Category Archives: Value Investing

The Graham Ratio and Application

The core of value investing is to obtain an investment for less than its worth. Professional investors will typically focus on the price to earnings (P/E) ratio which compares the current share price with its per share earnings. Although this is a good gauge, more than one ratio should be considered when assessing an investment. Students of value investing should also be familiar with price to book (P/B) ratio. This ratio (P/B) compares the current share price to the current shareholder equity.

In the book The Intelligent Investor, Benjamin Graham highlights a key concept which combined the two ratios [P/E and P/B] as a gauge on the valuation of a company. These combined ratios are known as the Graham ratio. The computation is elementary, simply multiply the P/E ratio with the P/B ratio. If the product is less than 22.5, the company may be of good value. This thesis is highlighted in Chapter 14 – Stock Selection for the Defensive Investor of The Intelligent Investor. We find this concept to be so compelling that we've decided to back test this ratio against our watch lists from 2012. Continue reading

Dow Theory: Buying in Scales

Reader J.P. asks:

“What is your recommendation for taking a position.  All in, or 1/2 in and average up or down. I can't find anything on this on the website.”

Our Response:

Continue reading

Investing in Foreign & Emerging Stock Markets

Subscriber R.G. asks:

“If emerging markets possess such a gambit due to their lack of similar history in the past how can we analyze the markets in order to capitalize on their surges of demand which quickly taper[s] off?”

Our general view on foreign and emerging markets is similar to that of Warren Buffett’s when he said:

“'If I can't make money in the $4 trillion US market, I shouldn't be in this business. I get $150 million earnings pass-through from the operations of Gillette and Coca-Cola. That's my international portfolio’ (source: Ellis, Charles D. Wall Street People. page 56. link here.)”

There seems to be little need to invest in foreign or emerging markets.  However, if there is a desire to invest in foreign markets then Dow Theory provides a reasonable template for how to approach investing in such a market.  In a section titled “Dow's Theory True of Any Stock Market,” William Peter Hamilton says the following:

“The law which governs the movement of the stock market, formulated here, would be equally true of the London Stock Exchange, the Paris Bourse or even the Berlin Boerse. But we may go further. The principles underlying that law would be true if those Stock Exchanges and ours were wiped out of existence. They would come into operation again, automatically and inevitably, with the re-establishment of a free market in securities in any great capital. So far as, I know, there has not been a record corresponding to the Dow-Jones averages kept by any of the London financial publications. But the stock market there would have the same quality of forecast which the New York market has if similar data were available. (source: Hamilton, William Peter. Stock Market Barometer. Harper & Brothers Publishers, New York. page 14. link here.)”

When we speak of Dow Theory, we are referring to the emphasis of values, fundamentals in relation to price as they pertain to individual stocks and the stock market.  We are putting less emphasis on the strict technical analysis of the equivalent industrial and transportation indexes. 

To be clear, because we live in the United States we emphasize investing in the U.S.  However, according to Hamilton, it does not matter which country that you’re in, investors should embrace the comparative advantage of living in a country other than the United States and should become experts of value opportunities in that region.

Virgin Media Gets An Offer and Other Important Lessons

On February 5, 2013, Virgin Media (VMED) was given a buyout offer at $47.87 per share by Liberty Global (LBTYA).  Virgin Media is already a member of the Nasdaq 100 Index while Liberty Global was recently added  to the same index on December 14, 2012 (see Nasdaq 100 re-rank here).

Virgin Media was featured in our Nasdaq 100 Watch List Summary section on December 16, 2011 (found here).  Our worst case scenario for the stock was that it might trade as low as $13.28, it never came to be.  In fact, VMED never traded lower and has subsequently gained as much as +117%.

image

There are a couple of important observations about fundamentals that need to be addressed.  First, there weren’t any offers for VMED at the December 2011 low. This suggests that many corporations either cannot identify values at the low or that they are willing to pay nearly twice the price in the name of a “good values.”

According to Liberty Global’s President and CEO, “adding Virgin Media to our large and growing European operations is a natural extension of the value creation strategy we've been successfully using for over seven years.”  As much as the CEO of LBTYA talks of the value that VMED will provide, the chart below suggests that this was an ill-timed purchase or could have taken place at a better point in time.

 image

The chart above shows a time range from December 16, 2010 to the present.  What the chart indicates is that the best time to buy out Virgin Media was on May 15, 2012. At that time, LBTYA shares were at their height compared to VMED, as LBTYA was trading at more than 2 times the price of VMED. Alternatively, LBTYA could have made a similar deal at multiple points before December 2011.

Today, Liberty Global is only buying VMED at 1 ½ times the February 5, 2013 closing price, which is no bargain.  Making an offer for VMED on May 15, 2012 could have saved current shareholders of LBTYA a significant amount of dilution in the stock, as Liberty is going to issue at least 151 million shares to acquire Virgin Media.

Another issue that is worth pointing out is the all too popular valuation metric known as price-to-earnings ratio (definition here). When Virgin Media was on our Nasdaq 100 Watch List on December 16, 2011, the stock was trading at $20.95 with a P/E ratio of 67.58.  Today, Virgin Media trades at a P/E ratio of 33, or exactly half of what the stock traded at when the stock was within 1% of the 1-year low.  This epitomizes the mixed signal that P/E ratios generate for fundamental investors seeking to identify quality companies as indicated in our article titled “P-E Ratios: Lesson From Conflicting Indications”.

In light of the offer made by Liberty, we’d like to remind you to get your scorecards out because there are going to be at least two new additions to the Nasdaq 100 with the possible departure of Dell (DELL) and Virgin Media (VMED). Look for Netflix (NFLX) to be one of the two stocks added to the Nasdaq 100 index as the stock is twice the price that it was when it was booted from the Nasdaq 100 Index in December 2012, less than two months ago.

Seth Klarman Review: Margin of Safety-Introduction

The following is a line for line analysis of Seth Klarman's book Margin of Safety.  we're providing the concept or idea that we think is being conveyed followed by the quote and page where you can find the citation.  Additionally, we follow-up with our thoughts on the concept.  We hope to review the complete book one chapter at a time.

According to GuruFocus.com, "Seth Klarman is a value investor and Portfolio Manager of the investment partnership The Baupost Group. Founded in 1983, The Baupost Group now manages $7 billion, and has averaged returns of nearly 20% annually since their inception. Seth Klarman is the author of the book "Margin of Safety" which sells for over $1000."

Introduction
  • Where investors go wrong
    • "Avoiding where others go wrong is an important step in achieving investment success. In fact, it almost ensures it.” p. xiii
        • In order to know where investors go wrong a person must first determine where and when the biggest mistakes have been made. Examining history and market tops, along with subsequent declines, help an investor to see the errors that were made right before the errors were fully revealed. In addition, the best assessments of a market decline are done afterwards as well. Hence, books like Security Analysis that followed the Crash and Depression of 1929.
  • Risk/Reward
    • Before you can focus on the remote possibility of rewards the market has to offer, you must first focus on the probability of risk of loss. p.xiii
        • No amount of stock market analysis is worth pursing if an assessment of loss, with the expectation of at least 50% loss, is not part of the equation.
  • Margin of Safety
    • Value investors should always allow “…room for imprecision, bad luck, or analytical error in order to avoid sizable losses over time.” p.xiv
        • Margin of safety means that the stock analyst expects to be wrong about their assessment and wouldn’t panic when the company that they’ve “invested” in doesn’t perform as planned.
  • The Ignorance of Indexing
    • …Indexing strategies [are] designed to avoid significant underperformance at the cost of assured mediocrity.” p. xv
        • Being categorically against indexing of all sorts, either through ETFs, Index Funds or mutual funds, it is quite apropos that Klarman would say this.
  • Know the Rationale of the Rules
    • …observing a few rules isn’t enough. Too many things change too quickly in the investment world for that approach to work [following some simple rules]. It is necessary instead to understand the rationale behind the rule in order to appreciate why they work when they do and don’t when they don’t.” Understanding the rationale behind the rules ensures success. p. xv
        • In order to really understand the rule and the premise behind them an appreciation of history is required. Such an appreciation is not for the purpose of linking disparate events together. Instead, the purpose is to learn the underlying actions and reactions that create the market rules we’re forced to adhere to today.
  • Buy Low and a lot, Sell High and buy very little
    • When prices are high risk very little capital, when prices are low risk a large amount of capital. p. xvi
        • Our allocation model states that we only buy, at the most, 5 companies when fully invested. We only buy after reviewing stocks that have reached a new low and have been thoroughly assessed. We only target the companies that have increased their dividend every year for a minimum 10 years in a row or are quality companies that are a part of required mutual fund purchases, like Nasdaq 100 stocks.
  • Avoid Market Fads (i.e. investment products)
    • The important point is not merely that junk bonds were flawed (although they certainly were) but that investors must learn from this very avoidable debacle to escape the next enticing market fad that will inevitably come along." Avoid market fads and fashions. p. xvii
        • Yield chasing and investing out of convenience ultimately doesn’t end nicely. Right now the current fad is towards stocks and funds that pay high yields. Inevitably, Wall Street will provide or create products that meet the highest demand. This will result in exceptional yields with exceptional risk. Another market fad that has existed for a long time is the belief in mutual funds and related products (ETFs, index funds, etc). These are instruments of convenience that takes the investor away from learning as they invest. The cumulative effect is that those who participate in instruments of convenience don’t accrue the “true” knowledge necessary to succeed in investing which makes them ripe for falling for the latest fad.
  • Speculation equals Opportunities
    • Speculators “…actions often inadvertently result in the creation of opportunities for value investors.” p. xvii
        • Speculators are often seen as the scrouges of the financial markets who create mayhem on whatever product they touch. However, successful speculators, of which there are few, usually quit while they’re ahead. Unsuccessful speculators, of which there are many, overreach and lose big or lose small frequently enough that the result is the same either way. The loses incurred by speculators ultimately result in the sale or disposition of assets at or below value. Value investors should be alarmed when they hear politicians clamoring for blood at the hands of speculators because many investment opportunities are created at the hands of willing sellers, typically speculators.
  • Rapid Rise and Fall
    • The rapid rise and fall of prices on a daily basis cannot possibly reflect the change in earnings on a quarterly basis. p. xviii
      • What seems most interesting is that some stocks fall in price as though there was a loss in quarterly earnings. A loss in earnings isn’t the same as earning less than expected. Some amusement is garnered from watching “investors” sell a stock simply because the company didn’t earn as much as expected. In certain instances, the rapid decline of a stock may present an opportunity to buy a stock at a reasonable price.

 Margin of Safety-Chapter 1

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Robert Rodriguez Review: September 1994

One person that the New Low Observer team truly admires in the world of investing is Robert Rodriguez. Mr. Rodriguez had an investment strategy that is very close to the approach that we have employed by examining quality stocks near a new low. The beauty of Rodriguez’s work is that he has an unparalleled investment record in the realm of small and mid-cap companies. From my perspective, there are so many challenges working against companies with a market capitalization of $1 billion or less. However, Rodriguez made it look easy even though we’re certain that it wasn’t. According to GuruFocus, during his time as the manager of the FPA Capital funds, Rodriguez “…has achieved an annualized return of 16.91% as of 9/30/2007. In the same period S&P 500 has returned 13.17% annually.”  (related FPA performance data)

In the Letter to Shareholders dated September 30, 1994 (PDF), Rodriguez says a couple of things that I feel are worth repeating. In the first excerpt, Rodriguez compares the market declines of 1987, 1990 and 1994. Rodriguez speculates as to the reasons why 1994 was different from 1987 and 1990. He mentioned that in 1987 the stock market crash was due to computer selling while in 1990 the prospect of war became a reality.
In 1987, Rodriguez thought that the ability to make the decision to sell stocks was easy. The unfamiliarity of computer selling made the choice to sell academic. Likewise, the prospect of war in 1990 was clearly bad so selling stocks wasn’t an issue for average investors.

According to Rodriguez, 1994 was different because of the following:
The Fed has shifted to a tighter monetary policy. Interest rates are rising while inflation fears are growing. Will these factors lead to a possible recession in 1995? All are situations that most investors have faced before; therefore, they have created a longer period of investor uncertainty.
This leads Rodriguez to conclude:
In this type of an environment, an individual stock’s characteristics tend to play a greater role than any one single event. Stock picking has a potentially higher probability of being a successful strategy and this is where we feel our strength lies.
My thoughts are that when compared to a market crash or a war, the prospect of a recession is a 50/50 proposition. This causes investors to waver as to whether they should buy or sell stocks. Undecided investors cause the market to become range bound allowing for companies to collect earnings that, in turn, builds value into the price of the stock creating unique value opportunities. This is not unlike the current investment environment where there market has fluctuated in a range due to the agonizing over the threat of a “double dip” recession. Whether a recession materializes, occurring shortly after a small uptick, is a topic for another day.

Rodriguez ends the September 1994 Letter to Shareholders with a quote that can’t be beat:

Thank goodness we focus on individual stocks rather than trying to forecast the stock market. The former is far more rewarding and predictable.
This last quote by Rodriguez explains why the New Low Observer team places so much emphasis on individual stocks rather than mutual funds, index funds and ETFs. With all of the aforementioned products, if a selling spree ensues, the fund can decline despite the quality of the holdings.
  • Hand wringing over the threat of recessions helps to create value in the market.
  • Individual stocks, not funds, have a greater probability of generating higher investment returns.

Correction to Graham Rule

I'd like to make a correction to my earlier mistake on calculating one of the Graham Rule. On May 14th watch list, I said that "I ran a new filter through this list using Graham rule of earning yield being higher than twice the long-term rate which I use 10 years T-bill."  This isn't the case.

The correct method as posted on an article "Benjamin Graham's Stock Selection Criteria" is for an earning yield at least twice the AAA yield (which can be found under market data on our side bar).

Based on that one criteria, the following five companies (from May 14th) past the test.

Symbol Name Earning Yield
LLY Eli Lilly & Co. 11%
GS Goldman Sachs Group 17%
HCC HCC Insurance Holdings 12%
SVU SUPERVALU INC 14%
MRK Merck & Co., Inc 14%

The AAA yield at the end of April 2010 is 5.29%. Any company with earning yield exceeding 10.58% would qualify under this rule.

This is just one of many rules Graham set. Many other look at the balance sheet for companies' viability if worse case hit. I'll be doing a study on the Dow 30 to see how well the Blue Chip fit into this model. - Art

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Benjamin Graham’s Stock Selection Criteria

A reader asked, "On Friday May 21, 2010 post, you mentioned 10 criteria that Ben Graham used for investing. How do I find them?"  You can find Graham's criteria from a research paper titled "A Test of Ben Graham's Stock Selection Criteria".

Here are the 10 criteria:

  1. An earnings-to-price yield at least twice the AAA bond yield.
  2. A price-earnings ratio less than 40 percent of the highest price-earnings ratio the stock had over the past five years.
  3. A dividend yield of at least two-thirds the AAA bond yield.
  4. Stock price below two-thirds of tangible book value per share.
  5. Stock price two-thirds “net current asset value.”
  6. Total debt less than book value.
  7. Current ratio greater than two.
  8. Total debt less than twice “net current asset value.”
  9. Earnings growth of prior ten years at least 7 percent on an annual basis.
  10. Stability of growth of earnings in that no more than two declines of 5 percent or more in the prior 10 years.
How well do these criterion work? I have yet to test this method myself, so I can only reference them to someone who has. This article highlight some of the findings. We urge anyone who is not familiar with the Ben Graham approach to value investing to pick up these two books, The Intelligent Investor and Security Analysis.  We will attempt to use some of these criteria and apply them to our watch list. - Art
Sources:
  • Klerck WG and Maritz AC, 1997, "A test of Graham's stock selection criteria on industrial shares traded on the JSE," Investment Analysts Journal, 45:25-33.
  • Graham M and Uliana E, 2001, "Evidence of a Value-Growth Phenomenon on the Johannesburg Stock Exchange," Investment Analysts Journal, 53:7-18.
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