Value Investment Strategy Roadmap

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In recent years, it’s become more popular to classify investors’ approaches as being either “value” or “growth.” These have become accepted as being polar opposites, almost like taking sides in a sports event: do you support “value” or “growth”? Value and growth are not enemies, nor are they based on incompatible beliefs. For investors, company fundamentals support either a value or a growth approach to selecting stocks. We could consider that value investing is the more profitable discipline in the long term, but there are many successful, fundamental growth investors. However, most speculators consider themselves “growth investors,” and it’s among this group that we may expect to see a high failure rate.

Which companies qualify as value companies, and how does a value investor know what to look for? Even though value companies come in all sizes—and from a wide variety of different industries—they tend to have some key characteristics in common.

Value Companies Characteristics
In many respects, value companies are hard to pigeonhole. Value investors find opportunities in a variety of industries and among companies of all sizes. (As a result, the strategy’s practitioners pay scant attention to the copious lists of companies by sales, market capitalization, and so on, published by Fortune, Forbes, and other financial magazines.) Similarly, location varies widely. Value opportunities may be found in San Diego, Sao Paulo, London, and elsewhere. It is possible, however, to list a few key traits that value companies tend to have in common. As noted earlier, value investors look for companies selling at substantial discounts to their intrinsic values. Therefore, the price of the business versus its long-term private business value is paramount. The companies most attractive to value investors typically also share the following characteristics:

1. Understandable products and services.
Without solid understanding of a business’s products and services—what it sells to earn money—how can its strengths and weaknesses be evaluated thoroughly? Moreover, how can its intrinsic value be determined? Value practitioners invest in companies whose products and services they can understand. Comprehension paves the way for in-depth analysis of investment opportunities as well as proper monitoring of existing holdings. Knowledge also provides an important measure of self-defense. Understanding a business diminishes the likelihood that you’ll buckle to sensational (but perhaps false) stories in the media that could adversely influence your investment decisions over the short term.

2. Consistent earnings generation.
Earnings records for value companies typically demonstrate lengthy, stable histories of income creation. That’s not to say that intermittent losses rule out a potential investment opportunity; to the contrary, the negative sentiment that frequently accompanies temporary earnings downturns sometimes pushes a company’s stock price down to attractive levels. Overall, value investors believe that—although past results do not guarantee future success—a consistent long-term earnings record can be a strong indicator of near-term future potential.

3. Strong financial health.
By generally focusing on companies with low debt levels, value investors help ensure that their holdings will stay strong in the event of economic or company-specific hard times. The next chapter reviews specific measures useful for conducting financial health checkups.

What about growth? As a value investor, I very much would like to see a business growing. At the same time, I want to ensure that this growth creates value rather than destroys it. Value-destructive growth occurs when a company’s investments generate returns below its cost of capital, which can occur in spite of sales or earnings per share growth. In other words, the opportunity costs of growing the business exceed the income that the business generates. This value-impairing growth can occur organically, such as when a company may become overly aggressive in its pricing to win new business, or externally, when a company overpays for acquisitions.

An example of shareholder impairment through acquisition can be seen in Service Corporation International (SRV), the nation’s largest funeral and cemetery provider. This industry had been very fragmented, characterized primarily by small, local, independent funeral homes and cemeteries. As early as the 1960s, SRV recognized the benefits of consolidating these independent operators into regional and national “clusters,” creating significant cost and revenue synergies. This resulted in attractive growth for the company, as it was able to generate these synergies at reasonable acquisition prices. SRV financed acquisitions with cash, by issuing debt, or by using its stock as currency.
However, in the middle to late 1990s, the acquisition environment turned decidedly less attractive. Other consolidators began bidding for possible target businesses, resulting in increasingly expensive acquisition prices. At the same time, the industry’s growth caught the attention of Wall Street, which encouraged and rewarded additional growth. Eventually acquisition prices rose to a level where new deals became value destructive, and successfully integrating the volume of acquired businesses became difficult. SRV was not alone. The entire industry’s problems became evident in 1998 and 1999 amid a difficult operating environment. Earnings targets were missed, resulting in reduced stock prices, and therefore an inability to do additional deals with their “rich currency.” SRV and others were left with excessive debt, and in some cases forced to divest previously acquired businesses at prices significantly lower than those at which they were purchased. The industry’s four largest companies saw their stock prices fall an average of 70 percent in 1999, and the second-largest competitor filed for bankruptcy.
The bottom line is that a value company’s attributes can include growth as long as that growth has a positive influence on the company’s wealth creation potential. Overall, although there are no hard and fast definitions of what makes a value company, low debt, consistent earnings, and comprehensible business activities are key traits that tend to characterize the equities that value investors prefer. Given these traits, it’s not surprising that true value investors did not purchase shares of dot-com companies during the Internet bubble of the late 1990s.

Top-down or Bottom-up Investing
Generally, investors begin their search for attractive candidates in one of two ways: top-down or bottom-up.

Top-down investors start broadly and narrow the search for individual stocks based on a number of assumptions. For example, before looking at the company-specific traits cited above, top-down investors might start by trying to gauge the strength of a certain country or region. They may study forecasts of economic growth, business sentiment, or the recent performance of stocks in that area. If pleased with the prospects for a region or country, they may then seek what they believe are the most promising sectors or industries within that area, perhaps drawing on projections of sales or the profit potential of new products or services. In addition, top-down investors may factor in expectations for interest rate moves, changes in the political climate, or shifts in broad economic trends. After weighing all these factors and targeting a specific niche, top-down investors will then try to pinpoint specific stocks within that niche.

Bottom-up investors start at the company-specific level. They evaluate thousands of individual businesses simultaneously, researching and analyzing companies in diverse industries, sectors, and countries. They seek the most attractive candidates they can find, regardless of where they are located. They pay less attention to macroeconomic factors such as interest rates or unemployment or gross domestic product. They do not have to forecast which sectors or industries will be the top performers in the short term. They focus principally on the prospects for individual companies.
Using the latest investment technology tools, a team of research professionals dedicated to evaluating businesses all over the world analyzes opportunities every day. Professional money managers may have more extensive resources than individuals. Despite these resources, they still may fall victim to the very behaviors that value investors seek to exploit, such as overconfidence and extrapolation. Strict adherence to a value investment approach is as important as selecting appropriate stocks.

Finding Value Investment Opportunities
There are a few specific areas where opportunities for investment might be found.

Out-of-Favor Industries
Value investors frequently search for bargains among companies or sectors relegated to the scrap heap by the public. For example, stresses on the financial system in the aftermath of the 2008 recession resulted in tremendous bargains in the banking sector. Many banks sold for below book value. As the economy recovered, regional and money-center banks staged a powerful rally.

Geographic Hard Times
The value strategy’s practitioners can also look for troubles unique to a particular geographic region. In the 1980s, the collapse of energy prices temporarily depressed economies in the oil patch of Texas and Oklahoma. Similarly, budget cuts in the defense sector hurt the California economy in the early 1990s. Economic woes and the threat of currency devaluation in Southeast Asia in 1997 weighed on sentiment and dragged down share prices for a number of solid businesses. Remember, the goal is to profit from the investing public’s overly emotional reaction to a temporary situation.

New Lows
Another source of potential bargains is the daily stock tables, which contain information on companies whose stock prices have fallen to new lows. Major business publications like Investor’s Business Daily or The Wall Street Journal regularly list companies that fell to new 12-month lows the previous day. Such companies certainly qualify as out of favor and could warrant further investigation. You may be surprised at how often companies that pop up in these three categories (out-of-favor industries and regions or in the new-low stock tables) also pass the tests of financial health, earnings generation, and understandable businesses.

“Falling Knives”
In addition to companies that have fallen to new lows, value investors may find opportunities among companies whose share prices have fallen sharply in a short period. The Brandes Institute—a division of my firm dedicated to research and education—published a study exploring the validity of the Wall Street adage “never catch a falling knife.” This long-standing maxim advises investors to avoid purchasing stocks that have declined sharply in a short period of time. When it comes to bankruptcy risk, Wall Street’s warning may be on to something. While the annual bankruptcy rate for publicly traded companies is under 1 percent, a full 13 percent of the “falling knives” identified in the study went bankrupt within 3 years. However, investors who “never catch a falling knife” might be missing an opportunity to earn significant returns. On average, the falling knives in the study, including those that went bankrupt, outperformed the S&P 500 Index by an annualized 17.7 percent in the 3 years following their identification. This means that a diversified portfolio of falling knives might enhance overall returns significantly.

Value Portfolios
You also might study the portfolios of value investors who have put together lengthy and outstanding track records. For example, a review of the equity offerings of value-based fund groups such as Longleaf Partners, Third Avenue Funds, or Tweedy, Browne could point to potential investment opportunities. A fund’s shareholder report, which lists its recent holdings, can usually be requested over the Internet, or in writing. Warning: Don’t buy a stock only because a highly touted professional investor has done so. You should understand and have confidence in the logic of the decision to avoid buying or selling at the wrong time or for the wrong reason.

Good value-based ideas can be found in such publications as Barron’s, The Wall Street Journal, The New York Times, Investor’s Business Daily, orThe Financial Times. These publications each print rosy developments—and some not so rosy—about companies that Wall Street already loves. Occasionally, however, they also feature information about companies that meet value criteria such as having undervalued assets. As you review these publications, try not to pay too much attention to one of their favorite topics: short-term movements in the price level of the overall market. Remember, true value investors focus on a bottom-up, company-by-company search for large discrepancies between a stock’s price and its fair value. Accordingly, the broad market’s day-to-day fluctuations are of little significance.

Typically, initial public offerings (IPOs) are not recommended for the average value investor. Consider the conflict of interest associated with these shares. Private owners seek to sell shares at the highest price possible while value investors seek the lowest possible price. Be especially wary of IPOs when the stock market is surging to successive record highs. The hype that usually accompanies IPOs during a bull market tends to push their valuations beyond the range that would interest a value investor. Price-earnings ratios for IPOs, for example, can reach double or triple that of the overall market; some of the hotter new offerings sell on nothing more than a wing and a prayer. With expectations set so high, the odds of disappointment are often too great. A value approach to stock selection requires that investors pay only for what is seen, not for what is hoped.
One example of the perils of IPO investing is eToys, which was a darling of the investment world in the late 1990s. The online retailer went public in May 1999 and soon boasted a market capitalization of $5 billion—despite recording only $100 million in annual sales. By comparison, Toys “R” Us, an Old Economy company with $12 billion in sales, was valued at only $1 billion by the market. eToys filed for bankruptcy 16 months later. In October 2002, eToys completed its Chapter 11 liquidation plan. “All equity interests in former eToys will be cancelled and shareholders will receive nothing under the plan,” reported. In contrast, by the end of 2002, the market cap for Toys “R” Us had doubled to $2 billion, and the company’s toys were sold through a joint venture with online retailer Despite horror stories like eToys, young public companies shouldn’t be dismissed out of hand. There is a time to look at them, but in most cases it’s after the stock has traded for a period and the initial fanfare has faded. Problems may have arisen in the young company’s fortunes: either management can’t handle growth, fails at diversification, and expands too rapidly or competition becomes more intense.

Two scenarios might occur: The stock is richly priced in the offering, rises for a while, then falls back as earnings difficulties arise. Or, the company’s stock is overpriced to begin with and immediately falls below the initial offering price.
Bargains are there for the asking in the post-IPO market if you have the patience to look and wait. You should determine, however, whether any problems with a young company are only temporary and will be rectified in a reasonable time.
Keep in mind that the absence of a lengthy operating history means many IPO opportunities don’t deserve a value investor’s time. Sometimes, however, companies with stable operating histories spin off divisions as IPOs. In other cases, a private company with a long-term track record may raise capital through an IPO. These special cases may present opportunities for value investors. Again, always evaluate the value of the underlying business against its stock price.

Value Investments Warning Signs
No matter where value investors search for opportunity, they’ll undoubtedly encounter dozens of potential investments that can be ruled out after a cursory review. How can undesirable businesses be spotted quickly? The following guidelines explore several easy-to-recognize warning signs. (Keep in mind that these guidelines are not necessarily universal. Experienced value investors might recognize opportunity in a company priced well below its true value, even if it falls short in one or more of the following categories.)

1. Avoid businesses loaded with debt. A good rule is “Businesses should have no more debt than equity.” (Of course, that’s not true in all cases. For example, the rule doesn’t apply to financial companies, whose lines of business often require high levels of debt relative to equity.)

2. Run from corporate managers who seem concerned with perks, golden parachutes, bonuses, and excessively high salaries in relation to the return to shareholders. How does the value investor get answers to these concerns? Simply thumb through a company’s SEC-required filings, such as the 10-K report or notice of shareholders’meeting and proxy statement. Also take a quick glance at industry reports, which provide benchmarks for executive compensation in a particular type of business.

3. Don’t invest in businesses that generate money through accounting cleverness rather than real cash. Such businesses require more investment as sales grow, resulting in a lack of working capital. Look at cash flow figures; a healthy cash flow indicates that a company can pay all of its bills with enough left over to buy shares, pay out a larger dividend, or invest.

4. Detour around companies that change character every time a hot idea appears on the horizon. Many defense contractors, for example, promote sweeping and risky new programs just to stay in business. Other managers assume so much risk it is literally a “bet your company” circumstance.

5. Stay away from companies committed to providing services or commodities at fixed prices for a long time in the future. Rising inflation could wreak havoc here.

6. Bypass capital-intensive companies. Often the cash flow of such companies is insufficient to provide a satisfactory return while still maintaining a plant at competitive levels. These companies must regularly borrow or issue stock to stay in business.

7. Be particularly cautious about businesses subject to government regulation. These firms generally don’t make good long-term investments since their rates of return are limited by law.

8. Watch out for companies with different classes of stock. Shareholders may be disenfranchised through limited or nonvoting stock. Also be careful to avoid foreign companies issuing different classes of stock for nondomestic shareholders. These shares may trade at substantially different levels from those of stocks owned by domestic investors.

9. Pass by companies with managements that only occasionally initiate cost-reduction programs. Cost reduction should be an ongoing way of doing business.

10. Avoid companies that continually issue additional shares. Each subsequent equity offering dilutes the ownership value of existing shareholders. The dilution also lowers a company’s earnings per share, an important factor in determining a stock’s fair value. Be especially cautious if the proceeds from a secondary stock offering are used to invest in businesses with lower rates of return or those for which management seems ill prepared. Remember, a bigger pie is not always a better pie.

Value Investment versus Star Company
One more general idea that value investors keep in mind is that a good company is not necessarily the same as a good investment. An established firm with high revenue levels and a stable, strong earnings record, for instance, certainly sounds like a good company. But like any company, that firm only represents a good investment if it can be purchased at a favorable price.
Take Cisco Systems as an example. In April 2000, Cisco qualified as a good company by almost any investor’s standards. As a supplier of data networking products for the Internet, the firm was logging strong sales and demonstrating real earnings power, as well. In 1999, Cisco posted $15 billion in revenue and $2.5 billion in net income. Even as many technology companies were fading fast, Cisco’s dominant market share in an important industry meant the firm’s future prospects were bright. Despite its strengths as a company, however, most value investors stopped short of calling Cisco a good investment. The firm’s stock price translated into an astronomical market capitalization of more than $465 billion—nearly half a trillion dollars! This figure dwarfed Cisco’s revenue and earnings numbers, an indication that shareholders were counting on tremendous long-term growth from the company in the years ahead. If this growth failed to materialize, Cisco’s market value faced the risk of substantial declines.
As a result, most value investors avoided Cisco and looked for stocks with prices that were less dependent on extremely high expectations.

Value Tests and Safety Tests
Ben Graham proposed some quantitative screens used to uncover compelling investment opportunities. The value tests focus on income and income-generating assets, while the safety tests put the spotlight on risk factors such as debt levels and earnings stability. If a stock satisfied at least one of the criteria on each list, he believed, it probably qualified as a good bargain.
Five Tests for Value
1. Earnings yield is at least twice the yield on long-term AAA bonds.
2. The P/E ratio falls among the lowest 10 percent of P/Es in the universe.
3. Dividend yield is at least two-thirds the yield on long-term AAA bonds.
4. Stock price is less than two-thirds of tangible book value (total book value minus goodwill) per share.
5. Stock price is less than two-thirds of net current assets (current assets minus current liabilities).

Five Tests for Safety
1. Debt-to-equity ratio is less than 1.0.
2. Current assets are at least twice current liabilities.
3. Total debt is less than twice net current assets.
4. Annual earnings growth is at least 7 percent over the previous decade.
5. No more than two year-to-year earnings declines of more than 5 percent during the previous decade.

The experienced value investor might possibly ignore one or more of the criteria, but only if compelling and well-researched reasons exist for doing so.

Estimating Intrinsic Value
Graham’s approach places strong emphasis on three factors that value investors consider critical. First is earnings strength, a quality measured by a variety of criteria including consistency of annual earnings per share and freedom from periods of net losses. Second is financial strength, which is typically evaluated using metrics like debt-to-equity ratios. Third is low price, a factor accounted for in ratios such as price-to-book and earnings yield.
All three of these factors are also integral to another key valueinvesting approach: purchasing companies at substantial discounts to their intrinsic values. But what is intrinsic value, exactly? And how is it calculated in practice?

Accordingly, the value strategy’s adherents tend to place significant emphasis on insights gained from a thorough analysis of a company’s past and present. This is where the three factors mentioned above come into play. To calculate intrinsic value, value investors rigorously examine qualities such as financial strength and earnings strength in the context of the company’s past results, its current operations, and its future prospects. Once calculated, this value is divided by the number of shares outstanding to arrive at an estimate of intrinsic value per share. Then, this per- share intrinsic value is compared with the company’s stock price. If the stock price is low enough to offer a significant discount to intrinsic value, the stock is purchased.

It’s important to note that an estimated intrinsic value range is often just as useful as a precise number when evaluating the suitability of a potential investment. As Ben Graham points out in Security Analysis, a book he coauthored with David Dodd in 1934, “It is quite possible to decide by inspection that a woman is old enough to vote without knowing her age, or that a man is heavier than he should be without knowing his exact weight.” Similarly, a ballpark estimate of intrinsic value sometimes can be enough to discern an investment opportunity if a stock is trading at a much lower price.
Another essential point is that value investors don’t expect to be able to come up with intrinsic value estimates for every stock in the market. Firms operating in nascent industries with rapidly changing dynamics, for example, are often surrounded by levels of uncertainty that make any estimates of underlying worth dubious. In cases like these, value investors recognize the limits of their abilities and move on to evaluate other companies.
Overall, the process of calculating intrinsic value may involve as much art as science. At the same time, the familiar factors of earnings strength, financial strength, and low price stand out as key themes. A focus on these qualities—applied within the realm of one’s expertise—is critical to the value investor’s approach.

The Price-to-Earnings Metric
The price-to-earnings or P/E ratio is an oft-mentioned metric that, despite its simplicity, can help greatly in the evaluation of investment opportunities. In its most basic form, the P/E ratio is calculated by dividing a company’s share price by its earnings per share (EPS) over the most recent four quarters.
By comparing XYZ’s P/E to the P/E ratio of the overall market, for example, you can get a quick idea of the company’s relative cost. An S&P 500 P/E of 15, for instance, means the going rate on $1 of earnings from the average company in the index is $15. XYZ would seem inexpensive by comparison and might warrant further investigation. The current P/E ratio for major market indices can frequently be found on the index providers’ Web sites. Over the last 40 years, the P/E ratio of the S&P 500 has ranged from a low of roughly 8 times earnings to a high of close to 45 times earnings. The main limitation on the power of the P/E is the fact that the “E” in the equation equals EPS from just 1 year.
A good way to account for the year-to-year fluctuations in EPS is to look at “sustainable EPS.” A nonscientific but useful way to calculate sustainable EPS is to simply average a company’s EPS figures over the last 3 to 5 years. that’s enough history to smooth out any unusual events and variations in the company’s business cycle. Of course, any analysis based on estimates of sustainable earnings estimates must incorporate any doubts as to the true sustainability of the company’s earnings power in the future.
Another P/E option involves “estimated EPS.” Many publicly traded firms are monitored by Wall Street analysts, who frequently publish estimates of the company’s EPS for the current year as well as the year ahead. These earnings estimates often ignore unusual items, so P/E ratios with estimated EPS in the denominator might help keep company-to-company comparisons legitimate. Earnings estimates must be used with extreme care, however; reality frequently diverges from Wall Street’s projections!