New Era Value Investing: Chapter 10

As the chief investment officer at Fremont Investment Advisors, Nancy Tengler employed the value approach she describes in her book, New Era Value Investing.

In this chapter, Tengler discusses why an emotionless approach to investing is important. She describes 7 learning points she has picked up, the cognizance of which can help investors improve their returns:

1) Wall Street tends to extrapolate current trends to infinity

In the mid-1970s, when the US economy was mired in a prolonged recession, it seemed to many as if the US would never again enjoy prosperity. In the late 1990s, it was believed that recessions were a thing of the past.

2) It is rarely "different this time"

One of the biggest challenges faced by investors is being able to resist popular assumptions that stock markets will behave differently as a result of new forces.

3) Market pullbacks are great investment opportunities

Certain industries and sub-industries can become out of favour, but often unjustifiably so.

4) Go with your research, not Wall Street's

The best time to invest in a stock is when analysts are down on it.

5) Investment managers need to challenge their beliefs every day

Feeling uncomfortable about an investment is good, because it makes the investor search for more facts, keeping an open mind.

6) Use the financial media to your advantage

The "always-on" media can exacerbate declines, creating opportunities for those who remain disciplined.

7) It's all relative

While Graham and Dodd focused on absolute returns, Tengler argues that its relative valuation that matters

New Era Value Investing: Chapter 9

As the chief investment officer at Fremont Investment Advisors, Nancy Tengler employed the value approach she describes in her book, New Era Value Investing.

Various low P/B or low P/E indexes have been created in order to separate out value and growth stocks. However, separating out stocks based on a single metric can lead to misleading results. Tengler argues that investing in second-rate companies in slow-growth industries that trade at justifiably low P/E ratios does not constitute value investing. Instead, buying the best companies relative to their peers and their own valuation history is a more legitimate value-oriented strategy.

Furthermore, most companies will shift between value and growth categories repeatedly, making it difficult to pigeon-hole them into one particular style. Tengler illustrates this point using examples of defense stocks (which have gone from growth to value to back again depending on war policy) and technology stocks (which went from growth to value after the bubble of the late 90's).

Tengler discusses Buffett's purchase of Coke as a great example of there being a blend between growth and value. While Coke has been a growth stock for most of several decades, it has run into its share of temporary problems that made investors reduce its P/E ratio. This is a great example of a value purchase, even though the P/E was high enough to scare off investors who look only at P/E ratios.

Tengler argues that it doesn't matter whether a company is considered growth or value across a few metrics. What's important to investors is that it is a strong company that trades at a discount relative to its own history and relative to its peers. Whether that company is a growth stock or a value stock, it is attractive and should be purchased.

New Era Value Investing: Chapter 8

As the chief investment officer at Fremont Investment Advisors, Nancy Tengler employed the value approach she describes in her book, New Era Value Investing.

Now that the selection of individual stocks has been discussed, Tengler turns to portfolio construction.

The first thing the investor should determine is the level of concentration in the portfolio. Tengler argues that fewer than 20 stocks are needed for proper diversification, but in her institutional portfolio she carries between 25 and 35 issues. This is due to the fact that clients are decidedly against volatility. Spreading the wealth around helps reduce volatility, even if it means putting money in one's 35th favourite idea rather than putting more money in one's favourite idea.

Tengler argues that the second most important aspect to building a portfolio is buying only the "best" companies. Effort in fundamental stock research aids the investor in this endevour.

Tengler further argues that investors should incorporate both RDY and RSPR (described in Chapters 3 and 4) rather than choosing one or the other. Often, one of these forms will be out of favour while the other can boost results. Furthermore, as the universe of RDY-type stocks declines, investors will still have the ability to apply the value framework by employing the newer RSPR.

Investors should also consider the correlation between issues in their portfolios. Some sectors will do well while others will stall, and so stocks with low correlation to other stocks in a portfolio provide protection against volatility.

Finally, Tengler shares how she maintains buying and selling discipline. She prefers to average into a stock, since she doesn't believe she can predict the bottom. She will start with a position that's around .5% of the portfolio, and spread her buys over time until she has accumulated an amount representing about 3-5% of the total portfolio. At no point can one single position occupy more than 6% of her portfolio, therefore she will begin to sell if the prices moves up such that this occurs. Once the price hits the sell level, she will look to exit her position completely lest the price drop back down. Tengler will also use stop-losses (using money management software) to protect from large one-day or one-week declines.

Tengler closes the chapter by discussing some of the mistakes she has made in her portfolio. The lessons that are illustrated in these mistakes are:

1) Beware of newly merged companies with different operating profiles (e.g. AOL Time Warner)

2) Beware of new companies with short operating histories

New Era Value Investing: Chapter 7

As the chief investment officer at Fremont Investment Advisors, Nancy Tengler employed the value approach she describes in her book, New Era Value Investing.

In a similar vein to the previous chapter, Tengler now describes specific stocks that she has bought as a result of using RSPR, the method described in Chapter 4. She notes that the types of stocks this method picks up, as opposed to RDY, tend to be more growth oriented, but are still fallen angels of sorts, since they would not qualify as bargains unless they had a relatively low price to sales ratios.

Throughout the technology boom, Tengler notes that RSPR underperformed the market, as the expensive, high-flying stocks were the securities that rose the most. But during the bust, RSPR stocks outperformed their peers, as stocks with high price to sales ratios came crashing down.

Intel (INTC) is a company that appeared cheap on an RSPR basis in 1988, 1991, and between 1995 and 1996. Despite a strong market position, Intel's earnings would be pressured near the end of a product cycle, as competition would compress the company's margins. This has allowed value investors to take advantage and get in at attractive prices. From 1999 to 2000, however, RSPR suggested Intel was a major "sell", and so the investor was afforded an opportunity to take profits prior to the crash.

Other stocks this method has resulted in identifying are Estee Lauder (EL) in 2002, Microsoft (MSFT) in 1995, Oracle (ORCL) in 1997, Disney (DIS) from 1999 to 2001, The Home Depot (HD) in the mid 1990s, Nike (NKE) in 1998, and Cisco (CSCO) in 1994, 1997 and 2002.

Occasionally, stocks will become undervalued according to both RDY and RSPR at the same time. These stocks are usually former high-flyers that have reached a stage of maturity. Tengler suggests investors switch to using the RDY method only for evaluating such stocks, as the RSPR method may not longer apply. RDY is also described as the more rigorous method.

New Era Value Investing: Chapter 6

As the chief investment officer at Fremont Investment Advisors, Nancy Tengler employed the value approach she describes in her book, New Era Value Investing.

In this chapter, Tengler describes some specific stocks that she has bought as a result of using RDY, the method described in Chapter 3.

Exxon Mobile (XOM) is a stock with tremendous volatility due to changes in investor sentiment with respect to the price of oil. While earnings fluctuate significantly, the company's dividend is a much better gauge of the company's long-term earnings ability than any one year's earnings. As a result, Tengler has purchased this stock when the yield compared to that of the market was extremely strong, and has sold when the yield has been relatively weak.

Wyeth is another example of a company that RDY identified in the late 1990s. The company was coming off the news of a failed merger, and had run into a number of bad news issues with some of the drugs it had developed. The market punished the stock, allowing value investors a buy opportunity which was identified by the fact that Wyeth's yield compared to the market was far out of line.

Despite being a great company for many years, General Electric (GE) stayed at a price that did not make sense for the value investor. Finally, in 2002, amidst a slew of bad news (CEO step-down, failed Honeywell acquisition) the stock fell to a level, relative to its dividend, that made sense to Tengler.

Tengler goes on to describe other RDY-identified buy prices for 3M, Kimberly-Clark, Gillette, Wells Fargo, and Marsh & McLennan. In these cases, temporary problems plagued companies, which hurt the stock for short periods of time. Buyers at these prices were rewarded.

Tengler finishes the chapter by discussing two stocks, Verizon and Heinz, that looked like buys per the RDY method, but never ended up rewarding their investors.

New Era Value Investing: Chapter 5

As the chief investment officer at Fremont Investment Advisors, Nancy Tengler employed the value approach she describes in her book, New Era Value Investing.

While RDY and RSPR (described in the previous two chapters) are great for identifying potential value stocks, the purchase decision must not be made until a company's fundamental factors have been looked at. After all, if the fundamentals are poor, a company could continue to appear cheap on a dividend or sales basis for many years to come.

Tengler discusses twelve fundamental factors she looks at for stocks that pass the RDY and RSPR screens. If a stock passes 2 of the 3 qualitative factors, and 5 of the 9 quantitative factors, it passes the test:

1) Are the company's products/services becoming obsolete? As an example, Tengler identifies JC Penny in 1998 as a company occupying a position in the retail market that no longer served a purpose.

2) Does the company have a franchise value? Nike and Gillette are cited as examples of companies with brands that help the company succeed. Other questions investors should ask to help answer this question include whether the company is growing market share profitably, and whether it can leverage its franchise to enter new markets successfully.

3) How good are management and the directors? Management should be accountable, should have low turnover, and should have their compensation tied to shareholder interests. Most directors should be independent.

4) Does the company consistently grow its sales? Sales growth serves as economic proof of the acceptance of the company's products.

5) What are the company's margins? Tengler advises looking at trends in operating margins over time and versus competitors.

6) What are the P/E ratios? Tengler looks at forward, trailing, normalized, peak and trough P/E ratios against those of competitors.

7) What is the company's free cash flow? Cash flow trends should be compared to those of earnings to establish the relationship there. Also, working capital turnover (using cash flow) should be examined relative to competitors.

8) What is the dividend situation? The payout ratio should be sustainable and in-line with the industry.

9) What is the asset turnover? Trends in this number should be examined to see if the company is paying too much for incremental sales growth.

10) What is the company's ROIC? Investors must determine if management is making good investments. Comparing the company's ROIC to its cost of capital should help in this regard.

11) Is the company over-leveraged? A company may be growing earnings only because it is utilizing leverage to grow its assets.

12) What is the company's financial risk? Off-balance sheet debt should be brought into the equation, and coverage ratios should be examined (e.g. EBIT/Interest).

New Era Value Investing: Chapter 4

As the chief investment officer at Fremont Investment Advisors, Nancy Tengler employed the value approach she describes in her book, New Era Value Investing.

Though Tengler claims the method described in Chapter 3 works, it is heavily reliant on the dividend. But as the market has evolved, the magnitude of the dividend as well as the number of companies paying a dividend has declined. As productivity has increased, companies have found more profitable areas in which to invest their earnings, and as competition has increased in what were previously slow-growth industries (e.g. telecom), investment in future technologies has become a key success factor. As such, to expand the investment universe, Tengler developed a valuation method that would not be dependent on the dividend.

The obvious and most commonly used factor associated with a stock is earnings. However, Tengler avoids using earnings due to the fact that it is subject to judgement (by management, in its determination) and because it can fluctuate tremendously (particularly for cyclical companies). Therefore, the factor Tengler prefers to use in her value approach is sales. Sales cannot be manipulated, and are also subject to far less fluctuation than are earnings.

The valuation method Tengler uses is therefore Relative Price to Sales Ratio (RPSR). A company's price to sales ratio compared to the market's price to sales ratio is computed on a historical basis. When the company trades at a low price to sales ratio as compared to the market's price to sales ratio on a historical basis, it becomes a buy candidate.

Tengler recognizes that these "relative" value approaches differ from the original Graham and Dodd "absolute" approaches. But she has found using relative valuation approaches more useful, as they can be employed during any market environment. In this way, she argues that the spirit of value investing can be employed to a much larger universe of stocks.

New Era Value Investing: Chapter 3

As the chief investment officer at Fremont Investment Advisors, Nancy Tengler employed the value approach she describes in her book, New Era Value Investing.

In this chapter, Tengler outlines a value strategy that she employs successfully, calling it Relative Dividend Yield (RDY).

With the increasing ability to use technology to compare various factors across a whole slew of stock issues in the 1970s, many investment ideas were spawned. Tengler believes RDY to be one that has much in the way of value appeal conceptually, along with a successful track record.

In RDY, a stock's dividend yield is compared to the market on a historical basis. If the stock's dividend yield beats that of the market by 25% or more, and the stock's yield is high on a historical basis (for this particular stock), it becomes an attractive buy. Should the stock rise to a point where the yield drops below the market's yield, it becomes a sell.

Tengler discusses several reasons that this strategy works. Dividends are more consistent than earnings, so while earnings can fluctuate, Tengler argues that dividends offer the best glimpse of management's view of a stable pay-out that the company can maintain for the long-term.

Furthermore, when a company's yield rises as compared to that of the market, it is a sign that it is not favoured by the market. Tengler argues that this is a good time to buy. She cites Coca-Cola and Johnson & Johnson as ideal examples of this in 2001-02.

Finally, Tengler notes that there are times when this strategy doesn't work. For example, if a stock's relative price to the market is uncorrelated with its RDY, Tengler notes that the strategy no longer outperforms.

New Era Value Investing: Chapter 2

As the chief investment officer at Fremont Investment Advisors, Nancy Tengler employed the value approach she describes in her book, New Era Value Investing.

Tengler takes the reader through the history of fundamental analysis in the stock market. While many value investors know the history as far back as Benjamin Graham and David Dodd's Security Analysis, Tengler goes further back to give credit to two New Yorkers who laid the groundwork that allowed Graham and Dodd to do their thing.

In the late 1800's, the stock market was akin to a casino, as fraudulent activities reigned throughout. Louis Guenther started a magazine in 1902 that reported on and exposed securities fraud, while Alfred Best published a service focused on reporting accurate information on insurance company financials, originally to allow customers to buy fire insurance from reputable companies that weren't going to go under. It was Best that first noted the concept of intrinsic value, whereby investors were encouraged to purchase stocks if they traded below the estimate of their intrinsic values.

In the 1930s came the groundbreaking work from Graham and Dodd, but even in subsequent editions of Graham's books did his methods evolve, though based on the same principles. This is because the market continued to evolve, as the methods that worked the best during the Great Depression were not the same as those that worked the best during WWII.

Over time, the dividend has also become less relevant. At one time, it was a mark of a great company that could continually reward its shareholders, but more recently it has become a sign that a corporation does not have profitable uses for its earnings. Dividend-focused value investors would be forced to change.

New Era Value Investing: Chapter 1

As the chief investment officer at Fremont Investment Advisors, Nancy Tengler employed the value approach she describes in her book, New Era Value Investing.

Tengler starts the book by discussing how value investors don't get sucked in by the "It's different this time" crowd. When certain industries or companies are out of favour in the market, that is often the best time to buy them.

Nevertheless, the market has changed in some ways over time, and value investors can refine their methods to identify more undervalued stocks. Some of the methods employed by traditional value investors can be more difficult to apply as the market evolves. For example, the percentage of companies in high-tech or growth areas has increased over the years, while the relative size of dividends has decreased. For example, technology and health care stocks have doubled to 30% of the S&P 500 since 1990. This has served to reduce the playing field for value investors looking to apply traditional methods of company analysis.

Despite these new methods that Tengler will discuss in this book, the principle of having a disciplined approach to buying stocks that trade at discounts to their intrinsic values still remains. As such, she argues her new methods are not suggesting that "it's different this time", but are rather meant to expand the securities in which value investors may show an interest.