfolio’s performance to the S&P 500 is specious at best. It is always more important to beat the market over the long-term than over short periods of time – and most well reasoned investment theses can take longer periods of time to play out in order to provide significant returns, in particular these deep value investments.

The real question everyone should have on their minds right now, though, is whether the 10% pullback yesterday means Xerox should be purchased. So, lets take a peak at the Equity Review of Xerox I prepared this morning to help me answer that same question relative to several new accounts that we have opened recently – in other words, should I take new clients money and buy Xerox or has the Deep Value investment thesis based upon a turnaround/business transformation strategy played out, or is there still enough value there to justify an investment.

Below is page 1 of our internal Equity Review – my apology for the lack of clarity, I scanned my hard-copy and it is a bit fuzzy:

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This page provides me with a summary of the Operating Performance, Key Statistics, Ownership Data, Dividends, and various Valuations we perform based upon several recognized methodologies.

In the Operating Performance box you can see that earnings growth over the past 5-years has been negative, sales growth has been in mid single digits, and book value has grown just under 10%. You can also see that its Gross Margin , Return on Investment and Return on Assets is subpar (the numbers in red tell me they are below industry comps – whereas numbers in green are above industry comps). These are pretty common results for a company in a turnaround situation.

In the Key Statistics box you can see that the Free Cash Flow Yield is almost 19% (what I would expect based upon our thesis of buying this company when it had high cash flow but priced below book value) however, the Enterprise Value to EBITDA ratio has moved back above 7. Trailing 12-month earnings growth is below our 15% benchmark and the five-year forecasted earnings growth is below that of the S&P 500 (no surprise since we didn’t buy this stock under a growth thesis, but a value thesis).

In the Ownership Data box, you can see that something VERY important is happening: Insiders are buying the stock and make up nearly 1/3 of all buyers – this means the insiders believe in the company and its turnaround story and are committing their own money to it. It is a bad situation to own a company in a turnaround and the insiders do not believe in their own ability to affect change.

The valuation methodologies appear in the Price Data box. For a turnaround situation, the exact numbers are less important than seeing that the overall trend of the calculations are positive. In the case of Xerox, you can see that the analysts have a consensus target price 10% above the current market (which is actually pretty good for a turnaround stock) but the valuations we calculate – the various Discounted Cash Flows, the Dividend Discount, etc., all show significant upside.

The Dividend box also shows us that dividends are strong (2.39% is a higher yield than the S&P 500), that they are growing significantly each year (31.95% growth rate) and that the company has more than adequate ability to pay them (the payout ratio at 21% and the Coverage Ratio at more than 8X).

All-in-all, this page makes me pretty happy.

Let’s look at page 2 of our Equity Review:

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This page is a collection of third party ratings, valuation metrics and technical indicators. One important one near the top is the Consensus Rating among all the analysts that follow it. They rate it a moderate buy, which is OK – better than kissing your sister but not quite like the homecoming queen.

Standard & Poors rates it 2 stars out of 5, which is not really surprising. They use more of an earnings and balance sheet strength system, and since this is owned under a Turnaround thesis, it makes sense. However, you will note that they rate it 5 of 5 for Fair Value, meaning they recognize the value of this company is greater than the market is currently recognizing.

Morningstar, however, rates it 4 out of 5, which is also not surprising since they utilize a value methodology. You can see that they give it a fair value of $12 per share and on page 1, in the Price Data box they say you should consider selling it when it gets to $16.20. Its pretty clear that Xerox rates pretty high in their methodology which is a good sign for a deep value stock.

The yellow box in the middle of the page shows you how this company rates on our proprietary ratings system. Even though neither rating is really apples to apples for a turnaround company, it still rates above 70 on both measures – our threshold is set at 60, so we are above that.

Looking at the Valuation Metrics box you can see that all of our ratios are below the benchmarks (except EV/EBITDA – I prefer to buy a new deep value stock when that measure is below 6, but below 7 is very acceptable). There is still plenty of value in this investment compared to its industry, the broader market, or our internal benchmarks.

At the bottom of the page, you will see a pink box showing that the Price-to-Book X Fwd P/E Ratio is well below the 22.5 threshold, at 8.24.

There are several other pages to the review, but this post is getting long and I don’t want to bore you much more than I already have. So I will just sum it up: This is not the original deep value investment we bought 18 months ago, but the fact that our valuation methodologies show significant upside, insiders are strong buyers of the company’s stock, one of our Deep Value ratios is still in play and the other just misses the threshold, our cashflow is still strong, the company has a shareholder friendly dividend policy, and the company has a long way to go before it is valued in line with its industry, I am inclined to go ahead and add shares to new client portfolios.

I don’t expect we will get the explosive 40% price increase that we received over the past 18 months in the coming 18 months. But even if we can move up to Morningstar’s $12 fair value, that represents a greater than 20% increase above today’s price. With S&P 500 earnings expected to increase 5% over the next year, your risk/reward for owning this investment seems to more than justify allowing management to continue to execute their turnaround strategy. As long as they are believers in it, as evidenced by their buying shares in the company, I am a believer in it as well.


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As always, this is not in any manner to be consider a recommendation for you to go buy this company. Always do your own analysis and make sure that any investment fits with your personal risk profile and objectives.

Have a great weekend!

Mark

Alpha and Beta – Is It All Greek To You?

Thursday, October 3rd, 2013

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I had a couple of interesting conversations today that gave me the idea that I should explain the practical aspects (as opposed to the theoretical ones) of Alpha and Beta in investing.

Investment markets move in cycles – sometimes the market seems to be going up no matter what ( sort of like the past couple of years with the impact of the Fed’s monetary policy – see the previous blog post for more on that) – and sometimes it seems like the market is going nowhere, but certain stocks are going up in spite of it.

This latter time frame is sometimes called a stock picker’s market because the successful investor concentrates their investments in the company’s with fundamentals that will grow their stock price when other companies are faltering – and they are able to buy and sell stocks at the right time to protect the gains they have made and avoid the losses inherent with the market.

This is exactly the concept of Alpha and Beta. Beta is the amount of total return that comes from movements in the market and Alpha is the amount of total return that comes from an investor being able to pick stocks with the right fundamentals at the right times in the proper allocation between capitalization and geographic distribution.

We have been in a Beta-driven market for the past few years – index funds have outperformed active management consistently during this time because: (1) index funds do not keep cash on hand and are 100% invested at all times; and (2) the rising tide lifts all boats, even those with some leaks – and the rising market lifts all stocks so the index goes up in spite of market fundamentals and macroeconomic forces.

Beta-driven markets tend to see: (1) people who don’t invest in stocks want to jump in near market highs; (2) people who are otherwise cautious tend to throw caution to the wind and forget about fundamentals like valuation, financial strength, and earnings growth in order to be 100% invested (or more if they are investing on margin) at times when risk management is a much better strategy; and (3) the S&P 500 Index outperforms all other indices, making a diversified portfolio’s return look bad even if it is performing better than indices of its component parts.

In an Alpha-driven market, the investor needs to focus on valuation, financial strength, and earnings growth as well as macro issues that are driving swings in the market.

I often write here on the blog about the Alpha issues that we focus on in picking stocks: Earnings Growth, Free Cash Flow Growth, Book Value, Debt-to-Equity, Return on Equity, Return on Invested Capital, Weighted Average Cost of Capital, Earnings Yield, Free Cash Flow Yield, PEG Ratio, Enterprise Value, EBITDA, Discounted Cash Flow, Dividends, and many others.

These factors are all part of the process we use to analyze a company and determine if it has the investment characteristics we view as providing superior long-term investment returns. If you have missed posts on this in the past, I promise to make my next post an analytical one showing how we tear apart a company’s financials and determine a target price for it.

But even in an Alpha driven market, your Beta is always there. Some portion of total return is always attributable to the movement of the market itself. So, a successful investor will employ a risk management process that takes advantage of the statistically significant points in the market cycle. Today, let’s focus on that Beta part of the process which I allude to often here on the blog but rarely explicitly explain.

In this part of the process, an investment manager has to focus on being invested at the right times, raising cash when the market moves to statistically unsupportable levels, and investing cash at levels that are statistically risk managed instead of passively allowing the market to dictate that portion of total return.

This Beta management is actually an Alpha activity because it requires active investment management to be a successful investor. Beta itself is the passive movement of the market and your job as an investor is to capitalize on those movements to maximize your returns. This is not timing the market, but rather a risk management activity to lessen equity exposure when the market is extended (check out the Shiller P/E10 chart from the previous post so you can see where we are now) and increase equity exposure when the market has moved below the mean.

So, just so you understand it – Beta is the passive movement of the market and Alpha is the activities the investment manager employs to manage the movements of the market and to pick the companies with the best fundamentals and allocating properly between large/mid/small-cap companies, domestic/foreign/emerging markets, and alternate investments like gold miners or real estate investment companies. It really is as simple as that, no matter how confusing the talking heads on TV and the internet try to make it.

There is so much noise associated with investment management these days perpetuated by the never ending news cycle, business TV, the internet, and all the celebrity “experts” who are eager to tell you what to do. There is so much focus on the short-term that it keeps many people from profiting from the long-term value creation of being in the stock market. They tend to hear someone on TV shout “Sell, Sell, Sell” at the bottom of a stock market cycle and liquidate their holdings at fire sale prices. Instead they should be buying based upon valuations and the statistically significant market levels that have proven to provide for long-term profits while managing risk.

Too much focus is now placed on what has happened in the past month or even year instead of what has happened over the course of the investment cycle, from bull-to-bear-to-bull-again in terms of risk adjusted returns. Maybe I believe this because I’ve been through it and have seen how you make real money – and keep it – through equity investing, but it is truly the only way to survive and thrive in the markets through crashes and new highs over the long term.

So in my 31 years of experience in this business (I can pinpoint it to that number because I have my 30-year Class Reunion from Illinois Wesleyan in 10 days and I started as an intern at the First National Bank of Normal’s Trust Department in 1982) I can tell you certain key buy and sell points that have survived multiple market crashes and blow-off tops to provide for compound annual growth rates much better than the broader market.

Check out the graph above of the S&P 500 Index since 12/31/1999. During this time, we started with a market top, experienced the NASDAQ Crash, peaked to a new market top, experienced the Subprime Mortgage Crash, and have returned to a peak.

During this time, if you remained a true Beta investor and kept your money in an S&P 500 Index Mutual Fund, your Compound Annual Growth Rate for that investment would have been a bit over 2.5%. The crashes tended to offset the returns to market tops, and as in investor you were virtually shaking hands with yourself.

If however, you had employed some simple Beta management tools and raised cash when the market told you that it was statistically ahead of itself and redeployed that cash when it showed you prices that can provide statistically significant risk adjusted returns, you would have done a whole lot better, much like my clients experienced. In this process, you make most of your profits during the low risk parts of the cycle and you get more conservative when the bulk of the investing community is buying near the top.

This is much like how Warren Buffet built Berkshire Hathaway and his multi-Billion dollar wealth. Here are a few bon mots from Warren that follow this thread of logic:

>Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results. [As quoted in Roger Lowenstein, Buffett: The Making of an American Capitalist, p. 77 (1995)]

>Investors making purchases in an overheated market need to recognize that it may often take an extended period for the value of even an outstanding company to catch up with the price they paid. [1998 Berkshire Hathaway Annual Meeting, quoted in The Essays of Warren Buffett: Lessons for Corporate America (1998), p. 92]

>Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful. [2004 Berkshire Hathaway Chairman’s Letter]

>Long ago, Ben Graham taught me that “Price is what you pay; value is what you get.” Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down. [2008 Chairman’s Letter]

>Success in investing doesn’t correlate with I.Q. once you’re above the level of 125. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing. [Quoted in Amy Stone, Homespun Wisdom from the “Oracle of Omaha” ((June 5, 1999), BusinessWeek]

>The stock market is a no-called-strike game. You don’t have to swing at everything—you can wait for your pitch. The problem when you’re a money manager is that your fans keep yelling, “Swing, you bum!” [1999 Berkshire Hathaway Annual Meeting, quoted in Mary Buffett and David Clark, The Tao of Warren Buffett, p. 145]

and, finally,

>The most common cause of low prices is pessimism—some times [sic] pervasive, some times[sic] specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer. [1990 Chairman’s Letter]

Getting back on topic, if you examine the graph, you will see some familiar lines that we discuss here: the red 50-day moving average (since this is a weekly chart, we are using the 10-week moving average) and the green 200-day moving average (here its the 40-week moving average), and the two blue lines that represent a band +/- 10% around the 200-day average.

Just by looking at the graph, you can see that the market mostly cycles up and down in relation to those red, green, and blue lines. So, if you keep the following rules of thumb in mind you can manage the market cycle and focus instead on the fundamentals of the companies you buy and sell.

In an up-trending market or one that is set to turn from down to up:

1. A very safe point to buy stocks is whenever the market drops below the blue line representing the level that is 10% below the 200-day moving average. It is pretty rare that this occurs – once a year or less – but when it does you should be a buyer confident that over time you will make more than acceptable profits (as long as what you buy is fundamentally sound).

The market dropped below the lower blue band because of pessimism and fear – so like Warren, that is the time to be a buyer when everyone else is yelling “Sell, Sell, Sell.” It is what we did in March of 2009, entering at a low risk buy point at 100% invested; it is only now that valuations are up and everyone else is jumping in that we are more cautious.

2. The Green 200-day moving average itself is a great buy point. You need to watch the market internals (things like the Bullish Percent Index, the HiLo Index, and the Advance/Decline line and others – all of which we’ve discussed here before) to make sure they are turning positive to give you a feel for whether the 200-day acts as support or whether it will likely be broken.

If your indicators tell you that buyers are entering the market at the 200-day, you can confidently commit capital to the market knowing that over the long-term profits are in your future.

3. The Red 50-day moving average line is a good place to commit money, again if the market internal indicators tell you buyers are entering the market and the 50-day will likely act as support for a new leg higher.

4. The Blue line that represents 10% above the 200-day moving average is consistently the place where you want to raise some cash. When the passive market moves to that level, sellers emerge to push prices down – it isn’t immediate, so you always have some trading days to formulate your plan and determine which of your holdings are sale candidates (maybe they have hit the price targets you’ve set, maybe there is a news related issue that you anticipate impacting the company’s share price, or maybe they just didn’t execute their operations and didn’t hit their earnings targets).

In a down-trending market, things are different – fortunately, you will have already raised cash by this point and you are simply waiting for the points to deploy it:

1. Instead of most instances of the market moving above the 200-day moving average and you using the 10% above blue line as your sale candidate, the 200-day moving average itself becomes your upper threshold for making sales. Based upon the internal market indicators, you can tell if the 200-day will act as resistance or whether the market is set to turn from down-trending to up-trending (see March 2009 for an example).

2. You will see many instances of the market falling to and below the blue line representing 10% below the 200-day moving average. You will want to buy selectively here, picking up shares of severely beaten down companies but making your purchases small, building a full position over time during the down market.

We often get questions about why we bought 25 shares of something – the reason is we were at a buy point and it allowed us to get exposure to a company at a good price, but given uncertainties in the market we could potentially pick up the other 75 shares of our target position size at a better price. This is a strategy that works in down-trending markets, even short-term ones like the +20% correction in 2011 (check out the move from the top blue line to the bottom blue line during 2011 on the graph).

3. Always keep cash on hand during the down-trending market until the market tells you it is ready to turn higher (see March 2009 on the graph). That turning point is the point of maximum fear and sellers have exhausted themselves moving to cash, selling shares of companies that they bought near the market top at prices significantly lower. The internal indicators we follow tell us when that is happening.

Here are links to a few of the blog posts from 2009 as the market was changing course to give you a feel for what we were doing/seeing as the market was turning. As I re-read them now, I see that we were all-in on the rally but cautious that the 200-day average might act as resistance and when resistance was broken confirming the change in trend, hopeful that it would act as support (good to know our thought process is consistent over the years):

Its a Rally – Here is what we are Doing and Thinkig

Perfect Action in our Rally

The Rally Continues

S&P Pattern Continues

Market Ready to Test 200-day Moving Average

There are many others in the archives that you can read.

I hope this helps you understand a bit about the Alpha and Beta of the stock market. The concepts are actually pretty easy – their application is trickier so I hope that this post provided some insight into how to manage a stock portfolio as the market is rolling through its various cycles.


Click here to watch today\'s video on YouTube

Mark