Part 4 in a series of tutorials on value investing: When it comes to valuing stocks, one size does not fit all.
Part 4: Building a Valuation Framework:
Fair Value Is An Opinion
As I’ve said before, fair value is an opinion, not a fact. You can’t directly measure fair value. What looks fair to one investor will look overpriced to another. Professional stock market analysts can put together incredibly complex valuation models. They can make detailed earnings estimates stretching 5 or 10 years in to the future and then extrapolate back to the present to come up with a target price to the nearest penny. Their reports can stretch to 25 pages or more with fancy graphs and charts that attempt to look at the business from every possible angle. While there is sure to be valuable information and insights in these reports and I, myself often spend hours researching a company before pulling the trigger, the detailed estimates they come up with are misleadingly precise. And, judging by the overall track record of most analysts, may not be worth the price of the paper they are printed on.
The business world is a chaotic place. Companies rise and fall and fortunes can turn on a dime. While thorough research and understanding are key, you can’t let yourself get too enamoured with your own analysis. I have found a few general valuation rules of thumb to be far more useful than trying to predict future earnings to the nearest penny. There is no way of knowing if a company should rightly be worth a p:e of 14 or 15 or 16 or if earnings will come in next year at $1.00 or $1.10 or 90¢. And that’s okay. All you need to do is get in the right ballpark. Because you’re always buying companies at a huge discount to what admittedly can only ever be a rough estimate of their true worth, if you’re ultimately off by 10% or 20%, you’ll still come out ahead in the long run. And for every company that disappoints and ends up being worth less than you thought it might, there is one that pleasantly surprises you and ends up being worth considerably more than what you had expected.
A Simple Strategy
One approach to investing in the market would be to simply buy the stocks that had the lowest p:e ratios. While not terribly sophisticated, it’s actually been shown that this approach would have been surprisingly successful, outperforming the overall market by a percent or two a year. With this approach, you’d end up owning a lot of crappy businesses, but every so often one of them would manage to pull a rabbit out of its hat and the resulting gains would make up for all the losses on the ones that didn’t fare so well.
By applying a bit of refinement to this basic low p:e strategy, you can build a portfolio that isn’t quite as stomach-churning and come away with better overall returns to boot.
Red Fish, Blue Fish
The stock market is a Suessian wonderland of different companies. There are technology superstars, blue chip stalwarts, young companies with fresh, new ideas and aging icons of industry from yesteryear. How does an investor even begin to make sense of this chaotic jumble of opportunities?
For starters, I simply discard from consideration many of the companies that make up the market. Entire sectors of the market get the cold shoulder from me. The resource industries: mining, oil and gas and forestry tend not to lend themselves well to my sort of earnings-based analysis. Certainly, the exploration companies are beyond my ken. I don’t have the expertise to know if a patch of moose-pasture in Saskatchewan has a high-grade vein of gold lying under it. Even the production companies give me problems; their fortunes are closely tied to future commodity prices and once again, I have no particular insight into what the price of zinc will be next year. I do invest in the companies that service the resource industries, though. These seem a bit more amenable to my style of analysis.
My analysis typically centers around a company’s earnings, or more accurately, what I expect its future stream of earnings to look like. And to help determine this, I look to its past record of profitability. Companies that have never made a profit don’t tend to lend themselves very well to my sort of analysis. I know where my strengths lie and it is not in being a future visionary, assessing the impact of paradigm-shifting new technologies or the strength of a company’s network effects. My analysis is often much more grounded than that. Is the company making money? How much? And how much do I have to pay to get a piece of that action? This means I miss out on many of the hottest investing fads of the day. The glamour or story stocks that make for exciting coffee shop chatter and speculation rarely show up on my screens. And that’s just fine. My stodgy old portfolio has provided me with plenty of excitement over the years. A construction company may not have the sparkle and shine of a biotech company working on a break-through drug, but when the stock quadruples in value, it can still get the heart racing.
Apples To Oranges
Even when limiting myself to the more prosaic sectors of the market, there are still a wide variety of companies to deal with. How do you compare a large auto parts manufacturer with a global footprint to a regional chain of heavy equipment dealerships? Or a rapidly growing software company to a struggling newspaper publisher? In other words, how do you compare stock market apples to stock market oranges?
To handle this confusing cornucopia of investment opportunities, I have 6 separate categories that I use to characterize the different kinds of companies I typically encounter. Between them, these 6 categories cover a broad enough cross section of the marketplace that I can usually find enough deep value opportunities to fill my portfolio. Once I’ve properly categorized a stock and calculated its approximate fair value, I can use this information to more accurately compare it to sometimes quite dissimilar companies in other categories. I simply buy whichever stock is trading at the biggest discount to its fair value.
I’m not just buying the lowest p:e stocks I can find, but what I am doing is not that far off. I’m essentially buying the lowest p:e stocks (or, in the case of an asset play, the lowest p:b stock) in each of the different categories. Provided, of course, that they pass passes a thorough vetting process first. (Most don’t.)
Here, then, are the 6 different categories that I’ve used to develop a more complete valuation framework.
One of the main factors I use to determine which category to slot a company in to is its growth rate. Given that a company’s value is primarily tied to its future earnings, it stands to reason that a company that is expected to double its earnings over the next few years is worth considerably more than a company that appears to be stuck in a rut.
You can’t be too precise when estimating a company’s future growth. There are a lot of factors that are going to determine that rate of growth and many of them are simply unforeseeable. When categorizing companies in terms of their growth profile, I typically only use three broad categories: high growth, average growth and no growth. This gives me enough wiggle room so that I don’t have to get too obsessive about trying to estimate growth rates to the nearest percentage point.
Over the past 50 years or so, small cap stock prices have risen by about 7% per year. This also means that earnings have grown at about the same rate. And this is the rate that I use when I refer to “average” growth. To qualify as average, I am looking for companies that are growing at somewhere between 5 and 10% a year. Over a 10 year period, this means that they will have roughly doubled in size. If you were to look back at the company’s results from 10 years previously, you should see that sales, earnings and book value were all roughly half of what they are today. Again, we don’t have to be too precise. If sales have climbed by 13% a year while earnings have risen by 8% and book value has climbed by 7%, that’s close enough. I’m just trying to ballpark things here.
An important exception occurs if the company has been issuing a high dividend. If the company is dividending out most of its earnings to shareholders, it is unreasonable to expect it to also be able to reinvest in its own growth. So a high payout ratio (which measures the percent of earnings that are paid out as dividends every year) can get a company into the average growth category even if earnings haven’t grown much over time.
Even though their growth may be wholly unremarkable, these kinds of stocks can still make wonderful investments if you can buy them at a big enough discount. In fact, this category of stock has probably made up the majority of my investments over the years. However, I’ll often try to tilt the odds in my favour by searching out those companies which may have exhibited average growth in the past but have some tricks up their sleeve which might end up surprising investors with higher growth in the future. Maybe they have a pile of cash on their balance sheet or a new product about to be introduced into the marketplace. Because the market is not expecting too much out of them, they are less likely to disappoint and may pleasantly surprise you instead.
Because of this potential, and because of the values you can often find here, I like to think of these stocks as not just average but “perfectly average”.
Moving down the growth spectrum, I have my “no-growth” companies. These are companies that are just treading water. They don’t pay out much of a dividend so we can’t give them a pass for that. Despite their best efforts, profits have been stagnating or declining for the past number of years. Maybe they are in a dying industry or are struggling with a legacy product that no one wants anymore. Maybe the company is just very badly run. For whatever reason, they are going nowhere fast. But every dog has its day. Sometimes they can get their act together and turn things around. Pivot into new lines of business, develop new products, hire more competent managers. If they do, the stock price can soar. I need to be able to buy this at a steep discount to make the gamble worth it, but even a dog like this has its price.
Some companies will have a line on something more exciting. Maybe a new technology, process, brand or service that lets them grow at a significantly higher rate. These companies can make great investments if you can find them at the right price. To qualify as a high growth company, I am looking for growth in earnings (ideally confirmed by a similar level of sales growth) of 20% or more per year and I want to be able to see ways in which this growth could continue for another few years at least. If I really expect earnings to double in the short term, I should then reasonably expect to pay almost twice as much, on a p:e basis, for this sort of company. In other words, a bargain price here is not the same as a bargain price for an average growth or no-growth sort of company; it’s a good deal higher. While these sorts of companies rarely come cheap, occasionally you’ll find one whose growth prospects are being overlooked or under-rated by the market and you can get in at a reasonable price. Not only do I get a nice ride from the p:e ratio re-rating upwards if my predictions of growth turn out to be true and the market realises its mistake, but I’ll enjoy an added tailwind along the way from an increase in the underlying earnings.
If you try to look too far out into the future, your crystal ball can get pretty cloudy. To qualify as high growth, I expect to see earnings doubling over the next 3 to 4 years but I don’t try to look beyond that. In fact, I generally expect growth to slow back down to an average rate at some point in the not too distant future. Which is why I don’t let myself get too carried away with breathless projections of future riches. I’ll pay up for a good growth story, but not too much. Generally speaking, about 2/3 more than what I’d be willing to pay for a similar “average growth” story. Granted, some companies will go on to produce stellar growth year after year, but they are very much the exception, not the rule. Especially in the small cap arena, spurts of rapid growth often have a limited lifespan. Some investors, including a certain famous investor out in Omaha, will try to identify these perennial outperformers by the “moat” they have built around their businesses. I’ve never been able to see those supposed moats very clearly myself and take a stodgier view: I assume periods of high growth have a reasonably short shelf life and I base my valuation assessments accordingly.
In these situations, growth doesn’t really enter into the equation. In fact, quite the opposite: earnings have taken a trip into the cellar. These are companies that have fallen on hard times. Often the company will be losing money or just scraping by. However, there is good reason to expect that the downturn is temporary. It may be due to external factors that are cyclical in nature. A recession may have dampened sales at a clothing retailer or a drilling rig operator may have got caught up in the periodic boom and bust cycle of the oil patch. The decline could also be due to company specific factors that you think can be rectified. Maybe the company launched a new advertising campaign that was a huge flop and this has temporarily hurt their results.
You can’t use a regular p:e ratio to value these companies because they often don’t have any earnings at the moment or if they do, they are severely depressed and not indicative of what the company might make going forward. In these turnaround situations, I still use a p:e ratio to evaluate their fair value but I go back and use an earnings number from before the downturn that I feel is representative of what they might earn once they get back on their feet. As well, I’ll demand a lower p:e ratio to these “peak earnings” (about a third lower) when compared to what I’d pay for the typical “average growth” company to compensate for the added risk that things may not, in fact, turn around as quickly or as completely as I expect.
Other factors besides earnings become more important in these situations. The company has to be financially solid, with no or low debt levels so that it can last a year or two without any profits coming in. Cash in the bank is even better. I also like to see positive cash flow even if earnings are negative from an accounting perspective. (Earnings often include non-cash expenses like depreciation. Cash flow backs out these non-cash items and gives you a sense of how much cold, hard cash is actually flowing into or out of the company.)
The risks are definitely elevated with this sort of investment, but the rewards can be worth it.
Most of the time I focus on small and mid cap companies. Here’s where I often find the greatest value opportunities. However, once in a while, a large cap company will cross my radar and this type of company merits some special consideration.
The average large cap stock often trades at a moderate premium to the valuations assigned to its smaller cap brethren. This valuation disparity makes sense if you consider the more volatile nature of smaller companies. A smaller company is more likely to see its earnings plunge during the periodic business downturns that affect the economy. Out of a 10 year business cycle, earnings might drop to zero in 2 or 3 of those years. When I calculate my p:e ratio I am using the earnings from a typical, non-recessionary year. Because of the frequent losses incurred during recessions, the average earnings over a full business cycle will tend to be lower than this number for the typical small cap stock, whereas for a large cap stock, recent earnings are more likely to be representative of their long-term average. Being more reliably consistent, the large cap earnings are worth more to investors than the more variable earnings of the small cap stocks.
The same logic holds true for what the market would call “defensive” stocks. Things like grocery stores or healthcare companies. These are companies whose area of business makes them less susceptible to the ravaging effects of the normal business cycle. People always have to eat, and they keep getting sick, recession or no recession. A small-cap company can have decidedly large-cap characteristics if it is in one of these more stable niches. Conversely, a large-cap company can sometimes be just as volatile as its smaller peers. Size is no guarantee of safety.
If I identify a company that I feel has a strong track record of stability and consistency in its earnings, going back at least through the last major recession, then I will sometimes pay up for this stability. A p:e ratio, based on those more consistent earnings, might be as much as 1/3 higher than that of the average small-cap stock and still represent good value.
The Asset Play
In the normal course of events, a company’s book value doesn’t figure heavily in to my calculations. It’s nice to see a relatively low price to book value ratio to give you some reassurance that there is something tangible there to support the stock price if things really go off the rails but I will gladly buy a high flyer for 5 or 6 times book value if the earnings and growth rate are there to support the decision. You can’t always have it all. It’s often the companies with relatively little in the way of hard, physical assets that can grow the most quickly.
However, for the more beaten up names in my portfolio, a bit of meat on the bones is a reassuring thing to have. In the wallflower and turnaround situations, a large tangible asset base is something the company can fall back on to secure additional bank funding and to help support the stock price, so I will pay more attention to the book value in these cases.
As well, there is a separate category of investment that I stumble across every now and then called the “asset play”. These are companies with a large asset that may be underappreciated by the market. Maybe it is a large hoard of cash or a valuable piece of real estate. Or maybe it is a fleet of unused drilling rigs that were mothballed in the last oil industry downturn. Whatever the source, the stock price is trading at a big discount to the value of this asset. The way in which the company will eventually manage to monetize this asset is often unclear, so this sort of investment requires patience and a bit of a leap of faith. But it helps to add a bit of variety to the portfolio.
For this category of stock, I use the price to book value ratio to assign it a fair value instead of the p:e. As a rough guideline, and a fairly conservative one at that, I’ll usually use a price to tangible book value of 1 as my estimate of fair value. If the company has significant assets and I can buy those assets at significantly less than their current dollar value then I feel I am getting a good deal.
The Market Environment
This overview of the valuation framework I use to value stocks wouldn’t be complete without mentioning the role that investor sentiment has on overall market prices. The market fluctuates between periods of over exuberance and irrational pessimism. I’ve had the privilege of getting a taste of both extremes on more than one occasion over the past 21 years. When the champagne is flowing on Wall Street, stock prices and average p:e ratios can get considerably higher than what you’d usually expect to see and when the tide turns the other way, p:e ratios and other valuation metrics can get driven down to unreasonably low levels.
My anchor has always been the typical small cap company with a reasonable amount of debt, growing at a decent rate of 5-10% per year (the “perfectly average” companies). When stock prices have been bid up, I have seen companies like this trading hands for as much as 20 times earnings. At the same time, the prices of everything else tends to rise as well. A sexy, high growth company might trade at a p:e over 30 in this environment while even no-growth dinosaurs and risky turnaround situations can sell at a pricey 13 times earnings.
Conversely when prices drop, as they did during the Great Financial Crisis of 2008, there were many “perfectly average” companies to be had for only 8 times earnings. You could snap up a promising turnaround play (and there were many) for 5 times peak earnings or less. My fair value calculations always have to take into account the kind of market environment I am in. When prices are high, I need to raise my fair value estimates and when times are tough, I need to dial them back down again.
Unfortunately, there is no easy way to tell exactly how much you should be adjusting your numbers by. The best method is often simple observation. Take a look at a bunch of average growth, small cap companies and see what their p:e ratios are. If they are clustering around the 20 mark, then you’ll know that you need to raise all your fair value estimates by a similar amount to compensate for the market’s over exuberance. Either that, or refuse to play along and park your money in cash. Likewise, when the market is in a funk, you may be able to tighten up your standards considerably and lower your fair value estimates accordingly.
What matters here is not so much absolute p:e levels, but rather relative ones. If I know that high growth companies, as I define them, tend to have p:e ratios that are about 2/3 higher than those of more average growth type plays then I know how to compare the relative merits of two different investment candidates, even though they may have markedly different growth prospects.
For example, let’s say that through my regular market investigations, I put together a list of a few dozen “average growth” type companies. While every company aspires to greatness, in reality, most of the companies in the market are merely average. The companies I want to look at are growing at around 5-10% per year and seem likely to continue along this path, barring some nasty surprise or unexpected windfall. Let’s say I put together a list of these sorts of companies, calculate their p:e ratios and then average those numbers out and find that their average p:e ratio is 12. Admittedly, we haven’t seen levels this low for a number of years now, but I can still dream.
If I ascribe a “fair value” p:e of 12 to my “average growth” category of stocks then this is how I would expect the other types of stocks to fall in to line around it…
Market Temperature: Just Right
High Growth – p:e 20
Defensive – p:e 16
Average Growth – p:e 12
No Growth – p:e 8
Turnaround – p:e 8 (to peak earnings)
Asset Play – p:b 1
If markets were to get very overheated and I saw that the average, small cap stock was trading at a p:e of 24 then I would likewise double the p:e ratios that I expected to see in my other investment categories. And if, some day, average p:e ratios fell in half, I would apply the same 50% haircut to all my different flavours of stocks.
Naturally, if I’m seeing that the typical average growth, small cap is selling at a p:e ratio of around 12, that’s not what I want to pay. I’m looking for at least a 40% discount to that price to give me the value I’m looking for. For an average growth stock, that would mean hunting for a company with a p:e ratio of 7.2 or less. If it was a high growth situation then a p:e of 12 would represent a similar bargain. Choosing between a high growth company with a p:e of 11 and a more pedestrian, average growth company with a p:e of 10, I’d naturally chose the former as it would be the one that was trading at the biggest discount to its “fair value” even though its p:e ratio was technically higher. Likewise, I’d much rather own an average growth company with a p:e of 7 than an exciting, high growth company trading at 18 times earnings. Despite the superior growth at the high-flyer, the more slowly growing company offers far more value.
The Valuation Framework
By using my 6 basic investment categories I can cover a good cross section of the investment universe. Not everything qualifies. There is no category for “money losing internet stock” or “prospective mineral exploration property”. But if the company is making, has made or is likely to make a profit then I can usually find some category to shoehorn it into. It may not be an exact fit, but it gets me into the rough ballpark and if I’m always buying at a big discount to whatever fair value this leads me to, that’s been more than enough to produce impressive long-term returns.
I can also use these basic categories as building blocks to cover more unique situations. Most of the time, for instance, if a company does not have a high enough growth rate to make it into the high growth category, it will get lumped in with all the other “perfectly average” companies out there. Sometimes, however, the company has displayed consistent, long term growth in the more middling range, say 15% per year. If I am fairly confidant that this will continue then I might assign it a fair value in between the average and high growth categories, using a p:e of 16, say (assuming average growth companies were trading at the time with p:e ratios of around 12). Or perhaps a company is a turnaround candidate which would normally get assigned a fair value of 8 times peak earnings in this sort of market environment, but they were growing at a high growth rate before a recession brought things to a screeching halt. If I think growth will resume once the recession fades, then I might bump up the fair value I assign to this turnaround candidate.
The valuation framework I use may sound overly simplistic but its simplicity is part of why I think it works well in practice. It opens up wide swaths of the market to consideration. I am not stuck just looking for bargains in one small corner of the market. I can identify value in tiny penny stocks or large cap bruisers. In new-age technology companies or old-line manufacturers. Risky turnaround plays or safe and steady defensive stalwarts. By opening up a wide cross-section of the market to examination, I have the elbow-room I need to be as choosy in my investment selection as possible. The wider the net I cast, the more likely it is that I’ll catch that rare, deeply undervalued gem.
With this valuation framework in place, I can now move on to the real nitty gritty of stock analysis. In part 5, I dissect in detail the step by step process I use to evaluate every potential new stock investment.