I believe that all good investing involves buying something below it real value. Up until now I have been concentrating on what may be called a Buffett strategy. This is essentially investing in good business at prices below their value. For example you can buy companies with high return on equity (ROE) and low P/E. You can make guesses about their probable future growth and so estimate their fair value P/E and buy if the market P/E is below that.
There is another way where you buy companies at low price to book value, P/B, regardless of whether they are good or bad. These strategies are connected because of the identity
P/B = P/E * ROE
This is true simply because ROE = E/B. So you can't really have low P/E , low P/B AND high ROE. You need to choose whether you want to go with high ROE and low P/E or low ROE and low P/B. With good companies like Coke or Walmart your going to get stable and predictable earnings, high ROE and high P/B. Generally you care about getting them at low P/E.
The other strategy is buying companies with low P/B. In the extreme you want to get things where the Current Assets - Liabilities is less than the market cap. This is tangible book value and is what you would get (hopefully) if the company was liquidated right away.
The main difference is that for the growth companies, you are valuing the companies based on the earnings that will come in the future. For the low P/B companies you are simply looking at what is there already. In some ways these low P/B companies are a more conservative bet. You don't need to project far in the future. You just look at what is there. The trick for these is to figure out whether your actually going to be able to extract that value.
Things can go wrong. The management can piss away stockholder value by trying to save the company with hair-brained schemes or outright fraud. When tangible book value is substantially more than market cap, the stockholders would usually be happy if the company simply liquidated and paid out a final dividend. However often this doesn't happen. If the CEO is getting a high salary he is often happy bleeding the company for years and simply collecting salary. He need to look for management with interests alligned with shareholders. You also need to look out for other liabilities that may arise such as pending lawsuits or other fishy things on the balance sheet or 10Qs.
Combining these two strategies is probably a good idea since they should be uncorrelated. In fact the low P/B stocks themselves should have practically no correlation and so is good for diversification. The diversification thing is more than just reducing volatility. Value investors shouldn't fear that. It has more to do with the fact that some of these companies will blow up and could cost you everything you put in. However most will return above book value. Some of these will more than triple in a few years and should make up for the occasional loss. It is not short term volatility that matters but rather volatility of long term portfolio growth. If you lose it all your done. This relates to the Kelly formula from gambling theory. Never bet your whole payroll on one bet. Figure out the right amount to bet on each based in your edge and the odds your getting.
Also with these low P/B companies you have low expectations of earnings growth. Generally you just want them to quit losing money, stablize their business and generate postive earnings with below average ROE. Then they return to above book value and you sell them. This could be considered more conservative than expecting an already good company to get even better and grow even faster. It is these low expectations that make them a reasonably good investment.
Friday, December 22, 2006
Thursday, December 21, 2006
Concord Camera (LENS)
This company is terrible. Their stock is abysmal. I just bought $2K of shares. Basically they sell single use cameras, traditional 35mm cameras and digital cameras. They are losing money not gaining it. However what makes them a buy is that they have little debt and lots of cash and they are selling for less than the cash on the books. Somewhere around half the tangible book value.
A company like this should be liquidated for its assets. Unfortunately that isn't going to happen. They may get bought out but probably will attempt to return to profitability. That might happen. I am just hoping that they will stop burning cash and stabilize so that the market starts to value them at something close to book value.
I think there is a decent chance of that happening. They are ditching the digital camera sales which is good because they had negative gross margins. They also must have required more R&D to keep up with the trends. They will be left with one time use cameras and traditionals which should be fairly easy to produce for a profit. Lets hope. I don't need to large profit to make me a profit. I just need them to stop bleeding cash. I think that is happening now. Last quarter they had break even cash flow.
Another positive is that the terrible CEO is buying shares. He seems like a greedy bastard but at least I can count on him to look out for himself. If he is buying he probably sees good times ahead or at least sees the company as being undervalued. With all of their assets, that is not hard to believe.
Then there is their new product, the OnGuard Kids Safety Watches.
http://www.onguardkids.com/
Basically they are watches for which kids can set off an alarm if they are grabbed by a stranger. These will sell for $39 and probably will make a decent gross margin. Sounds rediculous but then again so are paranoid american mothers. I think these will augment the operating margins and so I see this as a good thing.
If all goes well this company may double within the year. If all goes to hell, I think the major holders will force the company to liquidate while it still has assets. I don't think the downside is so bad and it has quite a bit of upside. Overall I think this is a good bet.
A company like this should be liquidated for its assets. Unfortunately that isn't going to happen. They may get bought out but probably will attempt to return to profitability. That might happen. I am just hoping that they will stop burning cash and stabilize so that the market starts to value them at something close to book value.
I think there is a decent chance of that happening. They are ditching the digital camera sales which is good because they had negative gross margins. They also must have required more R&D to keep up with the trends. They will be left with one time use cameras and traditionals which should be fairly easy to produce for a profit. Lets hope. I don't need to large profit to make me a profit. I just need them to stop bleeding cash. I think that is happening now. Last quarter they had break even cash flow.
Another positive is that the terrible CEO is buying shares. He seems like a greedy bastard but at least I can count on him to look out for himself. If he is buying he probably sees good times ahead or at least sees the company as being undervalued. With all of their assets, that is not hard to believe.
Then there is their new product, the OnGuard Kids Safety Watches.
http://www.onguardkids.com/
Basically they are watches for which kids can set off an alarm if they are grabbed by a stranger. These will sell for $39 and probably will make a decent gross margin. Sounds rediculous but then again so are paranoid american mothers. I think these will augment the operating margins and so I see this as a good thing.
If all goes well this company may double within the year. If all goes to hell, I think the major holders will force the company to liquidate while it still has assets. I don't think the downside is so bad and it has quite a bit of upside. Overall I think this is a good bet.
Thursday, December 14, 2006
The psychology of investing
Picking stocks can be a very frustrating experience. I think different people have different psychological problems when it comes to investing. Some example are
1) Getting caught up in a bull market
When stock are going up you feel your getting left behind. If you don't buy now, you might not get the chance to buy at all.
This is a dangerous one. I have learned to look out for it. My first experience was gold as it started to accelerate to $700/oz. Naturally I rushed into this one and bought at the top and then panicked when it crashed and sold at the bottom. I only lost $100 or so but enough to learn a lesson. The lesson there was mostly to avoid speculation. Gold is always a speculation. I can value stock fairly well but commodies? I am going to leave that one to other people and concentrate on what I can do well. I don't think I will get too caught up in this in the future but will be on the outlook.
2) Indecision on when to buy
This is always hard. Do I buy now or wait for it to go down further. I need to develop some kind of method for making this decision. This can be stressful since you tend to go back and forth everyday depending on how you feel about the economy and which article/webpage you happen to have read last.
3) Which to choose from?
Usually I can boil things down to a few candidates. For example right now some candidates on my list are JNJ, Walmart, K-Swiss, Meritage Homes, Home Depot. All are clearly undervalued but by how much? There is also the timeliness issue. Even if K-Swiss is undervalued, it is going to go down in a hurry if we have a consumer pull back. So maybe I should wait on those kind of stocks and buy stocks like JNJ which I only expect to go up. Of course you can be dead wrong on the short term direction of the stocks. I could always just buy all of them. The problem there is that I don't want to have a portfolio of 50 stocks since I don't have the time to cover all of them. If I am going to start buying so many stocks I might as well just buy the Dow. I want to keep my portfolio focused but feel afraid of missing a good opportunity.
4) Fear in a falling market
I haven't really experienced this too much except (as mentioned) with gold. I think if you have enough confidence in your stocks, you can avoid this. The trick is knowing your companies and knowing how much they are worth. Only then can you be confident that the market is wrong and you are right.
1) Getting caught up in a bull market
When stock are going up you feel your getting left behind. If you don't buy now, you might not get the chance to buy at all.
This is a dangerous one. I have learned to look out for it. My first experience was gold as it started to accelerate to $700/oz. Naturally I rushed into this one and bought at the top and then panicked when it crashed and sold at the bottom. I only lost $100 or so but enough to learn a lesson. The lesson there was mostly to avoid speculation. Gold is always a speculation. I can value stock fairly well but commodies? I am going to leave that one to other people and concentrate on what I can do well. I don't think I will get too caught up in this in the future but will be on the outlook.
2) Indecision on when to buy
This is always hard. Do I buy now or wait for it to go down further. I need to develop some kind of method for making this decision. This can be stressful since you tend to go back and forth everyday depending on how you feel about the economy and which article/webpage you happen to have read last.
3) Which to choose from?
Usually I can boil things down to a few candidates. For example right now some candidates on my list are JNJ, Walmart, K-Swiss, Meritage Homes, Home Depot. All are clearly undervalued but by how much? There is also the timeliness issue. Even if K-Swiss is undervalued, it is going to go down in a hurry if we have a consumer pull back. So maybe I should wait on those kind of stocks and buy stocks like JNJ which I only expect to go up. Of course you can be dead wrong on the short term direction of the stocks. I could always just buy all of them. The problem there is that I don't want to have a portfolio of 50 stocks since I don't have the time to cover all of them. If I am going to start buying so many stocks I might as well just buy the Dow. I want to keep my portfolio focused but feel afraid of missing a good opportunity.
4) Fear in a falling market
I haven't really experienced this too much except (as mentioned) with gold. I think if you have enough confidence in your stocks, you can avoid this. The trick is knowing your companies and knowing how much they are worth. Only then can you be confident that the market is wrong and you are right.
Monday, December 11, 2006
CRFT - How a drop in the dollar can kill it
I like this little company Craftmade International INC (CRFT) which makes ceiling fans and outdoor lighting accesories. They make good returns on equity (fairly steady ROE= 25%). They have been growing earnings at about 20% over the last 10 years. They are still tiny (market cap $96M) so have plenty of room to grow.
I even called around and and asked all kinds of people about their fans. Apparantly they are top notch. Based on the usual valuations they are quite cheap EBIT/EV = 17%. They even have an 8% Free cash flow yield (on EV). On top of that thet have a dividend yield of 2.6%.
So what is wrong with this company? Two things.
First of all they sell half of their product to the new home market. Housing starts are down 20% and will probably fall another 20%. So they may see a 20% revenue drop from that. But that is simply a cyclical phenomenon, not a problem with the business. Starts will rise again someday and the market will improve.
What will kill their business? A dollar decline could. To see this, we need to understand how this business works. Basically they are very light on assets. They design the fans, outsource manufacturing to China and Taiwan and sell them to US new home builders and home refurbishers. This company has fairly steady 6% net margins. This means that any change in their cost of goods and sales (CG&S) is magnified by a factor of 100/6=16.7 in net income.
They are very up front about this in their annual report
http://www.sec.gov/Archives/edgar/data/856250/000095013406017675/d39626e10vk.htm
They say that a 1% drop in the dollar will decrease annual net income by $1.15M. Net income is $7.1M so this is 16.2% which agrees with my 1/(Net Margin) calculation for the degree of magnification. In other words a 6.2% decline in the dollar versus these currencies will result in the entire loss of income. In fact a 26.3% decline in the dollar wipes out all $30.3M of stockholder equity.
Here is the dollar versus the Taiwanese dollar and the Yuan.
http://finance.yahoo.com/q/bc?s=USDTWD=X&t=2y&l=on&z=m&q=l&c=usdcny=x
The USD to TWD has lots of flucuation but has declined about 3% in a two months (this is Dec 11 2006). The dollar has been falling versus the Yuan since they unpegged it a little over a year ago. It is down almost 6%. If this continues then CRFT is history. It's entire business model is based cheap goods and sales from Asia and sold to the insatiable US consumer. How could it survive? It would have to raise prices to compensate. Can CRFT raise prices on ceiling fans amid a severe housing contraction? No way. In fact their will probably be a supply glut and prices will probably fall. CRFT may in fact be a good short opportunity.
I think this is an excellent micro example of a larger macro phenomenon. Most people think that if the dollar declines by 5% it means that their trip to Europe becomes 5% more expensive. They wouldn't think about a company going bankrupt because of it. The concept of leverage is clearly displayed here. However the dollar might not decline. Maybe globalization has created so much foreign labor that companies like CRFT will be able to keep lowering labor prices by shopping around. In fact I think this is why they have been moving away from Taiwan to China. Maybe they will be OK after all? Or maybe not. I think they began this move before the Yuan was unpegged and before the Secretary of the Treasury was going around asking the Chinese to lower their currency.
The moral of the story is (I think) to stick to companies with much higher net profit margins like JNJ (20%), KO (21%) and MSFT (28.5%) and stay away from little speculative companies that are highly leveraged to things like exchange rates. This is another reason to prefer old companies who have survived many such currency/economic cycles.
I even called around and and asked all kinds of people about their fans. Apparantly they are top notch. Based on the usual valuations they are quite cheap EBIT/EV = 17%. They even have an 8% Free cash flow yield (on EV). On top of that thet have a dividend yield of 2.6%.
So what is wrong with this company? Two things.
First of all they sell half of their product to the new home market. Housing starts are down 20% and will probably fall another 20%. So they may see a 20% revenue drop from that. But that is simply a cyclical phenomenon, not a problem with the business. Starts will rise again someday and the market will improve.
What will kill their business? A dollar decline could. To see this, we need to understand how this business works. Basically they are very light on assets. They design the fans, outsource manufacturing to China and Taiwan and sell them to US new home builders and home refurbishers. This company has fairly steady 6% net margins. This means that any change in their cost of goods and sales (CG&S) is magnified by a factor of 100/6=16.7 in net income.
They are very up front about this in their annual report
http://www.sec.gov/Archives/edgar/data/856250/000095013406017675/d39626e10vk.htm
They say that a 1% drop in the dollar will decrease annual net income by $1.15M. Net income is $7.1M so this is 16.2% which agrees with my 1/(Net Margin) calculation for the degree of magnification. In other words a 6.2% decline in the dollar versus these currencies will result in the entire loss of income. In fact a 26.3% decline in the dollar wipes out all $30.3M of stockholder equity.
Here is the dollar versus the Taiwanese dollar and the Yuan.
http://finance.yahoo.com/q/bc?s=USDTWD=X&t=2y&l=on&z=m&q=l&c=usdcny=x
The USD to TWD has lots of flucuation but has declined about 3% in a two months (this is Dec 11 2006). The dollar has been falling versus the Yuan since they unpegged it a little over a year ago. It is down almost 6%. If this continues then CRFT is history. It's entire business model is based cheap goods and sales from Asia and sold to the insatiable US consumer. How could it survive? It would have to raise prices to compensate. Can CRFT raise prices on ceiling fans amid a severe housing contraction? No way. In fact their will probably be a supply glut and prices will probably fall. CRFT may in fact be a good short opportunity.
I think this is an excellent micro example of a larger macro phenomenon. Most people think that if the dollar declines by 5% it means that their trip to Europe becomes 5% more expensive. They wouldn't think about a company going bankrupt because of it. The concept of leverage is clearly displayed here. However the dollar might not decline. Maybe globalization has created so much foreign labor that companies like CRFT will be able to keep lowering labor prices by shopping around. In fact I think this is why they have been moving away from Taiwan to China. Maybe they will be OK after all? Or maybe not. I think they began this move before the Yuan was unpegged and before the Secretary of the Treasury was going around asking the Chinese to lower their currency.
The moral of the story is (I think) to stick to companies with much higher net profit margins like JNJ (20%), KO (21%) and MSFT (28.5%) and stay away from little speculative companies that are highly leveraged to things like exchange rates. This is another reason to prefer old companies who have survived many such currency/economic cycles.
Saturday, December 9, 2006
The other vaulation method - EGM
There is another way to value stocks besides DCF that isn't too bad. I don't know what its name is but we can call it the explicit growth method (EGM).
It is fairly well based in reality. How do you make money on a stock? You buy it, hold it for some time and then sell it. The profit (or loss) is the dividends that you have collected plus the capital gains (or loss).
So lets assume that we have an initial valuation metric P/E. One could use any of them such as P/B or P/D P/CF etc.
Lets ignore dividends first off. If the stock grows at G for N years then the earnings will be E_0 * (1+G)^N. If the valuation P/E stays the same you will have obtained a anulaized return of G. That pretty easy. If the valuation changes then the price of the stock will be P=(P/E) * E_0 * (1+G)^N
Your anualized return will be R=[r^(1/N)*(1+G)] -1 where r is the ratio of the final valuation to the initial. Example. The stock grows earnings at 10% for 5 years. The P/E goes down from 20 to 15 so that r=0.75. That is a 4% return. If the vaulation went the other way from 15 to 20 it would be a 16.5% return. If the valuation stays the same it is a 10% return.
You also have to add in dividends. We want to assume that the dividend payout ratio stays the same so that the dividend grows with earnings. With no change in valuation this is simple. You just add the dividend yield (which stays constant) to the annualized return from capital gains. So for example if G=10% and the yeield Y=2% then the return is R=12%.
But what if the valuation changes? This now depends on when and how the valuation changes and whether or not you reinvest the dividends or whether you invest them somewhere else at some other rate (ie the discount rate). Lets assume a constant change in valuation (linear in time) and reinvested dividends. In this case the dividends help more in the beginning if the stock valuation rises and help more in the end if the valuation drops. Thus, dividends have been called a bear market protection device. If Altria groups has a 4% dividend yield and the P/E drops by 50% you may have lost in capital gains but are now getting a dividend yield of 8% as long as they keep the dividend at the same rate. Not bad.
I believe you can just take the geometric mean of 1+Y which means that the average number of shares that you gain each years is AY = Y* (1 + (1-r)/2)
So your annulized return R is (keeping first oder in yield)
1+ R = r^(1/n) * (1 + G + AY) with the adjusted yield, AY = Y* (1 + (1-r)/2)
Example r=0.75 as before, Y=0.02 G=0.1 you get R =0.06. A 6% gain is not bad for a stock that declines in P/E by 25%.
The trick is that you need to reinvest those dividens when it declines and not sell out low. ideally you want to benefit from all three things. Growth in earnings, growth in valuations and also reinvesting dividends.
Lets look at a plot. We are going to run a Monte Carlo simulation and make a random distribution of P/E expansion factor r. Lets assume this is log-normally distributed and has a mean of 1 and sigma(log)= 0.15. We want to generate the distribution of returns for the two cases when we have only growth and when we have growth and a dividend yield. We will assume in eaither case that the sum of growth and yield are equal. For example in the middle panel we have Y= 3% so that black is G=10% Y=3% and the red is for only growth G=13%. The lower panel is for a higher Y=6%. One can see that the mean return is the same. The effect of having a dividend yield is that it reduced the variance of return. However this reduction is not very large even for rather large yields of 6%. This is for 10 years periods. The variance reduction is even smaller for shorter periods where capital gains becomes more important. I think this makes the case fairly well that dividends don't really protect you much in bear markets. However it could well be the case that stock which pay a dividend will not fluctuate as much. That is probably true and so you should expect less variation in returns due to this. However you do much better in reducing volitility just by buying another few uncorrleated stocks. I don't think one should discriminate against non-dividend paying stocks. It seems that adding the dividend yield to the growth rate is a pretty good estimate of return as long as you expect the valuation to stay about the same.
One could argue that this isn't really a fundamental valuation method since you have just postponed the question of what the correct valuation should be. That is true and DCF is probably better in this way. However this method has its merits. It is actually better related to how one actually makes money in stocks. Your not going to hold a stock forever. Valuations are affected by demand as well as supply and demographics have an effect on valuations. This can be input into this model but not really in DCF (unless you raise the discount rate). It seems a better way of treating dividends. We have a long historical record of what the market has been willing to pay for earnings. The average P/E of the market is about 15. I would say that for most mature companies, the P/E should be somewhere in the range 10-20 depending on their profitability and other factors.
It is fairly well based in reality. How do you make money on a stock? You buy it, hold it for some time and then sell it. The profit (or loss) is the dividends that you have collected plus the capital gains (or loss).
So lets assume that we have an initial valuation metric P/E. One could use any of them such as P/B or P/D P/CF etc.
Lets ignore dividends first off. If the stock grows at G for N years then the earnings will be E_0 * (1+G)^N. If the valuation P/E stays the same you will have obtained a anulaized return of G. That pretty easy. If the valuation changes then the price of the stock will be P=(P/E) * E_0 * (1+G)^N
Your anualized return will be R=[r^(1/N)*(1+G)] -1 where r is the ratio of the final valuation to the initial. Example. The stock grows earnings at 10% for 5 years. The P/E goes down from 20 to 15 so that r=0.75. That is a 4% return. If the vaulation went the other way from 15 to 20 it would be a 16.5% return. If the valuation stays the same it is a 10% return.
You also have to add in dividends. We want to assume that the dividend payout ratio stays the same so that the dividend grows with earnings. With no change in valuation this is simple. You just add the dividend yield (which stays constant) to the annualized return from capital gains. So for example if G=10% and the yeield Y=2% then the return is R=12%.
But what if the valuation changes? This now depends on when and how the valuation changes and whether or not you reinvest the dividends or whether you invest them somewhere else at some other rate (ie the discount rate). Lets assume a constant change in valuation (linear in time) and reinvested dividends. In this case the dividends help more in the beginning if the stock valuation rises and help more in the end if the valuation drops. Thus, dividends have been called a bear market protection device. If Altria groups has a 4% dividend yield and the P/E drops by 50% you may have lost in capital gains but are now getting a dividend yield of 8% as long as they keep the dividend at the same rate. Not bad.
I believe you can just take the geometric mean of 1+Y which means that the average number of shares that you gain each years is AY = Y* (1 + (1-r)/2)
So your annulized return R is (keeping first oder in yield)
1+ R = r^(1/n) * (1 + G + AY) with the adjusted yield, AY = Y* (1 + (1-r)/2)
Example r=0.75 as before, Y=0.02 G=0.1 you get R =0.06. A 6% gain is not bad for a stock that declines in P/E by 25%.
The trick is that you need to reinvest those dividens when it declines and not sell out low. ideally you want to benefit from all three things. Growth in earnings, growth in valuations and also reinvesting dividends.
Lets look at a plot. We are going to run a Monte Carlo simulation and make a random distribution of P/E expansion factor r. Lets assume this is log-normally distributed and has a mean of 1 and sigma(log)= 0.15. We want to generate the distribution of returns for the two cases when we have only growth and when we have growth and a dividend yield. We will assume in eaither case that the sum of growth and yield are equal. For example in the middle panel we have Y= 3% so that black is G=10% Y=3% and the red is for only growth G=13%. The lower panel is for a higher Y=6%. One can see that the mean return is the same. The effect of having a dividend yield is that it reduced the variance of return. However this reduction is not very large even for rather large yields of 6%. This is for 10 years periods. The variance reduction is even smaller for shorter periods where capital gains becomes more important. I think this makes the case fairly well that dividends don't really protect you much in bear markets. However it could well be the case that stock which pay a dividend will not fluctuate as much. That is probably true and so you should expect less variation in returns due to this. However you do much better in reducing volitility just by buying another few uncorrleated stocks. I don't think one should discriminate against non-dividend paying stocks. It seems that adding the dividend yield to the growth rate is a pretty good estimate of return as long as you expect the valuation to stay about the same.
One could argue that this isn't really a fundamental valuation method since you have just postponed the question of what the correct valuation should be. That is true and DCF is probably better in this way. However this method has its merits. It is actually better related to how one actually makes money in stocks. Your not going to hold a stock forever. Valuations are affected by demand as well as supply and demographics have an effect on valuations. This can be input into this model but not really in DCF (unless you raise the discount rate). It seems a better way of treating dividends. We have a long historical record of what the market has been willing to pay for earnings. The average P/E of the market is about 15. I would say that for most mature companies, the P/E should be somewhere in the range 10-20 depending on their profitability and other factors.
PEG is a rediculous valuation metric
I have never understood why people use PEG (PE ratio divided by the growth rate) as a valuation metric. It really makes no sense. Here are a few reasons.
First of all, if you knew what the future earnings were going to be, you could value the company with discounted cash flow (DCF). That's the real way to value stocks. Lets give a few examples. We will assume a discount rate of 10% and assume that earnings are to be thought of as free cash flow.
First example. G=30% for 10 years followed by 20 years of 4% growth. The correct DCF PE is 90 and so the correct PEG is 3.
Now if instead we had only 5 years of 30% growth followed by 25 years of 4% growth the correct PE is 38.6 and so the correct PEG is 1.3. Finally lets consider two years of 30%, 8 years of 10% and then 20 years of 4%. That gives PE = 30.1 and so PEG=1.
So obviously the right PEG has everything to do with how long the company will grow its earnings at that initial rate. In most cases the recommendation of buying stocks with PEG < 1 is actually too conservative. In retrospect buying Walmart with PE=100 would have been a very profitable thing to do since it grew quickly for 2 decades.
But there are other things wrong with PEG. It ignores things like return on equity (ROE) and quality of earnings. Maybe companies can grow earnings but will never develop into very profitable companies. Maybe they are growing earnings so quickly only because their initial earnings are so tiny (compared to say invested capital or total assets). For companies that have positive equity and fast growing earnings but very low ROE, it is useless to look at PEG. You should instead analyse the business model and figure out what ROE they will eventually obtain and how long it will take to get there.
Another reason to hate PEG. For slow growth companies, it makes no sense either. Perpetually slow growing companies can be valued with P/E = 1/(DR-G) where DR is the discount rate and G the perpetual growth rate. This requires G < DR.
inverting this E/P = DR -G or DR = E/P + G
Your expected return will be the discount rate DR = E/P + G. So you can see that what matters is E/P + G not PEG=(P/E)/G. You could choose to write this DR = E/P * (1+ G/(E/P)) for your expected return. Now you see that what matters is the
valuation E/P and the ratio of growth to E/P not its inverse P/E. In other words the right PEG is 1/(G*(DR-G)) which still obviously depends on G and DR.
So PEG makes no sense for slow growers and for fast growers it depends critically on how long the fast growth will continue. So why it is used at all?
First of all, if you knew what the future earnings were going to be, you could value the company with discounted cash flow (DCF). That's the real way to value stocks. Lets give a few examples. We will assume a discount rate of 10% and assume that earnings are to be thought of as free cash flow.
First example. G=30% for 10 years followed by 20 years of 4% growth. The correct DCF PE is 90 and so the correct PEG is 3.
Now if instead we had only 5 years of 30% growth followed by 25 years of 4% growth the correct PE is 38.6 and so the correct PEG is 1.3. Finally lets consider two years of 30%, 8 years of 10% and then 20 years of 4%. That gives PE = 30.1 and so PEG=1.
So obviously the right PEG has everything to do with how long the company will grow its earnings at that initial rate. In most cases the recommendation of buying stocks with PEG < 1 is actually too conservative. In retrospect buying Walmart with PE=100 would have been a very profitable thing to do since it grew quickly for 2 decades.
But there are other things wrong with PEG. It ignores things like return on equity (ROE) and quality of earnings. Maybe companies can grow earnings but will never develop into very profitable companies. Maybe they are growing earnings so quickly only because their initial earnings are so tiny (compared to say invested capital or total assets). For companies that have positive equity and fast growing earnings but very low ROE, it is useless to look at PEG. You should instead analyse the business model and figure out what ROE they will eventually obtain and how long it will take to get there.
Another reason to hate PEG. For slow growth companies, it makes no sense either. Perpetually slow growing companies can be valued with P/E = 1/(DR-G) where DR is the discount rate and G the perpetual growth rate. This requires G < DR.
inverting this E/P = DR -G or DR = E/P + G
Your expected return will be the discount rate DR = E/P + G. So you can see that what matters is E/P + G not PEG=(P/E)/G. You could choose to write this DR = E/P * (1+ G/(E/P)) for your expected return. Now you see that what matters is the
valuation E/P and the ratio of growth to E/P not its inverse P/E. In other words the right PEG is 1/(G*(DR-G)) which still obviously depends on G and DR.
So PEG makes no sense for slow growers and for fast growers it depends critically on how long the fast growth will continue. So why it is used at all?
Monday, November 27, 2006
Best 50-year stocks
From Jeremy Siegels "The Future for Investors"
These are the best survivor firms from the past 50 years. Top 10 with annual return.
Note that all are either consumer brand names or pharmaceutical with the exception of Royal Dutch Shell and Crane. There are no tech stocks with the exception of Crane (industrial products). None of these obtained a 20% return by themself. If you wanted to beat Buffett's 22% you needed to buy and sell.
These are the best survivor firms from the past 50 years. Top 10 with annual return.
| Stock | Annual Return |
| Phillip Morris | 19.75% |
| Abbot Labs | 16.51% |
| Bristol Myers | 16.36% |
| Tootsie Roll | 16.11% |
| Pfizer | 16.03% |
| Coca Cola | 16.02% |
| Merk | 15.90% |
| PepsiCo | 15.54% |
| Colgate Palmolive | 15.22% |
| Crane | 15.14% |
| Heinz | 14.78% |
| Wrigley | 14.65% |
| Fortune Brands | 14.55% |
| Kroger | 14.41% |
| Schering-Plough | 14.36% |
| Proctor & Gamble | 14.26% |
| Hershey Foods | 14.22% |
| Wyeth | 13.99% |
| Royal Dutch Shell | 13.64% |
| General Mills | 13.58% |
Note that all are either consumer brand names or pharmaceutical with the exception of Royal Dutch Shell and Crane. There are no tech stocks with the exception of Crane (industrial products). None of these obtained a 20% return by themself. If you wanted to beat Buffett's 22% you needed to buy and sell.
Stock Valuation
I have been trying to figure out a good method for stock valuation. There are of course many models for valuation mostly based on discounted cash flow models DCF. The idea is that a company is worth the sum of all future cash flows to the owners between now and infinity, discounted by some discount rate. This discounting is because money now is worth more than money in the future. If I had money now I could invest it and get about 10% per year so that in 7 years it will double. The discounting of future cash flows accounts for this simple fact.
Here is a good link to an overload of information on variations of DCF.
However for stock picking I think these complex models are not required. If you knew the inputs precisely (i.e. growth rates etc) then it might be good to include all of these details such as changes in working capital and changes in payout ratio. However you don't. I am looking for a good proxy to use for the whole class of stock that I like to invest in. I want a generally useful tool: a jacknife of sorts that I can quickly use to compare all stocks.
So a simple N-stage DCF model should suffice. I have written one in the IDL computer laguage. Of course, you need to pick a discount rate. This is always difficult. They way I figure it, you you simply fix the discount rate and keep it constant for all stocks. This is possible because I am only going to invest in one kind of company: companies with stable earnings and somewhat predictable growth rates. I don't need a variable risk premium, I don't need to work out the correct WACC etc.
I just use 10%. This of course specifies the relative weight I give to earnings now versus earnings in the future. However 10% seems reasonable because it is approximately the average stock return, is not far from the average bond rate (plus a constant risk premium). It is also the number of fingers that I have. This gives a fair value P/E of 10 for a perpetually zero growth company and a fair P/E of 20 for a perpetual growth rate of 4.8% which is about the long term bond rate. The way I figure one most needs a discount rate to decide whether to buy stock at all. Once you have chosen one, just use DCF to decide between stocks. Buy the cheapest relative to the DCF value with a few caveats.
Next choice: which earnings to use. Some just use accounting earnings. The Usual E. Others use DCF with the dividend D in which case P/E becomes P/D or inverse of dividend yield. There is the handy formula for the dividend discount model for constant growth.
Y= D/P = DR-G
where Y is dividend yield (D/P) and DR is the discount rate and G is the dividend growth. This is called the Gordon Growth Model and is easy to derive (it is just a geometric series). This only works for DR > G so that you don't get infinite value D/P = 0. I find this equation useful in that it tells you what the correct discount rate should be. DR= Y + G. If you buy the stock and sell in the future, after dividends and earnings have grown by G, and the valuation D/P stays the same then your anualized return will be R=Y+G which is the discount rate. In other words, the discount rate is your expected return. You want to buy things that give you a rate equal to or better than you expected return. This is somewhat circular but really gives you an idea of what the discount rate should be. 10% is not so bad of a return. Naturally I would like a higher return so if I use DR=10% in my N-stage DCF and find things that are selling for a significant discount to this rate, then I will buy them.
There are still other choices for earnings. I think using free cash flow (FCF) is probably the best. Buffett calls this Owner Earnings and in my code I use OE as FCF per share. This is cashflow-capital expenditure. The trick here is knowing whether the capital expenditure is really different from expenses and different from real investment. I don't have a good feel for this. Should I simply just trust the accounting line "Capital Expenditure" and subtract that off? If you do that you see that Home Depot has significant OE but Walmart does not. I doubt these two companies are that different so I am not sure if this is just differences in accounting.
So for a company reinvesting all of its money, use OE as earnings and look at growth in OE for the growth rates, G. For price I use enterprise value (EV). This is what you use if you were going to buy the whole company for market value and I think this is the right way to think about buying stocks. You get whatever cash and cash equivilents that the company owns and are stuck their debt as well. So EV = P - Debt + Cash. So now OE/EV is the measure of valuation that I estimate with DCF.
What about dividends? I still need to figure how to include these properly. I think you can simply augment the growth rate by
the dividend yield. This is because you can just buy more shares which is equivilent to having a faster growth rate. If a stock is growing OE at 12% with a dividend yield of 2% then use 14% for G. Not sure if this is entirely correct but will do for now.
The final question is how many stages. You clearly need at least two since most companies that I look at grow at something close to or greater than DR=10%. There is no point in getting carried away and having more than four. For a stable company like JNJ I use 2 or 3. Sometimes I get creative with stocks like homebuilders which should see a decline in earnings and then a turn around. You can still use DCF for this.
The hard part of DCF of course are the growth rates. Garbage In = garbage out as they say. Here, you don't want to over estimate growth or you could end up paying way too much. I think the best way to do this is to use the historic growth rates over 10 years. I get these from S&P though my scottrade account. I think a good thing to do is to take the ten year pattern and divide into 2 five-year segments and get the growth rate for each. Use the lower of thr two and take off 2 percent to be conservative. By doing this you aren't assuming it can grow any faster than it already has. Avoid new companies that have grown quickly because they had no earnings to begin with. Avoid cyclicals that have just come off a huge bull market. Don't ever input very high growth rates like G=40% since they are not sustainable. In fact I want to find companies with high ROE since this tells you the sustainable growth rate. G = ROE (1-p) where p is the payout ratio. That is I will avoid the Googles and the unproven internet stocks etc with huge growth rates and low ROE. I would rather buy a company with G=10% and low valuations since these kind of growth rates are likely to persist and getting the growth rate correct as well as the period of growth is less important.
Finally an example. Johnson & Johnson (JNJ). A perfect company for me (see "My rules for investing" post).
Annual growth in OE over the past 10 years is 13.4% (by exponential fitting) and 14.8% (point to point). The two five year periods are
G=13.5% (first) and G= 17.6% (most recent) as determined by exponential fitting. The lesser is 13.5%. The dividend yield is
Y=2.3%. So I will use G=13.5+2.3-2=13.8%. I will use a 3-stage model with
---------------
N Years | Growth
-------------
10 13.8%
10 8.0%
20 4.0%
In IDL I simply type:
IDL> dcf,[10,13.8,10,8.0,20,4]
Using default DR 10.0000
12.1112 12.7136 13.6629
total V/E = 38.4878
This reports that the Value to Earnings of 38.5. That pretty high but I think reasonable for a great company like JNJ. Over the next 40 years that predicts a growth in earnings (dividend adjusted) of 17 or 7.7 adjusted for 2% inflation. Taking out the dividends it says that the company must grow by a factor of 6 or so in 40 years which I think is very reasonable considering that the developing world is getting richer and will desire the same level of health care as the developed world and also the developed world is ageing rapidly. The key to trusting high valuations that come out of DCF is to ask whether the company is truely great and is likely to remain a strong company in the extreme distant future. I am fairly certain Coke, JNJ and Budweiser will be around in 100 years unless they are bought by another company. I have no idea what will happen to Google or Yahoo.
So how much does JNJ cost? Since we are working with owner earnings, it is EV/OE that we look at for valuation. The inverse of this I call free yield FY=OE/EV. JNJ has FY = 5.43% or OE/EV=18.41. This is not too different from the usual P/E which for JNJ is 17.29.
So according to DCF it is underpriced by 50%. Quite a steal!
What will my return be? Over the next 20 years this is a rise of about 7.75 in earnings. If valuation stays the same that is an 11% annulaized return. Not bad. However as I mentioned, I think the right valuation is twice as high. So if it takes 10 years to obtain the right valuation this will be a 13% return. If it takes 10 years it is 19%. If it only takes 3 years, it is a 37% annualized return although over a shorter period. I figure this is a sure thing to obtain a 10% annulized return over some future interval and possibly as high as 30% as long as I hold on through any ups and downs. I will buy now and sell whenever it becomes overpriced. I would probably sell if P/E > 35 but may sell after a year if there are even better opportunities.
Of course the growth rates could be wrong. Lets try a simple 2-stage with 10% initial growth.
IDL> dcf,[10,7,20,5],val,e,de
Using default DR 10.0000
8.61628 9.64537
total V/E = 18.2617
That comes closer to the price but requires 10 years of only 7% growth followed by 20 years of 5%. I don't see anyone could think that JNJ would see such terrible growth rates especially with the demographics that we have. JNJ is definitely underpriced. A definite BUY. The only question is whether there are better buys out there which is always the source of all my stress.
Here is a good link to an overload of information on variations of DCF.
However for stock picking I think these complex models are not required. If you knew the inputs precisely (i.e. growth rates etc) then it might be good to include all of these details such as changes in working capital and changes in payout ratio. However you don't. I am looking for a good proxy to use for the whole class of stock that I like to invest in. I want a generally useful tool: a jacknife of sorts that I can quickly use to compare all stocks.
So a simple N-stage DCF model should suffice. I have written one in the IDL computer laguage. Of course, you need to pick a discount rate. This is always difficult. They way I figure it, you you simply fix the discount rate and keep it constant for all stocks. This is possible because I am only going to invest in one kind of company: companies with stable earnings and somewhat predictable growth rates. I don't need a variable risk premium, I don't need to work out the correct WACC etc.
I just use 10%. This of course specifies the relative weight I give to earnings now versus earnings in the future. However 10% seems reasonable because it is approximately the average stock return, is not far from the average bond rate (plus a constant risk premium). It is also the number of fingers that I have. This gives a fair value P/E of 10 for a perpetually zero growth company and a fair P/E of 20 for a perpetual growth rate of 4.8% which is about the long term bond rate. The way I figure one most needs a discount rate to decide whether to buy stock at all. Once you have chosen one, just use DCF to decide between stocks. Buy the cheapest relative to the DCF value with a few caveats.
Next choice: which earnings to use. Some just use accounting earnings. The Usual E. Others use DCF with the dividend D in which case P/E becomes P/D or inverse of dividend yield. There is the handy formula for the dividend discount model for constant growth.
Y= D/P = DR-G
where Y is dividend yield (D/P) and DR is the discount rate and G is the dividend growth. This is called the Gordon Growth Model and is easy to derive (it is just a geometric series). This only works for DR > G so that you don't get infinite value D/P = 0. I find this equation useful in that it tells you what the correct discount rate should be. DR= Y + G. If you buy the stock and sell in the future, after dividends and earnings have grown by G, and the valuation D/P stays the same then your anualized return will be R=Y+G which is the discount rate. In other words, the discount rate is your expected return. You want to buy things that give you a rate equal to or better than you expected return. This is somewhat circular but really gives you an idea of what the discount rate should be. 10% is not so bad of a return. Naturally I would like a higher return so if I use DR=10% in my N-stage DCF and find things that are selling for a significant discount to this rate, then I will buy them.
There are still other choices for earnings. I think using free cash flow (FCF) is probably the best. Buffett calls this Owner Earnings and in my code I use OE as FCF per share. This is cashflow-capital expenditure. The trick here is knowing whether the capital expenditure is really different from expenses and different from real investment. I don't have a good feel for this. Should I simply just trust the accounting line "Capital Expenditure" and subtract that off? If you do that you see that Home Depot has significant OE but Walmart does not. I doubt these two companies are that different so I am not sure if this is just differences in accounting.
So for a company reinvesting all of its money, use OE as earnings and look at growth in OE for the growth rates, G. For price I use enterprise value (EV). This is what you use if you were going to buy the whole company for market value and I think this is the right way to think about buying stocks. You get whatever cash and cash equivilents that the company owns and are stuck their debt as well. So EV = P - Debt + Cash. So now OE/EV is the measure of valuation that I estimate with DCF.
What about dividends? I still need to figure how to include these properly. I think you can simply augment the growth rate by
the dividend yield. This is because you can just buy more shares which is equivilent to having a faster growth rate. If a stock is growing OE at 12% with a dividend yield of 2% then use 14% for G. Not sure if this is entirely correct but will do for now.
The final question is how many stages. You clearly need at least two since most companies that I look at grow at something close to or greater than DR=10%. There is no point in getting carried away and having more than four. For a stable company like JNJ I use 2 or 3. Sometimes I get creative with stocks like homebuilders which should see a decline in earnings and then a turn around. You can still use DCF for this.
The hard part of DCF of course are the growth rates. Garbage In = garbage out as they say. Here, you don't want to over estimate growth or you could end up paying way too much. I think the best way to do this is to use the historic growth rates over 10 years. I get these from S&P though my scottrade account. I think a good thing to do is to take the ten year pattern and divide into 2 five-year segments and get the growth rate for each. Use the lower of thr two and take off 2 percent to be conservative. By doing this you aren't assuming it can grow any faster than it already has. Avoid new companies that have grown quickly because they had no earnings to begin with. Avoid cyclicals that have just come off a huge bull market. Don't ever input very high growth rates like G=40% since they are not sustainable. In fact I want to find companies with high ROE since this tells you the sustainable growth rate. G = ROE (1-p) where p is the payout ratio. That is I will avoid the Googles and the unproven internet stocks etc with huge growth rates and low ROE. I would rather buy a company with G=10% and low valuations since these kind of growth rates are likely to persist and getting the growth rate correct as well as the period of growth is less important.
Finally an example. Johnson & Johnson (JNJ). A perfect company for me (see "My rules for investing" post).
Annual growth in OE over the past 10 years is 13.4% (by exponential fitting) and 14.8% (point to point). The two five year periods are
G=13.5% (first) and G= 17.6% (most recent) as determined by exponential fitting. The lesser is 13.5%. The dividend yield is
Y=2.3%. So I will use G=13.5+2.3-2=13.8%. I will use a 3-stage model with
---------------
N Years | Growth
-------------
10 13.8%
10 8.0%
20 4.0%
In IDL I simply type:
IDL> dcf,[10,13.8,10,8.0,20,4]
Using default DR 10.0000
12.1112 12.7136 13.6629
total V/E = 38.4878
This reports that the Value to Earnings of 38.5. That pretty high but I think reasonable for a great company like JNJ. Over the next 40 years that predicts a growth in earnings (dividend adjusted) of 17 or 7.7 adjusted for 2% inflation. Taking out the dividends it says that the company must grow by a factor of 6 or so in 40 years which I think is very reasonable considering that the developing world is getting richer and will desire the same level of health care as the developed world and also the developed world is ageing rapidly. The key to trusting high valuations that come out of DCF is to ask whether the company is truely great and is likely to remain a strong company in the extreme distant future. I am fairly certain Coke, JNJ and Budweiser will be around in 100 years unless they are bought by another company. I have no idea what will happen to Google or Yahoo.
So how much does JNJ cost? Since we are working with owner earnings, it is EV/OE that we look at for valuation. The inverse of this I call free yield FY=OE/EV. JNJ has FY = 5.43% or OE/EV=18.41. This is not too different from the usual P/E which for JNJ is 17.29.
So according to DCF it is underpriced by 50%. Quite a steal!
What will my return be? Over the next 20 years this is a rise of about 7.75 in earnings. If valuation stays the same that is an 11% annulaized return. Not bad. However as I mentioned, I think the right valuation is twice as high. So if it takes 10 years to obtain the right valuation this will be a 13% return. If it takes 10 years it is 19%. If it only takes 3 years, it is a 37% annualized return although over a shorter period. I figure this is a sure thing to obtain a 10% annulized return over some future interval and possibly as high as 30% as long as I hold on through any ups and downs. I will buy now and sell whenever it becomes overpriced. I would probably sell if P/E > 35 but may sell after a year if there are even better opportunities.
Of course the growth rates could be wrong. Lets try a simple 2-stage with 10% initial growth.
IDL> dcf,[10,7,20,5],val,e,de
Using default DR 10.0000
8.61628 9.64537
total V/E = 18.2617
That comes closer to the price but requires 10 years of only 7% growth followed by 20 years of 5%. I don't see anyone could think that JNJ would see such terrible growth rates especially with the demographics that we have. JNJ is definitely underpriced. A definite BUY. The only question is whether there are better buys out there which is always the source of all my stress.
My rules for investing
Here is my list of rules for buying stocks. These will probably evolve with time. I will refrain from investing in any company which fails ANY of these rules. If a company passes these tests then I will buy it if it well priced compared to my personal valuation models.
1) I understand the business reasonably well. I know where profits come from and what drives earnings growth.
2) The company has little to no risk of failure.
3) The company has stable postive earnings and decent earnings growth over long periods of time, say 10 years.
4) The company's earnings growth is sustainable. It's growth is fed by high returns on equity. ROE > 15, minimum, preferably much higher.
5) This high ROE is maintained by some apparent competitive advantage.
6) The company has low or no debt or at least high interest coverage for it's level of earnings volatility. This should be reflected in low leverage and high ROA and ROIC. Shows strong financial strength.
7) The company produces free cash flow and/or dividends.
8) The company is well managed. Management hold shares in the comany and act rationaly as owners.
9) The company returns excess cash to shareholders though dividends or buybacks. Exceptions are when company can reinvest in the business as very high ROIC.
10) The company has a good long term outlook. There is no chance of becoming obsolete by new technology or fundamental changes is the world economy. It is poised to benefit from important megatrends of our time: ie globalization, demographics. Macro ideas may enter here but should not dominate other factors.
11) The company is not burdened by organized labor or unfunded pension liabilities or any other off balance sheet items
including major lawsuits.
12) The company's earnings are not heavily regulated by the government.
13) Insiders are buying or some Superinvestor is buying or I am just VERY confident about the stock.
14) The company can be purchased at a good price (see "Stock Valuation" post).
1) I understand the business reasonably well. I know where profits come from and what drives earnings growth.
2) The company has little to no risk of failure.
3) The company has stable postive earnings and decent earnings growth over long periods of time, say 10 years.
4) The company's earnings growth is sustainable. It's growth is fed by high returns on equity. ROE > 15, minimum, preferably much higher.
5) This high ROE is maintained by some apparent competitive advantage.
6) The company has low or no debt or at least high interest coverage for it's level of earnings volatility. This should be reflected in low leverage and high ROA and ROIC. Shows strong financial strength.
7) The company produces free cash flow and/or dividends.
8) The company is well managed. Management hold shares in the comany and act rationaly as owners.
9) The company returns excess cash to shareholders though dividends or buybacks. Exceptions are when company can reinvest in the business as very high ROIC.
10) The company has a good long term outlook. There is no chance of becoming obsolete by new technology or fundamental changes is the world economy. It is poised to benefit from important megatrends of our time: ie globalization, demographics. Macro ideas may enter here but should not dominate other factors.
11) The company is not burdened by organized labor or unfunded pension liabilities or any other off balance sheet items
including major lawsuits.
12) The company's earnings are not heavily regulated by the government.
13) Insiders are buying or some Superinvestor is buying or I am just VERY confident about the stock.
14) The company can be purchased at a good price (see "Stock Valuation" post).
The tug of war - inflation versus deflation
I find it best to think of the monetary environment as a great tug of war. On one side is inflation which threatens to blow price asset bubbles, raise worker wages as well as prices and set in place an expectation of further inflation. Unchecked, this leads to hyperinflaton, destruction of the currency and eventually economic collapse. Think Weimar Germany of the 1920 or more recently Argentina. Pulling against inflation is deflation, a dropping of prices due to either excess supply or deficient demand. This leads to industry shutdowns, unemployment, lower wages and also loss of corporate profits. Think the Great Depression.
While many people tend to concentrate on warning of one or the other, I like the tug of war analogy. There are plenty of inflationary as well as deflationary forces in the world. The key is whether or not they are balancing each other or whether one is getting the upper hand. Usually there is a back and forth as one side begins to gain ground and the other gives it followed by a reversal as the losing side pulls back. The great fear of the bears on either side is that one side will win, dragging the losers through the mud and causing an economic collapse.
The great deflationary force today (perhaps a better term is disinflationary force) is globalization. This introduces more and more workers into the world economy and keeps wages down, prices down and corporate profits up. Against this is the greater demand for commodities as the world develops and the high profits spawning price asset bubbles. The US trade deficit and growing national debt seems to require a dollar decline which would lead to inflating prices for the US consumer. For the most part, these forces act to cancel each other out. Despite the fact that each team is pulling harder than before, things haven't moved much. The last two decades have seen low and stable inflation.
There are the gold bugs who think that paper money is the root of all evil and that the promoters of this great evil are the Federal Reserve and other central banks who aim at positive inflation. Their prediction is always hyperinflation where gold will soar in dollar value and the gold bugs themselves will become imensely rich. So far these gold bugs have had miserable returns as they missed the great bull market in stocks from 1982 to 2000 even considering the rather impressive gain in gold of the past few years.
On the other hand are the deflationists. Gary Shilling comes to mind as their chief proponent. At least with Gary Shilling we find someone who has made some excellent returns with his predictions. Gary made the excellent decision to buy zero coupon 30 years treasuries at their yield peak in 1980 and keep buying them (even on margin) through all of the great bond 25 year bull market. His return has been over 20% anualized since bond yields have fallen due to the change from the high inflation 70s to the low inflation 80s and 90s. Shilling still predicts that the disinflationary forces of globalization will dominate and cause outright deflation. He predicts a popping of the housing bubble and a decline of US house prices by as much as 30%.
Who is right? I tend to side with Shilling who makes some excellent arguments. However I also wonder if there is something else at work which makes the inflation/deflation distinction, the wrong way to look at things. Certainly I see the housing bubble deflating. This is clearly deflationary and will lead to a US recession. But what of the rest of the world. I think they are unlikely to decouple and will follow the US into a world recession. But what of the dollar? It does seem that the trade deficit cannot get much larger and that foreign holders will eventually dump dollars driving up interest rates. So can one be a dollar bear and still a deflationist? Shilling is not a dollar bear as far I understand. How can he deny the dollar weakness? Can't the Fed simply inflate the currency and reflate asset prices if they choose. This seems to be what PIMCO bond guru, Bill Gross predicts. Of course this can cause inflation just as the Fed bailed out the NASDAQ crash in 2000. But then again, if a world recession hits, no country will want too strong a currency. So perhaps the Fed can ease significantly without the world dumping dollars. Perhaps investors will pull out sharply from foreign investments to buy safer US assets which will prop up the dollar. I think this is Shillings idea. The US dollar is a safe haven. Asian currencies are not. So how does this all work out? I find this quite perplexing. I see great danger in financial markets but am unsure of how to avoid it.
My solution so far is to buy some safe, large multinational US stocks like JNJ, KO, MO concentrating on the less economically-dependent areas like health care and consumer staples. I figure that these seem rather hedged against either senario and are
reasonably priced. About 60% of my money is still collecting 5% in the money market due to indecision and fear of these threatening global imbalances.
While many people tend to concentrate on warning of one or the other, I like the tug of war analogy. There are plenty of inflationary as well as deflationary forces in the world. The key is whether or not they are balancing each other or whether one is getting the upper hand. Usually there is a back and forth as one side begins to gain ground and the other gives it followed by a reversal as the losing side pulls back. The great fear of the bears on either side is that one side will win, dragging the losers through the mud and causing an economic collapse.
The great deflationary force today (perhaps a better term is disinflationary force) is globalization. This introduces more and more workers into the world economy and keeps wages down, prices down and corporate profits up. Against this is the greater demand for commodities as the world develops and the high profits spawning price asset bubbles. The US trade deficit and growing national debt seems to require a dollar decline which would lead to inflating prices for the US consumer. For the most part, these forces act to cancel each other out. Despite the fact that each team is pulling harder than before, things haven't moved much. The last two decades have seen low and stable inflation.
There are the gold bugs who think that paper money is the root of all evil and that the promoters of this great evil are the Federal Reserve and other central banks who aim at positive inflation. Their prediction is always hyperinflation where gold will soar in dollar value and the gold bugs themselves will become imensely rich. So far these gold bugs have had miserable returns as they missed the great bull market in stocks from 1982 to 2000 even considering the rather impressive gain in gold of the past few years.
On the other hand are the deflationists. Gary Shilling comes to mind as their chief proponent. At least with Gary Shilling we find someone who has made some excellent returns with his predictions. Gary made the excellent decision to buy zero coupon 30 years treasuries at their yield peak in 1980 and keep buying them (even on margin) through all of the great bond 25 year bull market. His return has been over 20% anualized since bond yields have fallen due to the change from the high inflation 70s to the low inflation 80s and 90s. Shilling still predicts that the disinflationary forces of globalization will dominate and cause outright deflation. He predicts a popping of the housing bubble and a decline of US house prices by as much as 30%.
Who is right? I tend to side with Shilling who makes some excellent arguments. However I also wonder if there is something else at work which makes the inflation/deflation distinction, the wrong way to look at things. Certainly I see the housing bubble deflating. This is clearly deflationary and will lead to a US recession. But what of the rest of the world. I think they are unlikely to decouple and will follow the US into a world recession. But what of the dollar? It does seem that the trade deficit cannot get much larger and that foreign holders will eventually dump dollars driving up interest rates. So can one be a dollar bear and still a deflationist? Shilling is not a dollar bear as far I understand. How can he deny the dollar weakness? Can't the Fed simply inflate the currency and reflate asset prices if they choose. This seems to be what PIMCO bond guru, Bill Gross predicts. Of course this can cause inflation just as the Fed bailed out the NASDAQ crash in 2000. But then again, if a world recession hits, no country will want too strong a currency. So perhaps the Fed can ease significantly without the world dumping dollars. Perhaps investors will pull out sharply from foreign investments to buy safer US assets which will prop up the dollar. I think this is Shillings idea. The US dollar is a safe haven. Asian currencies are not. So how does this all work out? I find this quite perplexing. I see great danger in financial markets but am unsure of how to avoid it.
My solution so far is to buy some safe, large multinational US stocks like JNJ, KO, MO concentrating on the less economically-dependent areas like health care and consumer staples. I figure that these seem rather hedged against either senario and are
reasonably priced. About 60% of my money is still collecting 5% in the money market due to indecision and fear of these threatening global imbalances.
Saturday, November 25, 2006
The macro environment
I try to select stocks without making too many asumptions about the economy. However, I wonder if one can't ignore the economy for certain sectors. For example, you cannot just buy homebuilders without some feel for how the economy is going to behave. Well, I suppose you could but really the earnings of home builders for the next five years will be greatly affected by whether or not the US sinks into a recession and whether this pulls the rest of the world along. Even more so for banking which is more highly leveraged.
Buffett always claims to ignore the economy but I am not sure that I believe him. He seems to have avoided many of the past recessions. I suppose he would claim that it was simply over-valuation that tipped him off and not the economic outlook. Recently he has been outspoken about the fact that the US dollar must decline. That is pretty macro for Buffett.
Perhaps it is best to go against the prevailing view of the economy. For example it is probably true that people overestimate economists ability to predict the direction of the economy. If so then the prevailing view will have biased valuations in that particular direction. If so, then then market is not exactly macro-efficient but rather macro-biased. There must be money to be made simply by ignoring the popular economic view and insisting that we know nothing of the where the economy is going. Just use prior information not posterior information (in Bayesian language). I think the same principle applies to microeconomics. Ignore the analysts and just look at past earnings, histoic ROE and use common sense. If analysts are pessimistic then you have a buying opportunity because the market will discount their bogus information. This is probably the guts of contrarian stock picking. But is it right?
Buffett always claims to ignore the economy but I am not sure that I believe him. He seems to have avoided many of the past recessions. I suppose he would claim that it was simply over-valuation that tipped him off and not the economic outlook. Recently he has been outspoken about the fact that the US dollar must decline. That is pretty macro for Buffett.
Perhaps it is best to go against the prevailing view of the economy. For example it is probably true that people overestimate economists ability to predict the direction of the economy. If so then the prevailing view will have biased valuations in that particular direction. If so, then then market is not exactly macro-efficient but rather macro-biased. There must be money to be made simply by ignoring the popular economic view and insisting that we know nothing of the where the economy is going. Just use prior information not posterior information (in Bayesian language). I think the same principle applies to microeconomics. Ignore the analysts and just look at past earnings, histoic ROE and use common sense. If analysts are pessimistic then you have a buying opportunity because the market will discount their bogus information. This is probably the guts of contrarian stock picking. But is it right?
Monday, November 20, 2006
Bargaining Power
One of the important things that I look for in a company or even industry is bargaining power. In a free market, prices are generally set by the action of bargaining between players. The player that benefits the most is the one with the most bargaining power. For example, I believe that Walmart has enormous bargaining power. It's size allows it to get the lowest prices on products that it buys. When Walmart says no to one of its suppliers, you see a huge drop in that suppliers revenues. Walmart can simply buy that product from some other manufacturer. This is why Walmarts loves to introduce new products of a more generic nature. As long as Walmart shoppers are willing to buy the lowest price item, Walmart holds a powerful hand.
Brand name suppliers like Procter and Gamble, resist the tyranny of Walmart by offering strong brands. No other supplier can sell Walmart Tide detergent, Tampax tampons or Gillette razors. But generic suppliers hold little bargaining power with Walmart and there are so many of them thoughout Asia and the world.
Another example is banking. I just read a book by Ron Chernow called "The Death of the Banker". He suggest that one can make a bar chart with three bars. In the middle is banking which is the intermediary of the other two: the providers of capital and the consumers of capital. More on this in my blog on "The Death of the Banker". His thesis is that today the banker is much weaker than in the previous times of the Rothschilds and J.P. Morgan when they virtually controlled world finance.
One could also consider a similar chart with the retailers like Walmart and Target in the middle with the suppliers on one side and the consumers on the other. I would argue that the retailers are rising in power and hold considerable sway over the two other sides. If you won't pay Walmart prices, you are unlikely to get the products you want. Who can profitably, sell them cheaper? Similarly, if you're a supplier, you are unlikely to get many of your products to the market if you refuse to sell to Walmart under their terms. In many ways Walmart looks like this century's Monster of Morgan.
I think it is fruitful to look at many industries in this same way. Buiild a graph of bar charts showing who in the chain has the most bargaining power. Often there are more than three players. For example consider the Pharmaceutical industry. There is the branded pharmaceutical maker, the generic drug maker, the insurance company, the goverment, the hospital, the patients etc. Big pharma has held considerable bargaining power for years. Much of that has to do with the patentability of drugs and the high barriers to entry. Will this remain the case? Many argue that the recently elected Democrats wish to put an end to this. I wish them luck but I am putting my money with Big Pharma.
picks: Pfizer (PFE), Bristol Myers Squib (BMY), Johnson and Johnson (JNJ)
Brand name suppliers like Procter and Gamble, resist the tyranny of Walmart by offering strong brands. No other supplier can sell Walmart Tide detergent, Tampax tampons or Gillette razors. But generic suppliers hold little bargaining power with Walmart and there are so many of them thoughout Asia and the world.
Another example is banking. I just read a book by Ron Chernow called "The Death of the Banker". He suggest that one can make a bar chart with three bars. In the middle is banking which is the intermediary of the other two: the providers of capital and the consumers of capital. More on this in my blog on "The Death of the Banker". His thesis is that today the banker is much weaker than in the previous times of the Rothschilds and J.P. Morgan when they virtually controlled world finance.
One could also consider a similar chart with the retailers like Walmart and Target in the middle with the suppliers on one side and the consumers on the other. I would argue that the retailers are rising in power and hold considerable sway over the two other sides. If you won't pay Walmart prices, you are unlikely to get the products you want. Who can profitably, sell them cheaper? Similarly, if you're a supplier, you are unlikely to get many of your products to the market if you refuse to sell to Walmart under their terms. In many ways Walmart looks like this century's Monster of Morgan.
I think it is fruitful to look at many industries in this same way. Buiild a graph of bar charts showing who in the chain has the most bargaining power. Often there are more than three players. For example consider the Pharmaceutical industry. There is the branded pharmaceutical maker, the generic drug maker, the insurance company, the goverment, the hospital, the patients etc. Big pharma has held considerable bargaining power for years. Much of that has to do with the patentability of drugs and the high barriers to entry. Will this remain the case? Many argue that the recently elected Democrats wish to put an end to this. I wish them luck but I am putting my money with Big Pharma.
picks: Pfizer (PFE), Bristol Myers Squib (BMY), Johnson and Johnson (JNJ)
Friday, November 17, 2006
Utah Medical Products (UTMD)
Utah Medical Products (UTMD) is a great small cap medical products company from Salt Lake City. Primarily they make disposable or reusable products for neonatal, obstetrics, fetal monitoring etc.
Here are three plots of interest for this company.
The top is the "owner earnings" (Buffett's term for per share free-cash-flow) over ten years. Note the nice growth rate of 16-17%. Note also the two-stage growth slowing from 24% to 9.6% in the two five year intervals. Back to that in a moment.
The second plot is return on equity (ROE). It flucuates between 20 and 40 which is excellent. They say they aim for at least 25.
The third plot is most interesting. This is shares outstanding. They buy back shares like crazy. They are reducing share count by 8.6% per year over ten years. In addition, they just started paying a dividend which is growing rapidly. The thing with this company is that they do not really grow much. They are simply very profitable and they use nearly all their earnings to buy back shares which raises EPS. This keeps them a microcap, only $132M. They are a great little cash machine that Wall Street ignores simple because they are too small for big mutual funds to buy.
This company was nearly shut down two years ago by the FDA due to some false accusation about safety violations that was thrown out by a judge. The stock crashed. They lost customers. They spent a ton in legal fees that they are now trying to recover from the FDA. That is now done. This hurt them financially. You can see this in their growth rate above (first plot). The second five year period is much slower growth 9.7 versus 24. With all of this behind them, they should be able to growth EPS at that higher rate of 24%. After all, why not? They are not really any bigger than 10 years ago. Most companie's earnings slow because they get bigger. This company stays the same size and buys back shares and will probably raise its dividend and hopefully make some smart aquisitions. Why shouldn't they be able to regain that level of profitability?
If they do this stock will have a great run. Even if they don't improve much they are fairly priced at P/E=17. This would be a great compnay for JNJ to buy. I have bough some shares and will probably buy more soon. Keep an eye on the insider transactions.
Here are three plots of interest for this company.
The top is the "owner earnings" (Buffett's term for per share free-cash-flow) over ten years. Note the nice growth rate of 16-17%. Note also the two-stage growth slowing from 24% to 9.6% in the two five year intervals. Back to that in a moment.
The second plot is return on equity (ROE). It flucuates between 20 and 40 which is excellent. They say they aim for at least 25.
The third plot is most interesting. This is shares outstanding. They buy back shares like crazy. They are reducing share count by 8.6% per year over ten years. In addition, they just started paying a dividend which is growing rapidly. The thing with this company is that they do not really grow much. They are simply very profitable and they use nearly all their earnings to buy back shares which raises EPS. This keeps them a microcap, only $132M. They are a great little cash machine that Wall Street ignores simple because they are too small for big mutual funds to buy.
This company was nearly shut down two years ago by the FDA due to some false accusation about safety violations that was thrown out by a judge. The stock crashed. They lost customers. They spent a ton in legal fees that they are now trying to recover from the FDA. That is now done. This hurt them financially. You can see this in their growth rate above (first plot). The second five year period is much slower growth 9.7 versus 24. With all of this behind them, they should be able to growth EPS at that higher rate of 24%. After all, why not? They are not really any bigger than 10 years ago. Most companie's earnings slow because they get bigger. This company stays the same size and buys back shares and will probably raise its dividend and hopefully make some smart aquisitions. Why shouldn't they be able to regain that level of profitability?
If they do this stock will have a great run. Even if they don't improve much they are fairly priced at P/E=17. This would be a great compnay for JNJ to buy. I have bough some shares and will probably buy more soon. Keep an eye on the insider transactions.
Graco (GGG)
This is a spectacular company. They manufacture equipment for handling fluids: spraying, pumping, dispensing all kinds of fluids. They dominate this niche market. Much of their usefullness is in adding cheap but high-value-added properties to products. For example, spraying the coat of paint on a new car doesn't actually cost the car maker that much compared to say making the engine of the car. However customers expect an excellent coat of shiny paint. It is what they see after all. A cheap paint job which may save the car company $100 will devalue the car by $1000 in the eye of the customer. It simple isn't tolerated. Car companies will pay for quality paint equpment since it is crucial to making their cars.
Similarly, a factory that dispenses a fluid (say Hershey's chocolate, a Graco customer) needs to do this is a precise way. They need to put a precise amount of the fluid into packages. They need to be able to keep the equpment running. They have no tolerance for pumps that jam, sprayers that get clogged, or equipment that otherwise breaks. They also don't want to spend their time solving these kind of problems. They hire Graco who is the world expert on solving these problems. Pumping fluids around is exactly the kind of thing that is a weak link. Whatever the factory is, you can bet that if they can't provide the right fluid (oil, water, chocolate, tomato paste, paint, adhesive, solvent, lubication whatever) at the right place at the right time, then their whole operation shuts down. The need the job done right and they call Graco to deliver the solution.
This enables Graco to attain high profitablity making a huge variety of products that are variations on a similar set of well understood ideas. They have been growing at about 17% for a decade. They are well mananged and return a significant amount of earnings to share holders. Average return on equity (ROE) is an incredible 50% over the past 10 years.
They trade at about 19 times earnings which is a reasonable price if not exactly cheap. Free cash flow yield is about 5% and per share FCF is growing at 18% with capital expenditure showing no long term upward trend. I will probably acquire some GGG in a week or so. Hoping for a downturn of a few percent. This would probably be a better stock to pick up during a recession which may finally come in 2007.
Similarly, a factory that dispenses a fluid (say Hershey's chocolate, a Graco customer) needs to do this is a precise way. They need to put a precise amount of the fluid into packages. They need to be able to keep the equpment running. They have no tolerance for pumps that jam, sprayers that get clogged, or equipment that otherwise breaks. They also don't want to spend their time solving these kind of problems. They hire Graco who is the world expert on solving these problems. Pumping fluids around is exactly the kind of thing that is a weak link. Whatever the factory is, you can bet that if they can't provide the right fluid (oil, water, chocolate, tomato paste, paint, adhesive, solvent, lubication whatever) at the right place at the right time, then their whole operation shuts down. The need the job done right and they call Graco to deliver the solution.
This enables Graco to attain high profitablity making a huge variety of products that are variations on a similar set of well understood ideas. They have been growing at about 17% for a decade. They are well mananged and return a significant amount of earnings to share holders. Average return on equity (ROE) is an incredible 50% over the past 10 years.
They trade at about 19 times earnings which is a reasonable price if not exactly cheap. Free cash flow yield is about 5% and per share FCF is growing at 18% with capital expenditure showing no long term upward trend. I will probably acquire some GGG in a week or so. Hoping for a downturn of a few percent. This would probably be a better stock to pick up during a recession which may finally come in 2007.
Meritage Homes (MTH)
I think the best publically traded home builder is probably Meritage Homes
Here is a plot of the book value of MTH over the past 10 years. Look at how stable this growth is, about 37%.
They have one of the highest Return On Equity (ROE) of the builders, about 30%. They retain all earnings and grow at about their ROE which is good. Debt level and leverage is reasonable. P/B is about 1.2. Earnings yield (EBIT/EV) is about 24% although earning of all hombuilders is plummetting. The only home builder with better numbers is NVR which has management ethics problems.
The only problem with Meritage and the reason that the market gives them a lower valuation then say Centex or Toll Brothers is that they are not very geographically diversified. They build houses in just 6 states. Texas, Arizona, California, Colorado and Florida and Nevada. These states may be some of the more bubbly ones and so people think this is a riskier stock. However these are also the best states to be in. These markets will have the most growth over the coming decade and that is why they are there and this is partly why there are more profitable than the others. Buying a home builder now only has one real risk. That is liquidity risk. They can go bankrupt. This happened to big home builders before. US Homes, NVR and UDC all went bankrupt. NVR just started out and walked right into than crash of 1991-1992. After coming out a bankruptcy they became one of the best stock to own over the 10 year period of 1995-2005; their stock price grew by a factor of 53. Home builders in general look like great long term investments right now. They just need to avoid going bankrupt due to a liquidity crisis during this crash. For that they need, low debt to equity, a decent available line of credit which nearly all big builders have (maybe TOA the exception).
Other home builders that I am looking at are TOL, RYL and HOV. I think the trick is not to pick the biggest and most diversified but rather look for the most profitable and best managed which will do the best over the long term. It probably would pay a bit to diversify a some between a few home builders since you never know.
Here is a plot of the book value of MTH over the past 10 years. Look at how stable this growth is, about 37%.
They have one of the highest Return On Equity (ROE) of the builders, about 30%. They retain all earnings and grow at about their ROE which is good. Debt level and leverage is reasonable. P/B is about 1.2. Earnings yield (EBIT/EV) is about 24% although earning of all hombuilders is plummetting. The only home builder with better numbers is NVR which has management ethics problems.
The only problem with Meritage and the reason that the market gives them a lower valuation then say Centex or Toll Brothers is that they are not very geographically diversified. They build houses in just 6 states. Texas, Arizona, California, Colorado and Florida and Nevada. These states may be some of the more bubbly ones and so people think this is a riskier stock. However these are also the best states to be in. These markets will have the most growth over the coming decade and that is why they are there and this is partly why there are more profitable than the others. Buying a home builder now only has one real risk. That is liquidity risk. They can go bankrupt. This happened to big home builders before. US Homes, NVR and UDC all went bankrupt. NVR just started out and walked right into than crash of 1991-1992. After coming out a bankruptcy they became one of the best stock to own over the 10 year period of 1995-2005; their stock price grew by a factor of 53. Home builders in general look like great long term investments right now. They just need to avoid going bankrupt due to a liquidity crisis during this crash. For that they need, low debt to equity, a decent available line of credit which nearly all big builders have (maybe TOA the exception).
Other home builders that I am looking at are TOL, RYL and HOV. I think the trick is not to pick the biggest and most diversified but rather look for the most profitable and best managed which will do the best over the long term. It probably would pay a bit to diversify a some between a few home builders since you never know.
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