In two recent posts I discussed my views on current stock market valuation, and observed that stocks are currently priced at previous peak levels, supported by extraordinary (and abnormal in economic terms) interventionist monetary policy and temporarily and artificially inflated profit margins. As such, I concluded that this is a dangerous market, wrought with pitfalls for the investor that pays little heed to long-term measures of valuation and corporate fundamentals.
Yet at the same time, despite such rich valuations, I believe that highly selective and intelligent investment in stocks offers the best means for me to grow my investment capital at an acceptable rate over the long-term, while also preserving the absolute value and purchasing power of my capital. I come to this realisation by simply looking at the alternatives available to me - Irish bank deposit savings rates of c. 3% (before DIRT tax of 33%!) and fixed income investments at record low yields, which are in fact negative in real terms on short-dated issues, and just about keeping pace with local inflation at longer maturity issues. In such an environment then, there is no real return to be earned on cash deposits or fixed income - the best possible "return" available is simply return of capital, rather than any actual return on capital. So while this may allow me to preserve capital (just about), it will not allow me to grow it over time. And so I must look to certain areas of the stock market to achieve my personal investment objectives.
Having made the decision that investing in stocks is the optimum way to achieve my investment goals at present, I am on the look-out to acquire a share in businesses that meet specific "value" criteria. As a brief reminder to help me to focus on the task at hand, in following the value investing tradition, I am looking for undervalued securities of businesses that are undervalued in the sense that they have been erroneously mispriced by the market for a variety of reasons. If these represent attractive investment opportunities, why might they be undervalued in the first place? In my view, there are two broad reasons for good investments becoming undervalued:
- Out of favour: a company may fall out of favour with the market, for reasons such as its securities are sold-off excessively given temporary, adverse news-flow about the company of sector (e.g. a quarterly EPS announcement "miss"), or that is not a "hot stock" (think anything Apple, or smartphone related during 2011/2012, or the more extreme "dot.com" bubble of the late 1990's). Of course the challenge in assessing an out-of-favour business is determining whether the sell-off and subsequent mis-pricing is attributable to a temporary or permanent difficulty or issue facing the company in question. Frequently, the market misunderstands this, leading to a value opportunity.
- Ignored: similar to the out-of-favour scenario, often times a business is mispriced by the market due to the simple fact that it has been ignored, in the sense that no analysts are following it - essentially, the market is ignorant of the potential opportunity. Typically, businesses in this category are small-cap issues, and given the lack of coverage, knowledge and understanding of the business, it resides in a "hidden corner" of the market, resulting in mispricing.
To my mind then, value investing makes sense as the most prudent strategy for investors wishing to protect principal and earn an adequate real return on their capital. Furthermore, in an expensive market such as the current one, I believe this especially holds true - however the difficulty in this rising market is that undervalued investment opportunities have become that bit rarer. The challenge then is to patiently identify those mispriced shares of businesses (or if suitable, other securities within their capital structures) that offer a value opportunity, using the margin of safety principle.
As I commence my investment programme, and being very cognisant of current near-peak stock market valuations, there are in my view three broad categories that offer the best opportunity for me to achieve my investment objectives (safety of principal, adequate return, compounding over the long-term). These three categories are as follows:
- Deep value
- Quality value
- Special situations
As I commence my investment programme I believe a deep value strategy affords the best opportunity for me to earn a satisfactory return while preserving my capital. By deep value I mean those businesses trading in the market at less than their liquidation or realisable cost, and which meet certain strict criteria. The pricing of businesses in this way is clearly illogical, as almost by definition we can know with a fair degree of certainty (something which can rarely be said in investing) that shares of such businesses are available for purchase at values less than they are actually worth, by reference to the realisable values of their underlying assets, i.e. they are bargain issues, or "cigar butts" in Graham parlance. The margin of safety resides in the discount to underlying asset value here. Additionally, bargain priced stocks often tend to lie in those hidden corners of the market, are frequently small-cap issues, and almost routinely are out-of-favour and unloved. In the present richly priced market then, seeking out and taking advantage of such opportunities seems a more sensible and promising prospect than chasing fairly priced businesses that have already been lifted as part of the significant rally in stock prices since March 2009. This deep value approach helps to reinforce the margin of safety principle.
An example of a potential deep value stock at present is Emerson Radio Corporation (MSN). This company has appeared on my own bargain-issue stock screen frequently in recent times, and from initial analysis appears to satisfy the core tenets of a deep value approach; for example it is not widely followed, being a micro-cap stock, and there are a number of clearly negative issues facing the company resulting in a depressed valuation (e.g. governance issues, litigation, loss of a significant customer). But being such an obviously unloved business based on its current market price, it may offer a compelling investment opportunity - at its current price of $1.65, it is trading at c. 30% discount to its Net Current Asset Value based on my own preliminary analysis, its cash balance of $58 million represents 130% of its current market cap of $45 million, and it is operating cash flow-positive over the 9 month period to 31 December 2012, so cash burn is not an immediate concern (although it may be in the future). On this basis I believe this company warrants further inspection and I will post further detailed analysis in due course.
"Quality value" is the label I use to refer to "Buffett-type" businesses, that is, companies with similar characteristics to those that Warrant Buffett sought out in the post-Buffett Partnership, Berkshire Hathaway building phase of his career. Quality-value opportunities essentially combine the prudent, value-focused principles of Graham with the more forward-looking growth-oriented concepts espoused by Philip Fisher inCommon Stocks and Uncommon Profits. Buffett's investment in Coca-Cola (KO) is perhaps the best example of quality value; when Buffett first purchased shares in Coca-Cola in 1988, its shares were priced at c. 15x earnings, not a bargain price, nor a low-multiple (in fact more indicative of a fair value multiple for a large, blue-chip business). So where was the value in this instance? The value resided in the qualityof the business, namely its consistency in terms of returns on capital and its favourable long-term prospects, which Buffett believed would result in the company being able to grow in value over time. This meant that Buffett was able to invest in a business at a price that was at an attractive discount to his reasonable estimate of its intrinsic value.
I am also conscious that my view of quality-value businesses should not simply be a coat-tailing of Buffett's (or any other successful investor's) investments however. In his profile of Michael Burry in The Big Short, Michael Lewis noted that if Buffett's track record has taught us anything, it is that to succeed in a spectacular fashion you had to be spectacularly unusual. Burry is quoted as saying that "If you are going to be a great investor, you have to fit the style to who you are… I recognized that Warren Buffett, though he had every advantage in learning from Ben Graham, did not copy Ben Graham, but rather set out on his own path, and ran money his way, by his own rules." In Buffett's case, he found that what worked for him as an investor was a synthesis of Graham and Fisher methodologies, which evolved with his own experiences and thinking over time. My takeaway from this is that independent thinking and original ideas, combined with a prudent valuation-centric approach is more likely to lead to investment success than lazy imitation or mechanical approaches.
It is important for me to be clear in my own mind that in seeking out "quality value" type investments, that they represent value for ME, in accordance with MY investment criteria, and not simply a stable blue-chip stock owned by Buffett, Klarman, Berkowitz etc. that happens to be trading at an ostensibly low PE ratio or other valuation metric.
Given the market's current pricing, quality value businesses are proving very difficult to identify, and extra rigour is necessary to ensure that I am not tempted to compromise strict value criteria and acquire shares of quality businesses at a fully-valued price level - an absolutist approach rather than a relative value approach is crucial here. Nevertheless, the continuous, noise-filled nature of modern day market commentary and news flow should intermittently lead to quality businesses being available for purchase at attractive prices below a reasonable and realistic appraisal of their intrinsic value. A rigorous application of the margin of safety principle is therefore required here.
A potential candidate for a quality value type business is Western Digital Corporation (WDC), a $12 billion computer hard-disk drive (HDD) manufacturer. It has consistently appeared on my personal quality value stock screen for some time. Why do I believe it may be an attractive investment opportunity? A few key highlights from the last ten years of reported results: consistently high returns on unleveraged net tangible assets (30%+ over the period), a steadily rising net income and free cash flow trend (both with ten year CAGR of c. 30%), consistent improving gross margins, a net cash position, a dominant market position at 44% share of the HDD market, and of course an attractive valuation at present, of c. 4x free cash flow. A number of counter-points to consider are that the stock price has risen by over 30% in the last 6 months, and the future prospects for the HDD are less than certain or predictable, if consensus commentary and expectations are to be believed. However, I believe WDC warrants further analysis based on its fundamentally sound track record to date and its attractive valuation. I intend posting a detailed analysis on this business in due course.
The third category that I believe may offer attractive opportunities for a value investor, is what is often termed "special situations." Businesses in such situations may include companies involved in corporate spin-off programmes, mergers and demergers, distressed situations and bankruptcy proceedings. However, I believe there is a distinct complexity to appraising and investing in such situations, which requires a thorough understanding of not just business fundamentals, but also legislation and other areas. As such, I intend to focus on more conventional deep and quality-based value investing for now, while continuing to learn more about the particular nuances of special situation investing area before entering into this arena. For the time being, the intricacies of special situations investing may well lie outside of my circle of competence, but in due course I would hope to learn and take advantage of such investment opportunities.
A current example of a possible special situations opportunity might be the much rumoured Vodafone (VOD) - Verizon Communications (VZ) transaction, which may take one of a number of forms, including a merger, a buy-out of Vodafone's 45% interest in Verizon Wireless or a break-up of the Vodafone Group itself by Verizon and AT&T (T). I have suspected that Vodafone's £85 billion average market capitalisation over the last 6 months did not fully reflect the value of its Verizon Wireless stake: with even a modest 5x multiple applied to Verizon Wireless' estimated free cash flow of c. $20 billion implying a valuation of $100 billion (or c. £65 billion) (with the Wireless business being debt-free), something does not appear to add-up on the surface at least. A transaction may well provide a catalyst for Vodafone shares, as Vodafone may be undervalued based on a sum-of-the-parts valuation approach. However, given the level of analyst coverage of both Vodafone and Verizon, and the fact that the rumour may already being priced into Vodafone's share price, I do not believe I would have any informational edge at this point that would enable me to profit from this special situation. On this basis, I am happy to pass on this for now.
For the time being I intend to devote my time to identifying those deep value and quality value opportunities that I believe will offer me the best returns while protecting my capital. In due course, I hope to take advantage of any attractive special situations also. But at the outset, my portfolio will contain a concentrated number of my best ideas for deep value and quality value investments, and a sizeable cash allocation given current expensive prices. This allocation will enable me to remain flexible and take advantage of new opportunities in the event of a broader market decline.