It is essential to have a strategy when investing. A lack of a sound investment strategy will most likely result in mediocre returns at best. I enjoy sharing my views on interesting companies and now I would also like to share my investment strategy with the readers. This is followed by examples of 11 undervalued companies with healthy underlying businesses, worthy of further research to the value investor - many of which you have probably never heard of before, since I am from Denmark and thus have a keen interest in European companies. Much of my investment strategy is associated with Benjamin Graham and his rational approach to investing. The margin of safety is therefore of chief importance in my strategy, together with the attitude regarding Mr. Market. Below I will present the main points in my strategy. These are only guidelines, and a company does not necessarily have to meet all the requirements.
A brief introduction to the strategy
I place particular emphasis on the following four quotes from Warren Buffett:
- "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price"
- "Only buy something that you would be perfectly happy to hold if the market shuts down for 10 years"
- "Be fearful when others are greedy and be greedy only when others are fearful"
- "The favorite holding period is forever"
The time horizon in my investment strategy is very long, and thus I trade as little as possible. One could argue that this is one of the few cases where laziness is a virtue. I prefer big, solid companies in mature and defensive industries with healthy financials. Furthermore, I want to understand the company's products and market risks. A stable development in revenues and profitability is preferred along with a strong capital structure. The yield should be sufficiently high and not decreasing. A lower dividend yield is acceptable if the company increases the dividend annually.
I will not pay a premium price for a company. I do not even want to pay a fair price. Price is king and I only buy a company whose shares are traded significantly below their intrinsic value. Therefore, the estimates of future price earnings figures must be at a low level and the same applies to the price to book value, where an actual discount on the equity is clearly preferred. As long as the company's financial performance is acceptable and the dividends are either maintained at a high level or rising from a lower level, then I will assess the case as being intact. An extraordinary deviation from the expected financial performance of the company should justify a reconsideration of the case. Each section is further elaborated below more or less.
The revenues must be resistant towards macroeconomic fluctuations
The company's sales sources must be resistant towards the macroeconomic development. This ensures a stable profitability and the long-term survival of the company since the future is not as uncertain and risky as is the case with many cyclical companies. Companies in defensive sectors also tend to pay back much of these earnings in dividends and stock repurchases since there is not much growth on these markets. Moreover, the investor with a portfolio full of defensive and healthy companies sleeps better at night.
The future of the industry must be secure
The company's sales sources must also exist in 50-100 years. We cannot avoid future uncertainty but the less the better.
The company must have a sizable market capitalization
I prefer companies with at least 500-1,000 million USD in market capitalization. Companies of a certain size are financially stronger but also in the context of critical mass within the industry. Larger companies are often less risky than small companies from the same industry, as large companies have the capital and resources to ensure survival in the market. Darwinism dictates that the strongest survive, and a large well established company (a large fish) is inevitably stronger than the lesser and riskier company (a small fish).
Diversification to reduce risk
A diverse allocation of capital is important due to risk control. The positions must be distributed between different industries so that a sudden and unpredicted "black swan" in a certain industry only affects a small part of the portfolio. Companies in the same industry may be accepted if the industry is defensive and if both companies satisfy the demands of the investment strategy adequately. Allocating over several parts of an industry's supply chain may in some cases be accepted as well.
Partial sales exposure to emerging markets
Emerging markets are developing rapidly and the general demand is increasing on several of these markets (particularly in Asia and South America). Exposure to these geographic areas helps to smooth out sales risks and represents a significant long-term potential for revenue growth.
I must be able to understand the product and the industry
I do not buy a company if I do not understand its business model, products and industry sufficiently. Some say that risk is not knowing what you are doing.
A satisfactory return on equity
The company must be adept at returning value to its shareholders, and thus I prefer a return on equity of at least 10%. This ratio shall of course also be seen in relation to its industry and any short-term fluctuations.
Stable or increasing dividends and share buybacks
These two factors indicate a shareholder friendly management. Dividends are essential to me. There are two ways to generate returns in the market: through capital gains and through income. The capital gains or losses appears when you sell the given stock. Income comes from the dividends that are paid quarterly, semi annually or annually to you through the company's profits. I choose to elaborate on this point because of its chief importance. Companies in rapid growth usually do not pay dividends since the management prefer to use the profits to further strengthen the business. This will hopefully create long-term shareholder value. Since I am a conservative and also a quite contrarian investor, I prefer companies that thrives in mature and perhaps also more boring industries. These companies are therefore not growing particularly fast. Thus, a large part of the profits must find their way back into the shareholders pockets.
Dividends act as a kind of insurance against bad times, as strong companies should be able to sustain dividend payments - even during tough macroeconomic conditions. Moreover, increasing or stable dividends indicates that the company is financially strong. However, it is important that the company's payout ratio is not alarmingly high due to the potential risk of dividend cuts. The total cumulative return over time will be highly rewarding if the company has a shareholder friendly dividend policy. If the dividend is just showing a stable and non-decreasing trend, then I prefer a dividend yield of at least 4-5% at the moment. A lower dividend yield is acceptable if the company increases dividends annually. Furthermore, companies with good earnings and strong capital structures tend to increase dividends substantially over time. Share buybacks are also clearly preferable together with dividends since the company also uses some of its profits to reduce the number of shares in the market. This will lead to an increased share price in the long term together with a higher EPS (and book value per share given that equity is constant). You generally get a larger share in the company's value and earnings when the number of shares is reduced. Share buy-back programs are far from as important as a sufficient dividend yield.
Increasing equity means a rising book value per share as long as the number of shares does not expand. When the book value increases, the shareholders will automatically get a larger share of the company's equity, and a rising equity also indicates increasing financial strength. All things being equal, this should result in increased market capitalization in the long run due to the price to book ratio. If the company is well managed with sound financials the market should appreciate the company more as the equity rises.
Solid capital structure
The capital structure of the company is of vital importance. Therefore the balance has a central role in my strategy. The company must have a sound and strong capital structure. Therefore, I prefer companies which have a low gearing (net financial debt relative to equity) and a high equity ratio (equity relative to total assets). The current ratio (short-term assets relative to short-term liabilities) is also important and should ideally exceed 2x. Furthermore, the interest coverage ratio (EBIT relative to interest expenses) must also exceed 3x. With a strong capital structure follows low capital risk and satisfactory dividends. We all love sound and healthy businesses.
Low price to book value
I do not pay a significant premium for any company's equity and the ideal case is a company traded at a discount (a price to book ratio of less than 1.0x). I prefer companies traded under or between 1.0-1.5x in P/B, but it depends on the industry and competitors regarding the given case.
Low price to earnings estimates
The companies I invest in are not growing quickly, thus the P/E ratio must be at a low level. Defensive sectors often consist of large, stable and solid companies. These markets are mature and global. This is why I prefer a future average P/E ratio of less than 10x. A low P/E ratio also provides the shareholder with a greater proportion of earnings, i.e. a higher earnings yield (comparable to the return of other assets such as bonds and corporate bonds).
Summary of my investment strategy
Let us sum up my strategy and requirements to make it more clear:
- Defensive sector
- Stable revenues and earnings
- Low price to book value (preferably <1x)
- Low price to earnings estimates (preferably <10x)
- High yield (minimum 4-5%)
- Strong and demanded revenue sources even in 50-100 years
- A satisfactory return on equity (preferably >10%)
- I must understand the company and its products
- A sizable market capitalization (500-1,000 million USD)
- A diversified portfolio
- Partly exposure to emerging markets
- Increasing equity
- A strong capital structure (low debt and a high equity ratio)
As stated in the beginning, the company does not have to fulfill all requirements. A company in the US can be a fantastic bargain without exporting any goods to e.g. Asia. Moreover, a company with a market capitalization of e.g. 350 million USD can be an attractive buy as well. The investor must therefore use his or her intuition regarding each individual case.
Examples of interesting companies
Below I have listed some companies that I think is worth noticing. As I state in the disclaimer, I own several of these companies my self. Each company may not cover all requirements but they are all sound businesses with strong capital structures. The following companies are:
Corning Inc. (GLW), Intel Corporation (INTC), Universal Corporation (UVV), Yara International (YARIY.PK), Austevoll Seafood (ASTVF.OB), Statoil (STO), Wilh Wilhelmsen (WLHSF.PK), Fortum (FOJCY.PK), K+S (KPLUY.PK), Südzucker (OTC:SUEZF) and Teva Pharmaceutical Industries Ltd. (TEVA).
Since Intel, Corning, Universal Corporation and Statoil are well covered by other contributors, I chose not to analyze these companies further. I have also published analytical articles regarding Yara International, Teva Pharmaceutical Industries and Fortum, I suggest that the reader looks at these articles if he or she is interested in getting to know the companies. I will however share my views on Südzucker, Austevoll Seafood, K+S and Wilh Wilhelmsen below.
This German company is the largest sugar producer in Europe with an annual production of around 4.8 million tones. The products include normal sugar, starch, frozen products and functional ingredients for food, animal feed and the pharmaceutical sector. The company's fruit segment produces fruit preparations and juice concentrates. Finally Südzucker is one of the leading manufacturers of sustainable produced bioethanol in Europe. Südzucker is the leader in several industries with a very secure earnings basis even in 100 years since sugar is a vital part of numerous different industries. As the global population rises so will the demand for Südzucker's products.
The company has approximately 17,000 employees and a market capitalization of 4.5 billion EUR. Since 2008 the revenues have increased by 34% from 5.9 to 7.9 billion EUR while the earnings have quadrupled from 183 to 735 EUR equaling to a ROE of 15% in 2012. An interesting fact is that the company has as many employees today as in 2008 and has more than doubled the dividend during the last five years. Südzucker has a very strong capital structure with a gearing of only 0.1x and an equity ratio of 54%. The current equity of 4.7 billion EUR results in a quite satisfying price to book value of only 0.9x. The current ratio is precisely 2.0x and the interest coverage ratio is 11.7x. Thus the company passes the requirements regarding a strong capital structure. The stock has declined from 34 EUR to 22 EUR due to severe market pessimism. This is because of the potential EU regulations of the sugar market. The current minimum prices on sugar beets are expected to expire in 2016/2017 and this will put a pressure on the margins and prices. However, the issue is still up for debate in the EU and the expiration date may be extended. Südzucker has a strong market position to endure these obstacles. It seems like most of the downside is already reflected in the stock price with a P/B value of 0.9x and a forward P/E of 9x. The recent decline in the stock price results in a dividend yield of 4%. This looks like a very attractive investment case deserving further research.
Austevoll Seafood ASA
Austevoll is one of the greater global suppliers within the fishing industry. The company is headquartered in Norway and owns fishing quotas in three of the world's most important fishery countries: Norway, Chile and Peru. Operations include fishing fleets, fishmeal and oil plants, canning plants, frozen fish plants and salmon farming. The annual revenue in 2012 was 12 billion NOK and the earnings amounted to 650 million. NOK. The company has 5,300 employees. It is estimated that Austevoll constitutes 5-10% of the global salmon market. The global demographic trends indicate that the rising middle class on many emerging markets demands more western luxuries. This includes premium quality fish like e.g. salmon which is one of the company's most important sales sources. Thus salmon prices are of chief importance and the long term demographic trends will probably secure a sensible development due to the stable increase in demand despite the potential for short term fluctuations. The balance looks sound with an equity ratio of 47% and a current ratio of 2.2x. Moreover, the interest coverage ratio is 4.8x. The share price of 32 NOK results in a dividend yield around 3.7%, but I expect a considerable dividend increase. The market estimates a 2013 EPS of 4.0 per share which equals to a forward P/E of only 8x and a ROE of 8%. The equity of 10 billion NOK derives a book value of 49 NOK. The company can therefore be acquired with a nice discount of 35% on the equity.
Kali und Saltz is a German fertilizer and salt producer. The company is the market leader in the salt industry and a large supplier of different fertilizer products. 14,300 employees achieved company revenues of 3.9 billion EUR in 2012 together with earnings of 640 million EUR constituting a ROE of 19.4%. The equity ratio of 52% together with a current ratio of 3.9x and a gearing of only 0.23x results in a solid capital structure. The strong earnings provides an interest coverage ratio of 7.6x. In 2013 an EPS of 2.40 EUR is expected forming a forward P/E ratio of 8.8x. Moreover, the P/B ratio of 1.3x makes this company very interesting. The 2012 dividend of 1.4 EUR makes up a current dividend yield of approximately 6%. The stock has declined nearly 40% from 39 to 22.5 EUR the last 12 months due to the issue regarding the potential oversupply of fertilizer which will put a pressure on market prices. The earnings estimates of K+S are therefore lower than the historical results. It looks like the market is very fearful at the moment and this may be a good entry point for the patient long term investor. The company's revenue sources are highly demanded and their products will be needed in 100 years as well.
Wilh Wilhelmsen ASA
This Norwegian company is a leading global maritime industry group. Wilh Wilhelmsen offers global logistics solutions through sea transportation like e.g. car transportation. Other product areas include services to the shipbuilding industry and cargo transportation. Company figures are calculated in USD due to the company's global presence. Wilh Wilhelmsen achieved a revenue of 3.9 billion USD and earnings of 446 million USD in 2012 which was made possible by the 16,000 employees worldwide. The market capitalization amounts to 9 billion NOK. An EPS of 5.3 USD is expected in 2013 resulting in a forward P/E ratio of only 6x. Moreover, the price to book ratio is 0.9x at the moment and the stock yields 4%. The current ratio is exactly 2.0x and the equity ratio amounts to 41%. One should notice that the company's gearing is 0.57x which I think is quite high, but even though this is true, the interest coverage ratio is still 5.1x. Wilh Wilhelmsen reached a ROE of 24% in 2012 and this company looks like a worthy candidate for a value investor's portfolio just like the rest of my suggested picks. I strongly recommend the reader to do his or her own due diligence regarding the mentioned companies.
In this article I have presented my investment strategy and my general approach to the market. I have furthermore presented examples of companies I find interesting due to their sound and healthy businesses together with low valuations. One of the most important things to remember is that the market is your servant and not your master, and since the market is your servant you can only have one enemy and that is your self. It can be hard to stick to a strategy when it does not seem to work. This can lead to panic reactions and I choose therefore to emphasize the chief importance of discipline, rationality and patience. The market can be unpredictable, irrational and fierce in the short term but with patience and a time, the market will acknowledge the sound and wonderful businesses. Meanwhile you should just as well ignore the daily bonanza. I do not pay any attention to the macroeconomic environment and why should I? If my analysis of the company concludes that it is a true bargain then why should I care about the global economy? Nobody can predict the future so why bother wasting time and effort on trying to time the market? Instead I should stick to what I know: that this company is a true bargain. The only fact that we can say about the future is that it will surprise us. Remember that a value investor should not fear the market nor a bear market since a bear market is full of bargains. So let's have a crash. This is where the chances of high returns are big and the risks are low because the stocks are already cheap, thus creating a good margin of safety. This is when the value investor becomes greedy and exploits the market's fear and pessimism. Yesterdays losers are often tomorrows winners. Instead of looking at stock charts and interest rates the investor should look at the company's financials. If the company is well managed with sound financials, sufficient dividends and a strong market position in a stable industry with enduring sales sources then why care about what the market offers for your shares? The moment when Mr. Market offers you an euphoric and extremely optimistic price for your shares - that's when you care.
Additional disclosure: I may initiate a long position in Südzucker AG withing the next 72 hours.