Geoff Gannon On Valuation, Bargain Hunting and Over-Diversification

Oct.24.06 | About: Hanesbrands Inc. (HBI)

Last Wednesday, the value investing site Modern Graham hosted a round table discussion involving three participants: Rick Konrad of Value Discipline, Doug McIntyre of 24/7 Wall St. and Geoff Gannon (me) of Gannon On Investing.

You can read the entire discussion here.

I have pulled a few of my own answers from the discussion to share with you. I'll let Rick and Doug talk about their answers on their own blogs.

How do you value a particular stock, and further what valuation techniques do you utilize in doing so?

Well, I would say I tend to value businesses rather than stocks, by which I mean I look first to a "capitalization independent" measure like EV/EBIT. I think the inverse (EBIT/EV) is a good measure for comparing the yields on various stocks and bonds. So, that would be the standard measure of how cheap or expensive a stock is for me.

However, there are many situations (and here is usually where you find some bargains) where the EV/EBIT measure is not the most useful. When I can predict a high free cash flow margin with confidence, I use a very long-term discounted cash flows calculation. For instance, this is what I would do with Hanes Brands (NYSE:HBI), which was recently spun-off from Sara Lee (SLE). On an EV/EBIT basis, it may not look cheap. But, looking truly long-term, I'm convinced the intrinsic value of each share is much closer to the $45 - $65 range than the roughly $23.00 a share at which it now trades. But, that's a special case – Hanes is a special business.

In other situations, where I don't think the company can do more than the industry average long-term, I'll use book value. So, that would be banks and insurance companies obviously as well as some industrials on occasion.

What are your views of the current market and the direction we are headed?

Since my approach is completely bottom up rather than top down, I really do see it as a market of stocks rather than a stock market. So, I can't comment on the level of the general market, but I can comment on the presence of bargains – they're scarce.

That isn't to say most stocks are terribly expensive. But, it has become increasingly difficult to find bargains – at least the kind of bargains I'm looking for.

This isn't a time of the Nifty Fifty or the dot com bubble – you don't have wide price disparities that are clearly unjustified. What you do have is a pretty flat and (in my view) barren investing landscape.

I mentioned Hanes. That's a notable exception, but it's also a spin-off. I think that's telling. I don't have very many good ideas these days – honestly, I'm at the lowest point since 2000 in terms of good ideas. For me, this is definitely the toughest environment in more than half a decade.

Finally, a quote from me on the dangers of diversification:

I think a lot of investors don't really confront the issue of concentration versus diversification. What's an appropriate amount of market risk? What's an appropriate amount of business risk? Sometimes, the results for individuals are devastating even if they aren't obvious. They have some really good ideas, but they're convinced they need a little of this fund and a little of that fund – some bonds, some international exposure, etc. But, if you don't know that stuff and you do know a few cheap stocks or a few great fund managers, you're making a mistake.

Of course, I said other things in the discussion. These are just some highlights on topics I thought might interest readers of this blog.

Overall, I thought the discussion went well. Modern Graham did a great job of picking interesting participants. I couldn't ask for better co-discussants than Rick and Doug. I read both of their blogs religiously.

If you haven't given Value Discipline or 24/7 Wall Street a try, I encourage you to do so now. Also, do check out the forum thread for the round table discussion. Despite the difficulties of doing a "live" forum discussion, I think it went well and the thread reads pretty clearly.