Buying Stocks For Less Than What They Trade For

At Barel Karsan, we are all about the concept of buying stocks for less than their intrinsic values.

For example, a few months ago, we considered the discounts to net asset value that a few closed-end mutual funds were trading at. This basically means that these funds could be purchased for less than the value of what they owned. Due to the recent decline in the general stock market, the prices of many closed-end funds have taken a large beating. Below is a graph showing the percentage of net asset value that the median closed-end fund trades at (thanks to Kevin Gates for putting this together using Bloomberg):

At first glance, it appears that closed-end funds are trading at tremendous discounts by historical standards. While the chart indicates that the median fund trades at more than a 25% discount to its net assets, investors must pay careful attention!

If you're considering the purchase of a closed-end fund due to its discount, you must consider several factors. First of all, how up to date is the net asset value calculation? If the NAV listed is from 10 days ago, and the market has dropped since then, the price of the fund might be low but the NAV is lower than is shown.

Second, many funds own assets that are not part of the stock market. In these cases, management has some discretion over the methodology used in the determination of the fair value of such securities. As was raised in an SEC speech here, fund ownership of illiquid securities can lead to NAV valuation inaccuracies that can mislead investors. We met this valuation challenge when we looked at Equus, a fund concentrating in the alternative energy space.

Don't buy a closed-end fund blindly due to its discount! Understand what the fund owns, when its assets were valued, and how much you can trust that valuation (i.e. are its assets traded on a liquid public market, or is some other valuation metric used).

Evaluating Management: Inventory

One of the most important factors in determining whether a company is worth an investment is the quality of its management. Unfortunately, this assessment can at times be highly subjective. Reading interviews or comments from management can often be of little value. After all, management may have great communication or oratory skills, but that doesn't necessarily translate into good business execution. In fact, many value investors even prefer not to meet managements to avoid being influenced by factors unrelated to execution.

So how then to evaluate management? One way is to simply evaluate the financial results of their companies. Unfortunately, certain factors which manifest themselves in the financials may be out of management control. For example, competition in an industry and/or time period might be fierce, or a company may be at a brand disadvantage - not necessarily the fault of current management, so how do we differentiate across managements?

One method analysts like to use is to evaluate the number of days inventory a company has on hand. The lower the number, the more efficient management is (as cash is freed for other purposes, like paying shareholders)...as long as there are no stock-outs hurting revenues! The number of days of inventory a company has on hand can be estimated with the following formula:

inventory * 365 / COGS = days of inventory on hand

This number can be compared to that of competitors or the industry, with the caveat that differences in product mix must be taken into account. Below are average days of inventory for several industries as per the IRS:

A high days inventory doesn't necessarily mean bad management, however. But this concept can be extended to a company's days receivable and days payable. This can offer a clue as to how effective management is at running an efficient operation, which can translate into other facets of the business.

From the Mailbag: Liquor Stores Income Fund: Part 2

As I wrote about previously, Liquor Stores Income Fund (TSE:LIQ.UN) operates retail liquor stores in Alberta and British Columbia. From a book value perspective, there is a great degree of variation in the resulting price to book ratio depending on whether you accept the full $260M of goodwill as realizable or not. One way to approach the issue of goodwill is to accept the book value only if the earnings value of the company exceeds its asset value.

Another way to look at goodwill is to first determine if the company is earning its weighted average cost of capital (WACC). If a company's return on invested capital exceeds the WACC, it's an indication that the company has healthy business economics working it its favor and makes a strong case for supporting the goodwill value on the books. In this case, you need to have a well researched opinion on whether the company can continue earning its WACC on operating assets in the future!

A few problems in calculating future earnings for LIQ include 1) assessing the impact of Bill-C52 which initiates the new Canadian tax law on business trusts commencing Jan 1, 2011 and 2) what applicable growth rates to use (if any) in valuing the company.

Under my own conservative valuation assumptions used on LIQ, I have found that the company is not earning its WACC on invested capital and that the earnings value of the company is less than its asset value. Under those conditions, I prefer to write down the goodwill and adjust the price to book ratio accordingly.

Since inception in 2004, LIQ has grown revenues 10 fold, primarily via acquisitions, and these acquisition have resulted in the substantial goodwill on the balance sheet. I believe the major risk in accurately valuing LIQ, is how to account for their future growth and whether you believe that growth is creating value or destroying it for shareholders. My approach in valuing LIQ's goodwill asset was very conservative, perhaps too conservative, but I would rather err on the side of caution, especially when the goodwill value is such a large percentage of the total asset base.

The New Buffettology: Chp 8: Interest Rates and Stock Prices

Warren believes that investments compete against each other for investors' dollars. He also believes that a business is worth what it can earn for investors during the time that it is owned. The comparison of available investment returns between various investments will determine the selling price for a given company.

The value of a company's earnings is dependent on interest rates. If interest rates drop, investors generally have more choice of stocks with superior earnings potential to that of bonds (all other things equal). For this reason, when interest rates decline, stocks prices generally rise and when interest rates rise, stock prices decline.

One situation where interest rate movements may not have much affect on stock prices is during a bubble situation where the market has succumbed to momentum trading. In these situations, the market may need to see a slowing down of the economy before it makes any stock price adjustments, which at that time can be very dramatic.

Dividend Yield: Does It Matter?

All else equal, is it better to own a company with a higher or lower dividend yield? Theoretically, ignoring certain tax implications, it makes no difference. The company with the lower dividend gets to re-invest the retained earnings to generate more cash in the future that makes up for the current lower payout.

In practice, however, companies with higher dividend yields actually outperform the market. In a study by Bauman et al, researchers discovered that stocks in the highest dividend yield quartile outperformed those in the lowest by 4.8% per year, which translates to huge portfolio differences over a long period of time.

There are many theories suggesting why stocks with higher dividend yields offer better returns. One popular theory is that investors are overly optimistic (and thus overpay) for growing companies with "future" earnings that don't end up materializing. Another theory is that companies that don't pay dividends end up wasting their retained earnings on projects that don't generate the same returns as the core business that generated the original earnings. Evidence of this theory is embodied in the fact that when a company does nothing but increase its dividend, its share price rises, even though theoretically the company hasn't changed.

Whatever the reason, investors who purchase companies that place a priority on returning money to shareholders fare better than those who do not.

The New Buffettology: Chp 7: Using Warren's Investment Methods to Avoid the Next High-Tech Massacre

Warren doesn't put any "stock" into investing in new industries since 1) investors will run up share prices in anticipation of immediate wealth, 2) there is lots of competition in new industries, 3) many of the new companies don't survive and 4) the new businesses don't have a history of a product with a durable competitive advantage.

A great example of Warren passing over a new and in fashion industry was during the .com internet boom. It was during this time that Warren was referred to as a "dinosaur investor" since he wasn't investing in technology stocks, but rather was investing in "old stodgy"companies.

Warren believes that investors should ask themselves the following question before making an investment decision: if I could buy a company outright at the current market price, would I do so with all my cash? If the answer is yes, then he suggests you should invest in the company, even if it means only acquiring a modest amount of shares. Conversely, if an investor had the financial means but is not willing to purchase the company outright, he feels that you shouldn't even buy a single share in the company.

Profit Margins

We often talk about profit margins on this site. Analyzing the profit margins of a company can help you determine its profitability relative to its competitors. For example, if two competitors have equal net incomes but one has twice the profit margin of the other, then over time we may see the more efficient company steal market share and grow at a faster rate. (This can happen for several reasons, one being that it can simply lower its prices until its competitor is no longer profitable, thus driving it out of markets.)

One type of profit margin is a company's gross profit margin, which is its gross profit divided by its revenues. It gives a pretty good indication of a company's pricing power versus its product costs. Here we saw that Coke has a gross profit margin of 64% , indicating people are willing to pay quite a bit more for Coke's products than it costs Coke to produce them.

For comparison purposes, here are the gross profit margins for several industries in 2005:


A company's net profit margin is its net income divided by its revenue. Profit margins for 2005 for a few industries are depicted below:



Note that profit margins are not the be-all end-all when it comes to profitability as they don't consider asset utilization. A company able to generate revenue and income on fewer assets is preferable to one that constantly needs capital infusions to grow.