Wall Street’s Comfort Zone
We believe the natural tendency of investors is to buy stocks as they are heading higher and/or gathering attention from all sides of the media and analyst community. Investors typically go after glamour stocks, in other words. We can group these sorts of investors under the growth or momentum category, as opposed to value investing, which takes as its mantra the following: buy stocks that have fallen in value, are out of favor, and, in true Benjamin Graham fashion, offer a compelling margin of safety.
Criteria For Which Value Investors Screen
We believe the art of value investing can be broken down to a few simple criteria. For starters, value investors look for stocks that are trading at discount to their book value, or net asset value (assets – liabilities). While low price-to-book opportunities are rare, they do exist. Value investors also look for names that are suffering for transitory events. We define transitory events as those that bring stock prices drastically down but will have below-consensus material effects on the core operational performance of the company in question. For instance, in the 90s, after Hilary Clinton announced her new plan for the health care industry, drug stocks took a whacking. Aghast but with joy, value investors watched share prices of drug juggernauts like Merck (MRK) plummet. At 52 week lows, shares of drug stocks looked like basement bargains. And they were: the Clinton administrations agenda for universal health care was shot down by conservatives and libertarians alike and in 1994 it was clear that “Hilary Care” was a dead duck. Merck, along with other large cap pharmas, went on to rally to Miltonic heights. We should note that determining how adverse an impact something like legislation is difficult and subjective, and different investors will have different approaches. We use a probability scheme and understand mean-reversion to pinpoint where we think a stock might trade back to.
There must also be a case made for the boring industries and hard asset plays value investors tirelessly look for. Boring industries tend to be overlooked by most Wall Street practitioners, who are typically chasing the hottest new technology or controversial management team. What this means for the value investor is that there is a potential mispricing in securities of companies who have seen their coverage dropped by analysts. One way we screen for value in this respect is through the EV/EBITDA ratio. We prefer this ratio the ubiquitous P/E ratio for several reasons, the chief one being that P/Es fail to capture the purity of a firm’s core operational performance. Cable stocks, for example, because of their higher fixed costs and capital intensity, face massive depreciation charges. Because of the large deprecation expense, cable names should not be valued on price/earnings multiples per se but on metrics that will capture how much cash the business is throwing off prior to any capital expenditure decisions. The numerator of the EV/EBITDA tells us how much it would cost to acquire the firm today. Adding the two together, we are able to determine how much it investors would be willing to pay for each dollar of operating cash flow.
For bonafide value investors, the balance sheet is more important than one’s mother. Great value stocks in our experience have been those whose balance sheets masked key assets, both intangible and tangible. Brand equity, for example is not part of a company’s balance sheet. A firm like Starbucks (SBUX), for example, is recognized all over the world. This intangible asset must be accounted for, appraised, and tied back to a sound understanding of what a firm like Starbucks is worth.
On the other hand, sometimes tangible assets like land may be undervalued and thus incorrectly reflect what the firm’s book value is. The tendency of firms to state land on their balance sheets at acquisition costs, rather than fair market value, means that if that land has appreciated significantly with time, investors may be mispricing shares. One stock we have been watching lately is Pep Boys (PBY). The automotive parts retailer has land, we think, valued somewhere in the $1B range. Curiously, the entire market capitalization of the company is well under that, $850MM as a matter of fact. Since we initiated coverage in November, shares of PBY have risen more than 17%. We think the stock is worth $18, conservatively speaking.
The last thing we look at when screening for value names is insider participation and dividend streams. Typically, we like to see insiders buy large levels of stock in their companies, especially when those stock prices are tumbling to new lows. This activity confirms that the people closest to the company’s books think there is value manifesting. Value stocks, which tend to be large cap mature names, should be throwing off plenty of cash and returning it to shareholders, either through stock repurchase programs and/or dividends. Assuming paring down debt, making an acquisition, or engaging in a positive NPV project is out of the question, these mature firms should be focused on doing more than just leaving cash sitting on the balance sheet. One clear illustration of this would be Microsoft’s (MSFT) Herculean dividend payout in mid 2004.
What to Look Out For
Low price/book or price/earnings stocks are not necessarily good values. Case in point: in 1998, Kmart (SHLD) was trading at a depressed valuation. Several investors jumped on the stock, only to see the firm declare bankruptcy four years later. A more rigorous analysis of Kmart would have discerned that the retailer lacked a competitive business model and was facing further operational deterioration. Another red flag to watch out for: overvalued sectors. If a sector is piping hot, even the worst house in the neighborhood may be sold. With time, however, the weak foundation and chipping paint of those poorer quality names will confirm the obvious: serious investors must carefully select which names in a sector are buys and which are dogs that won’t hunt.
Breakin’ Up: Valuation Models of Choice
We prefer the DCF valuation model to all others when screening for value plays. A robust DCF model will give a potential investor a range of where the stock should be fairly priced, but investors should be careful what assumptions they are making, particularly when it comes to the cost of capital [WACC] they are assigning to the cash flows of the firm that they want to discount back to the present. The other model of choice is a simple sum-of-the-parts, which screens for companies whose parts may be worth more than their whole. We accomplish this in 3 steps: breaking up the firm into disparate units, isolating its various cash flows, and assigning a multiple to those flows. Assuming the comp group is fairly valued, the multiple we assign to our business unit cash flows may reveal that the firm’s individual units are undervalued and have gotten lost in the hodgepodge of activities the parent company is involved in. A breakup is certainly in order.
One example in this respect would be Citigroup (C), which we are long term shareholders of. We are not only Citi stockholders, but customers as well, and as far as we can tell, the firm has gotten too big for its own good and should break up into 3 or 4 separate units. Although the wave of consolidation sweeping the financial services space is compelling in terms of potential economies of scale – and Citi remains a financial supermarket with a global footprint -- it is hard to deny that Citigroup's size has created a bureaucratic environment that is not only causing customer dissatisfaction, but serving as overhang on its stock price. Recently, shareholder dissent has sent shares of Citi upward, which we applaud.
In conclusion, the cardinal aim of value investors is to buy stocks that are trading beneath their absolute valuation. Absolute valuation can be determined through a DCF; relative valuation, such as a sum-of-the-parts model, goes a long way in isolating what a large firm’s disparate business units may be worth. Value stocks tend to belong to firms that are boring, throw off ample cash, and undergoing a transitory event (CEO departure, lousy quarter, litigation mess). Fallen on hard times, the stock prices of these firms could be hidden treasure for patient, astute investors who are not afraid to buck the trend and ignore the latest energy drink stock or technology pump-and-dump. When bought at the right time, in other words, value stocks can skew the risk/reward in the value investor’s favor and ultimately generate excess returns.
Disclosure: Author is long C.