Two value strategies

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.

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.

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.

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.

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.

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?