Market conditions are uncertain. VIX recently spiked above 24%, the NYSE advance/decline line definitively turned over about a week ago, and the market has had two hard weeks in a row. A market pullback is in the offing. In short, times are great - if you are a value investor. The art of value investing is all about finding stocks with good long-term prospects and then finding the right entry price. Good entry prices only come along every 12-18 months or so, and the current market conditions have value investors everywhere licking their chops and writing down what every investor should have - a shopping list. I'm in the process of updating mine. This article is a progress report for the halfway point of assembling the technology sector shopping list.
For me, value is all about return to shareholders; for continuing operations - and we all hope to buy into continuing operations - the only value a company can return to shareholders is either in dividends or in growth in tangible book value per share. Dividends are a concept that every reader understands, but I will make some small discussion of tangible book value in case you are not 100% confident with this term.
As you can see from the diagram below, a balance sheet is made up of two halves - assets on one side and liabilities & shareholders' equity on the other. The two sides must balance. On the assets side, we have current assets, made up basically of cash and anything that will or can easily be turned into cash inside 12 months and long-term assets which are typically illiquid assets such as property, factories, long-term investments, etc. We also have intangibles which consist largely of two things:
- First, there is goodwill which is typically accumulated through company acquisition as anything above tangible book value of companies that you acquired that you paid for the company, minus estimated market value of legal intangibles you could sell, like patent rights, copyrights, etc. Cynics and value investors call it "what you paid for but didn't get."
- Second, there are other intangibles, defined as non-monetary assets that cannot be seen, touched or physically measured. Some are legal intangibles such as patents, trade secrets, rights to do business, etc. that can be sold and some are "intangible intangibles" such as know-how, partnerships, etc. that have value to the company but which cannot be sold. International accounting standards do not allow internally-developed intangibles to be recognized as assets, whereas GAAP does, but many U.S. companies follow the more conservative international standards anyway.
While there is a portion of intangible assets that can be monetized - particularly patents and copyrights, it is fair to say it is unusual for them to monetized other than in company liquidation or breakup, and most of them depreciate quite quickly. Goodwill and "intangible intangibles" disappear in a puff of smoke on company liquidation and hence are really only an accounting "plug" to recognize cashflows. As we will see a little later, they also inflate a company's book value and pose some challenges for valuation.
Turning to the liabilities and shareholders' equity side of the balance sheet, we have short-term liabilities which are liabilities that need to be paid in the next 12 months and long-term liabilities that do not need to be paid in the next 12 months. If the company is valuable, then assets will exceed liabilities and the amount that is needed to balance the balance sheet is called shareholders' equity, or sometimes retained earnings or owners' funds. This is in fact the part of the company that is "owned" by shareholders.
So on both sides of the balance sheet we have two hard, quantifiable items of current and long-term assets/liabilities and two plugs. You should also notice that if you increase the size of intangibles by $1, you increase the size of shareholders' equity by $1. So as a shareholder, the amount you "own" is directly affected by the size of an item that is non-monetary, cannot be touched or physically measured and, in event of company breakup, is mostly worthless in most cases.
Enter tangible book value. Tangible book value is that portion of book value that is monetary, measurable and readily realizable. Shareholders' equity with goodwill and intangibles subtracted is, in most cases, a fairly accurate estimator of tangible book value. Tangible book value can be seen as the most basic value of a company. The expectation of future growth of tangible book value plus expectation of future dividend flows usually mean that we pay a significant premium above tangible book value for shares in a company. Unless a company is actually destroying value, a market capitalization below tangible book value is an arbitrage opportunity.
Tangible book value is also hard to fake. For example, a company that issues a lot of shares during a particular year but balances that out with share repurchases will see its earnings per share unaffected compared with the case where there was no dilution and repurchase, but the tangible book value per share will be negatively impacted.
Another consideration is that a company can undertake a series of value-destroying acquisitions for quite some time without seriously impacting book value per share, because the overpayment for the acquisition gets stored right up there in the "goodwill" section. If the acquisitions do not add value, it will soon show up in tangible book per share, though.
Consequently, we can measure the rate at which a company is adding value to your shares by looking at a combination of dividends and the rate of increase of tangible book value. A value investor is essentially looking for companies that are adding value fast but are not highly-priced. Fundamental value is a good indicator of how well a stock will do in the long term, and the closer the value of the stock is to tangible book value, the shorter that "long term" will be. To try to capture this, I created a screen which I have initially run across technology sector stocks listed on U.S. stock exchanges:
- Share Price > $10. (Shares under $10 are usually a bit too volatile for my tastes.)
- Market Capitalization > $1B. (leave small-caps out of this)
- Price/book value for the latest quarter < 1.6. (We are looking for stocks that will get down close to Book value in a downturn.)
- Tangible book value/share > $5. (once again, looking for larger stocks Of course this will eliminate some strong turnaround stories, but that is a different value driver.)
- Current ratio for the latest quarter > 2.0. (We are only looking for very solvent companies, because we want them to still be valuable after a pullback. A company that has plenty of cash at the bottom of the economic cycle will recover much faster than a company that is running out of cash.)
- Tangible book value/share increasing consistently since 2007, as measured in the quarter ending December 31 each year. I allowed one year-on-year drop of up to 5% as long as it was more than recovered in the following year.
I then calculated a value that I call the company's dividend-adjusted 4-year compound annual tangible book yield (DACATBY) by adding dividends, inflated by the growth in tangible book value/share since the year of dividend back into the tangible book value/share for the most current year and then calculating the CAGR of tangible book value/share between that value and the31st December, 2007. Then I ranked the 11 companies that got through the screen by that result as per the table below:
The second part of this analysis is to go into the most recent couple of quarterly and annual reports of these companies to separate the diamonds in the rough from the lumps of coal with glitter paint. In particular, an assessment has to be made of the future outlook for the stock and a "buy-in" price has to be established for the ones with a high hardness rating. You will notice that several are already trading at below book value, and are worthy of immediate attention. Over the next few weeks I hope to present a few much more detailed report cards on some of these stocks where I feel qualified to talk about their outlook, but here is a quick summary for now:
- GrafTech International Ltd. (GTI): Some databases categorize this company as an industrial rather than a tech stock. Graftech International is a manufacturer of synthetic and natural graphite and carbon-based products. The stock is currently beaten down because it has suffered a significant YoY drop in EPS to the current quarter. Analyst outlook is good, and many think the outlook for graphite in general is good, so this stock on the face of it seems worth a look, with a 54% 4-year DACATBY.
- Sohu.com Inc. (SOHU): This Chinese media, search, gaming, community and mobile services group has not done well share price-wise this year. It has also suffered a YoY EPS decrease. The fact that gaming is high on the list of things they do and social media is low on the list encourages me, but I will be checking who does their audit. To now, it has been adding tangible book/share at 51% per annum, so cannot be ignored.
- Enersys (ENS): This is another stock that is also often classified as an industrial. It is a manufacturer, marketer and distributor of industrial batteries. Its share price is up more than 10% year-to-date and delivered a +16% earnings surprise in its latest quarterly report. A cursory glance at its numbers reveals no red flags, and with a 4-year DACATBY of 40%, it is prima facie a strong candidate for the shopping list.
- First Solar Inc. (FSLR): This company's share price has taken an enormous battering over the last 12 months as the outlook for the solar energy industry has gone from bad to worse. Shares are down about 90% in the past year. It is also the only company in this group that destroyed value in the first 3 months of 2012. I would regard this stock more as a turnaround punt than as a value pick, but it might be a very good one.
- Corning Incorporated (GLW): This company makes hi-tech glass and related products. For example, it makes the Gorilla Glass on the front of iPhones and iPads. Unfortunately it also makes the glass in front of TV display panels and through its Dow Corning joint venture it makes polysilicon substrates for solar cells, so shareholders have sold off as earnings declined. This stock has been range trading between about $12.50 and $14.50 since October. Opinions are divided as to whether this is a value bargain at the moment or whether it is in carcass mode. The fact remains that it is trading only very slightly above tangible book per share and below book value, it is still delivering 2.3% dividend yield while growing tangible book value monotonically - and it has survived a massive decline in the demand for its products in the past and come back strongly. You could try to pick it up at below $12.90 per share or you could wait for it to break out above the current range trade.
- Bio-Rad Laboratories, Inc. (BIO): This company makes instruments and devices for life sciences, healthcare and analytical chemistry. At 22% compound annual growth of tangible book and decent analyst rankings, it would seem to be worth investigation, but it is at the upper end of the price/book range so may never reach bargain status.
- General Cable Corporation: (BGC): Another stock often classified under industrials, and another stock trading below book value, General Cable makes all kinds of communications and electrical cables. Although they have been able to add tangible book value consistently (CAGR: 20%) in the past, they are one of the companies that had a tangible book value reduction, and it was in the most recent year. At the very least they should be watched for a couple of quarters.
- Research in Motion Ltd. (RIMM): You probably don't need me to tell me that RIMM has been troubled recently by its massive loss of market share in the smartphone segment to Apple Inc. (AAPL)'s iPhone and Google Inc. (GOOG)'s Android systems. Like FSLR, this stock is probably a turnaround punt rather than a value play, and I'd wait for the new version of their Blackberry Operating System and see how the market reacts before I did anything with this stock.
- Juniper Networks, Inc. (JNPR): Juniper Networks makes routers, switches and security equipment for both service providers and enterprise customers. Lately they have been moving into software products as well, although it is yet to be seen how successful this turns out to be. There can be no arguing with the fact that Juniper had a very disappointing quarter ending March 31, so it is not surprising the stock dropped from the $22-$24 range to the $17-$19 range. There is a lot to be optimistic about in the Juniper outlook though, including a slew of major new products for the service provider and cloud service provider markets and hopefully some recovery in Japan where Juniper has tended to punch above its weight in the past. With a DACATBY of 17% (which is somewhat depressed by the fact that cash covers nearly 30% of their share price) and a current ratio in excess of 3, this company is in a very strong position to take advantage of a downturn. Price/Book is only 1.3, so this stock doesn't have far to fall to be a real bargain.
- MKS Instruments, Inc. (MKSI): This company makes instruments and subsystems for the measurement and control of manufacturing processes. Their current-year EPS was down 21% compared to the previous year, but they still managed to add tangible book value/share and pay a dividend of 2.4%, so they have been returning value to shareholders at a rate of 13% for the past 4 years which is not bad. The share price would need to get quite a bit closer to book value, or I would want to continued turnaround in EPS growth to be interested in this stock as a value play.
- Fairchild Semiconductor International (FCS): Fairchild makes semiconductor products, mostly power semiconductors and analog semiconductor devices, rather than digital devices. FCS' growth of tangible book has been smooth and monotonic for a long time, but DACATBY over the last 4 years has only been 9%. There are higher yields out there. If its price fell below book value in a selloff, I would become interested.
I hope this little exercise has been interesting for readers, and I hope even more fervently it proves profitable for some! Please bear in mind that at this stage this is not a buy list. We still need to do the outlook and red flag search, and we need to estimate a good entry point. For companies that are currently adding value, that entry point will be above book value, but in most cases below the current price, given the assumption that we will see further market pullback. For companies that have suffered revenue drops, we may be looking at some number between tangible book value and book value. Technical indicators should also be considered. TA is useless for predicting long-term growth, but it is very useful in choosing an entry point. I intend to go through this exercise for some of the stocks above in forthcoming articles. Then we'll look at some other sectors. The screen will need a little tweaking on a sector-by-sector basis.