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