Historical Results and Commentary
August 11, 2005
Holdings
|
|
Aug-05 |
|
1 |
F |
|
2 |
NBG |
|
3 |
YHOO |
|
4 |
NKE |
|
5 |
BA |
|
6 |
VRSN |
|
7 |
SNP |
|
8 |
CAT |
|
9 |
JNJ |
|
10 |
C |
|
11 |
CA |
|
12 |
FNF |
|
13 |
MWD |
|
14 |
TKC |
|
15 |
HMC |
|
16 |
CRYP |
|
17 |
X |
|
18 |
AAPL |
|
19 |
COP |
|
20 |
ACH |
Performance of Individual Stocks For last 3 months:
|
Aug-05 |
|
|
FNF |
15.09% |
|
COP |
26.66% |
|
CAT |
22.68% |
|
NKE |
5.60% |
|
BA |
11.86% |
|
VRSN |
-14.88% |
|
SNP |
20.62% |
|
YHOO |
0.17% |
|
JNJ |
-4.89% |
|
NSM |
23.61% |
|
CA |
-2.59% |
|
F |
8.43% |
|
MWD |
8.88% |
|
TKC |
2.89% |
|
HMC |
7.29% |
|
CRYP |
-39.29% |
|
X |
6.64% |
|
AAPL |
23.56% |
|
NBG |
17.43% |
|
ACH |
16.45% |
Total Increase (Decrease) since last quarter: 7.81%
Additions: C
Subtractions: NSM
Commentary: First of all, a friend showed me how to set up a web counter on the front page, so I can finally see how many people are reading this thing.
Over the past five and a half years I have learned a lot from the stock market through maintaining this website. However, I don’t yet feel that I have formed a consistent and coherent strategy for acquiring stocks. In a previous commentary I posited the strategy of asset substitution as being the guiding principle for portfolio management, but although this is a great theoretical framework, it doesn’t seem to work all that well in real life because it is so difficult. This quarter I have spent a lot of time thinking and researching different strategies for evaluating stocks. The following is heavily based on the work of Benjamin Graham and much is borrowed from his landmark work The Intelligent Investor. So, read on, and if you have suggestions for how I can improve this, please email me!
Stock Acquisition Principles From A Value Perspective
Clearly this is a website dedicated to value investing. However, for anyone who has been following this portfolio, it is obvious that sometimes I have tried to make timing plays that don’t have a solid foundation in value. Examples include CA, VRSN, and JDSU, all of which failed. However, stocks such as YHOO, NSM, TKC, and even X were all very successful picks. Was this just dumb luck, or lack thereof? Perhaps. However, I feel that the strategy of value investing which I am about to describe is more useful at certain points in a market’s evolution than in others. If the evolution of a market can be approximated by a sine curve tweaked upwards by some linear factor and then randomized somewhat, then a value strategy is the best strategy to have in the mature part of such a cycle, where valuations are becoming over-inflated, or during the corresponding correction. However, during the initial period, right after such a correction, it may make sense to invest in cyclical stocks with low or negative earnings, or stocks that have recently fallen out of favor but still have a high probability of rebounding. This is because a discounted cash flow valuation model that lacks sufficient historical perspective will place too much weight on recent low earnings rather than treating them as a cyclical blip. Since Wall Street thinks in such a fashion, this presents a great opportunity to jump in and acquire such securities that are well poised to have an equally dramatic ascent once earnings start to rise again. In other words, value investing is a good strategy when asset prices are high, but when they are cheap, it may be more profitable to temporarily employ a cyclical strategy.
Basic Strategic Principles
The mantra of value investing is the margin of safety. This means that acceptable investments are those made in quality companies that are trading at bargain (or at least reasonable) prices relative to the net asset value of the company. The basic strategy of value investing is that of making diversified bets on the performance of companies that meet this criteria over a time scale that is longer than the average professional investor cares about, or needs to care about. For the average investor, diversification means a portfolio of stocks in various sectors (and, increasingly, in various global markets). The actual number of stocks to own varies depending on an individual’s financial resources, existing sources of income, and assets,[1] but a good number might be 20-30 stocks. Since every portfolio requires a consistent effort in maintaining and updating it, an amateur investor’s portfolio is partially constrained by the amount of time that will be devoted to researching companies.
When purchasing a stock you are buying an equity stake in a company, essentially becoming a part-owner of the company as one of its shareholders. Stock acquisition needs to be based on the following question: given ample resources, would you purchase the entire company of which you intend to buy shares at the price currently offered by the market? If and only if the answer is yes to this question should an acquisition be made.[2] Although an investor is only purchasing a small fraction of the total available shares in a company, he or she is paying a proportionally smaller price for these shares. Therefore, pretending if one would buy the full company is a good way of deciding whether or not one would pay a proportionally smaller price for a proportionally smaller fraction of the total available shares in that company (it also lets you pretend that you are really really rich ;) ).
The fundamental principle in value investing is the ‘margin of safety.’ Securities should be acquired so as to minimize exposure to the two major classes of risk: speculative risk and economic/business risk. It is much easier to minimize the former than the latter, but both components require careful consideration before a purchase can be made. This process can be divided into two basic processes: first selecting solid companies and then within this subset of companies selecting attractive stocks.
The Evaluation of Companies
All companies are faced with the risk that they will go out of business or suffer serious and prolonged negative results. There are several factors that impact this sort of risk, including technological changes, the competitive environment, regulatory changes, the macroeconomic situation, and the effectiveness or incompetence of management. All companies will face hard times – but some are better positioned to emerge successfully from these gloomy spells while others have lower odds of surviving a nasty downturn in business conditions.
The following conditions allow for some degree of individual interpretation, as their exact definitions can vary depending on the market, sector, and epoch an investor is studying. However, these are the basic criteria for good companies from a conservative and defensive value investing standpoint, as espoused by Benjamin Graham.
The Evaluation of Stocks
The evaluation of stocks is essentially the evaluation of current market prices within the subset of companies that meet the criteria listed above. Once one has found quality, as defined above, one then needs to see if it can be obtained for a reasonable price. There are three major factors that contribute to the current price of a stock and need to be looked at when evaluating price. Listed in order of importance they are:
All three of these factors play a role in determining the price of each and every stock. However, it is often the case that for certain types of stocks, one of these three factors plays a disproportionately important role in influencing the price of a stock.
It is also worth noting that the short-term movements of stock prices are primarily driven by changes in earnings and growth information. As a result, they receive a disproportionate amount of news coverage and attention from the investment community. Since the net value of assets changes much more slowly, it is not as widely talked about. However, it is the most important figure to look at.
Net Asset Value
Paying $60 for something worth $100 is the classic definition of a bargain, while someone paying $100 for something worth $60 is the classic definition of a sucker. The net asset value of a stock, sometimes also called its ‘book value,’ is the simplest form of value to understand. Net asset value is all of a firm’s assets minus all of a firm’s liabilities. For our purposes, tangible book value is more important than book value, as certain ‘intangible’ assets can be included to inflate a company’s asset base. For this computation, soft asset classes such as goodwill and intangible assets are ignored, since they usually have no real value in the marketplace. Net tangible assets is the most important valuation criterion from the perspective of a value investor, since it represents the tangible items of value to which a stockholder has claims5.
To some extent, anything trading at a price above tangible book value is a bad deal from the perspective of the value investor, and many things trading at a price less than tangible book value are a bargain. In other words, if one were to purchase all the shares in a company, then turn around and liquidate all the company’s assets and pay off all of its liabilities, would he or she end up with more money than the purchase price? If the answer is yes, this is a bargain, if the answer is no, there needs to be a compelling reason why someone would want to purchase this company (or a small stake in this company). This compelling reason often comes from earnings.
Earnings
Most stocks trade at market capitalization above their tangible book value because most companies make money. This is an easy concept to understand. For example, if geese were selling for $20 a goose at the market, I would be inclined to buy a goose at any price less than $20 dollars, knowing I could always sell it at market for a profit. However, if I could find a goose that laid a golden egg once every week, I would probably pay much more than $20 dollars for this goose. In this case, the value of the goose would basically be the $20 I could get for the goose at the market, plus the value of all the eggs it would produce over its lifetime.
The price of companies is affected in much the same way that the gold-egg-bearing-capacity of a goose would affect the price one would pay for it. A shareholder benefits from earnings, either by directly receiving dividend payouts or by seeing the money reinvested into the company, thereby improving the value of its assets (and thereby the company’s book value and the value of the equity stake each shareholder owns).
Investors can use a company’s ratio of price to earnings (called the P/E ratio) to quantify the rate of return on an investment. Essentially, a company with a P/E ratio of 20 will ‘payout’ 5% per year whereas a company with a P/E ratio of 40 will ‘payout’ 2.5% per year. These ‘payouts’ are a combination of direct dividend payouts and reinvested earnings that improve the value of a shareholder’s claims on the company.
Probably the single biggest mistake that amateur value
investors make is to not understand the difference between reported earnings
and true earnings. Legions of
accountants make their living by playing around with company earnings for a
variety of reasons. In the
[1] A person’s place of employment or skill sets should be taken into account when assessing and refining one’s stock portfolio. For example, a person working at a chemical company already has significant exposure to the chemical industry (because his or her paycheck depends on this industry). Furthermore, a homeowner already has significant exposure to the regional economy where they live, as their house price may depend greatly on the local economic situation.
2 This analogy is not quite perfect. If an investor were to purchase an entire company, he or she would probably gain control over management decisions, which could impact the performance and value of the company. Obviously, the amateur investor has a limited ability to impact the management of the companies he or she owns stocks in.
3The use of debt capital to expand business is something I have thought about a lot, especially in these periods of low interest rates. If a company has a return on debt capital that is much higher than the interest payments on such loans, then perhaps it would be prudent to increase financial leverage above the 110% ceiling. Also, if equity capital is especially expensive for a company to issue (ie the stock is currently undervalued), then shifting the capital composition towards debt could make sense. So, debt needs to be looked at in terms of growth and the cost of equity financing.
4The emphasis here is on a moderate level of growth, not a high level. Of course, high growth rates are spectacular, but they tend to be accompanied by a high speculative component in the stock’s price. If a solid high growth company can be found, then it should be watched until growth rates start to fall. This inevitable fall should be accompanied by a spectacular decline in price, since the exponential projections of most discounted cash flow valuation models will cause the stock price to tumble once growth rates falter. Then, perhaps, the stock could be considered a good buy.
5Properly defining ‘Net Asset Value’ can be tricky, and I don’t claim to be very good at this. One can try to value things that don’t show up in balance sheets such as brands, research assets, or political capital from governmental ties. It’s a lot of fun to play around with these numbers, so I encourage other enterprising investors out there to give it a shot.
Back to Quarterly Commentaries
Historical Results and Commentary
[1] A person’s place of employment or skill sets should be taken into account when assessing and refining one’s stock portfolio. For example, a person working at a chemical company already has significant exposure to the chemical industry (because his or her paycheck depends on this industry). Furthermore, a homeowner already has significant exposure to the regional economy where they live, as their house price may depend greatly on the local economic situation.
[2] This analogy is not quite perfect. If an investor were to purchase an entire company, he or she would probably gain control over management decisions, which could impact the performance and value of the company. Obviously, the amateur investor has a limited ability to impact the management of the companies he or she owns stocks in.