Value Investing and Contrarian Thinking

Value investing by its very nature is contrarian. 

Out-of-favor securities may be undervalued; popular securities almost never are. 

What the herd is buying is, by definition, in favor. 

Securities in favor have already been bid up in price on the basis of optimistic expectations and are unlikely to represent good value that has been overlooked. 

Where may value exist?

If value is not likely to exist in what the herd is buying, where may it exist? 

In what they are 

• selling, 
• unaware of, or 
• ignoring. 

When the herd is selling a security, the market price may fall well beyond reason. 

Ignored, obscure, or newly created securities may similarly be or become undervalued. 

Contrarians are almost always initially wrong

Investors may find it difficult to act as contrarians for they can never be certain whether or when they will be proven correct. 

Since they are acting against the crowd, contrarians are almost always initially wrong and likely for a time to suffer paper losses. 

By contrast, members of the herd are nearly always right for a period. 

Not only are contrarians initially wrong, they may be wrong more often and for longer periods than others because market trends can continue long past any limits warranted by underlying value. 

When contrary opinion can be put to use.

Holding a contrary opinion is not always useful to investors, however. 

1.  When widely held opinions have no influence on the issue at hand, nothing is gained by swimming against the tide. 

• It is always the consensus that the sun will rise tomorrow, but this view does not influence the outcome. 

2.  By contrast, when majority opinion does affect the outcome or the odds, contrary opinion can be put to use. 

• When the herd rushes into home health-care stocks, bidding up prices and thereby lowering available returns, the majority has altered the risk/ reward ratio, allowing contrarians to bet against the crowd with the odds skewed in their favor. 
• When investors in 1983 either ignored or panned the stock of Nabisco, causing it to trade at a discount to other food companies, the risk/reward ratio became more favorable, creating a buying opportunity for contrarians. 

Market Inefficiencies and Institutional Constraints cause stocks to sell at depressed prices

Ask:  Why the bargain has become available?

The research task does not end with the discovery of an apparent bargain. It is incumbent on investors to try to find out why the bargain has become available. 

• If in 1990 you were looking for an ordinary, four-bedroom colonial home on a quarter acre in the Boston suburbs, you should have been prepared to pay at least $300,000. 
• If you learned of one available for $150,000, your first reaction would not have been, “What a great bargain!” but, “What’s wrong with it?” 

A bargain should be inspected and re-inspected for possible flaws.

The same healthy skepticism applies to the stock market. A bargain should be inspected and re-inspected for possible flaws. 

• Irrational or indifferent selling alone may have made it cheap, but there may be more fundamental reasons for the depressed price. 
• Perhaps there are contingent liabilities or pending litigation that you are unaware of. 
• Maybe a competitor is preparing to introduce a superior product. 

When reason for undervaluation can be clearly identified, the outcome is more predictable

When the reason for the undervaluation can be clearly identified, it becomes an even better investment because the outcome is more predictable. 

• By way of example, the legal constraint that prevents some institutional investors from purchasing low-priced spinoffs is one possible explanation for undervaluation. Such reasons give investors some comfort that the price is not depressed for an undisclosed fundamental business reason. 
• Other institutional constraints can also create opportunities for value investors. For example, many institutional investors become major sellers of securities involved in risk-arbitrage transactions on the grounds that their mission is to invest in ongoing businesses, not speculate on takeovers. The resultant selling pressure can depress prices, increasing the returns available to arbitrage investors. 
• Institutional investors are commonly unwilling to buy or hold low-priced securities. Since any company can exercise a degree of control over its share price through splitting or reverse splitting its outstanding shares, the financial rationale for this constraint is hard to understand. Why would a company’s shares be a good buy at $15 a share but not at $3 after a five for-one stock split or vice versa? 

Market inefficiencies cause stocks to sell at depressed levels

1.  Obscurity and a very thin market can cause stocks to sell at depressed levels. 

Many attractive investment opportunities result from market inefficiencies, that is, areas of the security markets in which information is not fully disseminated or in which supply and demand are temporarily out of balance. 

Almost no one on Wall Street, for example, follows, let alone recommends, small companies whose shares are closely held and infrequently traded; there are at most a handful of market makers in such stocks. Depending on the number of shareholders, such companies may not even be required by the SEC to file quarterly or annual reports. 

2.  Year-end tax selling also creates market inefficiencies. 

• The Internal Revenue Code makes it attractive for investors to realize capital losses before the end of each year. 
• Selling driven by the calendar rather than by investment fundamentals frequently causes stocks that declined significantly during the year to decline still further. 
• This generates opportunities for value investors.

When is a bargain not a bargain?

Once you have assembled a list of likely bargain candidates, you have to determine

• which to put your money into and 
• which to avoid and move on.

Many of the companies in your initial list are cheap for a reason;; they have fundamental problems that make them decidedly not valuable.

On the list of value candidates whose stock price had fallen significantly in the past were Enron, Global Crossing, MCI, US Airlines and Pacific Gas and Electric.   These companies ended up filing for bankruptcy and shareholders lost a significant portion of their investment if not all their money.


To achieve your wealth-building goals, you have to determine 

• why a company's shares are cheap and 
• which ones have little chance of recovery.

1.  Too much debt

The first and most toxic reason that stocks become cheap is too much debt.  In good times, companies with decent cash flow may borrow large amounts of money on the theory that if they continue to grow, they can meet the interest and principal payments in the future.  UNFORTUNATELY, the future is unknowable, and companies with with too much debt have a much smaller chance of surviving an economic downturn.  

Ben Graham explained that he used a simple yardstick to measure health.  A company should own twice as much as it owes.  This philosophy can help you avoid companies that owe too much to survive.


2.  Company falls short of analysts' earnings estimates.

Analysts seem to be more focused on short-term earnings gains than future long-term success   These quarterly or yearly earnings estimates have been proven to be notoriously unreliable.  Routinely, large and good companies get pushed to new stock price lows because they missed the estimates of the thundering herd of Wall Street  Missing earnings is not fatal, and it tends to create opportunity for the value buyer; if the trend continues, however, the shares will likely continue to fall.


3.  Cyclical stocks

Some cyclical stocks may show up on your list of potential bargains.  They are highly dependent on how the economy is doing.  Industries like automobiles, large appliances, steel and construction will experience lean times and stock prices are likely to reflect this fact.   Although we have had recessions of varying lengths and depths, the economies of industrialised nations have always rebounded.  It is important to note that in the bad times, cyclical companies with heavy debt loads may well face insurmountable problems.  Adhering to a policy of avoiding overly leveraged companies will serve you well.


4.  Labour contracts

Stocks may also fall because of labour contracts.  During good times, some companies and industries cave into labour union demands that were affordable at the time.  Little did they realize that they were mortgaging their future.  As new competition unburdened by costly labour contracts enters their industries, their profits disappear.  In many cases, the unions have been unwilling to grant concessions.   It is never easy to give back something you have, even if not doing so threatens the very existence of the company you work for.  Although holding on to expensive contracts may or may not benefit management or the unions in the long run, the one person that most assuredly does not benefit is the stockholder.  

Many large corporations (old-line industrial companies) have pension liabilities - benefits promised to workers - that they simply will be unable to pay  Generally speaking, if a company has excessive pension liabilities or there exists a contentious labour environment, it may be best to put these companies' shares on the no-thank-you list.


5.  Increased competition

Highly profitable industries attract new competition.  The most serious form of this comes when an industry in one country has high-priced labour or expensive regulatory rules.  Other nations unburdened by such costs can often produce and export the same goods cheaper.  Think China.  Throughout the world, countries have seen foreign manufacturers of automobiles, appliances and other goods make significant inroads into their market.  If a company is facing strong competition from a more efficient competitor with lower costs, it is perhaps best to utter those comforting words "no, thank you" and move on to the next candidate.


6.  Obsolescence

Obsolescence is another potentially fatal cause for falling prices.

Although the last large scale manufacturer of buggy whips or hand-cranked automobile starters made a very fine product, there was simply no longer a need for its product.  There may be some small demand for these products, but a company that depended on them for most of its sales would soon be out of business

Consider the field of technology.  The rate of "creative destruction" has never been faster.  Newer and better products turn up every day making the older products obsolete  The new products are a boon to the consumer but the bane of the legacy company.  

Today, we can go online and order any movie from NetFlicks and never have to leave the comfort of your own home.  For this reason, you should avoid companies that are subject to technological obsolescence.  The world is simply changing too fast to depend on products and services that someone else can deliver better and for less cost.  Avoid these.


7.  Corporate or accounting frauds

These are perhaps one of the most dangerous reasons for share price drops is corporate or accounting fraud.

Although these crimes against investors are the exception and not the rule, and most CEOs are dedicated leaders who care about their companies and their shareholders, fraud does happen.  In recent years, the world has experienced some of the largest cases in history, Enron, Parmalat, Tyco, WorldCom and others.  Regulators have since done much to help prevent future occurrences but there will always be some form of shenanigans.

Criminals exist in every walk of life.  There is almost no way to uncover fraud before it becomes public.  By the time it is discovered, it is too late  The best the investor can do is to steer clear of financial reports that seem overly complicated.


8.  Companies you do not understand or are not comfortable with

If there is something you do not understand or are not comfortable with, put these in the no-thank-you pile.   If a company has too many problems - too much debt, union and pension problems, stiff foreign competition, they too go to the no-thank-you pile.  You have the luxury of filling your portfolio with stocks you are comfortable with and want to own for the long term wealth building it offers.



Summary

You should approach your list of investment candidates with a healthy dose of scepticism.

You should stick to businesses you understand and for which there is an ongoing need (products or services).

You should also like food, beverage, and consumer staples like detergents, toothpaste, pens, and pencils - the stuff you consume on a daily basis. Many of these products engender brand loyalty that keeps the same product day after day, week after week.  We are all creatures of habit, and we will usually repeat our consumer preference when we go shopping.

Your best friend in the whole investing world is your no-thank-you pile.  Knowing your no-thank-you pile gives you the value investing opportunities to build your wealth building portfolio.

"Cheap" classic value companies versus Quality (growing intrinsic value) companies

Classic value metrics such as P/B, P/E or DY do not represent intrinsic value. 

To illustrate this, Grantham says when he poses the following question to investment audiences

• “I give you Coca Cola at 1.2x book or General Motors 1.0x. 
• Which would you have?” he gets no takers for GM. 

That is the clearest difference between P/B as a corner stone of classic value, and not intrinsic value.

The extra qualities represented by Coca Cola are worth a premium. The only question is, “how much?’ 


OUTPERFORMANCE OF INTRINSIC VALUE (QUALITY) VS. OF LOW P/B.

What this means is that

• any outperformance of intrinsic value (quality) is pure alpha, 
• where outperformance of low P/B (as it is for many small caps) is compensation for a high risk premium. 

To support this point, Grantham points out that had the US government not bailed out the behemoths of the US financial system in the crises of 2008, many companies trading at low price to book ratios would have gone bankrupt (not just in the US, but across the world due to the interconnectedness of the global financial system).

What we learn from Buffett’s review of the first 25 years of his investment experience is that this risk premium sometimes comes back to bite you. 

It should not be surprising that in times of deep economic crises, more of these “cheap,” classic value companies go bust than is the case for the “expensive” intrinsic value companies.

Further studies found that classic value investment opportunities tend to coincide with other characteristics such as

• small capitalization, 
• illiquidity, 
• high leverage, or 
• dissipating fundamentals due to severe cyclical conditions.  

 “The pure administration of classic value investment style really needs a long term lock-up, like Warren Buffet (Partnership) has or it will have occasional quite dreadful client problems.” 

Investment history is replete with examples of such dreadful client problems – Gary Brinson of UBS in the late 90s, Tony Dye who ran a value based contrarian portfolio for Phillips and Drew, and low PE value manager David Dreman in 2008, all lost the majority of their clients due to severe underperformance. 

The big lesson to learn here is not that classic value investing doesn’t work. 

It is the fact that it works far less frequently in recent times than it used to, enough to produce dreadful client problems.  

Bargains in Bonds and Preferred Stocks: How to profit from these bargains?

Bargains in Bonds and Preferred Stocks

The field of bargain issues extends to bonds and preferred stocks which sell at large discounts from the amount of their claim.

It is far from true that every low-priced senior issue is a bargain (there are default risks on non payment of interest and/or  principals).

The inexpert investor is well advised to eschew or stay away these completely, for they can easily burn his fingers.

There is an underlying tendency for market declines in this field to be overdone; consequently the group as a whole offers an especially rewarding invitation to careful and courageous analysis.

In the decade ending in 1948, the billion-dollar group of defaulted railroad bonds presented numerous and spectacular opportunities in this area.

Bargain-Issue Pattern in Secondary Companies (2): How to profit from these bargains?

Bargains in stocks of Secondary Companies

If secondary issues tend NORMALLY to be undervalued, what reason has the investor to hope that he can profit by such a situation?

For if this undervaluation persists indefinitely, will he not always be in the same position market wise as when he bought the issue?

The answer here is somewhat complicated.

Substantial profits from the purchase of secondary companies at bargain prices arise in a variety of ways.

1. First, the dividend return is high.
2. Second, the reinvested earnings are substantial in relation to the price paid and will ultimately affect the price.  In a five- to seven-year period these advantages can bulk quite large in a well-selected list.
3. Third, when a bull market appears, it is most generous to low-priced issues; thus it tends to raise the typical bargain issue to at least a reasonable level.
4. Fourth, even during relatively featureless market periods a continuous process of price adjustment goes on, under which secondary issues that were undervalued may rise at least to the normal level for their type of security.

An illustration of performance of undervalued securities (bargains companies)

Performance of two groups of undervalued securities selected at the beginning of 1940.

(Reference:  pp 689 and 690 of Security Analysis, by Graham and Dodd, 1940 Edition)

                                               (Excluding Dividends Received)

                                         Market Price                            Market Price

                                         Dec 31, 1939                           Dec 31, 1947

Group A 

10 Stocks

Total                                 120 5/8                                    449

Group B

10 Stocks     

Total                                  115                                         367 7/8

Total of Both Groups        236                                         817 
                                                                                         INCREASE 246%

Observations and Inferences/Conclusions

This performance is superior not only to that of the Dow-Jones list but to that of the growth-stock list as well.

Allowance should be made for the fact, that nearly all the smaller companies benefited more from the war than did the bigger ones.  

The figures, thus, prove without a doubt that under favourable conditions, bargain issues can yield a handsome profit.

His experience over many years led Benjamin Graham to assert that the average results from this area of activity are satisfactory.

Bargain-Issue Pattern in Secondary Companies (1): What led to creating these bargains?

Definition of Secondary Companies

A secondary company is one which is not a leader in a fairly important industry.

It is usually one of the smaller concerns in the field.

It may also equally be the chief unit in an unimportant line.

Any company that has established itself as a growth stock is not ordinarily considered as "secondary" company.



Stock Market's Attitude toward Secondary Companies

(a)  1920

In 1920, relatively little distinction was drawn between industry leaders and other listed issues, provided the latter were of respectable size.

The public felt that a middle-sized company

• was strong enough to weather storms and 
• that it had a better chance for really spectacular expansion than one which was already of major dimension.

(b)  Post 1931 -1933 depression

The 1931 - 1933 depression had a particularly devastating impact on companies below the first rank either in size or inherent stability.

As a result of that experience, investors have since developed a pronounced preference for industry leaders and a corresponding lack of interest in the ordinary company of secondary importance.

This has meant that the latter group has usually sold at much lower prices in relation to earnings and assets than have the former.

It has meant further that in many instances the price has fallen so low as to establish the issue in the bargain class.



No sound rational reasons for rejecting stocks of secondary companies

When investors rejected the stocks of secondary companies, even though these sold at a relatively low prices, they were expressing a belief or fear that such companies faced a dismal future.

In fact, at least subconsciously, they calculated that ANY price was too high for them because they were heading for extinction - just as in 1999 the companion theory for the "blue chips" was that no price was too high for them because their future possibilities were limitless.

Both of these views were exaggerations and were productive of serious investment errors.  

Actually, a typical middle-sized listed company is a large one when compared with the average privately-owned business.

There is no sound reason why such companies should not continue indefinitely in operation, undergoing the vicissitudes characteristic of our economy but earning n the whole a fair return on their invested capital.



The stock market's attitude toward secondary companies create instances of major undervaluation.

The stock market's attitude toward secondary companies tends to be unrealistic and consequently to create in normal times innumerable instances of major undervaluation.


As it happens, the war period and the post-war boom were more beneficial to the smaller concerns than to the larger ones, because then the normal competition for sales was suspended and the former could expand sales and profit margins more spectacularly.

• Thus by 1946 the market's pattern had completely reversed itself.  
• Whereas the leading stocks in the Dow-Jones Industrial Average had advanced only 40 percent from the end of 1938 to the 1946 high, Standard & Poor's Index of low-priced stocks had shot up no less than 280 per cent in the same period.  
• Speculators and many self-styled investors - with the proverbial short memories of people in the stock market - were eager to buy both old and new issues of unimportant companies at inflated levels.   

Thus, the pendulum had swung clear to the opposite extreme.

• The very class of secondary issues which had formerly supplied by far the largest proportion of bargain opportunities was now presenting the greatest number of examples of over-enthusiasm and overvaluation.
• If past experience can be relied upon, the post-war bull market will itself prove to have created an enlarged crop of bargain opportunities.
• For in all probability a large proportion of the new common stock offerings of that period will fall into disfavour, and they will join many secondary companies of older vintage in entering the limbo of chronic undervaluation.

The Intelligent Investor
Benjamin Graham

Value of a Business to a Private Owner

Value of a Business to a Private Owner Test

The private-owner test would ordinarily start with the net worth as shown in the balance sheet.


How to search for a bargain opportunity?

1.  Using the net worth as the starting point

The question to ask is:  Is the indicated earnings power sufficient to validate the net worth as a measure of what a private buyer would be justified in paying for the business as a whole?

If the answer is definitely yes, an ordinary investor should find the common stock attractive at a price one-third or more below such a figure.  


2.  Using the working capital as the starting point

If instead of using all the net worth as a starting point, the investor considered only the working capital and applied his test to that, he would have a more convincing demonstration of the existence of a bargain opportunity.

For it is something of an axiom or is self evident, that a business is worth to any private owner AT LEAST the amount of its working capital, since it could ordinarily be sold or liquidated for more than this figure.

If a common stock can be bought at no more than two-thirds of the working capital value alone - disregarding all the other assets - and if the earnings record and prospects are reasonably satisfactory, there is strong reason to believe that the investor is getting substantially more than his money's worth.



An example of how to find a bargain common stock:

[Peculiarly, in 1947, many such opportunities present themselves in ordinary markets.  Benjamin Graham]

National Department Stores as of January 31, 1948, the close of its fiscal year.
The price of the stock was 16 1/2.
The working capital was no less than $26.60 per share.
The total asset value was $33.30.
Deducting contingency reserves - mainly to mark down the inventory to a "LIFO" (last in first out) basis, these figures would be reduced by $2.20 per share.

The company had earned $4.12 per share in the year just closed.  The seven-year average was $3.43; the twelve-year average was $2.29.  (Growing earnings)
The year's dividend had been $1.50.  (Paying dividends)
Compared with a decade before,
-  the working-capital value had risen from $7.40 per share to $26.60,
-  the sales had doubled and (Increasing sales)
-  the net after taxes had risen from $654,000 to $3,224,000.  (Increasing profits)


Thus, we had a business
-  selling for $13 million,
-  with $25 million of assets, mostly current.  (Price < Net Assets)
-  Its sales were $88 million.  A fair estimate of average future earnings might be $2 million. (earnings record and prospects are reasonably satisfactory  or Not gruesome)

The average earnings prior to 1941 had been unimpressive, and the company was regarded as a "marginal" one in its field - that is, it could earn a reasonably good return only under favourable business conditions.  (Qualitative assessment)

In the past eight years, however, it has improved both in financial strength and in the quality of its management.  (Qualitative assessment - earnings record and prospects are reasonably satisfactory or improving quality of business and management)

Let us grant that Wall Street would still consider the company as belonging in the second rank of department-store enterprises.  (Investor sentiment/Market sentiment/Neglected by market)

Even after proper allowance is made for such an unfavourable factor, we may still conclude that on the basis of the figures the stock is intrinsically worth well above its market price.  (Worse case scenario, still Value > Price)


Conclusion:  At 16 1/2, the conclusion in the case of National Department Stores remains, whether we apply the appraisal test or the test of value to a private owner.  (Undervalued / A bargain)

Purchases of Bargain Issues

A bargain issue is defined as one which, on the basis of facts established by careful analysis, appears to be worth considerably more than it is selling for.

This includes:

• bonds and preferred stocks selling well under par, as well as
• bargain common stocks.

To be as concrete as possible, a suggested guide is an issue is not a true "bargain" unless the indicated value is at least 50% more than the price.

How to detect a bargain common stocks?  What kind of facts would warrant the conclusion that so great a discrepancy or bargain exists?

There are two tests by which a bargain common stock is detected.

1.   By method of appraisal.  

• This relies largely on estimating future earnings and then multiplying these by a factor appropriate tot he particular issue.
• If the resultant value is sufficiently above the market price - and if the investor has confidence in the technique employed - he can label the stock as a bargain.

2.  By the value of the business to a private owner.

• This value also is often determined chiefly by expected future earnings - in which case the result may be identical with the first method (the method of appraisal).
• In the second test more attention is likely to be paid to the realizable value of the assets with particular emphasis on the net current assets or working capital (current asset - current liabilities).

How do these bargains come into existence?  How does the investor profit from them?

1.  LOW POINTS IN THE GENERAL MARKET

At low points in the GENERAL MARKET, a large proportion of common stocks are bargain issues, as measured by the above standards.

[A typical example would be General Motors when it sold at less than 30 in 1941.  It had been earning in excess of $4 and paying $3.50, or more, in dividends.]

It is true that current earnings and the immediate prospects may both be poor, but a level-headed appraisal of average future conditions would indicate values far above ruling prices.

The wisdom of having courage in depressed markets is vindicated not only by the voice of experience but also by application of plausible techniques of value analysis.

2.  EXISTENCE OF MANY INDIVIDUAL COMMON STOCK BARGAINS AT ALMOST ALL MARKET LEVELS

The same vagaries of the marketplace which recurrently establish a bargain condition in the general market list account for the existence of many INDIVIDUAL BARGAINS at ALMOST ALL market levels.

The market is always making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks.  

A mere lack of interest or enthusiasm may impel a price decline to absurdly low levels.

There are two major sources of undervaluation:

(a) currently disappointing results and

(b) protracted neglect or unpopularity.

[Example of the first type (a):  In 1946, Lee Rubber & Tire Company, aided by the bull market and by steadily rising earnings, the stock sold at 72.   In the second half of 1947 the reported profits fell off moderately from the previous year's figures.  This minor development apparently generated enough pessimism to drive the shares down to 35 in early 1948.  That price was much less than the working capital alone (about $50 per share) and no greater than the amount actually earned in the previous five years.]

[Example of the second type (b):  During the 1946-47 period the price of Northern Pacific Railway declined from 36 to 13.5.   The true earnings of Northern Pacific in 1947 were close to $10 per share.  The price of the stock was held down, in great part, by its $1 dividend.  It was neglected, also, because much of its earning power was concealed by conventional accounting methods.]

The Intelligent Investor
Benjamin Graham

Everyone loves a bargain. But some people are willing to work harder to get it. Investors are like shoppers.

Marc Lichtenfeld, Friday, May 11th, 2012

Your Money >>> 

Finding the Best Cheap Stocks to Buy

My mother believes shopping is a sport. If it were, there’s no doubt she would be a world champion. I’d say an Olympic gold medalist, but she lost her amateur status years ago.

When my mom shops, she’s not satisfied unless she’s getting top merchandise for at least 40% off.

And like a hunter who can’t wait to brag about the 12-point buck he took, my mother will tell anyone who’ll listen about the $300 sweater she got for $80. But unlike the tales of hunters and fishermen, when it comes to my mom and shopping, the big one doesn’t get away.

Everyone loves a bargain. But some people are willing to work harder to get it. Investors are like shoppers. Some will stand in line to buy the latest hot Apple product (or stock), while others will wait patiently until the product or stock they want goes on sale.

When investors look for cheap stocks, they often concentrate on the price-to-earnings ratio (P/E). The P/E is simply the price per share divided by the past year’s earnings per share.

So in the case of Intel (Nasdaq: INTC), for example, the company earned $2.36 per share in the last 12 months. The current share price is $27.69. Divide $27.69 by $2.36 and you get a P/E of 11.7.

You can use that number to compare it to the P/E of the S&P 500 (15.3), its industry average (15.4), its historical average (17.1) or other specific stocks in its sector, to get an idea of whether the stock is cheap or pricey.

Analysts also look at forward price to earnings, which divides the price by the consensus analyst estimate for the next year. In Intel’s case, analysts project earnings of $2.49 per share in 2012, giving it a forward P/E of 11.1.

Methods better than P/E
But I believe investors pay too much attention to earnings and not enough to cash flow. You can also obtain a company’s valuation based on price to cash flow and, like P/E, compare it to industry averages, the S&P 500, etc.

Other popular valuation metrics include the price-to-sales ratio (P/S), which is the share price divided by revenue per share. If revenue per share isn’t readily available, all you do is divide the last 12 months’ sales and divide by the number of shares.

Price to book value (P/B) is also a popular tool. Book value is the value of the assets investors would get if the company were liquidated. Book value is simply shareholders’ equity (found on the balance sheet) divided by the number of shares outstanding.

Which one is more important when it comes to price performance?

Let’s take a look at each. I ran a stock screen and a corresponding backtest to measure the performance of all stocks whose valuation in each of those four metrics (separately) was below the average of its industry.

Price-to-earnings ratio
Over the past 10 years, if you bought every company (that was profitable) trading below its industry’s average P/E and held the stock for one year, you’d have outperformed the S&P 500 by 218%. In only two out of the 10 years would that formula have underperformed the market — and not by much.

A recent example is Apache Corporation (NYSE: APA), trading at 7.8 times earnings versus the average insurer at 17.8.

Price to cash flow
Testing undervalued, cheap stocks based on price-to-cash flow also turned out a stellar outcome, beating the market by 749%. It underperformed the market in three out of 10 years, but the worst year was only by 3.15%. Conversely, in six of the seven years it beat the market it did so by double digits, several times by 50% or higher.

Sprint Nextel (NYSE: S) currently trades at just 1.9 times cash flow, which is dirt cheap, even in its industry, which only trades at an average of 4.6 times cash flow, compared to the S&P 500, which is valued at 9.1 times cash flow.

Price to book value
The results were even better on stocks trading at a lower price-to-book value than their industry average. Over the 10-year period, those stocks climbed 2,193% versus the 13% of the S&P 500. These stocks beat the market every year, including by over 100% in 2009 and 2010.

A current example is NVIDIA Corporation (Nasdaq: NVDA), which trades at 1.8 times its book value, versus its industry average of 2.8.

Price-to-sales ratio
When I ran the backtest using companies whose price-to-sales ratio was below the industry average, something incredible happened. A $1,000 investment in 2001 turned into $286,535! While the same amount invested in the S&P 500 was worth $1,130.

The screen beat the S&P 500 in every year. But what was really interesting was that in 2003 and 2009, years in which the overall market recovered from steep sell-offs, the low P/S stocks went nuts. They outperformed the S&P 500 by 232% in 2003 and 745% in 2009.

Keep in mind, this involved owning a few thousand stocks, so this isn’t easily copied in real life, but it might give you a starting point the next time we start to come out of a nasty bear market.

Symantec (Nasdaq: SYMC) is a current example, trading at just 1.8 times sales versus its peers’ average of 3.8 times sales.

You obviously don’t want to run a screen, throw a dart at the list and buy a stock. You want to dig a little deeper. But by knowing which types of stocks tend to outperform the market, you increase your chances of getting a bargain that you’ll be as happy with as my mother is with a $400 designer jacket that she got for $35 (true story).

Value Investing - Key Points

Value investors are bargain hunters and many investors describe themselves as such. But who is a value investor? We argue that value investors come in many forms. 

• Some value investors use specific criteria to screen for what they categorize as undervalued stocks and invest in these stocks for the long term. 
• Other value investors believe that bargains are best found in the aftermath of a sell-off and that the best time to buy a stock is when it is down. 
• Still others adopt a more activist approach, where they buy large stakes in companies that they believe are undervalued and push for changes that they believe will unleash this value.

Value investing is backed by empirical evidence from financial theorists and by anecdotal evidence—the success of value investors like Ben Graham and Warren Buffett are part of investment mythology—but it is
not for all investors.  Investors need to consider what they bring to the table to succeed at value investing.


http://media.wiley.com/product_data/excerpt/32/04713450/0471345032.pdf

Value Investment Philosophy

Value investing is the discipline of buying securities at a significant discount from their current underlying values and holding them until more of their value is realized. The element of a bargain is the key to the process. In the language of value investors, this is referred to as buying a dollar for fifty cents. Value investing combines the conservative analysis of underlying value with the requisite discipline and patience to buy only when a sufficient discount from that value is available. The number of available bargains varies, and the gap between the price and value of any given security can be very narrow or extremely wide. Sometimes a value investor will review in depth a great many potential investments without finding a single one that is sufficiently attractive. Such persistence is necessary, however, since value is often well hidden.


The disciplined pursuit of bargains makes value investing very much a risk-averse approach. The greatest challenge for value investors is maintaining the required discipline. Being a value investor usually means standing apart from the crowd, challenging conventional wisdom, and opposing the prevailing investment winds . It can be a very lonely undertaking. A value investor may experience poor, even horrendous , performance compared with that of other investors or the market as a whole during prolonged periods of market overvaluation. Yet over the long run the value approach works so successfully that few, if any, advocates of the philosophy ever abandon it.

Margin of Safety Concept in Undervalued or Bargain Securities

The margin-of-safety idea becomes much more evident when we apply it to the field of undervalued or bargain securities. 

• We have here, by definition, a favorable difference between price on the one hand and indicated or appraised value on the other. 
• That difference is the safety margin. It is available for absorbing the effect of miscalculations or worse than average luck. 
• The buyer of bargain issues places particular emphasis on the ability of the investment to withstand adverse developments. 
• For in most such cases he has no real enthusiasm about the company’s prospects.

True, if the prospects are definitely bad the investor will prefer to avoid the security no matter how low the price. 

But the field of undervalued issues is drawn from the many concerns—perhaps a majority of the total—for which the future appears neither distinctly promising nor distinctly unpromising. 

• If these are bought on a bargain basis, even a moderate decline in the earning power need not prevent the investment from showing satisfactory results. 
• The margin of safety will then have served its proper purpose.

Ref:  The Intelligent Investors by Benjamin Graham

CHAPTER 20  “Margin of Safety” as the Central Concept of Investment





Also read:

• Margin of Safety Concept in The Business Venture of Buying and Selling Stocks
• Margin of Safety Concept in Conventional and Unconventional Investments
• Margin of Safety Concept in Speculation and Investment
• Margin of Safety Concept in Diversification
• Margin of Safety Concept in Undervalued or Bargain Stocks
• Margin of Safety Concept in Growth Stocks
• Margin of Safety in Good-Quality and Low-Quality Stocks.
• Margin of Safety Concept in Common Stocks
• Margin of Safety Concept in Bonds and Preferred Stocks

Price-Earning Ratio 101

What actually is PER?

It's often said that the PER is an estimate of the number of years it'll take investors to recoup their money. Unless all profits are paid out as dividends, something that rarely persists in real life, this is incorrect.

So ignore what you might read in simplistic articles and note this down: a PER is a reflection not of what you earn from a stock, but “what investors as a group are prepared to pay for the earnings of a company”.

All things being equal, the lower the PER, the better. 


But the list of caveats is long and vital to understand if you're to make full use of this metric.

PER:  Historical versus Forward or Forecast PER

The PER compares the current price of a stock with the prior year's (historical) or the current year's (forecast) earnings per share (EPS). Usually the prior year's EPS is used, but be sure to check first.

For example:

Last financial year, XYZ Ltd made $8 million in net profit (or earnings). 

The company has 1 million shares outstanding.

So it achieved earnings per share (EPS) of $8.00 ($8 million profit divided by 1 million shares). 

In the current year, XYZ is expected to earn $10 million; a forecast EPS of $10.00.

• At the current share price of $100, the stock is therefore trading on a historic PER of 12.5 ($100/$8). 
• Using the forecast for current year's earnings, the forward or “forecast PER” is 10 ($100/$10).

Quality has a price to match

Quality usually comes with a price to match. 


It costs more, for example, to buy handcrafted leather goods from France than it does a cheap substitute from China. Stocks are no different: high quality businesses generally, and rightfully, trade on higher PERs than poorer quality businesses.





Low PER doesn't alone guarantee quality business

• Value investors love a bargain. Indeed, they're defined by this quality. 
• But whilst a low PER for a quality business can indicate value, it doesn't alone guarantee it. 
• Because PERs are only a shortcut for valuation, further research is mandatory.
• 
  

High PER with strong future earnings growth maybe a bargain

• Likewise, a high PER doesn't ensure that a stock is expensive. 
• A company with strong future earnings growth may justify a high PER, and may even be a bargain. 
• A stock with temporarily depressed profits, especially if caused by a one-off event, may justifiably trade at a high PER. 
• But for a poor quality business with little prospects for growth, a high PER is likely to be undeserved.

Avoid a Common trap: Use underlying or normalised earnings in PER


There's another trap: PERs are often calculated using reported profit, especially in newspapers or on financial websites. 


But one-off events often distort headline profit numbers and therefore the PER. 


Using underlying, or “normalised”, earnings in your PER calculation is likely to give a truer picture of a stock's value.





What is a normalised level of earnings?

That begs the question; what is a normal level of earnings? That's the $64 million dollar question.


 If you don't know how to calculate these figures for the stocks in your portfolio, now is the time to establish whether it's skill or luck that's driving your returns. And if you don't know that, history may well make a monkey of you.




An old encounter with low PE stock: Hai-O


It is nostalgic to re-read an old post on Hai-O by ze Moola. 

http://whereiszemoola.blogspot.com/2008/04/more-on-haio.html

Sunday, April 13, 2008
MORE ON HAIO

My dearest BullBear,

A low PE stock means only one thing and that is the stock is trading on a lower valuation compared to what it is currently earning.

Some simply consider that what is happening is the stock is being ignored in the market despite its impressive earnings.

Why?

The market could be wrong and that perhaps this is a stock that's an ignored gem. Yeah, the classical hidden gem and if this is the case, investors who invests in the stock could be rewarded for their stock selection.

However, on the other hand, sometimes the market could be right and that they do sense something is not right within the stock.

And because of this reasoning, I have always realised that a low PE stock does not make a stock a QUALITY stock.

It just means the stock is trading 'cheaply'.

It could be a bargain but it could also be a trap.

Once-in-a-generation sales

Investments in the bargain bin
Once-in-a-generation sales have sprung up in this crazed market.

Closed-end blue-chip stock funds
Closed-end funds and regular mutual funds both invest in a portfolio of stocks, bonds and other assets. The key difference: Closed-end funds are bought and sold like individual stocks on public exchanges. Historically, shares of the average closed-end fund have traded at a price around 5% below the actual value of the portfolio's underlying assets. Thanks to the vicious bear, though, closed-end large-cap stock funds are trading at discounts four times as large.
By Janice Revell, Money Magazine senior writer

Inflation-protected bonds
Real TIPS yields, which are shielded from inflation, are at a seven-year high. Fears of inflation have been replaced by fears of deflation. So demand for Treasury Inflation-Protected Securities, or TIPS, has collapsed. The result: Inflation-protected yields on TIPS are soaring. Five-year TIPS, in fact, are actually yielding 0.42 percent age points more than Treasuries. That means as long as inflation is not less than -- 0.42% in the coming years, you'll make more with TIPS. That's a good bet, given the enormous amount of cash Uncle Sam is pumping into the economy. An easy way to buy TIPS: iShares Lehman TIPS Bond (TIP), a Money 70 recommended ETF.

Pfizer
(ticker: PFE)This drug giant hasn't been immune to what ails the market. Its shares plunged almost 30% in the past year. The silver lining: Pfizer's dividend yield now stands at a hefty 8%, more than double the average of the S&P 500. Of course, when a stock's yield is that generous, the market often believes the dividend will be cut or the share price will continue to fall -- or both. But Pfizer has some strong defenses, says Banc of America Securities analyst Steven Lichtman. The firm boasts a solid balance sheet and sits on $26 billion in cash. And though its blockbuster drug Lipitor is slated to go off-patent in 2011, Lichtman believes earnings from Pfizer's other drugs will hold up well.

Triple-A-rated municipal bonds
Normally, yields on Treasuries and munis are about equal after you factor in taxes. Today muni yields are much higher. With taxes likely to rise, you'd expect demand for bonds issued by city, county and state governments to grow -- thanks to their tax-exempt status. Think again. Things have gotten so out of whack in this credit crisis that 10-year triple-A munis are yielding 4.14%. Assuming you're in the 28% bracket, that's like getting 5.75% on a Treasury. Yet 10-year Treasuries are yielding only 3.33%. True, munis can default. But even in a recession, the threat is not nearly enough to justify this differential, experts say. Go with a diversified Money 70 fund like Vanguard Intermediate Term Tax-Exempt (VWITX).

Eaton
(ticker: ETN) As Warren Buffett is fond of saying, the best time to be a buyer of equities is when everyone else is selling. Well, one stock that certainly meets Buffett's criterion of being unloved -- and that the Oracle has been loading up on -- is an industrial manufacturer you may not have heard of: Eaton Corp. Its price has plummeted more than 50% over the past year, and it's now trading at a price/earnings ratio of 6, compared with 12.4 for the S&P 500. According to a recent filing, Buffett's firm, Berkshire Hathaway, bought 3 million shares in the six months ended in September. Many pros think Eaton's recent sharp price decline makes the stock extremely attractive relative to the firm's earnings prospects. For example, Goldman Sachs analyst Terry Darling, who rates the stock a buy, expects Eaton's earnings to soften a bit in the next two years as the economy struggles. But he says the cheap stock price more than reflects that weakness.

Investment-grade corporate bonds
The spread between yields on corporate bonds and Treasuries has ballooned this year -- signaling a big buying opportunity in investment-grade corporates.The bonds of high-quality firms normally yield one to two points more than the going rate of U.S. Treasuries to compensate you for added risk. But Wall Street is so spooked that investment-grade bonds are now yielding more than 8% -- five points more than 10-year Treasuries. That's just too good to pass up, experts say. In fact, the prices on corporates have fallen so far that their yields currently "compensate for default rates worse than the Great Depression," according to Citigroup. A simple way to get onboard: Vanguard Short-Term Investment-Grade (VFSTX), a Money 70 fund.

Bargains abound in the stock markets

http://www.raymondjames.com/inv_strat.htm



In conclusion, we received a plethora of questions regarding the quote we used last week from The Wall Street Journal (WSJ) that there are currently one in ten listed companies trading for less than the value of the cash and marketable securities on their balance sheets. To proof test this statement we ran a similar screen and found more companies than the WSJ did. Of course the screen they must have used was similar to ours in that “net debt” on the balance sheet was excluded. When we included “net debt” we come away with a much smaller number. Still, this exercise goes to show that “things” are overdone on the downside and people like Warren Buffett are taking notice. Verily, when investors en masse attempt to adjust their portfolios toward more conservative investments, there is a negative feedback loop that leads to a decline in the price of less liquid assets, which in turn begets even more selling pressure, causing an overshoot on the downside. And that, ladies and gentlemen, is where we are currently.



----------



P.S. – “Strikingly, today’s conditions bear quite a close resemblance to what Graham described in the abyss of the Great Depression. Regardless of how much further it might (or might not) drop, the stock market now abounds with so many bargains it’s hard to avoid stepping on them. Out of 9,194 stocks tracked by Standard & Poor’s Compustat research service, 3,518 are now trading at less than eight times their earnings over the past year – or at levels less than half the long-term average valuation of the stock market as a whole. Nearly one in 10, or 876 stocks, trade below the value of their per-share holdings of cash – an even greater proportion than Graham found in 1932.” (The WSJ the week of October 6, 2008.)

Ref:

Business Valuations versus Stock-Market Valuations (2) - an illustration
"The company is worth more dead than alive." The A&P Example

Bargain Conundrum - another cognitive error

A stock has done tremendously well for a period of time. Investors tend to extrapolate linearly, assuming that a company which has done well in the last few years is expected to continue to do so.

Then came the correction. For many buyers, it was an opportunity to get in.

Here lies the bargain conundrum - another cognitive error that consistently lead us to make irrational decisions. The belief is that the price uptrend would resume. That this correction could be a reversal may not feature in the thinking or radar of most.

One risk in the investment world that is often overlooked is behavioural risk. Recognising such flaws which the field of behavioural finance has uncovered is the first step towards being more rational in one's investing.


Also read:
Evaluating Changing Fundamentals (Part 3 of 5)
· Don't automatically buy because a stock falls in price; re-evaluate as if new.
Ask ourselves:
Is the correction a true bargain?
Maybe the price uptrend would resume?
Or, maybe not, this being a reversal of the uptrend?
Obviously, having an idea of where the "fair value" of the stock is, helps.