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

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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).

Buy, Sell, Hold: What it Really Means. Just remember as an individual investor not to put too much value the next time you see a report stating an analyst rates a stock a “Buy,” “Hold,” or “Sell.”

Gary Spivak, Tuesday, June 12th, 2012

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Buy, Sell, Hold: What it Really Means

In early May, I was intrigued when a few brokerage firms “initiated” coverage of Facebook with “Buy” ratings and price targets in the mid-$40 range — even before the stock was publicly traded. Now, if the stock were to trade near its $38 IPO price, is it still a “Buy” if it’s only going to get to the mid-40s?

Given the disappointing post-IPO performance of the stock and questions about what a particular analyst said or didn’t say to some clients, I thought it would be a good time to look at what makes a sell-side technology equity research analyst tick.

More importantly, how do they generate revenue for their firms?

For the most part, a technology equity analyst (which I have been for the past 14 years) is an honorable, hard-working person trying to make a decent living in a highly competitive environment where trading commissions are declining. But what you need to know is that, in most cases, the analyst isn’t compensated if they make you — John or Jane Q — money on stock picks. From a purely economic standpoint, they simply don’t care.

Billy Crystal used to have a recurring skit when he was a regular on Saturday Night Live called Fernando’s Hideaway. That’s the one where he coined the phrase “You Look Mahvellous!” In the skit, he would frequently utter the saying, “It is better to look good than to feel good.”

For the typical sell-side analyst, it’s better to look good than to be good. It’s more important to be interestingthan it is to be right.

My point is — don’t be taken in when an analyst says, “Buy.” I’m certain they believe it, but there are other factors and conflicts you should be aware of.

“Buy,” “Sell,” or “Hold”

To understand why, let’s review what an analyst does. The analyst works hard to produce a report, sometimes fairly detailed, sometimes with a unique perspective, sometimes merely updating investors on current events, but almost always with a “Buy,” “Hold,” or “Sell” recommendation attached to it.

This report is summarized in “The Morning Meeting,” where the analyst conveys the essence of the message to the sales force. The sales force then may ask questions of the analyst to better understand the message. Ultimately, the salesperson then gets on the phone to their clients to deliver the message — “we say ‘Buy’ XYZ today, and here’s why.”

In many cases, the top clients are the large mutual funds and hedge funds. Why? They’re the ones that pay the most commission dollars. If the portfolio manager at the fund finds the comment interesting, he may place a trade with the brokerage firm issuing the research report. And that is primarily how the cash register rings.

Now, please notice that I said “finds the comment interesting.” I did not say “finds the comment convincing.” Let’s look at why.

When asked what they value in sell-side research, portfolio managers typically point to “idea generation” and “access to management.”

They do not say, “We look for the best stock pickers.” There are two obvious reasons why they don’t say this.

First

If they admitted that they got their stock picks from listening to a sell-side analyst, they would be failing to justify their own existence.

Second

The sell-side analyst who truly is a great stock picker ends up on the buy side. That’s where the decisions are made, and that’s where a good stock picker is worth the most money.

So, whether it’s self-serving or not, the buy side will admit to paying little attention to whether an analyst has a “Buy” rating or not. They’re looking for the incremental things — is this analyst looking at something differently, have they spoken to somebody I haven’t that may have a particular insight, have they recently spent time with the management team?

Believe it or not, there’s nothing sinister in this. It’s just a natural result of the environment for an analyst. Just remember as an individual investor not to put too much value the next time you see a report stating an analyst rates a stock a “Buy,” “Hold,” or “Sell.”

Young Professionals Mistakenly Put Off Financial Planning. Waiting until you consider yourself ‘established’ will hamper your long-term success. Get Financially Educated EARLY.

Henry Stimpson, Friday, June 1st, 2012

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Young Professionals Mistakenly Put Off Financial Planning

Most young professionals put off serious financial planning until they’re older, which is a mistake, says a certified financial planner (and young professional).

 

Most rising professionals avoid making financial decisions, or worse, make bad decisions because they lack good information or professional help, says Anthony Criscuolo with Palisades Hudson Financial Group in Fort Lauderdale, Fla.

 

“This is the time to put your financial house in order,” he says. “The decisions you make from about 30 to 40 may have the most significant impact on your future financial success.”

 

Once you’re making enough money to set some aside, you’ll need an investment plan with a sensible asset allocation, he says. Too many young professionals go to the extremes of either keeping everything in cash or betting aggressively on a few stocks.

 

“We see 50-year-olds come to our office with $500,000 parked in cash because they feel they had to wait until they were wealthy enough to get financial advice and start investing,” he says. “If they had received good investment advice years ago, they could have accumulated two or three times as much.”

 

It’s more than just investment advice. Young professionals often gloss over insurance. Besides car and home or renters’ insurance, most married professionals need term life insurance. Disability insurance is important for all professionals. Selecting the best insurance coverages can be complicated, and it takes research and sometimes outside advice, Criscuolo says.

 

While tax and estate planning may seem premature at this stage, it’s important to lay the groundwork early for more complicated planning later in life, he says. For instance, if you have children, you’ll need a will to specify who’ll take care of them in case both you and your spouse die.

 

How to Get Unbiased Advice

Knowing where to look for help isn’t always easy. Most young professionals either take a do-it-yourself approach or find a transaction-focused, commission-based advisor who pushes his firm’s products.

 

While you may be working with ethical and competent people, they’ll usually steer you to products that produce big commissions, according to Criscuolo.

 

“It’s not that their advice is always bad or wrong, but it can be biased,” he says.

 

Furthermore, most brokers, agents and bankers don’t provide comprehensive, integrated financial planning. They know just their piece of the pie.

 

A comprehensive, fee-only financial advisor can address investments, taxes, estate planning, insurance and retirement planning together rather than in isolation. But the best full-service financial planning firms are usually only interested in working with clients who have a lot of money to invest.

 

“This creates the false sense that financial planning is only for those who are already well established in their lives and careers,” he says.

 

So, where can a rising professional turn?

 

Not all fee-only planning firms will show you the door. Some are willing to waive their minimums and work with a young professional on a limited basis, he says. For instance, the advisor may recommend a one-time meeting to create an investment plan that the client can self-implement.

 

“Find a firm that’s willing to see the value in building a long-term relationship and working with you now and throughout your career,” Criscuolo says.

 

As the professional matures, he or she can turn to the advisor for additional services over the years and eventually become a full-service client.

 

“Waiting until you consider yourself ‘established’ will hamper your long-term success,” he says.

 

An advantage of starting early with a top-notch, comprehensive advisor is that you’ll be able to keep that firm for many years, Criscuolo points out. If you start out with a smaller or less sophisticated advisor, you’ll need to switch when you’re older and have more complex and diverse needs.

 

“You want an advisor that you can grow with,” he says.

Valuing Stocks the Warren Buffett Way

The Warren Buffett approach to investing makes use of “folly and discipline”: the discipline of the investor to identify excellent businesses and wait for the folly of the market to drive down the value of these businesses to attractive levels.


Most investors have little trouble understanding Buffett’s philosophy. The approach encompasses many widely held investment principles. However, its successful implementation is dependent upon the dedication of the investor to learn and follow the principles.




Like most successful stockpickers, Warren Buffett thinks that the efficient market theory is absolute rubbish. Buffett has backed up his beliefs with a successful track record through Berkshire Hathaway, his publicly traded holding company.

Unfortunately, Buffett has never expounded extensively on his investment approach, although you can glean tidbits from his writings in the Berkshire Hathaway annual reports. However, a cottage industry has sprung up over the years as outsiders have attempted to explain Buffett’s investment philosophy. One book that discusses his approach in an interesting and methodical fashion is “Buffettology: The Previously Unexplained Techniques That Have Made Warren Buffett the World’s Most Famous Investor” (Scribner, 1999) written by Mary Buffett, a former daughter-in-law of Buffett’s, and David Clark, a family friend and portfolio manager.

This book served as the basis for two stock screens developed and tracked by AAII—Buffettology EPS Growth and Buffettology Sustainable Growth. These screens are also pre-built into AAII’s Stock Investor Pro fundamental stock screening and research database program.

In this article, we provide an overview of Buffettology as a method of identifying promising businesses. In addition, we present a Buffett valuation spreadsheet that uses various valuation models to measure the attractiveness of stocks passing the preliminary screens.

Defining an Attractive Company

Warren Buffett seeks first to identify an excellent business and then to acquire the firm if the price is right. Buffett is a buy-and-hold investor who prefers to hold the stock of a good company earning 15% year after year over jumping from investment to investment with the hope of higher, short-term gains. Once he identifies a good company and purchases it at an attractive price, Buffett holds the stock for the long term until the business loses its attractiveness or a more attractive alternative investment presents itself.

Buffett seeks businesses whose product or service will be in constant and growing demand. In his view, businesses can be divided into two basic types:

• Commodity-based firms—selling products where price is the single most important factor determining purchase. They are characterized by high levels of competition in which the low-cost producer wins because of the freedom to establish prices. Management is vital for the long-term success of these types of firms.
• Consumer monopolies—selling products where there is no effective competitor, either due to a patent or brand name or similar intangible that makes the product or service unique.

While Buffett is considered a value investor, he passes up the stocks of commodity-based firms even if he can purchase them at a price below the intrinsic value of the firm. An enterprise with poor inherent economics often remains that way. The stock of a mediocre business generally only treads water.

How do you spot a commodity-based company? Buffett watches out for these characteristics:

• Low profit margins (net income divided by sales);
• Low return on equity (earnings per share divided by book value per share);
• Absence of any brand-name loyalty for its products;
• The presence of multiple producers;
• The existence of substantial excess capacity;
• Profits tend to be erratic; and
• Profitability depends upon management’s ability to optimize the use of tangible assets.

Buffett instead seeks out consumer monopolies—companies that have managed to create a product or service that is somehow unique and difficult for competitors to reproduce due to brand-name loyalty, a particular niche that only a limited number of companies can enter, or an unregulated but legal monopoly such as a patent.

Consumer monopolies can be businesses that sell products or services. Buffett recognizes three types of monopolies:

• Businesses that make products that wear out fast or are used up quickly and have brand-name appeal that merchants must carry to attract customers. Apple Inc. is a good example of a firm with a strong brand name in demand by customers. As a result, consumers are willing to pay a premium price for Apple products. Other examples include leading newspapers, drug companies with patents, and popular brand-name restaurants such as McDonald’s.
• “Communications” firms that provide a repetitive service, which manufacturers must use to persuade the public to buy their products. All businesses must advertise their items, and many of the available media face little competition. These used to include worldwide advertising agencies, magazine publishers, newspapers, and telecommunications networks. Today, “new media” outlets such as Google and Yahoo! provide on-line advertising that threatens the traditional business models of print media.
• Businesses that provide repetitive consumer services that people and businesses are in constant need of. Examples include tax preparers, insurance companies, and investment firms.

In her Buffettology book, Mary Buffett suggests going to your local convenience store to identify many of these “must-have” products. These stores typically carry a very limited line of must-have products such as Marlboro cigarettes and Wrigley’s gum. However, with the guidance of the factors used to identify attractive companies, we established two basic screens to identify potential investments worthy of further analysis.

The Buffettology Screen

The criteria used for our Buffettology screens are summarized in Table 1. AAII’s Stock Investor Pro is used to perform the screens.

Consumer monopolies typically have high profit margins because of their unique niche; however, a simple screen for high margins may highlight weak firms in industries with traditionally high margins, but low turnover levels.

Our first screening filters look for firms with both gross operating margins and net profit margins above the medians for their industry. The operating margin concerns itself with the costs directly associated with the production of the goods and services, while the net profit margin takes all of the company activities and actions into account.

Table 1. Translating the Buffett Style Into Screening

Questions to determine the attractiveness of the business:


Consumer monopoly or commodity?
Buffett seeks out consumer monopolies selling products in which there is no effective competitor, either due to a patent or brand name or similar intangible that makes the product unique. Investors can seek these companies by identifying the manufacturers of products that seem indispensable. Consumer monopolies typically have high profit margins because of their unique niche; however, simple screens for high margins may simply highlight firms within industries with traditionally high margins. For our screen, we look for companies with operating margins and net profit margins above their industry norms. Additional screens for strong earnings and high return on equity will also help to identify consumer monopolies. Follow-up examinations should include a detailed study of the firm’s position in the industry and how it might change over time.

Do you understand how the business works?
Buffett only invests in industries that he can grasp. While you cannot screen for this factor, you should only further analyze the companies passing all screening criteria that operate in areas you understand.

Is the company conservatively financed?
Buffett seeks out companies with conservative financing. Consumer monopolies tend to have strong cash flows, with little need for long-term debt. We screen for companies with total liabilities relative to total assets that are below the median for their respective industry. Alternative screens might look for low debt to capitalization or low debt to equity.

Are earnings strong and do they show an upward trend?
Buffett looks for companies with strong, consistent, and expanding earnings. We screen for companies with seven-year earnings per share growth greater than 75% of all firms. To help indicate that earnings growth is still strong, we also require that the three-year earnings growth rate be higher than the seven-year growth rate. Buffett seeks out firms with consistent earnings. Follow-up examinations should include careful examination of the year-by-year earnings per share figures. As a simple screen to exclude companies with more volatile earnings, we screen for companies with positive earnings for each of the last seven years and latest 12 months.

Does the company stick with what it knows?
A company should invest capital only in those businesses within its area of expertise. This is a difficult factor to screen for on a quantitative level. Before investing in a company, look at the company’s past pattern of acquisitions and new directions. They should fit within the primary range of operation for the firm.

Has the company been buying back its shares?
Buffett prefers that firms reinvest their earnings within the company, provided that profitable opportunities exist. When companies have excess cash flow, Buffett favors shareholder-enhancing maneuvers such as share buybacks. While we do not screen for this factor, a follow-up examination of a company would reveal if it has a share buyback plan in place.

Have retained earnings been invested well?
Earnings should rise as the level of retained earnings increase from profitable operations. Other screens for strong and consistent earnings and strong return on equity help to the capture this factor.

Is the company’s return on equity above average?
Buffett considers it a positive sign when a company is able to earn above-average returns on equity. Mary Buffett indicates that the average return on equity for the last 30 years is approximately 12%. We created a custom field that calculated the average return on equity over the last seven years. We then filter for companies with average return on equity above 12%.

Is the company free to adjust prices to inflation?
True consumer monopolies are able to adjust prices to inflation without the risk of losing significant unit sales. This factor is best applied through a qualitative examination of the companies and industries passing all the screens.

Does the company need to constantly reinvest in capital?
Retained earnings must first go toward maintaining current operations at competitive levels, so the lower the amount needed to maintain current operations, the better. This factor is best applied through a qualitative examination of the company and its industry. However, a screen for high relative levels of free cash flow may also help to capture this factor.

Understand How It Works

As is common with successful investors, Buffett only invests in companies he can understand. Individuals should try to invest in areas where they possess some specialized knowledge and can more effectively judge a company, its industry, and its competitive environment. While it is difficult to construct a quantitative filter, an investor should be able to identify areas of interest.

The companies typically passing the Buffettology screens represent a diverse group of companies. An investor should only consider analyzing those firms operating in areas that they can clearly grasp.

To see the companies that are currently passing the AAII Buffettology screens, visit the Stock Screens area of AAII.com.

Conservative Financing

Consumer monopolies tend to have strong cash flows, with little need for long-term debt. Buffett does not object to the use of debt for a good purpose—for example, if a company uses debt to finance the purchase of another consumer monopoly. However, he does object if the added debt is used in a way that will produce mediocre results—such as expanding into a commodity line of business.

Appropriate levels of debt vary from industry to industry, so it is best to construct a relative filter against industry norms. We screen out firms that had higher levels of total liabilities to total assets than their industry median. The ratio of total liabilities to total assets is more encompassing than just looking at ratios based upon long-term debt such as the debt-equity ratio.

Strong & Improving Earnings

Buffett invests only in businesses whose future earnings are predictable to a high degree of certainty. Companies with predictable earnings have good business economics and produce cash that can be reinvested or paid out to shareholders. Earnings levels are critical in valuation. As earnings increase, the stock price will eventually reflect this growth.

Buffett looks for strong long-term growth as well as an indication of an upward trend. In her book, Mary Buffett looks at both the 10- and five-year growth rates. Stock Investor Pro offers seven-year growth rates, so for the predefined Buffettology screens we use the seven-year growth rate to filter for long-term growth and the three-year growth rate to filter for intermediate-term growth. The Buffettology screens first require that a company’s seven-year earnings growth rate be higher than that of 75% of the stocks in the overall database.

It is best if the earnings also show an upward trend. Buffett compares the intermediate-term growth rate to the long-term growth rate and looks for expanding earnings. For our next filter, we require that the three-year growth rate in earnings be greater than the seven-year growth rate.

Consumer monopolies should show both strong and consistent earnings. Wild swings in earnings are characteristic of commodity businesses. An examination of year-by-year earnings should be performed as part of the valuation.

Figure 1. Buffett Valuation Worksheet for VCA Antech

VCA Antech (WOOF) passed the Buffettology Sustainable Growth screen as of May 15, 2009, and is used in Figure 1 to illustrate the Buffett Valuation Spreadsheet. The company operates the largest network of animal hospitals and veterinary diagnostic labs in the country. The company’s earnings per share are displayed in the spreadsheet. [While Stock Investor Pro provides seven-year growth rates, which requires eight years of data, the program provides seven years of financial statement data for display purposes. The spreadsheet displays six years of data to calculate the five-year growth rates.] As we can see, VCA’s earnings per share EPS growth has been strong and consistent, with annual increases over each of the last five years (where Year 1 is the most recent year).

A screen requiring an increase in earnings for each of the last seven years would be too stringent and would not be in keeping with the Buffett philosophy. However, a filter requiring positive earnings for each of the last seven years should help to eliminate some of the commodity- based businesses with wild earnings swings.

A Consistent Focus

Companies that stray too far from their base of operation often end up in trouble. Peter Lynch also avoided profitable companies diversifying into other areas. Lynch termed these “diworseifications.” Quaker Oats’ purchase and subsequent sale of Snapple is classic example.

Companies should expand into related areas that offer high return potential. VCA Antech is the leader in the animal diagnostic lab business, servicing more than 14,000 of the 22,000 animal hospitals in the U.S. This segment offers impressive operating margins, which should benefit the company going forward.

Buyback of Shares

Buffett views share repurchases favorably since they cause per share earnings increases for those who don’t sell, resulting in an increase in the stock’s market price. This is a difficult variable to screen, as most data services do not indicate buybacks. You can screen for a decreasing number of outstanding shares, but this factor is best analyzed during the valuation process.

Investing Retained Earnings

A company should retain its earnings if its rate of return on its investment is higher than the investor could earn on his own. Dividends should only be paid if they would be better employed in other companies. If the earnings are properly reinvested in the company, earnings should rise over time and stock price valuation will also rise to reflect the increasing value of the business.

An important factor in the desire to reinvest earnings is that the earnings are not subject to personal income taxes unless they are paid out in the form of dividends.

Buffett examines management’s use of retained earnings, looking for management that has proven it is able to employ retained earnings in the new moneymaking ventures, or for stock buybacks when they offer a greater return.

Good Return on Equity

Buffett seeks companies with above-average return on equity. Mary Buffett indicates that the average return on equity over the last 30 years has been around 12%. During the valuation process, this average should be checked against more current figures to assure that the past is still indicative of the future direction of the company. Our screen looks for average return on equity of 12% or greater over the last seven years.

Inflation Adjustments

Consumer monopolies can typically adjust their prices quickly to inflation without significant reductions in unit sales, since there is little price competition to keep prices in check. This factor is best applied through a qualitative examination of a company during the valuation stage.

Reinvesting Capital

In Buffett’s view, the real value of consumer monopolies is in their intangibles—for instance, brand-name loyalty, regulatory licenses, and patents. They do not have to rely heavily on investments in land, plant, and equipment, and often produce products that are low tech. Therefore, they tend to have large free cash flows (operating cash flow less dividends and capital expenditures) and low debt. Retained earnings must first go toward maintaining current operations at competitive levels. This is a factor that is also best examined at the time of the company valuation although a screen for relative levels of free cash flow might help to confirm a company’s status.

The above basic filters help to indicate whether the company is potentially a consumer monopoly and worthy of further analysis. However, stocks passing the screens are not automatic buys. The next test revolves around the issue of value.

The Price Is Right: Using the Buffett Valuation Spreadsheet

 The price that you pay for a stock determines the rate of return—the higher the initial price, the lower the overall return.  Likewise, the lower the initial price paid, the higher the return. Buffett first picks the business, and then lets the price of the company determine whether to purchase the firm. The goal is to buy an excellent company at a price that makes business sense. Valuation equates a company’s stock price to a relative benchmark. A $200 dollar per share stock may be cheap, while a $2 per share stock may be expensive.

Buffett uses a number of different methods to evaluate share price. Three techniques are highlighted in the “Buffettology” book and are used in the Buffett spreadsheet template (Figure 1). You can download the spreadsheet from at AAII Web site: www.aaii.com/ci/buffettology.xls.

Buffett prefers to concentrate his investments in a few strong companies that are priced well. He feels that diversification is used by investors to protect themselves from their stupidity.

Earnings Yield

Buffett treats earnings per share as the return on his investment, much like how a business owner views these types of profits. Buffett likes to compute the earnings yield (earnings per share divided by share price) because it presents a rate of return that can be compared quickly to other investments.

Buffett goes as far as to view stocks as bonds with variable yields, and their yields equate to the firm’s underlying earnings. The analysis is completely dependent upon the predictability and stability of the earnings, which explains the emphasis on earnings strength within the preliminary screens.

VCA Antech has an earnings yield of 6.5% [cell C13, computed by dividing the current (trailing 12 months) earnings per share of $1.56 (cell C9) by the closing price on May 15, 2009, of $24.04 (cell C8)]. Buffett likes to compare the company earnings yield to the long-term government bond yield. An earnings yield near the government bond yield is considered attractive. With government bonds yielding slightly more than 4% currently (cell C17), VCA compares very favorably. By paying $24 per share for VCA, an investor gets an earnings yield return greater than the interest yield on bonds. The bond interest is cash in hand but it is static, while the earnings of VCA Antech should grow over time and push the stock price up.

Historical Earnings Growth

Another method Buffett uses to value prospective stocks is to project the annual compound rate of return based on historical earnings per share increases. For example, earnings per share at VCA Antech have increased at a compound annual growth rate of 23.9% over the last five years (cell B30). If earnings per share increase for the next 10 years at this same growth rate of 23.9%, earnings per share in year 10 will be $13.34. [$1.56 × (1 + 0.239)10]. (Note this value is found in cell B47 and also in cell E37. Using a calculator, results may differ due to rounding.) This estimated earnings per share figure can then be multiplied by the five-year average price-earnings ratio of 25.0 (cell H10) to provide an estimate of price [$13.34 × 25.0 = $333.19]. (Note this value is found in cell E40.) While VCA does not pay a dividend, if a company you are valuing pays dividends an estimate of the amount of dividends paid over the 10-year period should also be added to the year 10 price. (Note that when evaluating dividend-paying stocks, this value is found in cell E41.)

Once this future price is estimated, projected rates of return can be determined over the 10-year period based on the current selling price of the stock. Buffett requires a return of at least 15%. For VCA Antech, comparing the projected total gain of $333.19 to the current price of $24.04 leads to a projected annual rate of return of 30.1% [($333.19 ÷ $24.04)1/10 – 1]. (Note this value is found in cell E43.)

Sustainable Growth

The third valuation method detailed in “Buffettology” is based upon the sustainable growth rate model. Buffett uses the average rate of return on equity (ROE) and average retention ratio (1 – average payout ratio) to calculate the sustainable growth rate [ROE × (1 – payout ratio)]. For companies that do not pay a dividend, the sustainable growth rate equals the return on equity.

The sustainable growth rate is used to calculate the book value per share (BVPS) in year 10 [BVPS × (1 + sustainable growth rate)10]. Earnings per share can then be estimated in year 10 by multiplying the average return on equity by the projected book value per share [ROE × BVPS].

To estimate the future price, you multiply the earnings per share by the average price-earnings ratio [EPS × P/E]. If dividends are paid, they can be added to the projected price to compute the total gain.

For example, VCA Antech’s sustainable growth rate, based on average five-year data, is 22.3% [22.3% × (1 – 0.0)]. (The sustainable growth rate is found in cell H11.) Again, since the company does not pay a dividend, its sustainable growth rate equals its return on equity. Thus, book value per share should grow at this rate to roughly $65.91 in 10 years [$8.81 × (1 + 0.223)10]. (Note this value is found in cell B62.) If return on equity remains 22.3% (cell H6), in the tenth year, earnings per share that year would be $14.69 [0.223 × $65.91]. (Note this value is found in cell C62 and also in cell E52.)

The estimated earnings per share can then be multiplied by the average price-earnings ratio to project the future price of $366.88 [$14.69 × 25.0]. (Note this value is located in cell E55.) If dividends have been paid, you would use an estimate of the amount of dividends paid over the 10-year period and add this to the projected price to arrive at the total gain. This total gain is then used to project the annual rate of return of 31.3% [(($366.88 + $0.00) ÷ $24.04)1/10 – 1]. (Note this return estimate is found in cell E58.)

Data Sources

For users of Stock Investor Pro, the projected returns based on the earnings growth rate and sustainable growth rate are already built into the program using seven-year data (found in the Valuations data category). For those who do not subscribe to Stock Investor Pro, all of the data you need to populate the Buffett valuation spreadsheet can be found in company 10-K reports, which are available on-line from numerous sources. You will have to search through multiple years, however, in order to get the six years of data required for this spreadsheet. Alternatively, the SmartMoney Web site (www.smartmoney.com) provides 10 years of financial statement data for free.

Conclusion

The Warren Buffett approach to investing makes use of “folly and discipline”: the discipline of the investor to identify excellent businesses and wait for the folly of the market to drive down the value of these businesses to attractive levels. Most investors have little trouble understanding Buffett’s philosophy. The approach encompasses many widely held investment principles. However, its successful implementation is dependent upon the dedication of the investor to learn and follow the principles.

http://www.aaii.com/computerized-investing/article/valuing-stocks-the-warren-buffett-way?forceFull

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http://www.learnoutloud.com/Results/Author/Mary-Buffett/993

Corporate Indonesia Is Most Bullish; HK the Least

Companies in Indonesia, Southeast Asia's largest economy, are the most optimistic in Asia, with almost 9 out of 10 firms expecting their businesses to improve in the third quarter of the year, while Hong Kong, whose open economy is increasingly tied to mainland China, is the most pessimistic, according to a quarterly survey conducted by Standard Chartered.

Indonesia is less dependent on exports and more reliant on domestic demand compared to its peers elsewhere in Asia, and its middle-class, along with per-capita income, is growing, the British bank said in the survey. These themes shield the country from weakness in demand in U.S., Europe and China, Asia's biggest export markets.

"The overall (global) economy is still very much focused on defensive mode," Clive McDonnell, Head of Equity Strategy, Standard Chartered, told CNBC Asia "Squawk Box" on Wednesday. "Yes, Indonesia does export quite a bit of coal to India and China so there are nuances there. Indonesia stands out from its North Asian peers because it is domestic-demand focused."

Because of this domestic demand, about 81 percent of Indonesian companies expect new orders to rise 10 percent in the current quarter, compared to a regional average of 66 percent, according to the survey. Eight out of 10 Indonesian firms also expect margins to improve, far higher than the average of 45 percent among respondents.

Conversely speaking, because of weakness in foreign markets as well as increasing reliance on domestic buying, demand has become the biggest concern in the region. Respondents worried this indicator jumped from to 26 percent from 4 percent in the previous quarter. Concerns about input costs fell as inflation moderated in the second quarter.

The most pessimistic respondents in the region were in Hong Kong, which is the most vulnerable to a slowdown in the global economy because trade makes up 223 percent of GDP . Respondents in Hong Kong expect to invest and hire less as growth opportunities decline. While they also forecast input costs to drop and hence margins to rise, they also think that a slowdown in China's economy would offset any benefit of a margin increase.

"The drop in Hong Kong's ranking to the market with the lowest corporate sentiment reflects a confluence of negative factors including the slowdown in mainland Chinese tourist arrivals and, in turn, the absence of their spending," Standard Chartered said in the report. "It may also reflect the slowdown in China's economic growth."

Unlike in Hong Kong, the domestic consumer should be able to prop up Indonesia, for which trade accounts for only 25 percent of the economy. Vishnu Varathan, Market Economist at Mizuho Corporate Bank in Singapore, agrees that the Indonesian consumer looks resilient now, but warns that risks are building for the Indonesian economy.

"I think people are getting a little bit more cautious. Credit growth has been very strong, but I don't know how sustainable these straight-line projections of consumption are," Varathan told CNBC. "Wage growth has actually not been keeping up with inflation and GDP growth."

For the second-quarter survey, Standard Chartered interviewed about 350 'C-level' executives across all markets and industry groups in Asia ex-Japan in June.

- By CNBC's Jean Chua.

http://finance.yahoo.com/news/corporate-indonesia-most-bullish-hong-033455755.html

The Roles Of Traders And Investors In The Marketplace

July 11 2012

Many people use the words "trading" and "investing" interchangeably when, in reality, they are two very different activities. While both traders and investors participate in the same marketplace, they perform two very different tasks using very different strategies. Both of these parties are necessary, however, for the market to function smoothly. This article will take a look at both parties and the strategies that they use to make a profit in the marketplace.

SEE: Passive Vs. Active Management

What Is an Investor?An investor is the market participant that the general public most often associates with the stock market. Investors are those who purchase shares of a company for the long term with the belief that the company has strong future prospects. Investors typically concern themselves with two things:

• Value - Investors must consider whether a company's shares represent a good value. For example, if two similar companies are trading at different earnings multiples, the lower one might be the better value because it suggests that the investor will need to pay less for $1 of earnings when investing in Company A relative to what would be needed to gain exposure to $1 of earnings in Company B.
• Success - Investors must measure the company's future success by looking at its financial strength and evaluating its future cash flows. 

Both of these factors can be determined through the analysis of the company's financial statements along with a look at industry trends that may define future growth prospects. At a basic level, investors can measure the current value of a company relative to its future growth possibilities by looking at metrics such as the PEG ratio- that is, the company's P/E (value) to growth (success) ratio.

SEE: PEG Ratio Nails Down Value Stocks

Who Are the Major Investors?There are many different investors that are active in the marketplace. In fact, the vast majority of the money that is at work in the markets belongs to investors (not to be confused with the amount of dollars traded per day, which is a record held by the traders). Major investors include:

• Investment Banks - Investment banks are the organizations that assist companies in going public and raising money. This often involves holding at least a portion of the securities over the long term.
• Mutual Funds - Many individuals keep their money in mutual funds, which make long-term investments in companies that meet specific criteria. Mutual funds are required by law to act as investors, not traders.
• Institutional Investors - These are large organizations or persons that hold large stakes in companies. Institutional investors often include company insiders, competitors hedging themselves and special opportunity investors.
• Retail Investors - Retail investors are individuals that invest in the stock market for their personal accounts. At first, the influence of retail traders may seem small, but as time passes more people are taking control of their portfolios and, as a result, the influence of this group is increasing. 

SEE: Institutional Investors And Fundamentals: What's The Link?

All of these parties are looking to hold positions for the long term in an effort to stick with the company while continuing to be successful. Warren Buffett's success is a testament to the viability of this strategy.

What Is a Trader?Traders are market participants who purchase shares in a company with a focus on the market itself rather than the company's fundamentals. Markets that trade commodities lend themselves well to traders. After all, very few people purchase wheat because of its fundamental quality - they do so to take advantage of small price movements that occur as a result of supply and demand. Traders typically concern themselves with:

• Price Patterns - Traders will look at the price history in an attempt to predict future price movements, which is known as technical analysis.
• Supply and Demand - Traders keep close watch on their trades intraday to see where the money is moving and why.
• Market Emotion - Traders play on the fears of investors through techniques like fading, where they will bet against the crowd after a large move takes place.
• Client Services - Market makers (one of the largest types of traders) are actually hired by their clients to provide liquidity through rapid trading. 

Ultimately, it is traders that provide the liquidity for investors and always take the other end of their trades. Whether it is through market making or fading, traders are a necessary part of the marketplace.

SEE: What Can Traders Learn From Investors?

Who Are the Major Traders?When it comes to volume, traders have investors beat by a long shot. There are many different types of traders that can trade as often as every few seconds. Among the most popular types of traders are:

• Investment Banks - The shares that are not kept for long-term investment are sold. During the initial public offering process, investment banks are responsible for selling the company's stock in the open market through trading.
• Market Makers - These are groups responsible for providing liquidity in the marketplace. Profit is made through the bid-ask spread along with fees charged to the clients. Ultimately, this group provides liquidity for all the marketplaces.
• Arbitrage Funds - Arbitrage funds are the groups that quickly move in on market inefficiencies. For example, shortly after a merger is announced, stocks always quickly move to the new buyout price minus the risk premium. These trades are executed by arbitrage funds.
• Proprietary Traders/Firms - Proprietary traders are hired by firms to make money through short-term trading. They use proprietary trading systems and other techniques in an attempt to make more money by compounding the short-term gains than can be made by long-term investing. 

The Bottom LineClearly, both traders and investors are necessary in order for a market to function properly. Without traders, investors would have no liquidity through which to buy and sell shares. Without investors, traders would have no basis from which to buy and sell. Combined, the two groups form the financial markets as we know them today.

Read more: http://www.investopedia.com/articles/basics/07/trading_investing.asp#ixzz20KcDub4Q