Thursday, January 29, 2009

The Little Book Of Value Investing: Step 2

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.

Step 2 Analysis: In-Depth Analysis of Individual Companies
Now that you have a hit list of potential value plays, consider the following:

  • Reasoning for Stock Price: Here, you try to determine why the company is trading a such low multiples. If the company has simply fallen out of favour with the market, that may present a great opportunity! If the company missed estimates, that is no problem, because those are short term and good companies will tend to focus long term. Consider historical growth and check whether the estimates it missed were its own or the street’s. If the company is doing poorly because it is heavily tied to the economy as a whole (e.g. homebuilding), that may be alright too, IF it can survive until the economy rebounds - consider the next thing in determining this:
  • Debt: Look at your candidates and consider how much debt they have. The more debt they have, the less likely they can weather potential storms (or black swan events). Don’t invest if the company has a D/E ratio of greater than 0.5 (i.e. look for companies with at least twice the amount of equity as debt). Consider also the debt coverage ratio and interest-only coverage ratio. Compare all of these figures to other companies in the industry, to get an idea of how much debt the industry as a whole tends to hold. Also, remember to consider its pension liabilities!
  • Liquidity: Consider its current ratio (Look for 2+ minimum), compare to its industry, and to the same company over time. What is the trend? Look for stable or increasing current ratios, or better than average for the industry. Consider its working capital - what is the trend over time? Consider also the Acid Test.
  • Earnings: Compare the company’s sales trends, by division if possible. Compare to itself overtime, as well as the industry as a whole. Consider also the profit margin trends (You want the gross profit margin to be stable or increasing). Remove all extraordinary events (and be careful about what you call extraordinary. Is this company having extraordinary events every year? If so, they are ordinary!).
  • Earnings Per Share: Look at the difference between diluted and undiluted. If diluted is significantly lower, this indicates that a potential purchase may not be as good as deal as you think, because if the company does improve, options will be exercised in which case your proportionate ownership will decrease.
  • Product/Service: Compare this company’s product or service to its competitors. Is it obsolete? Does it do a poor job in its core products/services? If so, this will negatively affect its ability to operate in the future. Beware!
  • Inventory: Has its inventory been increasing over time or stable? What are its revenue recognition policies (look for conservative policies, rather than fudged imaginary sales figures)?
  • Value Funds: Check out to see if any of the companies on your hit list are also held by value funds. This is a good indication that other investors are seeing value too. This is a double-edged sword though: If the stock IS held by other value funds, it may indicate the value no longer exists. If the stock IS NOT held by other value funds, it may have already been picked over and determined to not be the value it seems. Be careful to not let this be the sole determinant!
  • Insiders: Buy when insiders buy (this is a strong indication of perceived value by those that know the most about the company) and watch for any sudden sell-offs. If there are sell-offs by insiders, look at what the reasoning is (e.g. Is it just one member selling, and is his daughter getting married?). Share buy-backs by the company are also good signs that the company thinks it is being undervalued (Consider whether the shares outstanding are declining)

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