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Value
Investing
Value investing is finding a good quality stock that you are proud to own
for an inexpensive or bargain price.
Besides being potentially profitable, value investing
is popular because it’s a hands-on way for investors to be actively involved
in their stock selections. It’s literally scavenging the internet or digging
through annual reports and news articles trying to find that bargain stock.
It’s like trying to find a valuable antique at a garage sale. Many people
love doing this!
I call value investing the cookbook approach to
investing. Adjust for this, adjust for that, and see what you have. Over
time, by using value-investing techniques you probably will become good at
understanding financial statements and business concepts. Value investing
uses fundamental analysis to determine the value of a company, the
financial, operational and market risks involved in the business, and the
approximate price one should pay for the stock. Contrary to what many people
believe, you do not have to be a math wiz, but you will need a basic
understanding of practical math, some knowledge of accounting principles,
good reading skills, and a skeptical mind.
Basically, a value stock
has a low price to book value and a low price to earnings ratio.
In determining whether a stock is
inexpensive or not, one needs to analyze the company’s book value, also
known as shareholders’ equity. You need to determine what the true net worth
of a company is by calculating a tangible book value.
Tangible net worth is the equity of a company’s hard assets. This is the
portion a company’s equity that hopefully can be converted into cash
somewhat easily. Intangibles, however, are “soft” assets that may not have
readily available resale values. Intangibles should be subtracted from book
value: examples are goodwill, prepaid expenses, deferred acquisition costs,
etc. These assets often have no cash value. Goodwill, for example,
“evaporates” as earnings decline. Prepaid expenses, normally, are
non-refundable deferred costs that are impossible to convert to cash. If an
asset has no cash value, new investors should not bail out the old
shareholders by paying for them. The main focus is to be conservative with
your money.
Over the years I found
that if one doesn’t understand a complicated asset type, it usually has no
cash value. Don’t pay for anything you don’t understand.
Also, adjust for what I
call economic accounting valuation differences. These are more common sense
type accounting adjustments that should be made to get a clearer picture of
the true market value of the company. For example:
- The financial
statements of bank stocks in a recessionary period may not fully reflect
the severity of a deteriorating loan portfolio. In such situations, try to
calculate what you feel is a truer picture of the bank’s loss reserve and
subtract the additional amount (net of taxes) from book value.
- If a company has a
large unrecorded pension liability, or is using unrealistic future
investment return estimates, estimate the projected short fall and reduce
book value by that amount.
- Try to give a company
credit for undervalued assets. If a company has land that has greatly
appreciated in value but is valued on the books at cost, add the
unrecorded appreciated value to book value.
- If a company has
written off its fixed assets, but market conditions have improved and
those same fixed assets have become valuable, then add back the
appreciated amount to book value.
When finished,
recalculate the per-share book value. If the stock is selling at a
substantial discount to its tangible book value, that is one of the signs of
a value stock.
Remember, you are
looking for economic value, not accounting value; focus on the equity of the
hard assets. Historically, soft assets tend to lose their value in a
downturn.
True value investors
only buy if a stock is trading substantially below its tangible book value.
I understand the reasoning, but it’s hard finding these types of situations
in all your investments, while maintaining diversification and balance in
your portfolio. I just use this as a guide and not as a “must have.” Over
the years, I have noticed these types of values in the banking, energy and
chemical industries, among others.
Another factor you
need to find in a value stock is a low price to earnings (“P/E”) ratio.
You are looking for a beaten down stock in an out-of-favor industry. A nice
P/E discount is 20% to 50% of the industry average over a few years. You
then have the potential to make a nice return on both the natural rotation
of the industry to a higher timeliness, as well as the stock regaining
market favor. Many investors view cyclical stocks as value stocks. Cyclical
stocks are value stocks only if they sell at an earnings discount to their
peers and meet the book value criteria as mentioned above. If the company is
selling at a discount to its tangible bookvalue, but its earnings have
disappeared, it becomes a possible turnaround situation and not a value
stock.
In addition to earnings, look for a decent
dividend yield, so that you are earning a cash return while you are waiting
for the stock to increase in value.
This limits your down side because of the yield protection and makes it
emotionally easier to hold the stock longer to realize its full return. It’s
also a reflection of the company’s intent and ability to return excess
profits back to its shareholders.
After your review, if
the company still has a low price to tangible book value and low price to
earnings ratio, it becomes a serious potential value play.
It’s now essential to
analyze the company’s solvency status. Companies need to be able to pay
their bills to stay in business. Try to find a company where current
assets exceed current liabilities by 1½ to 2 times. The 1st time
is used to pay off the company’s current creditors; the 2nd time
is the equity needed to replenish the company’s working capital
requirements, if supplier financing dries up. It can also be used to pay off
the longer term obligations of the firm. It’s hard to find a company with a
current ratio of two or more, but under one times means the company has a
negative working capital and may need to borrow money to fund the shortfall.
The assets decline in value, but the debts
still need to be paid back. Look for a company whose tangible book value
exceeds its debt.
Additionally, you need
to be ensured that the company has emergency availability under its credit
facilities. It’s surprising, however, that credit lines tend to dry up and
disappear quickly when a company has a downturn in business. When a company
really needs money, it’s often hard to come by and expensive. Lastly,
regarding liquidity, analyze the company’s debt maturity schedule to ensure
that the company can meet any long-term debt payments that may be coming
due. Basically, try to get a comfort level that the company can pay its
obligations as they come due and that they are not over leveraged.
Other key statistics are
the company’s bank covenant ratios. The covenants normally specify
shareholder equity levels that a company must maintain, as well as, among
other restrictions, cash flow to interest expense and cash flow to debt
ratios that must be met. If a company falls short in its financial
covenants, or misses a filing requirement, the banks can, and often do,
substantially increase interest rates and fees. The bankers can also call
the loan and put the company into bankruptcy. Currently, however, covenants
are rarely disclosed and many young adults don’t even know that they exist,
or don’t realize their importance to the survival of a company. I hope the
accountants will make loan covenant disclosures a mandatory requirement.
It’s critical to pick a company with an
excellent management team.
Investor conference calls are increasingly popular and are very interesting
to listen in on. At the end of the day, however, you need to be cautious.
Pleasant looking executives with good communication skills, command over the
numbers, and a rehearsed script, does not necessarily equate to managers who
can grow a company and increase its stock price. Nonetheless, this is a very
good starting point in understanding a company and its management.
Message boards are
informative, but often participants have hidden motives, or grudges against
management, that might make their comments suspect. They should be read
skeptically.
CEO's personal lives can also affect investment returns. Studies in
Denmark linked "CEO family deaths to companies' profitability over a decade.
In two years after the death of an CEO's child or spouse the profitability
of their companies slipped 15% to 20%." - wsj 9/5/07
It’s also important
to see some sort of upward trend in revenues and earnings growth.
Value Line Investment Survey is found in most libraries and does a nice job
showing long-term company trends. No one likes a company that constantly
does worse than the year before, no matter what the value is! Every company
needs some sort of “curb appeal” for you to profit from your investment. At
some point, you need to sell in order to make money from your investment.
Upward trends help on the resale side of your investment.
Many investors find it
hard to distinguish between “cheap” stocks and value stocks. Most times,
stocks are low because they deserve to be low. There is nothing wrong with
buying a “cheap” stock as long as you know and understand the risks. There
are many stocks out there that have large annual losses, high debt levels
and no equity. That does not necessarily mean you can’t make money on them,
but you should call it gambling rather than investing.
Last, but most
important, take a step back from the numbers. Look at the big picture. How
does the company fit into the economy; and is there a need for the
company’s products or services. Look at the company’s business model
(found in the company’s SEC form 10k) and determine if it coincides with
your thinking, your goals and your investment objectives.
Value
Investing is a time tested investment strategy that works in most market
environments.
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