Tuesday, September 30, 2008

The New Buffettology: Chp 1: The Answer to Why Warren Doesn't Play the Stock Market

This book review summarizes the ideas and opinions of Mary Buffett and David Clark. Warren Buffett did not participate in the writing of the book.
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The authors opine that Warren has created tremendous wealth by not playing the stock market but rather by playing the people and institutions who play the market. They explain that Warren capitalizes from market participant's short sightedness and pessimism by buying the great quality stocks that others are panicking to sell. The author's state that the vast majority of stock market participants are short term motivated and this is one reason why Warren has been able to prosper with his selective contrarian investing techniques.

The other major reason why Warren has been so successful as an investor, is that he has recognized that the long term economics of a business will eventually prevail and reflect appropriately in companies' share prices. Undervalued companies with strong underlying business economics will eventually be repriced upwards and overvalued companies will eventually be re-priced downwards in the market.

Some examples of when we may observe over-pessimistic stock prices are during times of uncertainty (war is mentioned), major industry downturns or missed quarterly earnings. Warren's genius is that he understands the short-term market mentality that dominates the stock market and also that this mentality acts to undervalue great businesses. He then buys those great businesses at bargain prices from a long-term economic point of view.

Banks And Bottoms

We often get asked if we see value in some banks at these depressed levels. We don't approach stocks from a timing point of view, but rather from a value point of view. Unfortunately, it is just too difficult for us to determine the intrinsic values of these "black boxes", for several reasons.

First of all, determining the value of the assets of these institutions is a guess at best. As we've discussed before, some businesses are easier to understand than others. With the complex behemoths banks have become, their business models are very difficult to understand. I can't honestly say that they fall within my circle of competence.

But even if one could determine what the assets are worth to some range of values, the amount of leverage used by the banks seriously clouds the value of the equity, which is what you're buying as a shareholder. For example, for Bank A, you may believe the assets are worth $10,000 plus or minus 10%; but if Bank A uses $9000 in debt to fund those assets, the remaining equity value could be anywhere from $0 to $2000. As long as the shares trade in that range, you have no idea if you're buying at a discount to intrinsic value.

Needless to say, the high debt levels used by banks also make them much more susceptible to collapse during downturns, which is a phenomenon we are seeing right now. As we've discussed here, as value investors we much prefer companies with low debt as they have much greater power to weather downturns.

Though many banks have been offering high dividend yields of late, it's extremely important to understand where that dividend is coming from in order to attain reasonable assurance that it is sustainable, as we saw here with WWE. Buying blindly for dividend yield is not an option.

Are there circumstances under which we could buy banks? Certainly. Under a situation where the entire industry is undervalued for example, a purchase of a basket of several banks helps diversify away the risk of failures here and there. This is a similar situation to our approach on pharmaceuticals, where large amounts of research money are being spent, but it's unclear which companies will reap the rewards. Reyer has taken a preliminary look at the attractiveness of the banking sector as a whole here.

The bottom line is, buying individual banks is a risk unless you understand the value of what it is you're buying. Buying because stocks are down, or because momentum is up, or because yields are high does not adequately protect your capital.

Monday, September 29, 2008

The Intelligent Investor: Chapter 8

The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.

An investor must prepare both financially and psychologically for the fluctuations certain to occur in the market.

There are two ways an investor tries to profit from fluctuations:

1. Timing: Buy when you think the price will go up, and then sell once it goes up.
2. Pricing: Buy when the price is below fair value and sell once it reaches or exceeds fair value.

Consistent market timing is exceptionally difficult, as is evident by the countless market predictions and forecasts by industry professionals that differ from actual events by a wide margin. The variety of these predictions is great enough that an investor can make any move he chooses and find a prediction that supports this move.

Graham goes so far as to say it is absurd to think that the general public can ever make money out of market forecasting. There is no basis in logic or history to believe otherwise.

With regard to the pricing approach, Graham says that this is also extremely difficult to properly execute. Cycles often last for 5 years or more which causes people to lose their nerve and act irrationally. For example, in a prolonged bull market, people may fear being left behind, so they buy at the slightest indication of a bear market, feel vindicated as the prices escalate further, and then lose when the real bear market returns.

Also, any signals identified by experts to help determine whether this is a bear or bull market have been shown to be inconsistent in successfully identifying the position in the market cycle.

Conclusion: If you are banking on market fluctuations, you will not consistently perform well. Market fluctuations are not sound portfolio policy!

The intelligent investor uses a formulaic approach to determine whether stock prices have risen too high and he should sell, or prices have dropped significantly, and he should buy. Or, in other words, if he should alter the allocation of stocks to bonds in his portfolio (as per the tactical asset allocation policy that Graham discusses in previous chapters). The ideal approach is the rebalancing approach discussed in previous chapters (varying from 50-50 allocation to up to 75-25, and reviewing at set intervals throughout the year).

Business Valuation and Stock-Market Valuation
The stock market is paradoxical in that the highest grade stocks are often the most speculative because they gain great premiums over book value and are based more on the changing moods of the market and its confidence in the premium valuation it had put on the company in the first place. Thus, for conservative investors, they would be best to focus on companies with relatively low premiums placed upon them - a market rate no more than 1/3 above the net tangible-asset value.

However, a stock does not become sound because it can be bought close to asset value. The intelligent investor must also demand a satisfactory price-earnings ratio, sufficiently strong financial position, and the prospect of earnings being maintained over the years.

Intelligent Investors with portfolios close to the net tangible asset valuation of the underlying companies need worry less about stock market fluctuations than those who paid high multiples of earnings and assets. The intelligent investor should disregard the market price and not allow the mistakes that the market will make in its valuation to affect his feelings about the business. Do not let the market’s madness fool you into selling your shares at a loss - such a move requires reasoned judgment independent of the market price.

It is in this chapter that Graham creates the oft-cited Parable of Mr. Market. Essentially, you are a private business owner. You own a share that you purchased for $1,000. Your partner is Mr. Market. Every day, Mr. Market quotes you a price for your interest and also offers to sell you his interest for the same price. Sometimes the quote is rationally connected with the business. On other days, it is clear that Mr. Market’s enthusiasm or fear has gotten to him, and the value he has placed is irrational. Graham says the Intelligent Investor would only let Mr. Market’s daily quote affect him if the Intelligent Investor agrees with the price (due to his own analysis of the value of the company), or he wants to buy from or sell to Mr. Market. Unless you want to transact with Mr. Market, you would be wiser to make your own analysis of the value of the company. If you want to transact, then you must compare Mr. Market’s value to the value you reached independently. This parable reflects the way a stock market investor should treat his relationship with the stock market.

Operating Income Pension Adjustments

Defined Benefit (DB) pension accounting can be tricky and non-intuitive for investors to understand, primarily I would say, because of all the assumptions that are required as part of the calculations. The purpose of this article is to point out a few adjustments that investors should consider making to the reported pension expense items included in financial statements.

The pension expense that shows up on income statements (I/S) typically gets included in the calculation of net operating income. The key contributing factors to the total I/S pension expense include:

- Current service costs
- Pension interest expense
- The expected return on pension assets as a reduction of this expense

(Note: There are other DB pension related components that are included as part of comprehensive income, including past service costs and actuarial gains/losses due to changes in actuarial assumptions. I am not referring to those components in this article.)

Current service costs represent the increase in the pension obligation for services rendered by employees during the current reporting period. Another item is pension interest expense, which is the current period interest accrual on the existing pension obligation. The expected return on plan assets reduces the pension expense. It should be noted that it is an expected return based on assumptions of rate of return on plan assets that is used in this calculation, not the actual return on plan assets! Management is permitted (under U.S. GAAP and IFRS) to use the expected return on pension assets in order to reduce volatility of reported income from one period to the next.

One problem with pension expense being included as part of operating expenses, is that it is comprised of elements that are not typically considered operating in nature. It makes sense to keep current service costs as an operating expense since it arises due to work performed by employees during the current reporting period. However, pension interest expense is really a financing expense so why leave this under operating expenses? Calculations such as EBIT are supposed to be before interest expense, so it makes sense to back this out of operating expenses.

Likewise, expected return on plan assets seem more related to an investing activity rather than an operating activity and therefore it also makes sense to back this out of the operating earnings calculation. These adjustments should improve both the accuracy and comparability between different companies' operating income, related ratios and other calculations that depend on operating income.

If a company has a defined benefit pension plan, check the notes to financial statements to read the details on what was done and assumptions made for the pension accounting. As discussed here, there is a lot of important info you can find in the notes!

Sunday, September 28, 2008

Value Investing Today: Chp 14: Above All be Patient

This is the final chapter in the book, and while short, Brandes closes off by stressing the importance of patience. Especially during periods when stocks are not performing well, above all, he recommends to be patient. He advises not to worry and fret because of all the noise the media is making and the fear and panic that may be ensuing as a result in the financial markets. As Brandes puts it, you shouldn't worry because "its doubtful that the business cycle has been conquered!".

Brandes reminds value investors that risk is not synonymous with the possibility of stock price declines. Rather, value investors need to avoid a real loss of capital and can do this by having long term objectives guide our investment decisions, not the short term fluctuations in market prices.

I'll close with Brandes' reference from Graham's book, the Intelligent Investor:

"For indeed, the investor's chief problem, and even his worst enemy - is likely to be himself ... We have seen much more money made and kept by "ordinary people" who were temperamentally well suited for the investment process than by those who lacked this quality, even though they had an extensive knowledge of finance, accounting, and stock-market lore."

Land Ho!

In 2006, Forbes published an article titled "Land Ho!" where they discussed five stocks (HZO, ATML, BJ, STAR, PBY) which own land values far in excess of their carrying values. In other words, these companies' balance sheets understated the true value of the real-estate owned by these companies.

Three of the five stocks, however, are down big. MarineMax (HZO) is not in a favoured industry right now and has lost 65% of its value since that article. Atmel (ATML) has lost over 20% of its value, and Pep Boys (PBY) has been clobbered by around 35% since the time of writing.

So what gives? Wouldn't you expect these stocks to do better over time than the rest of the market? Not necessarily. It is faulty to assume that the market has no idea about the market value of a company's real estate holdings. If a journalist can figure it out, so can investors. These are not exactly obscure stocks, which is where we tend to find the most inefficient pricings, as discussed here.

Even if the market did not recognize the hidden value of these real-estate holdings, there are many factors that go into a company's valuation. One cannot simply look at one component of a company and determine that it is undervalued. For example, in the case of ATML, it had a price to book value of 2.4. After adjusting for the value of the real estate, it still had an adjusted book value of 2.2, which at first glance doesn't exactly scream value.

The bottom-line is, there are no short-cuts to investment success from reading about large-cap companies from mainstream media outlets. For sustainable investment success, each investment you make in the stock market must undergo the same scrutiny as if it were a private investment of yours. You wouldn't unequivocally purchase a house or car on account of a journalist's report, neither should you a stock investment.

Saturday, September 27, 2008

Value Investing Today: Chp 13: Staying the Course


Brandes starts the chapter by reminding us that people have inherent psychological biases that if unchecked, can cause irrational investing behaviour. His suggestion is to follow a value investing approach and safeguard against irrational behaviour by writing down your investing rules to help us maintain consistent behaviour. He re-emphasizes that value investing works by capitalizing on the temporary differences between business value and market prices for shares.

Brandes refers to Graham's introduction of the fictional character Mr. Market. Graham suggests imagining that you own a $1000 stake in a business. Mr. Market is your business partner and every day "he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis". Brandes emphasizes that as value investors, we chose how and when we interact with Mr. Market. Mr. Market will tempt us to sell low and buy high but instead, we can choose to sell out to him at ridiculously high prices and buy at bargain prices.

Brandes advises investors to be as objective as possible in their decision making process. Stick to analyzing the fundamental of a company. Also, by having a deep understanding of ourselves (Socrates - know thyself!) we will be more cognizant of our biases and thus better able to safeguard against them. Hope and regret should have no place in investing. If you buy a company and the underlying business value falls significantly below the market price, selling is not wrong. The decision to buy and sell has to be as unemotional as possible. Brandes states that investing should only be based on a comparison between stock price and underlying business value, that's it.

Brandes believes that if you stick to value investing, at some point, you may look quite foolish in your stock picks, at least in the short term. Your portfolio may decline when others are surging. His advice is to avoid the temptation to abandon the value principles and above all, be patient.

What's So Bad About Inflation?

We've discussed here and here how unanticipated inflation can take a bite out of both stock prices and free cash flow. But if inflation is allowed to creep higher, and is stabilized at a higher level, would that be a problem going forward for the broader economy? Assuming retirement benefit payments are linked to CPI, if our inflation target was 10% instead of 3%, would that be an issue? Common sense suggests nominal interest rates would adjust, and in the long-term this would have little effect on the country's real GDP (i.e. after adjusting for inflation). However, digging a little deeper we do find extra costs associated with a higher inflation rate, even when that rate is expected and anticipated!

First of all, a higher inflation rate (even when stable and fully anticipated) results in something called "shoe leather costs". These are the result of increased spending due to the fact that money loses value. Workers spend their paychecks as soon as they get them, since they could not buy as many goods next month with the same amount of money. Economist opinions of the relative quantity of these transaction costs range anywhere from 0% to 2% of GDP for a stable inflation rate of 10%.

One might think that a worker would get paid higher savings interest rates, therefore why would he spend his paycheck immediately? Unfortunately, tax consequences for savings distort incentives drastically. We pay taxes on our savings at nominal rates (i.e. the rate the bank posts). So if inflation is 10%, you would require at least that rate for your savings account. However, if your savings interest rate is 12%, after taxes your earnings would not be enough to offset the losses from inflation! As such, the savings rate has to increase dramatically, raising borrowing costs, which lowers investment and hurts long-term growth.

Finally, even with a stable inflation rate at a higher level, higher uncertainty persists. Will the inflation rate stay high, or will it come down? This uncertainty leads to lower investment, and a misallocation of resources, as portions of the economy will spend time and effort trying to profit from forecasting inflation rather than creating products and services that add value to society.

These are some of the main reasons why the Fed targets a low rate of inflation, and does everything in its power to keep it that way.

Friday, September 26, 2008

Be Careful Of Earnings Per Share

Too many investors blindly incorporate earnings per share (EPS) as a primary component of their valuations. EPS gets multiplied by a P/E multiple, or it is used as a base for growth rate multipliers to be discounted back to present value. However, for several reasons, investors must avoid using such short cuts in company valuations.

First of all, EPS can fluctuate wildly from year to year. Writedowns, abnormal business conditions, asset sale gains/losses and other unusual factors find their way into EPS quite often. Investors are urged to average EPS over a business cycle, as stressed in Security Analysis Chapter 37, in order to get a true picture of a company's earnings power.

EPS, averaged or otherwise, still does not provide adaquate information regarding a company's debt levels. Two companies could have the same EPS, but one could be capitalized with 99% debt while the other could have 0% debt. While the earnings to the shareholder is the same in both cases, one company is extremely risky and susceptible to bankruptcy should anything unexpected occur. To factor in debt levels, investors are encouraged to value a company based on its operating earnings (instead of its EPS) and subtract debt obligations from this value, and compare debt/equity values.

Finally, EPS does not give adaquate information regarding dilutive securities that have not yet been converted into common shares. "Diluted EPS" is a required reporting component of an income statement, but it only incorporates those options that are above water. For example, if a company has 100,000 shares that have averaged trading at $2.00/share, and 500,000 options outstanding at an exercise price of $2.01/share, not a single one of these options will be recognized in the diluted EPS calculation, despite the fact that these securities are potentially extremely dilutive! To avoid this trap, investors must subtract the value of options outstanding from the arrived at intrinsic value of the company.

EPS is a quick and easy way to refer to a company's earnings. It does not, however, serve as a replacement for prudent analysis of a company's true earnings power and obligations.

Share Based Compensation and Incentives

There are many different ways to compensate company employees. Share based compensation is intended to align employees' interests with those of the existing shareholders, but it doesn't always work out this way. In general, the more responsibility you have in a company the more potential you have of receiving significant amounts of share based compensation. Different forms of share based compensation have different benefits and drawbacks and this post will examine a few of them.

Some of the different types of share based compensation schemes include:

1) stock grants
2) stock options
3) stock appreciation rights

Stock grants are company shares that are granted to employees and often are contingent upon achieving specific company performance goals. Achieving performance goals is often measured through various accounting metrics. One of the drawbacks to stock grants that are dependent upon accounting numbers, is that managers often have influence over company accounting and this could lead, however unintended, to accounting manipulation (a few names certainly come to mind).

One of the problems in awarding stock options, is that they have significant upside potential without the downside risk. This imbalance between risk and reward may lead to overly risky employee behaviour, as discussed in Security Analysis. Stock options are worth more when the market price of the company stock moves higher, and so employees, especially executives, may act imprudently (examples here) by rushing to take on risky projects in an attempt to make their option holdings more valuable.

Both stock grants and stock options can lead to ownership of the company's shares by employees. One of the advantages of having share ownership is purportedly that employees will think and act more like shareholders. One of the criticisms against employee company share ownership, is that they may behave too conservatively in an attempt to protect their stock capital. Personally, I have a hard time with that argument, especially if I measure the statement against Warren Buffett, who as the largest shareholder of Berkshire Hathaway does not seem to have suffered in his management style due to significant share ownership.

Nevertheless, one way to circumvent potentially cautious employee behaviour due to share ownership, is through stock appreciation rights of SARs. With SARs, the employees' share compensation depends on the movement in the stock price and does not depend on having ownership of the stock. In addition, SARs do not cause ownership dilution amongst existing shareholder's but they do require a cash outflow from the company if they are paid out.

Thursday, September 25, 2008

Value Investing Today: Chp 12: Are Stocks an Intelligent Investment?

Brandes explores the idea of whether stocks have historically been a good asset class to invest in. He references a report by Ibottson that shows 75 years of return performance for the S&P 500 stocks, U.S. government bonds and U.S. government treasuries. The compounded rates of return over that time frame are 10.2%, 5.5% and 3.8% for the stocks, bonds and cash asset classes respectively. He concludes, that at least historically, it was prudent to have money invested in stocks over that time horizon.

Brandes takes a closer look at gold and real estate as alternative investments to stocks. First, with gold, he states that although it has a reputation as being an inflation hedge, the metal has only returned 2.6% compounded annually between 1900 and 2000. With inflation averaging 3.2% over the same period, he concludes that gold has not historically been a good hedge against inflation. In addition, even if you looked at the "golden" age of gold, between 1926 and 1981, the price of the commodity only rose 5.8% per year, which is just a little over half the return of the S&P 500 over the same time period.

Brandes comments that real estate without the effects of leverage has not been a great investment over time compared to stocks. One report by Ibbotson shows a 7.6% average yearly return for real estate versus 12.7% return for U.S. stocks between 1982 and 2002. He also makes the argument that people need businesses to generate the income to pay for their homes. His opinion is businesses have to do well in order for real estate to do well and that businesses need to be more profitable than real estate (as investments), otherwise, real estate would be largely unaffordable.

Since investing in stocks appears to be the prudent choice, Brandes takes a look at investing during adverse conditions, namely, during market declines. He notes that there have been 12 major market declines of 15% or more in the S&P 500 since World War II. The average duration of these market declines was 12.5 months. However, the average market rise in the first year following each of these 12 periods has been 31%! This demonstrates the resilient ability of the market to recover from adverse price conditions.

Brandes is not a proponent of market timing because of the impossibility of accurately predicting each market bottom and also the potential for losing out on stock appreciation by not being invested in the market. He references research that demonstrates $100,000 invested in the S&P 500 between 1983 and 2002 would have appreciated to $625,583. The amazing fact, is if investors missed just 10 of the biggest market gain days in that time period, the $100,000 would have grown to only $365,750, or 41.5% less than if investors had remained in invested continuously.

Brandes concludes that time is the most precious commodity to investors, and that time in the market will be an advantage to those seeking long-term appreciation of wealth.

Value Investments Gone Wrong?

In 2004, motor vehicle sales were booming, as the economy was strong and customers continued to buy larger and larger vehicles. The stock prices of most car manufacturers (domestic and foreign alike) were at recent highs. Today is a different story, as the stock prices of GM (GM) and Ford (F) have plummeted from those highs, while Toyota (TM) and Honda (HMC) have held their own despite the tough environment. Assuming investors couldn't see the future (which would consist of high gas prices and a shift to fuel efficient vehicles), could investors have seen this coming back in 2004? After all, Ford and GM own some of the best consumer brands around...could they have represented value investments that just went wrong?

Not a chance. True value investors would have considered GM and Ford investments of only the most speculative variety. Why? Debt levels. Here's a look at the 2004 debt to equity ratios of the four companies discussed above:

Debt to equity levels much more than 1 make us a little bit uncomfortable. Debt to equity levels above 9 are astronomical!

As we've discussed before, low debt levels allow flexibility, add more certainty to the estimated equity value, and allow a company to weather downturns and emerge from them stronger than ever (as Toyota and Honda appear poised to do). Going forward, make sure you know the debt levels of any company you plan on buying for the long term.

Wednesday, September 24, 2008

The Intelligent Investor: Chapter 7

The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.

While the last chapter discussed the things that the enterprising investor should NOT do, this chapter outlines the things that an enterprising investor SHOULD do.

There are four possible ways the enterprising investor may try to make money:

  1. Buy in low markets and sell in high markets
  2. Buy carefully chosen growth stocks
  3. Buy stocks that are a bargain
  4. Buy into “special situations”
With regard to the first option - buying in low markets and selling in high markets - Graham shows that this is easier said than done. There is no mathematical basis for evaluating whether the market is high or low, and generally to make such a determination requires a great deal of experience. Without any reliable mathematical guide, Graham urges ordinary investors to stay away from this.

The second option - buying growth stocks - is also discounted. Graham looks at the performance of funds that invest solely in growth stocks and showed that they underperformed the market. If the fund managers, with greater research facilities, time and experience than the average intelligent investor cannot properly select growth stocks, what chance does the intelligent investor have? Also, Graham notes that growth stocks as a class have a tendency toward wide fluctuations in market prices due to the market’s overreaction to their earnings.

Graham suggests that the intelligent investor place a maximum price-earnings ratio of 25 on the stocks he purchases, and of course, the lower the better. Note that Graham uses average price-earnings which lowers the odds that you will overestimate a company’s value based on temporary bursts of sales. Zweig points out that the current practice of calculating price/earnings on future expected sales is anathema to Graham’s philosophy.

The fourth option, buying into special situations, deals with companies that are the target of acquisition, or companies that will emerge from restructuring at a higher price. While there is a great deal of money to be made, this class of investing requires expert knowledge of the situation and is thus not recommended for the intelligent investor.

This leaves the third option - buying bargain stocks - as the only remaining method, and it forms the basis for Graham’s Value Investing philosophy. The general example given for value investing is buying something with an intrinsic value of more than $1.00 for $0.50. Graham discusses three ways for enterprising investors to do this:

Value Play #1. The Relatively Unpopular Large Company
Since we know that the market will overvalue companies that show strong growth or are “hot” (e.g. tech stocks in 2000), we can expect that the market will likewise undervalue companies that are out of favour for some reason. So, Graham says there is a value play in investing in large companies that are going through a period of unpopularity. He recommends large companies because small companies have the risk of completely losing profitability and protracted neglect by the market despite improved earnings. Large companies have the resources to carry them back to improved earnings, and the market is more likely to recognize a comeback-kid and respond with improved valuations.

Graham looks at the low-multiplier companies on the DJIA over the 1937 - 1969 period to show how the low-multiplier companies significantly outperformed the high-multiplier companies.

Graham cautions that the low-multiplier is not enough for a definitive purchase decision - you must supplement this with other quantitative or qualitative analyses of the company.

Value Play #2. Purchase of Bargain Issues
A bargain issue is one which appears to be worth at least 50% more than the current price. There are two methods of determining the intrinsic value:

  1. Appraisal Method - estimate future earnings and then discounting them back to find the value per share.
  2. Private-Owner Valuation - estimate the value of the company to a private purchaser. This focuses more on the net realizable value of the assets. Net Working Capital is also important.
In identifying companies for further analysis, focus on those that have (1) currently disappointing results and (2) protracted neglect or unpopularity. These are most likely to be undervalued.

You need more than poor results. You are looking for reasonable stability in the past and reason to believe that there is sufficient size and strength for the company to recover in the future. Look for large, prominent companies selling below past average price and past average price/earnings multiple.

In some cases, the share price is valuing the company at less than its net working capital (current assets less current liabilities) and so a purchase of the company at that price would mean the fixed assets are being purchased for free. The long term trend will likely be for the price to move up to a value in excess of the net working capital, to take into account the net assets.

Often, companies that are secondary in an industry are more likely to be undervalued than the industry leader. These can provide a great opportunity, as secondary companies often have high dividend returns, and a bull market will ordinarily be most generous to low-priced issues like these. Additionally, acquisition is a more common possibility in consolidating industries, which would lead to a substantial premium over the purcahse price.

Value Play #3. Bargains in Special Situations
As mentioned above, these are for experts. Often, a lawsuit or something has caused the share price to fall disproportionately low, creating a bargain situation.

Pension Accounting Made Easier

As of September, 2006, U.S GAAP implemented SFAS 158, which requires companies to now fully recognize on the balance sheet, the over-funded or under-funded status of their pension plans and other post-retirement benefit plans.

There are direct implications of this accounting change on performing ratio and trend analysis. Under the new rules, if a company previously had an under-funded pension liability that was not fully reflected on the balance sheet, the balance sheet items will now be affected by typically increasing pension liabilities, decreasing shareholders' equity (net of tax) and increasing deferred tax assets.

This pension accounting rule change will not affect net income. However, under the under-funded off-balance sheet pension plan scenario, even if net income were to stay the same year over year, with this new standard, shareholders' equity would decrease and thus for non-economic reasons, the ROE would increase! In the same way, if long-term debt levels stay the same, a decreased shareholders' equity would act to increase the debt/capital ratio. If you include pension liabilities as part of long term debt, it exacerbates the situation by increasing the debt/capital ratio even further. So be careful if you are doing ratio and trend analysis before and after 2006 on companies that file under U.S. GAAP.

The other impact of this new accounting standard, is in valuing companies' intrinsic values. Prior to SFAS 158, value investors may have been doing their own calculation of the after-tax impact of off-balance sheet pension assets or liabilities. Now, the pension asset or liability is fully reflected on the balance sheet, so calculations to bring it on-balance sheet are no longer necessary. In fact, continuing to do these off-balance sheet calculations could lead to faulty analysis if all the existing balance sheet items are not fully accounted for.

Analysis of pension and other post retirement plans is still prudent, since there are many management estimates used in constructing both the value of the plan assets and obligations. Identification of overly aggressive or conservative management estimates can be a useful indicator for investors, in order to gauge management's disposition in producing the financial reports.

Tuesday, September 23, 2008

Value Investing Today: Chp 11: Managing Risks and Your Portfolio

Brandes defines investment risk as the potential of losing money. He suggests that a portfolio needs to be designed to limit risks. Short term fluctuations in stock prices is not risk by his definition, since value investors invest with a relatively long time horizon and at a stock price that makes economical sense.

Brandes suggests to always to weigh a businesses value against its stock price. You can control risk by buying a company significantly below its intrinsic value. If a stock rises above its IV, sell the stock, if it's a good quality company and trades below its IV with a margin of safety, buy it. You can also control risk by diversifying across countries and industries. This diversification is not done with the purpose of reducing short term price volatility, but rather, to prevent a poor performing investment from significantly dragging down the overall portfolio's return.

To properly diversify, Brandes recommends to not place more than 5% of your portfolio, based on cost, into any one stock. Also, he advises to not invest more than 20% of your portfolio in any one industry or country. Brandes suggests that even diversifying across 10 stocks can reduce your portfolio's risk by 90%. He also mentions that holding even a hundred stocks is fine, provided that each company investment meets the criteria of having its stock price trading significantly less than its underlying business value.

Brandes feels that fears of buying stocks that have low share liquidity are largely unfounded. Over the long term, companies' fundamental value will get recognized in the marketplace. People's fear of liquidity amounts to worrying about whether they can quickly exit an investment without incurring a negative price impact in the process of selling. Brandes points out that this is of concern to short term traders, and possibly very large money management firms, not for the majority of value investors. He references Buffett who wrote "only buy a stock that you would be comfortable owning if they closed the stock exchange for three years tomorrow".

Lastly, Brandes is not a proponent of dollar cost averaging for value investors when buying individual stocks, since it could violate the basic value investing tenet of only buying shares when the price is less than the underlying business value (with a margin of safety).

Price To Cash Flow: A Useful Measure?

We discussed here the study undertaken by Bauman, Conover, and Miller that demonstrated superior returns of stocks of the lowest P/B quartile. In the same study, the trio studied relative returns of stock quartiles separated by Price to Cash Flow (P/CF). Cash flow is quite a volatile number, as it can be affected by a number of accounts including working capital, investments, loans, dividends etc. For the purposes of this study, Bauman et al. defined cash flow as simply earnings with depreciation (a non-cash charge included in earnings) added back.

Despite the simplicity of the concept, the value group (those defined as having the lowest P/CF) outperformed the other three quartiles as depicted below:

Unlike what we saw in the P/B study, the highest standard deviations actually belong to the companies with the highest P/CF. Changing predictions of expected future cash flows for this group may be causing relatively wild gyrations in its stock prices.

One of the conclusions drawn from this study is that investors are far too willing to overpay for "growth" companies. The median P/CF for the value quartile was 4.4 while it was a whopping 34.2 for the high P/CF group! This is why as value investors we prefer buying companies with stable cash flows and prices to those cash flows which are at reasonable multiples.

Monday, September 22, 2008

Value Investing Today: Chp 10: Unique Aspects of Global Investing


Brandes points out that although he recommends investors to participate in global investing, foreign investments are subject to currency exposure, political risks and different accounting standards than domestic investments.

Investment returns with global investments will depend on the change in price and the change in the relevant currency valuations. Brandes believes that exposure to foreign currencies provides another layer of diversification and is a good thing for value investors. However, he does not believe that value investors should engage in currency hedging for the reasons of 1) it is practically impossible to understand the true currency exposure for a given company, 2) the costs associated with currency hedging and 3) the potential for doing more harm than good in trying to hedge.

Brandes is a bottom up investor and for that reason he recommends looking across the globe to discover good quality companies selling at cheap prices prior to considering specific country related political risks. After a solid business investment is found, investors can change the required entry price for the investment to account for unique political risks. In general, Brandes recommends investors diversify away political risks by "limiting portfolio assets to the greater of 20% of portfolio assets or 150 percent of that country's weighting in a comparable index" (direct quote from Brandes). In this way, it offers flexibility to the investor as well as benefits of country diversification.

Accounting standards vary between different countries. Some countries don’t allow the two sets of financial statements like the U.S. and Canada allows, one for tax reporting purposes and one for financial markets. The implication is that for those nations, the net income may be understated. Other examples of differences between country accounting standards are some allow or even mandate faster rates of depreciation, some only recently allowed the recognition of goodwill on acquisitions and some amortize goodwill over short time periods. For these reasons, Brandes warns that directly comparing earnings and other related ratios (e.g. P/E) between companies in different countries is problematic. He does suggest that comparing cash flows from international companies is much more useful than comparing reported earnings, because they will be less distorted.

Brandes has the opinion that investors that have done the diligence and understand the different accounting treatments in different nations will have a decided advantage in valuing companies.

Value In Action: Dundee Corp

Dundee Corp (DC.A) is a majority owner in several business lines consisting of wealth management, real-estate and natural resources.

At the end of 2002, it had a market cap around $350 million, but it had net assets (assets less liabilities) of $480 million, and was profitable. These stats alone show only a low Price to Book value; one must still investigate the assets to determine whether the real value of those assets can be determined.

In the case of Dundee, pretty much all the assets consisted of client receivables and an investment portfolio consisting of mostly public companies which had an aggregate market value which was higher than the book value at which Dundee was listing them. These details can be seen in the company's annual report.

As such, it would appear that Dundee traded at a substantial discount to its intrinsic value. An astute investor who recognized this price/value discrepancy by April 2003 (enough time to have knowledge of the Dec 2002 accounting statements) saw Dundee shares double from $13.50 to $27 by April 2004.

Today's "Dundees" are out there! But you've got to find them.

Sunday, September 21, 2008

Home Builder Discounts

One quarter ago, we looked at the discounts that many home builders were trading at relative to their book values. Let's see what they look like now:

Right off the bat we see that a couple of home builders with high debt levels were unable to continue in their former states. Writedowns in this industry continued in the past quarter, as book values continued to fall. In many cases, however, market values actually rose, and therefore many of the discounts are not as pronounced as they were one quarter ago.

Looking at a distribution of these companies across debt and discount levels reveals the following:

As value investors, we are of course interested in low debt, and large discounts (we care nothing for the stock's momentum, its moving average, its support levels, and other criteria that are completely unrelated to its intrinsic value). As such, the two companies which are circled, (MHO) and (LEN) in the chart above, may offer value. Of course, this cursory glance only scratches the surface of these stocks, and so we will have to take a closer look at these companies in future posts...

Value In Action: H Paulin

H. Paulin (TSE: PAP.A) is a company that manufactures construction quality fasteners such as bolts and screws. In April 2005, the stock traded at $37.50 per share and paid a 50 cent yearly dividend. At that time, the company had a market cap of around $40 million dollars and had a price to book ratio of 0.93.

The operating margins of the company during the last business cycle looked healthy. In fact, the company had no operating losses in any of the five years prior to and including 2004. The operating margins were also very stable with an average operating margin of 5.9% and a standard deviation of 0.6% for the five years ending Dec 2004. The financial leverage seemed moderate as the company had a debt/capital of 41% which included the impact of operating leases. H. Paulin in 2005, is another example of value in action.

The asset quality looked pretty good as there were no goodwill or intangibles items on the books and $68M of the $85M of assets were current assets primarily comprised of accounts receivable and inventory. A 143 days inventory didn’t seem unreasonable given that the company's products should have a long shelf life and probably don’t get design changes all that often (how often do nuts and bolts get design changes?).

Using the value investing methodology taught by George Athanassakos, I estimated the intrinsic value of the business to be worth $56.75 per share by the end of 2004, with both the earnings power and asset values above $55 per share! With a market price of $37.50 per share in April 2005, you could have bought the stock at a 34% discount to this intrinsic value at that time!

How would investors who bought the stock in April 2005 have fared one year later? Well, including dividends, investors would have seen the stock price appreciate to $54.75 per share and had they elected to sell, would have ended up with a 47.3% gain in one year. Not a bad pay day for reading some annual reports and staying disciplined to require an adequate margin of safety. Incidentally, this stock would also have met all of Brandes’ criteria for finding value in April 2005, as discussed here.

Today, this stock may be a bargain again, as we've discussed here.

Saturday, September 20, 2008

Value Investing Today: Chp 9: How To Invest in Companies Worldwide

In this chapter, Brandes explains options on how to purchase shares in a foreign company. Investor's wanting to buy foreign stocks can purchase ordinary foreign shares (ORDs), depositary receipts, foreign shares listed directly on a local exchange (typically only large multinationals do this) and/or packaged investments such as mutual funds or exchange traded funds ETFs.

Purchasing foreign stock exchange ORDs direct from a foreign broker is an option, although somewhat complicated. There are issues of which broker to deal with, currency conversion, custodianship, and where to accrue the foreign currency dividends. A simpler option is to look for over the counter (OTC) ORDs trading on e.g. the Nasdaq. Another option is to find a local brokerages that can custody, price, and payout ORD dividends (for a fee) in a local currency.

Brandes suggests an easier and more transparent way of buying foreign stocks is to purchase depositary receipts. There are American Depositary Receipts (ADRs) and Global Depositary Receipts (GDRs). These are similar structures except that the ADRs have been geared towards U.S. investors.

ADRs are listed on U.S. exchanges (e.g. NYSE), are priced and pay dividends in U.S. dollars. Unsponsored ADRs (created by banks without the consent of the underlying company) are not very popular with investors since company information and performance reports are not always readily available. Sponsored ADRs (most of the ADRs) are generally listed on the OTC market. Exchange-listed ADRs are also sponsored, listed on a major exchange and have the added benefit of requiring the companies to adhere to the exchanges reporting requirements.

ETFs represent a basket of securities and and trade like a single stock. ETFs are passivley managed. Some ETF strengths include ample liquidity, low expense ratios and tax benefits. Brandes lists some ETF weaknesses as the associated trading costs and the fact that many simply track indices, which can be heavily weighted towards larger cap stocks and stocks that have had undergone a tremendous increase in market cap.

Home Depot vs Lowe's: Return On Equity

Here's a look at the ROE of Home Depot and Lowe's over the last few years:

Considering all the negativity surrounding Home Depot, this has to come as a surprise to most. But looking at ROE alone does not tell the full story of how well a company is managed. If one company is too highly leveraged, then ROE can look good for a long period of time, before finally crashing down and leaving shareholders in the lurch (consider many US Banks and certain home builders).

So let's break down the ROE equation to determine what component debt is playing in boosting ROE, and what component approximates returns on invested capital.

ROE = Net Income / Equity = (Net Income / Assets) * (Assets / Equity)

(Net Income / Assets) is simply Return On Assets, which should give us a decent estimate of what kind of returns management gets on every dollar it invests in the business (e.g. land, buildings, inventory etc.). Here's the ROA of both Lowe's and Home Depot:

We see slightly better returns for Home Depot, which is consistent with what we saw when we analyzed the sales per square foot and profits per square foot of these two companies. Note that this measure is not a perfect one. It's possible that Home Depot has assets on its books that are understated as compared to Lowe's (e.g. land, which is stated at cost, even if it has appreciated in value).

And the second half of the equation above will show us how leveraged these two companies are:

We see that in the last couple of years, Home Depot has been further boosting its ROE by levering itself up. Is it too leveraged? The answer to this question is never clear. But one thing we do know is that recent quarters have not been kind to the housing market, and as a result, these two retailers have experienced declining business. Let's take a look at how well Home Depot has been able to cover it's interest payments in recent quarters during these rough times:

It would appear that throughout this downturn, they have had ample room to cover their fixed obligations, suggesting their debt load is at fairly safe levels.

Home Depot has been mired in negativity in the last few years. However, judging from these metrics, it would seem that they have run the business well. Of course, there have been some bumps in the road. As we saw here, many of the shareholder returns HD has generated were used to buy back stock at terrible prices. Going forward, however, HD seems to be in a position to provide shareholders with decent returns.

Disclosure: The author has a position in both HD and LOW

Friday, September 19, 2008

The New Contrarian Investment Strategy: Chp 13: Are Common Stocks a Good Investment Today

In this final chapter of the book, Dreman explores whether high inflation is bad for equity investments.

The well understood type of inflation is when too much money is chasing too few goods. However, Dreman presents other factors that have recently been sources of inflation including 1) higher commodity prices being transferred in from overseas, 2) the sociopolitical belief that real income needs to increase for working people and labor forces able to enact this belief and 3) anticipatory product pricing used by businessman to maintain profit margins. Dreman observes that a rise in one of these forces causes a corresponding rise in the other two forces.

Dreman suggests that businessmen normally establish prices by projecting costs of labour, material and other costs in order to maintain profit margins. He observes that profit margins in companies has remained very stable regardless of whether inflation was 2% or 10% over recent years. Dreman shows data between 1952 and 1981 split up into 3 distinct time periods (1952-1961, 1962-1971 and 1972-1981), that demonstrate average profit margins of 14.8%, 15.5% and 14.9% for S&P 400 Industrials during those time intervals. Dreman observes that during the ten years ending 1981, a period of accelerating inflation, corporate earnings were robust despite the rise in prices. Dreman also shows evidence that dividends of the S&P 400 between 1971 - 1981, have increased almost as fast as the rise in prices. In addition, a paper by Modigliani and Cohn, has produced evidence against the widely accepted belief that corporate profits decline sharply during periods of high inflation.

To sum up, Dreman finds the belief that corporations can't pass on inflationary costs to consumers and that earnings and dividends are stymied during inflationary periods not well supported. He asks the question, "why then have returns on stock investments done poorly during high inflationary periods"?

Modigliani and Cohn attribute the poor performance of stocks in inflationary periods to institutions not understanding the effect of inflation on corporate profits. In fact, they claim that institutions place too low a valuation on stock earnings relative to interest rates and high-grade bonds during inflationary periods. The problem is that institutions use bond interest at nominal rates in determining the acceptable earnings yield for stocks, thereby systematically requiring returns that are too high from stocks during inflationary periods.

According to Modigliani and Cohn, another problem with stock valuations during high inflationary periods is that certain accounting adjustments are made such as reducing swollen profits from inventories and increasing the impact of future depreciation expense but there is failure to account for the fact that a company's debt is actually decreasing in real terms.

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This concludes my review of The New Contrarian Investment Strategy. I have found the book to be exceptionally informative and relevant despite being published in the early 1980's! I am sure I will be referencing this book in years to come and it is a most welcome addition to my investment book library.

New Dragon Asia Corp...Cheap?

New Dragon Asia Corp (NWD) produces and distributes noodle and soybean products to wholesalers and retailers in China. It's in a stable industry, provides a diversified array of food products to various customers, has a P/E of 4.2 and a P/B under .5, warranting a closer look.

As we've discussed many times now, you cannot properly value a company without reading the notes to its financial statements. It is too easy for companies to hide off-balance sheet obligations, such as the examples of operating leases and corporate airplanes that we've discussed.

Another reason to read the notes to the financial statements emerges for NWD: stock options. On the surface, NWD has listed it's number of shares at 58 million. Throughout the notes, however, we find three separate convertible securities that, if exercised, represent significant ownership share:

1) 8 million options outstanding thanks to an employee stock-based compensation plan
2) 6.5 million in warrants outstanding that have been issued to various financiers
3) 8 million shares of preferred stock convertible into common

All in all, you may think you're buying a company with 58 million shares, but it could very well have 80 million shares if all these options get converted. Does this automatically eliminate it as a buy? Not quite, but these options (which have varying strike prices and maturity dates) must factor into your valuation. In general, value investors tend to avoid companies with a high number of options due to the uncertainty involved, and the warped incentives they provide to management, which we've discussed here, and demonstrated by example here. Proceed with caution!

Disclosure: Author does not own a position in NWD

Thursday, September 18, 2008

The Intelligent Investor: Chapter 6

The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.

As discussed in earlier chapters, the difference between defensive and enterprising investors is small. The enterprising (or aggressive) investor should still divide his portfolio between high-grade bonds and high-grade common stocks. The difference between these two investor personas is that the enterprising investor will be willing to purchase securities that do not fall within these categories so long as there is a well-reasoned justification for doing so. Again, as discussed in earlier chapters, the risk does not increase, because the enterprising investor has more time to research and analyze these departures.

So, what should the enterprising investor look at? Well, Graham starts first with what the enterprising investor should NOT do. The enterprising investor should NOT:

  • Invest in high-grade preferred stocks (for the reasons outlined in earlier chapters - namely, these are worst-of-both-worlds investments)
  • Invest in junk bonds unless they can be bought at bargain levels (30% under par for high-coupon issues)
  • Invest in foreign-government bond issues, even though the yield would be attractive
  • Invest in new issues (see note below)
  • Invest in convertible bonds and preferred stocks
  • Invest in common stocks with excellent earnings confined to the recent past
Graham warns against buying bonds or preferred shares which lack adequate safety (i.e. are not high grade) only because the yield is attractive. Don’t fall prey to the siren call of yield. Failing to heed this warning may leave you highly susceptible in poor economic times, when interest or dividends are suspended. Graham refers to this as the Businessman’s Investment Fallacy - It is wrong to accept greater odds of a loss of principal in exchange for a 1 - 2% gain in annual income.

Zweig points out that in Graham’s day, this was a concern, whereas today investors can easily and inexpensively diversify away the risks associated with junk bonds. However, most of the funds that invest in junk bonds charge high fees that eliminate the benefit of investing in junk bonds.

Remember: “Buying a bond only for its yield is like getting married only for the sex. If the thing that attracted you in the first place dries up, you’ll find yourself realizing there is nothing left

Investing in New Issues
Graham recommends that all investors be wary of new issues. New issues require more examination and must meet a higher threshold than the securities of well-established companies. Two reasons:

  1. New Issues come with a certain salesmanship that requires significant resistance. Underwriters make significantly more money on new issues, and so they work significantly harder to sell these.
  2. Most new issues are sold in market conditions favourable to the seller, not the buyer. Corporations often choose to issue an IPO at the market peak, and so often these issues are overvalued.

From the Mailbag: Kaboose

Kaboose (KAB) is an online advertiser and marketer geared towards families and children. Some of the websites they run include bounty.com, babyzone.com, amazingmoms.com, funschool.com, zeeks.com and bubbleshare.com. Kaboose generates revenues through online commerce and advertising. The company has been growing revenues primarily by making strategic acquisitions of websites geared towards their target market segment.

First, lets review some of the Kaboose value indicators. The stock has a market cap of $101.5M based on the current market price of $0.73/sh. The relatively small market cap suggests that analyst coverage is likely low and could lead to pricing inefficiencies with the stock, as we've discussed here. The company is not yet profitable, however, with an equity value of $180M the price to book ratio is 0.53. Depending on the quality of the assets, the low P/B value could indicate value.

As a value investor, I heed the warnings of Graham, Dreman and Athanassakos (and others) and do not attempt to forecast a company's earnings. Rather, I assess earnings strength by looking at the track record of what a company has already accomplished and make a judgment if the results are repeatable or not (look out for value traps!). Kaboose is not at a stage where they can show consistent positive free cash flow, and for this reason I personally would never buy a company like Kaboose until they have demonstrated the capacity to do so. For that reason, let's review the quality of Kaboose's assets to see if value can be found there.

Total assets for Kaboose total $249M. Reviewing the assets, I found that goodwill and intangibles are on the books at $107.5M and $103.5M respectively. Goodwill is the excess value paid over the fair value of the assets acquired. Presumably, Kaboose is paying more than fair value for the acquired assets because they believe those assets will generate adequate returns in the future to justify the price paid. However, since Kaboose has yet to demonstrate profitable operations, I have deep reservations about recognizing goodwill at its book value. By the same line of reasoning, I have similar reservations about recognizing the full intangible value on the books.

Even though the price to book value looked promising for Kaboose, the tangible asset value of the company is rather small compared to the total assets. Since the goodwill and intangibles represent $210.5M of the total asset value of $249M, if those "softer" assets are impaired significantly, an investor may be investing in a company with a very high price to book ratio. The extremes then for price to book would be the 0.53 if you accept goodwill and intangibles at book value ranging up to 2.6 if you write them off completely. I don't know what the real value of goodwill and intangibles should be but without a reliable gauge on earnings strength I would tend towards being more conservative rather than optimistic in my judgment.

To summarize, since Kaboose has not yet demonstrated the ability to consistently generate positive free cash flows and that the asset value of the company is predominantly made up of goodwill and intangibles (84.5% of the total assets), I would consider putting money into the company's stock at this time speculative in nature without adequate protection of capital. Of course, people that decide to speculate under such circumstances and subsequently do well may be left with an exciting sense of precognitive abilities that are bound to disappoint in the future.

Wednesday, September 17, 2008

Value Investing Today: Chp 8: Why Go Overseas

In this chapter, Brandes begins to focus on the topic of investing globally. He suggests some reasons to consider investing overseas including 1) you have more selection, 2) you can often find better opportunities abroad than in your domestic market (because most of the world's businesses are outside your domestic market) and 3) you can reduce risk by finding undervalued companies.

In 2001, a study by Yale University professors shows that the return correlation between U.S. and non U.S. stocks is cyclical in nature. This implies that the portfolio diversification benefits available by investing internationally are not constant over time. During some periods, the correlation of returns are high, indicating limited diversification benefits and during other periods, the correlation is low, indicating diversification benefits are more prominent. For this reason, Brandes advises to always maintain enough portfolio international equity exposure in order to capitalize on opportunities in other parts of the world while reducing risk.

Some investors believe that investing in U.S. multinational companies (companies that are headquartered in the U.S. but bring in significant foreign revenues) offers the same diversification benefits as investing with foreign equity securities. Brandes doesn't believe this is the case and references a study conducted between 1985 and 1998 that shows U.S. multinationals had a high correlation (0.89) with the S&P 500 Index. Over the same time period, the MSCI EAFE Index (a measure of returns in developed markets outside the U.S.) had a much lower correlation (0.48) with the S&P 500 Index. This suggests that U.S. multinational companies are not a good substitute for non U.S. stocks included in the MSCI EAFE Index. Brandes recommends to buy companies abroad to obtain meaningful international diversification benefits for your portfolio.

Brandes references another study which demonstrates the cyclical nature of international currency valuations relative to each other. This study included the British Pound, the Japanese Yen, the European Euro and the U.S. dollar. Since relative currency valuations tend to vary over time, Brandes recommends maintaining adequate exposure to international currencies in order to provide the opportunity for currency appreciation and diversification benefits in a portfolio.

Brandes believes that the single most important factor for reducing security equity risk is buying a good company at a favourable price. For this reason, he does not advocate taking a top down approach in deciding which country to invest in. Rather, he recommends taking a bottom up approach and selecting the best opportunities around the world.

Price To Book: What Is It Good For?

We discuss the Price to Book values of various stocks quite often on this site, but how useful a metric is it? From a logical standpoint, as a purchaser of a business (which is how we view all our stock purchases), a prudent buyer ensures - barring certain exceptional circumstances - that he does not pay too much more for a company than the value of its assets. In this way, he receives downside protection to a certain extent. Though book value is not a perfect measure of the value of a company's net assets, it does provide at least some level of a proxy for it.

That's all well and good in theory, but what of it in the investment world? Do stocks with low P/B values outperform the market? There have been several studies that suggest that historically, stocks with lower P/B values have in fact outperformed, however, there are certain caveats to keep in mind.

One study that has gained industry credence was carried out by Bauman, Conover, and Miller. The authors used an international sample of stocks and divided them into quartiles based on P/B. They observed over the ten-year period of their study that the quartile of the lowest P/B stocks had mean returns of 18.1%, while those of the highest P/B had mean returns of 12.4%, representing an annual spread of 5.7%.

Based on this data, buying a basket of low P/B stocks may get you outstanding returns, but you may do even better if you can determine which of the low P/B stocks are worth purchasing and which are about to go bankrupt: the standard deviation of the returns for the lowest P/B stocks was 70 as compared to 57 for the highest P/B quartile, suggesting there were some big winners along with some big losers.

This is why looking for companies with low debt and good liquidity among issues trading at discounts to their book values can present great investment opportunities, some of which we discuss here.

Tuesday, September 16, 2008

Value Investing Today: Chp 7: Corporate Governance and the Value Investor

Brandes describes corporate governance as the relationship between a company and its shareholders. The board of directors are elected by the shareholders and have fiducial responsibility for the shareholders. The board of directors appoint officers to manage the company. Problems often arise because of a lack of alignment between shareholders and the management of the company. Shareholders own stock and get their rewards through return on investment whereas management often receives upside only returns (no downside risk like shareholders) through salaries and stock options.


Brandes suggests watching out for the following principles to help avoid potential conflicts between shareholder and management:

1) The board should be made up of a majority of non-executive, truly independent directors
2) A board nomination committee should exist and be responsible for putting forth the director nominees
3) A board compensation committee should exist and establish fair and transparent compensation for the executive directors
4) A board audit committee should exist and ensure the integrity of the company's financial information
5) There should be transparent, effective and fair procedures available for how to conduct shareholder meetings and for how to allow shareholders to exercise their votes.


Shareholder activism is one way to try to make changes on how management is behaving. Brandes believes that effective shareholder activism needs to be conducted by institutional investors (generally they have more leverage than individual investors) and should focus on corporate governance values rather than operational issues. To be effective with shareholder activism, the activists need to be persistent and consistently raise the same issues with management until they are resolved. Many institutions forgo shareholder activism because it is time consuming, can be expensive with professional legal assistance and might hurt the institutional firms chances of getting (or lose) business from the target company for example to manage their pension assets.


Unlike many institutional money management firms that invest for short term (speculative) profits, value investors invest for much longer time frames as they wait for the market to recognize a company's intrinsic value. For this reason, value investors may be more interested in being active shareholders.

Analysts Continue To Bewilder

How can investors trust analysts who can't tell the difference between a company that's solvent and one that is worth virtually nothing to shareholders. We've seen other examples here where analysts appear fraudulent in their recommendations. The latest example? That of Lehman Brothers (LEH).

Yesterday, the company filed for bankruptcy, and the share price lost 95% of its value. However, rumours have persisted for months that this bank is due to fail. The company has been desperately trying to sell off assets to raise cash to remain solvent, but last week it appeared their last-ditch efforts had failed.

Yet on the Friday (Sept 12th) before the imminent bankruptcy, here is a summary of the recommendations of the 19 analysts that were covering LEH according to Thompson/First Call:



There is not a single 'Sell' rating on this chart! So are the analysts just guessing? One would think that if they were, then surely at least one analyst out of nineteen would rate this a sell. Were some of these ratings made months ago? Perhaps, but they are nevertheless still current (and not listed as suspended). In fact, 3 days before the would-be bankruptcy was announced, both Citigroup and Argus downgraded LEH from 'Buy' to 'Hold'. Hold?! Not 'Sell'? Does this industry have any credibility?

Monday, September 15, 2008

Value Investing Today: Chp 6: Gathering Company Information

Brandes provides some sources of information that will assist investors in answering the key questions of whether they want to own a particular company and at what price. Brandes first likes to understand a company's history, its line of businesses and any recent events that may have significantly affected the price of the stock. After this, if he is still interested, Brandes will do a valuation on the company.

Hoovers (www.hoovers.com) is a good place to visit to read company profiles and obtain other content (e.g. historical timelines). It offers a free service as well as fee based reports. Valueline (www.valueline.com) provides a wide range of financial data on various companies in a compact form. Kiplinger (www.kiplinger.com) has a useful stock finder tool. J.P Morgan offers useful content on international issues (www.adr.com). EDGAR is the place to visit to access current and historical U.S. financial statements (www.sec.gov).

Understanding how to read financial statements is extremely important for investors. Brandes shares a few things to watch out for when reading the financial statements. On the balance sheet, keep in mind that adjustments to assets will have an impact on shareholders equity (book value) and in turn could have impact important ratios such as the debt to equity ratio. Understanding if a company uses LIFO or FIFO inventory method could have a material impact on current assets. Hidden and undervalued assets can significantly increase a company's worth and should be identified. Land is often an undervalued asset since it is on the balance sheet at cost and generally appreciates over time. Also, research and development is often recorded as an expense even though in many cases it really represents an asset.

With the income statement, focus on identifying a company's sustainable earnings. Don't focus too heavily on earnings in any one period, but rather normalize earnings over multiple periods to get a better indication of a company's earning power.

The cash flow statements should be analyzed to get an understanding of whether current operations can sustain or increase cash to the company. A company with frequent negative cash flow could prove fatal and investors are well-advised to be wary of this condition.

Reading the notes to financial statements will provide more detailed financial disclosure. Review the auditor's report carefully to see if the opinion is clean or qualified. Qualified opinions should act as a warning and investors should proceed carefully. Read the proxy statements to get an understanding if management is acting in a fair manner or if they have been over-indulging through their salaries and through special company transactions.

Oil Demand Starts To Falter

As we discussed here, oil at these prices does not make for a good long-term investment, contrary to what alarmists will tell you. High oil prices cause a decrease in oil demand, and therefore a drop in the oil price, over time. Yes, demand is fairly sticky in the short-run, as it takes time for energy efficiencies to be implemented and for changes to occur in the make-up of the economy's fixed assets (e.g. a phasing out of SUVs in favour of smaller vehicles).

If this hypothesis is correct, over the next several years we should see a gradual decline in consumption take hold. This process has in fact already started. For example, June 2008 numbers for US motor vehicle miles driven were recently released, and 12-month rolling totals ending in June of every year since 1983 are depicted below:

On a long-term chart the drop in consumption may not look like much. However, as mentioned this is a gradual process and will continue to take place going forward. Further, this chart only measures miles driven, not the efficiency of those miles, which is also improving. And finally, these are 12-month totals, which don't fully capture recent drops in consumption which have been relatively larger than those of several months ago. For example, you have to go back to 2002 to find June numbers lower than those of 2008, suggesting 12-month rolling totals will continue to fall.

The bottom-line is, as demand falls and supplies catch up, the long-term oil price will fall, not rise as many expect it to.

Sunday, September 14, 2008

The Intelligent Investor: Chapter 5

The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.

As mentioned in earlier chapters, Graham suggests that all portfolios, regardless of how aggressive or defensive the investor, must include both bonds and stocks. The major differences between defensive and aggressive investors is the proportion split between these two types of securities and the time spent maintaining the respective portfolios (aggressive investors must dedicate much more time, and in turn should achieve higher returns). This chapter discusses the stock portion of the defensive investor’s portfolio.

It deserves repeating to say that the reason common stocks are a necessary element of all portfolios is that they offer a considerable (though not perfect) degree of protection against inflation, whereas bonds offer no protection, and that common stocks have provided a higher average return (both appreciation of the security and dividend yield).

Graham provides four rules for defensive investors in selecting common stocks:

  1. Have adequate, though not excessive diversification. Generally 10 - 30 stocks.
  2. Each company should be large, prominent, and conservatively financed (Look for Debt-to-Equity ratio of 0.5 or less)
  3. Each company should have a long record of continuous dividend payments. (At least 10 years)
  4. The investor should impose a limit on the price he is willing to pay for an issue in relation to its average earnings. Graham suggests 25 times average earnings over the previous 7 years, or 20 times those of the previous 12 months.
Dollar-Cost Averaging
In following these four rules, Graham suggests defensive investors use Dollar-Cost Averaging to purchase their shares over time. Dollar-Cost Averaging is the purchase of a set dollar figure of shares at regular intervals. So, if the share price goes up, you purchase fewer shares. Likewise, as the share price goes down, you purchase more shares. So the average price per share trends downward (since the lower prices are weighted more heavily by purchasing more of these shares). This eliminates the investor’s tendency to buy into the hype and purchase more shares as the price increases. Dollar-Cost Averaging maintains steady, patient investment.

A quote from the chapter on Dollar-Cost Averaging is: “no one has yet discovered any other formula for investing which can be used with so much confidence of ultimate success, regardless of what may happen to security prices, as Dollar Cost Averaging”

A note on Growth Stocks
Graham uses part of the chapter to discuss growth stocks, which are those that have increased per-share earnings above the average growth for other common stocks. Graham cautions against investing in these with the familiar maxim “The hotter they are, the harder they fall.” He points to Texas Instruments and IBM to show how their strong growth led to the market pricing their shares at significant multiples of earnings, but once their earnings inevitably drop off, the market similarly overreacts to the lower earnings by reducing the share prices disproportionately. In other words, investment in growth stocks is risky and expect much greater volatility.

The Investor’s Personal Situation
Graham looks at three different personal situations (a successful doctor mid-career, a widow with dependents, and a young man starting his career). What is interesting from this section is that Graham once again goes back to his earlier discussion of risk and aggression and tells the reader that we must put away our preconceived notions of what portfolio policies these three different investors should adopt. The widow may very well have more time to devote to her portfolio than the doctor and as such she should invest more aggressively. The doctor, on the other hand, may have very little time to put toward his portfolio, so it would be more intelligent for him to not adopt risky policies.

I found this quite interesting because I had immediately reached knee-jerk conclusions as to what these three example investors should do. Everyone together now: how aggressive an investor should be depends on his willingness to put time and energy into his portfolio. Graham repeats this often.

Risk vs. Safety
Graham uses the end of the chapter to clarify the meaning and use of “risk.” Risk should NOT be used to refer to declines in the price of the security. Price fluctuation may be cyclical and temporary in nature. If the shares show a satisfactory overall return over a satisfactory time period, then it is safe - regardless of whether there are price fluctuations (because these can be expected).

Risk should only be used to refer to the likelihood of a significant deterioration in the company’s position.

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