The Art of Value Investing
(Guest Commentary - June 23, 2005)
As I mentioned in our weekend commentary, I have asked a very active poster, Bill R. (a.k.a nodoodahs) to be a guest commentator for this Thursday morning's commentary. Bill is truly a great stock picker, and in this commentary, he will be giving us a basic run-down on how he typically screens for individual stocks. Judging from the emails that I have gotten over the last few months, I believe this will be a very popular topic, indeed.
Before we begin, I believe a little bit of introduction is in order. Like I mentioned in our weekend commentary, I asked him for a quick profile of himself and this is how he responded. A very modest guy, indeed: "Bill R. drank his way out of a scholarship to Tulane in 1985, and went back to college for his math degree years later, graduating in 1995. Since then, Bill R. has been in the P&C insurance industry as an actuary, product manager, and pricing manager. Bill and his wife are amateur investors with a variety of holdings, but they prefer to buy and hold value investments." Bill is a math nerd like myself and eats, breathes, and thinks about numbers all day. Without further ado (most of our readers are probably getting tired of my writing so much already!) - here is Bill R.'s commentary on "The Art of Value Investing." [For the true die-hards, I will probably post a short update on our discussion forum sometime tonight - it will most probably just be a collection of current thoughts, conjectures, etc.]
First and foremost I would like to thank Henry for giving me the opportunity to expound on value investing. For me, value investing is more than just a strategy. It's an expression of my personal philosophy. It's a bold statement of disagreement with the "strong form" Efficient Market Hypothesis, a marker of my place on the "speculation vs. investing" debate, and a very "retro" statement of risk vs. return. Value investing is my way to have fun learning more about what makes companies tick, while managing a portion of my investments.
I would rather buy a three-year-old car off lease and write a check for it, than be turning that car in at the end of the lease. I would rather live in a $150,000 house and own three $80,000 rental homes, than live in a $390,000 house. I'm ambivalent about WMT the stock but love shopping at Wal-Mart the store. I'm OK purchasing investments with the intention of holding them for years; I'm 80+% long 80+% of the time. I like the old-fashioned, quaint idea of buying a portion of a company's future revenue stream for cash, now. I can even watch my stocks get hammered without feeling like I've "got to sell." I saw the beating my energy and metal stocks took in mid-May and thought, "Wow, now they really ARE a bargain! I wish I had the cash to buy more shares today!" I firmly believe that price is separate from value, and the price paid for any purchase, compared to the utility of that purchase, is the most important aspect of the transaction.
There is a strong collection of evidence that value investing does produce above-average results, with less risk to principle, over time. It certainly is not a "get rich quick" way to invest, but it is a "get ahead of the market with less risk than an index fund" way to invest. A strong collection of the relevant research has been put together by Tweedy, Browne Company LLC, in a paper called "What Has Worked in Investing." I am not affiliated with them, do not have any funds under management by them, but I have read not only their paper but also many of the ones referenced by it. If the name sounds familiar, it should. If you're interested in their research compilation, by all means "Google" them and download the paper.
I won't quote their research here, but I will detail my own independent analysis. From 2001 to 2005, I looked at one-year total return for thousands of stocks, generating 14,606 observations with relevant data. Of those 14,606, I separated the 1,013 of those with profits, a Price/Earnings of 12 or less, and a Price/Book of 1.50 or less, from the remaining 13,593. The stocks with lower price ratios were 34% less likely than the remainder to have a negative return and 36% more likely than the remainder to beat the average return. As a "buy and hold" investor, I like the idea of improving my odds by more than a third!
There are as many approaches to value investing as there are value investors, and a lot will depend upon the selected time horizon and definition of value. There are balance sheet approaches, discounted cash flow approaches, sector approaches, etc. What they all have in common is an estimate of the stock's "intrinsic value" compared to the price paid. Value investing has a lot in common with both contrarian investing and behavioral finance. When the stock market is tanking and there's blood on the Street, it means, "look out for falling prices!" to the value investor. Likewise during the tech and net mania, value investors stayed away because, while a few of them might have been good companies, none were worth the price. Behavioral finance provides an explanation for the market's inefficiency in the short-to-medium term. You might say I'm a "super-weak EMH" advocate. I believe that a stock's market price will reflect its fundamental value eventually, but that can take months or years - months or years during which I may have to hold the stock. A key difference from the disciplines of both contrarian investing and behavioral finance, however, is the emphasis on the use of fundamental data in stock selection.
One key point of value investing is the "margin of safety" that is built by purchasing stocks at a discount. When a stock is "priced to perfection," the slightest disappointment, even a quarter that meets but doesn't exceed expectations, can cause a "giant sucking sound" to emerge from the market. Buying the stocks that have been beaten down already creates a margin of safety, that I attempt to enlarge through looking at every stock from a bottom up perspective with a cookbook approach that helps keep me from buying bad companies. If I buy a good company, at a cheap price, good things just might happen for me.
While I could argue that the "market" as defined by various indices is overvalued, that's immaterial to me. I'm not investing in the "market." I'm buying individual equities. Since I'm interested in intrinsic value, not relative value, I'm not searching for the "least overpriced" tech or health care stock. Given that I can, as I write this, get about a 4% "risk free" return from 10-year Treasuries, my equity investments should yield more than that. After all, I'm putting capital at risk! I prefer to use the inverse of the PE, called "earnings yield," and search for companies with yields in the neighborhood of 10%, placing my target PE around 10, give or take. Note that, by shopping at the bargain bin I will invariably be looking at stocks that are out of favor in the market - it's not intentionally contrarian but it appears to be. I also generally like stocks with significant insider ownership, but not insider control. High insider ownership means their bread is buttered the same way mine is, and checking insider purchases and sales gives me a clue as to their opinion of the company's prospects.
As an example of a screening option, I used Yahoo!Finance's very nice (and free!) Java screener on Memorial Day and checked for stocks with both a forward and trailing PE <= 10, insider ownership between 1% and 20%, 5-year earnings growth >= 25%. I netted 19 names, and I'll discuss the largest of them here. I will look at each stock and try to determine if the stock is a good company for sale cheap, or a cheap company that's fully priced. Be forewarned, searching for value investments is a tedious process, and for every stock that shows promise I will discard nine fairly quickly.
In that search, Countrywide Financial (CFC) was the largest by market cap. I rule them out on my first check, which is insider activity. Sales have been 99.9% of transactions by share ratio! Insiders have sold $214 million in the last year, $31.5 million in the month of May alone. If the insiders have that poor an opinion of their own company, I don't need to waste any more time looking at it.
Ford Motor Company (F) was next. Bill Ford is buying, which is a good sign amidst some pretty big selling. So I go to step two in my cookbook, which is downloading 5 years of financial statements from MSNMoney. I like their site for this because they have 5 years and 5 quarters, and regardless of the industry type, the format is consistent, so I can design a spreadsheet to automate my calculations. I notice that revenues are flat over the five year period, that ROA and ROE are consistently near zero, and that inventory as a percent of sales is climbing (from 4.3% in '02, to 6.3% in '03, to 6.7% in '04). A glaring item is the accounts receivable line on the balance sheet, moving from $6.2 million in 2000 to $116.7 million in 2004, during a time when revenues were essentially flat. None of these are the mark of a healthy company - actually they are a glaring sign of poor earnings quality - so I move on (ask Henry - I wrote this about Ford about a week ago!).
D.R. Horton (DHI) had no insider sales in 2005, so I downloaded their numbers. Right off the bat I don't like having data only through Sept 2004. Would a good company be two quarters behind in publishing data? Forgiving them (temporarily) for this slight, I review the growth in net income, revenues, book value, and find them pleasant. ROE and ROA are sizable. In checking the cash flow statement, I notice the company has negative OCF and negative FCF in 4 out of the last 5 years. If you are out of cash, you're out of business. I move on to the next one on the list, Pulte Homes (PHM), and find the same cash flow problem. Next!
New Century Financial (NEW) had a really big sale from the CEO, but it was actually an option exercise for $11 million and he still holds over $50 million worth of stock, claiming the sale was for diversification purposes. Growth metrics and ROA/E look good, and we have positive OCF and FCF in all years, which is a relief after looking at those two homebuilders. My first red flag is the increasing NI with declining OCF in 2003, which won't rule a company out, but "inspires" me to dig into the finances a bit further to make me comfortable. My next red flag is having a net income that exceeds cash flow from operations in both 2003 and 2004. How do they DO that? Looking down my spreadsheet to solvency metrics, I notice that [Interest Payments / (OCF + Interest Payments)] is increasing from 2002 through 2004. I like this calculation better than Interest Payments / EBIT simply because most companies generate more cash than income, and OCF is generally more consistent than NI or EBIT. Regardless of your choice of metric, interest payments are taking a progressively larger bite of the cash from operations, and 56% is awful high. What's left to build the company with?
A major area of focus when doing "due diligence" is "quality of earnings." Part and parcel of downloading the numbers is my attempt to separate wheat from chafe, companies with strong earnings and good prospects from those with neither. Having screened for "low price to earnings" I now want to ascertain the quality of those earnings. I want to purchase companies that can generate their cash through operations, not through financing with debt or share issuance. To some extent a company may generate acceptable cash through investments, say an insurer or other financial service company, but even in that class I prefer earnings generated through operations. For example, if a company has more net income than cash from operations, on an annual basis or in multiple years out of the last 5-10, they have to be getting that income from somewhere. Are they booking revenues before they're received? Are they not accruing or depreciating properly, or have they changed their policies on these items? Are they "smoothing" earnings somehow to make up for the current year's cash deficit? Is there cash coming from the financing end that shows as revenue? This is where the downloading of annual statement data comes in so handy. By checking the ratios of accounts receivable and inventory to revenue on a year-to-year basis, one can detect signs of these shenanigans. If we sum the cash from financing as a ratio to average assets, we should see numbers very close to zero for most companies - and negative numbers (indicating paying down debt or share repurchases) for most healthy companies! Financing cash inflow exceeding 5% of net average assets should be alarming, unless you have a good reason behind it and it's an outlier. If financing cash inflow is consistently high, stay away! If you want to see examples of this in action, download statements for GM or KKD and "ignore" what you know today - just look at the year before their "surprise" and you'll see the flags.
If I ever get a company to pass the price/earnings test, the insider opinion test, and the red flag test from running the five-year numbers through my spreadsheet, I would proceed to download the annual and quarterly statements along with the most recent proxy statement for review. My purpose is to rule out as many risks as possible, to build my margin of safety by buying a company with a history of profits and clean financials, and a business that I understand. If I can't describe what they do, in fifty words or less, to a total stranger, I don't buy it. I personally try to rule out companies with excessive derivative risk, lots of investment in mortgage-backed securities or bonds from GSEs, or insurers heavily active in surety, credit insurance, or finite reinsurance lines of business. All of those tasks involve some rather boring reading.
Let's look at some companies that I think do represent value, and that you may not have heard of. As disclosure, one should always assume that when I speak highly of a stock that I either have, or want, a beneficial interest in it. As an aside, 11 of my 13 current long stock positions pay a dividend and the TTM cumulative yield based on acquisition price is 3%. I firmly believe that dividends should be considered as part of the stock's total return and should be 100% reinvested.
Everest Re (RE) is a property and casualty reinsurer. As a Bermuda company, they enjoy significant tax benefits and the ability to hedge currencies easily. They have a reasonably long history of near double-digit ROE, double-digit revenue and income growth, and profit margins above 5%. The largest players in the P&C insurance segment currently sell for 12 to 18 times earnings, making RE seem like a bargain to me anywhere under $95. Everest Re doesn't have perfect metrics - net income grew 8% in 2004 when OCF declined by 5% - but on closer examination the net income as a percent of OCF moved from 33% to 37%, which seems reasonable to me. Everest Re isn't completely clean of mortgage backed securities, but their investment portfolio has a lower concentration of MBS than those of their peers, and they are among the last of the reinsurers to get subpoenaed in the latest round of reinsurance probes, which gives me some comfort. Several analysts have picked up on RE (as well as ALL) as a good buy, so you might have seen the mention of Everest on Bloomberg TV's morning show. I grabbed RE on April 27 at $82.36, and received a $0.11 dividend per share since then. With Wednesday's close of $92.05 the gain is 11.9%.
Overseas Shipholding Group (OSG) is a good play for oil, LNG, and China, as well as representing a value in my eyes. The spike up in liabilities (and down in free cash flow) this quarter is due to their commissioning new LNG (liquefied natural gas) carriers for purchase. LNG is projected by some as a future growth area for energy, and OSG is attempting to be a player. Singapore is one of their several locations. Shipping can be a terribly cyclical industry, but I take heart that OSG has only one unprofitable year in the last five, and even in that year they paid a dividend and generated positive operating cash flow. Technically OSG is levered to shipping rates, not the price of oil. However, I believe that crude oil demand will influence rates for crude oil shipping, long term. I also don't see how the trend is, long term, going anyplace but up. If you believe that global growth is slowing or that demand growth is slowing, put OSG on your "watch list" and wait for the dip to buy. I would call OSG a solid bargain below $65. I grabbed OSG on April 27 at $58.50, and received a $0.175 dividend per share since then. With Wednesday's close of $59.40 the gain is 1.9%.
Ingle's Markets (IMKTA) is a more traditional type of value play. Ingle's is a small grocery store chain operating out of North Carolina, with stores in adjacent states. Their business operation has three basic phases: groceries, real estate, and dairy products. The grocery operation specializes in rural small town America, with an operating strategy that makes small stores able to turn profits. The majority of stores are within 250 miles of their distribution center, which ensures a fresh product, and many products are purchased locally if applicable. Ingle's prefers to own their store locations, which results in a price book ratio well below the average for this industry. Their cash flow and profitability has been impaired of late by a needed "store modernization" effort, which I think will contribute to considerable earnings growth as it is completed. The dairy operations provide goods for the stores, as well as selling to other companies as a separate profit center. Finally, the real estate business is composed of shopping center holdings where they rent to tenants; most centers have Ingle's locations but some do not. They also have holdings of undeveloped land. Most notable is that the land owned by Ingle's is nowhere near any real estate "frothiness" - their land is in rural NC, TN, GA, and other areas of the Southeast. I suspect it is held at book values significantly under its current market value. The company has significant family ownership, with the "Laura Lynn" store brand named after the founder's daughter (who works for the company). Their accounting is conservative and they pay a dividend. I believe this stock represents a value anywhere below $14, and I just picked it up today.
The above are some of the stocks that I think currently represent value, through low multiples of price to earnings and/or book value that can be bought at a margin of safety from their true value. As always, I'm expressing my opinion and each investor should be responsible for their own due diligence.
Signing off for now,