Category Archives: Search for New Ideas

My Watchlist – October 12, 2010

I have reviewed issue 7 of Value Line and added companies that have exceptional returns on equity. I have also included several stocks that are widely held by prominent value investors. The list is not perfect and some judgment is required in deciding whether to include a particular stock. As always, I welcome your feedback and comments.

The idea here is to have a dashboard of substantially all the high quality businesses in the U.S. in one place that you can review at least weekly to see what Mr. Market is making available to you.

Here is the updated watchlist.

Stocks Added This Week

Emerson Electric Co. (EMR)

FLIR Systems, Inc. (FLIR)

Garmin Ltd. (GRMN)

Amphenol Corporation (APH)

Intel Corporation (INTC)

Apple Inc. (AAPL)

Dell Inc. (DELL)

Hewlett-Packard Company (HPQ)

International Business Machines Corp. (IBM)

Western Digital Corp. (WDC)

Lexmark International, Inc. (LXK)

Expected return calculations were added for the following stocks because they were wthin 10% of a 52-week low:

U.S. Bancorp (USB)

Colgate-Palmolive Company (CL)

FLIR Systems, Inc. (FLIR)

Expected return calculations were added for the following stock because their earnings yield exceeded 8%:

Garmin Ltd. (GRMN)

Intel Corporation (INTC)

Hewlett-Packard Company (HPQ)

Western Digital Corp. (WDC)

A few thoughts…

Please note that I used 10-yr sales growth in lieu of 10-yr EPS growth for the expected return estimates for FLIR and WDC. Also, I used 10-yr asset growth for USB in lieu of 10-yr EPS growth.

Buffett was asked in a 2009 interview with Fortune what his favorite metric is for valuing a bank. Here is his answer:

It’s earnings on assets, as long as they’re being achieved in a conservative way. But you can’t say earnings on assets, because you’ll get some guy who’s taking all kinds of risks and will look terrific for a while. And you can have off-balance sheet stuff that contributes to earnings but doesn’t show up in the assets denominator. So it has to be an intelligent view of the quality of the earnings on assets as well as the quantity of the earnings on assets. But if you’re doing it in a sound way, that’s what I look at.

Over the last ten years, U.S. Bancorp has averaged a return on assets of about 1.75% and currently has assets of $281 billion. There are 1.859 billion shares outstanding. This would suggest normalized EPS of $2.64. If USB can grow its assets at 5% a year, which seams conservative given its strong position and the large number of bank failures, earnings could reach $3.37 in five years. At a P/E of 13, which is its median P/E over the past ten years per Value Line, USB would have a stock price of $43.80. That’s a return of about 14.5% from today’s price and it does not include dividends.

USB has a long-term record of strong dividends and I expect, based on comments from management, that the dividend will be reinstated when they are comfortable that they understand the final outcome of efforts to reform banking regulations. Berkshire Hathaway owns 3.6% of the shares outstanding.

Also of note, the FPA Capital Fund has built a 5% position in WDC. The stock has an earnings yield of almost 14% based on estimates for 2011 earnings.

The author of this blog is NOT an investment, trading, legal, or tax advisor, and none of the information available through this blog is intended to provide tax, legal, investment or trading advice. Nothing provided through these posts constitutes a solicitation of the purchase or sale of securities/futures. The data and information presented in this blog entry is believed to be accurate but should not be relied upon by the user for any purpose. Any and all liability for the content or any omissions, including any inaccuracies, errors or misstatements in such data is expressly disclaimed.

More Thoughts on Small Cap Investing

On October 4, 2010, I wrote a post entitled Small Stock Investing: The Path to Riches?, which outlined some of the differences between investing in small caps and large caps.

The post considered the idea that there is more opportunity in small caps. Upon reflection, perhaps it would have been better to make the distinction between micro-caps and large-caps, as micro-caps – stocks with market capitalizations less than $250-300 million – are more the area of the market I was writing about.

I have a few more thoughts on this thread.

I don’t think there is as much opportunity in this area as there was when Buffett was operating his partnership. There were no value-oriented hedge funds scouring the market with computer screens, so the market was less efficient. In 1963, there were 284 candidates for the CFA. In 2007 there were nearly 100,000 CFA charter holders.

Munger has made the point that the Great Depression so shell shocked equity investors that it caused a lasting multiple compression that created a period of opportunity for early value investors. Using Munger’s metaphor, now, when you run your Geiger counter looking for mispriced micro-caps, it may not click. The practical implication here is that to operate in this sector – given the potential paucity of candidates – you may find yourself reaching for companies of questionable quality.

A point that was made in the prior post – but that deserves re-emphasis – is that Buffett was an exceptionally gifted investor. He was the only student to get an A+ in Ben Graham’s investment class and is widely acknowledged as the best investor of his generation, if not all time. The point is that investing in micro-caps can be tricky. These companies don’t typically have the resilience of large caps and the lack of information that contributes to their mispricing may make it difficult to determine their intrinsic value.

For what it’s worth – and it may say more about me as an investor than the risks of micro-cap investing – I have lost more money in this area than in investing in large caps. Perhaps it would be prudent to “cut your teeth” in large or mid caps and prove to yourself that you know what you’re doing before seeking opportunity in micro-caps.

A case in point of the challenges of micro-cap investing is the example of Paul Sonkin. Sonkin is a hedge fund manager who specializes in micro and nano-cap investing (market caps under $50 million). Bruce Greenwald has looked at Sonkin’s trades and concluded that his initial positions were only minimally profitable and that the majority of Sonkin’s returns came from buying more stock as the price declined below his original purchase price. This means that Sonkin had to have a high degree of confidence in his valuations to be able to buy more stock as the priced declined. This could be a recipe for disaster if you didn’t know what you were doing.

Finally, a couple thoughts regarding Buffett.

First, Buffett points out in his partnership letters that he had a built-in hedge when investing in under-valued micro-caps. If he established a position and the stock went up, he made money. If the stock price stayed low, or declined further, Buffett could keep buying and eventually acquire a controlling interest in the business. He could then unlock the value in the business by changing management. Very few investors are in a position to utilize this hedge.

Second, Buffett did not put all his eggs in one basket. He made three types of investment in the partnership: 1) undervalued securities (what he called “generals”), 2) workouts, and 3) control situations.

I am not trying to discourage investing in micro-caps, but rather trying to point out some of the challenges so that, if you decide to do so, you will maximize your odds of success.

My Watchlist – October 5, 2010

I have reviewed issue 6 of Value Line and added companies that have exceptional returns on equity or growth in book value. The list is not perfect and some judgment is required in deciding whether to include a particular stock. As always, I welcome your feedback and comments.

The idea here is to have a dashboard of substantially all the high quality businesses in the U.S. in one place that you can review at least weekly to see what Mr. Market is making available to you.

Here is the updated watchlist.

Stocks Added This Week.

Fastenal Company (FAST)

Lowe’s Companies, Inc. (LOW)

The Home Depot, Inc. (HD)

Sherwin-Williams Company (SHW)

The Clorox Company (CLX)

Colgate-Palmolive Company (CL) – within 5% of 52 week low

Kimberly-Clark Corporation (KMB)

Newell Rubbermaid Inc. (NWL)

The Procter & Gamble Company (PG)

WD-40 Company (WDFC)

A few thoughts…

In general, stocks do not look particularly cheap. This is not surprising given the run-up in stocks over the past three months.

Although it’s a very crude indicator, the number of stocks within 5% of their 52 week high – those with cells colored red in the “% below 52 week high” column – gives a useful quick read of how cheap or expensive the market is. Waiting for the majority of stocks to be within 10% of their 52 week lows – cells in the “% above 52 week low” column colored green (within 5%) or yellow (within 10%) – may be a constructive period to start becoming greedy.

Small Stock Investing: The Path to Riches?

Some years ago, Buffett created a stir of sorts when he stated that if he were investing $1 million today he could generate annual returns of 50%. I wrote about it in an earlier post.

In an interview with blogger Jacob Wolinsky, value investor Whitney Tilson was asked if Buffett’s investment style had changed as a result of his different circumstances at Berkshire and if he would be a net-net investor if he was managing less cash. Here’s Tilson’s answer:

Yes, that is absolutely true. He has been asked this question many times and responded that if he were to be managing very little money he would be looking in the nooks and crannies looking for extreme temporary mispricings. If you know where to look, you can sometimes find extreme temporarily mispriced stocks. However these stocks are usually small and it is hard to put much money into them. Not in a million years would Buffett own Kraft if he was managing $10 million.

Recently on The Corner of Berkshire & Fairfax Message Board, an excellent investing forum run by value investor and investment manager Sanjeev Parsad, the question was asked “What percentage of your portfolio is in Fairfax Financial?” The level of discussion on the board is quite high and it’s clear many of the members are capable investors.

For those who are not familiar with the company, Fairfax is an insurance company with outstanding investing capabilities that has compounded book value at a rate of 25% over the past twenty-four years under the leadership of Pre Watsa. Fairfax is often compared to an earlier stage Berkshire Hathaway. Many members of the forum have a material investment in Fairfax.

One member, rick_v, criticized having a large investment in Fairfax because, in his view, it is easy to find cheaper micro-caps with greater opportunity. In response, another member, coc, defended investing in Fairfax and challenged the idea that it is easy to find micro-cap investments that will outperform the market.

I thought the exchange crystallized some of the important decisions investors face when defining their own investment process and philosophy. The exchange also provides some food for thought to those who, inspired by Buffett’s remark, choose to seek opportunity in micro-caps.

Here’s rick_v

I truly hope that all you guys mentioning stakes of 20-30%+ in Fairfax are either passive investors or older in age.

I think its a shame for a young or professional value investor to have such a large percentage of their portfolio in a stock like Fairfax. Afterall, even if Fairfax doubles in a few years that is not how you are going to generate alpha or get rich for that matter…

As a young or professional value investor you should be studying Fairfax and Buffet’s performance to identify your own value plays. Thats where the alpha will come from.

It is very easy with permanent capital to find securities which will outperform the market when you are looking in the 0-250m range. This range is not looked at by Prem, Buffet, and most of the other major value investors anymore due to their size. As such it represents where I see most of the opportunity for up and coming value investors.

Just my thoughts…

Here’s coc’s response:

I’m surprised you all let this go. I’d like to comment on two things, both of which I consider nonsense.

1. It is “very easy” to find securities that will outperform the market.

2. Holding Fairfax is inferior to running around finding these “very easy” securities.

I think investors vastly underestimate how good Warren Buffett was at his job back in the 1950’s and 1960’s when he was buying these niche securities. He’s even better now, but obviously runs so much capital that his returns are lower. There seems to be this “Buffett envy” going on in value investing circles whereby investors feel the need to look for little cigar butts similar to what Warren used to – largely influenced by his talks to students and his biography.

And yet, I have seen precious few investors who have successfully done it. Beyond the platitude that smaller areas of the market are “inefficient,” there are considerable risks. You are usually investing in second rate businesses that destroy value, or at least are not really building any. Often these businesses are run by inexperienced managers and have little advantage over their competitors. Thus, the business risks you assume are big ones, although most investors think a cheap valuation makes up for it. Sometimes, but not always.

Take for an example Dempster Mill Mftg – a well known Buffett investment way back when. If you think through the situation, there was a good probability that the investment was not a wise one. It took heroic efforts by a new manager to keep Dempster from going under, and even then, it was not an absolute home run. Yet, most Buffetteers admire these types of investments Warren used to make.

But what was Warren’s largest partnership investment? American Express, a well known company then and now, not a micro-cap dishwasher manufacturer. He also had a successful investment in Disney, and one in GEICO, again two companies that were well known. What was probably his best stock investment at Berkshire? The Washington Post, not exactly “unknown.”

Yet we’re told that he made all of his great returns back then because he could look small. Well, as with everything in life, the answer is yes and no. I think there is a great myth that you need to look where no-one else is looking and be creative in the investment process. That you should get points for creativity or something. But the very same people propagating this myth are students of Charlie Munger, who once wrote to Wesco shareholders that “We try to profit more from always remembering the obvious then grasping the esoteric.”

Let’s talk about a few more of Warren’s home runs. Petrochina, one of the largest companies on the planet. Freddie Mac, one of the largest companies on the planet. Coca-Cola, the most well-known brand on the planet. BYD, one of China’s most well-known and well-respected companies. These are investments where, for the first 5-10 years, he made 25%+ compound annual returns. Who are these people not getting rich by consistently generating 25% compound returns? Where is this stock market where 25% annual returns don’t generate “alpha”? Why do small investors need to run around looking at micro-caps?

***

Let’s also look at some other legendary investors. What sort of returns did they achieve and what were they buying? Lou Simpson – 20%+ type returns buying very well known companies. Rick Guerin – 25% type returns investing in a pretty broad range of securities small and large. Ruane, Cunniff – 15% over 40 years investing in large stocks. Eddie Lampert at ESL – you would probably know of almost every company he ever invested in – 30% CAGR for a 15-20 year period. Glenn Greenberg at Chieftain – did 25% for about 20 years, again you’d probably recognize almost every stock he owned.

These guys are legends, they’re all rich, and they invested in a huge range of securities.

Who do we know of that was investing in small securities that no one has heard of? Here’s two: Schloss and Graham. Did either of them do 50% compounded? Hell no. They’re hall-of-famers with 15-20% returns. Do I need to bring up Charlie’s returns? What has he bought over time?

So I dispute this notion that investors are somehow doing themselves a disservice by sticking with companies they know well and that others know well. Well-known companies are often just as mispriced as small ones. “To a man with a hammer, everything looks like a nail,” says Munger. Yet the Buffetteers seem to only admire one tool for finding cheap stocks (size constraints), when myopia, ignorance, and a host of other biases are just as powerful in creating misvalued securities.

To wrap this up a little, I’m not saying there aren’t lots of small mispriced stocks. Buffett did very well with them, and there are probably others doing great, too. But recognize two things: 1. Huge CAGR’s are really, really hard. 2. You can do extremely well investing in larger companies, great companies, and well-known companies, without a lot of the risks of investing in broken-down nags. This is well proven.

So if you rationally evaluate Fairfax and come to the conclusion that you’re going to get 15-20%+ CAGR (eminently reasonable given the fact that they are a relatively small player in a gigantic global insurance market and are run by one of the smarter investment teams on the planet), don’t worry about how much “alpha” you’re not generating by looking elsewhere. Was it a mistake to invest in Berkshire when it had a billion dollar market cap and was well known? I repeat, there are no points for creativity. Don’t forget it takes a unique cast of mind to just sit on some great companies and compound at high rates with no taxes, professional investor or not.

I’m probably not going to convert anyone who believes strongly that they have to be looking in the dirty alleys for cheap stocks, but if you’re on the fence, hopefully this is food for thought.

Here’s a link to the thread if you want to read more.

My own opinion is that there is no reason to limit yourself to certain investments based on market capitalization, just like it doesn’t make sense to make a false distinction between value and growth. You can get rich investing in either. For example, today large caps offer unusually strong risk-adjusted returns.

In investing, what really matters is how much cash you get back and when for the cash you invest and how certain you are of the outcome. I do think it’s fairly obvious that Buffett would be more active in small and micro caps if he were investing far less money, although not to the exclusion of investing in large caps. He would simply have greater options.

My Watchlist – September 28, 2010

I have reviewed issue 5 of Value Line and added companies that have exceptional returns on equity or growth in book value. The list is not perfect and some judgment is required in deciding whether to include a particular stock. As always, I welcome your feedback and comments.

The idea here is to have a dashboard of substantially all the high quality businesses in the U.S. in one place that you can review at least weekly to see what Mr. Market is making available to you.

Here is the updated watchlist.

Stocks Added This Week.

Cisco Systems, Inc. (CSCO)

Nokia Corporation (ADR) (NOK)

Express Scripts, Inc. (ESRX)

Avon Products, Inc. (AVP)

The Estee Lauder Companies Inc. (EL)

Nu Skin Enterprises, Inc. (NUS)

Stocks Moving Within 10% of Their 52 Week Low:

Techne Corporation (TECH)

Paychex, Inc. (PAYX)

If you see a stock that looks interesting, here are some questions that may be useful in determining if it is worth pursuing further:

1. Is it within my circle of competence, i.e. do I understand how the business works and where it will be in five to ten years? Be mindful of overconfidence bias.

2. If yes, spend an hour reading the annual report and recent filings. Read these with a purpose. Try to develop a preliminary investment thesis that you are trying to substantiate or disprove.

3. Calculate EBIT (EBITDA – maintenance capex)/Enterprise Value to see how cheap it is.

4. Calculate return on tangible capital employed to see how good a business it is.

5. Ask yourself if it is as good or better than your best holding(s). See Opportunity Cost: Buffett & Munger’s Powerful Investing Filter

6. Ask yourself if it meets your hurdle rate, i.e. 15%, 20%, etc. If you don’t know where you’re going, any road will take you there.

7. Ask yourself if it is better than the other stocks available on the list or that you have found elsewhere. All things considered, buy the cheapest asset available.

8. If it passes all these relatively quick tests, it may warrant your research time.

The author of this blog is NOT an investment, trading, legal, or tax advisor, and none of the information available through this blog is intended to provide tax, legal, investment or trading advice. Nothing provided through these posts constitutes a solicitation of the purchase or sale of securities/futures. The data and information presented in this blog entry is believed to be accurate but should not be relied upon by the user for any purpose. Any and all liability for the content or any omissions, including any inaccuracies, errors or misstatements in such data is expressly disclaimed.

Watch List Question: Where’s the Implied Valuation and Margin of Safety?

Yesterday, I received the following comment and question regarding my watch list. I thought I would answer the question in a blog post in case others had the same question and to better explain the methodology of my watch list.

Hi Greg,

Great site, thanks very much for all of your ideas.

I’ve looked at your watch list every time you’ve posted it, but I’m finding it very unintuitive.

I think I understand your concept of Expected Return expressed as a %, but why not have an implied valuation and Margin of Safety columns as well so you can quickly see the variance from current price and best opportunity to research?

If I understand correctly, you could just rank opportunities from greatest yield to least, but the metric feels very unfamiliar.

I’m interested in your thoughts,

thanks,

aron

First, I want to thank Aron for the question. I would start by saying that there is not a perfect way to value a company. All valuations are based on future assumptions that are inherently suspect. There are two basic approaches to this reality: 1) limit future projections to companies with exceptional economics and a long track record (Buffett) or 2) don’t make projections and look for things that are cheap based on current assets and earnings power.

The idea behind the watch list is to focus on those companies that have exceptional economics as evidenced by ten years of exceptional returns on equity without undue leverage. These are the companies where an investor has at least a fighting chance of projecting long-term future earnings and growth.

In order to prioritize the list and highlight areas of opportunity, I wanted to include a valuation metric. I chose to express this as an expected return, which is the sum of the earnings yield and the expected growth rate. This is the approach used by Glenn Greenberg. (Greenberg also seems to suggest that Buffett approaches valuation in a similar way.) The benefit is that it is simple and gets you to focus on two central questions:

  1. Is it cheap today? (earnings yield)
  2. How fast can intrinsic value grow? (growth rate)

It is also easy to calculate.

Aron asks why I don’t rank opportunities from greatest yield to least. The answer is that I wanted to include growth in the valuation since growth is such an important part of a company’s intrinsic value. As Buffett pointed out in his 1991 letter to shareholders, a business with “bob-around” no growth earnings is worth 10 times after tax earnings using a discount rate of 10%. A good business that can grow earnings at 6% is worth a “whopping” 25 times after-tax earnings.

The expected return approach I take is simply another form of a discounted cash flow (DCF). There are three components to a DCF: 1) the discount rate (or expected return), 2) the projected stream of cash, and 3) the present value (PV) of those cash flows.

For a growing stream of cash flows we can use the following calculation:

PV = current earnings x 1/(discount rate) – (growth rate)

Assume I find a stock on the watch list with an earnings yield of 10% ($50 stock price and an EPS of $5) and an expected growth rate of 5%. I would calculate that stock to have an expected return of 15%.

Using the formula above, here’s the math:

$50 = $5 x 1/(15% – 5%)

We can say that the $50 stock price is discounting a 15% future return, assuming a growth rate of 5%.

Often DCF’s are done by first setting the discount rate – or alternatively, the hurdle rate – and calculating the present value of the stock. (I believe this is the approach that Aron is looking for.) If this value is greater than the current stock price, we can look at the difference between the PV and the current stock price and judge whether it provides a sufficient margin of safety, typically expressed as a percentage derived by dividing the discount by the PV of the stock

For example, let’s use a discount rate of 10%. 10% is often used as a proxy for an expected return on an equity investment. (Alternatively, we could follow Buffett and use the yield on long-term government bonds.)

In that case, the present value is far greater because of the reduction in the discount rate from 15% to 10%:

$100 = $5 x 1/(10% – 5%)

We could then say that the stock is selling at a 50% discount to present value.

What I intended to show is that the approach I take in the watch list and the approach of expressing the PV using a fixed discount rate are essentially two sides of the same coin.

Aron also asks about having a margin of safety value so it could be easily compared with that of other stocks on the list. First, I think some caution should be used in expressing the margin of safety as a single percentage in that it can give the impression that the figure is precise. Intrinsic value is better understood, I believe, as a range of values. (Of course, in fairness, the same critique could be made of expressing the expected return as a precise figure, which is why I stress that this is a starting point, nothing more.)

Having said that, the expected return does imply a margin of safety. An asset with a true expected return of 15% is worth far more than an asset with an expected return of 8%. Think of it this way: many things could go wrong with the former asset and it could still outperform or equal the latter asset paying only 8%.

I hope this answers the question. If not, please let me know. Also, I welcome all comments and questions on this most important investing topic of valuation.

My Watch List – September 21, 2010

I have reviewed issue 4 of Value Line and added companies that have exceptional returns on equity or growth in book value. The list is not perfect and some judgment is required in deciding whether to include a particular stock. As always, I welcome your feedback and comments.

The idea here is to have a dashboard of substantially all the high quality businesses in the U.S. in one place that you can review at least weekly to see what Mr. Market is making available to you.

The valuations are very simplistic, although the basic conceptual framework is sound. Over time, an asset should deliver a total return equal to the sum of its current free cash flow yield and its growth rate (assuming that growth rate continues over the long-term).

The valuations attempt to calculate the annualized return that is discounted in a stock’s current price. The first component of the valuation is the company’s earnings yield based on the consensus estimate for this year’s earnings. This may overstate or understate the true free cash flow yield depending on a number of factors, primarily the company’s level of depreciation and amortization and its level of capital expenditures. Ideally, it makes more sense to look at the ratio of EBIT (EBITDA – maintenance capex) to enterprise value in order to compare businesses, so as to normalize earnings and the capital structure. See Greenblatt’s book The Little Book that Beats the Market for more details.

Nevertheless, the earnings yield is easy to calculate and, since we’re looking for stocks that are compellingly (obviously) undervalued, it should serve as a useful screen so we can focus our time on stocks with the greatest potential.

The second component of the valuation is the growth rate. Here I take 60% of the growth rate over the past ten years. The use of 60% is an attempt to be conservative. Caution: even taking 60% of the past growth rate can grossly overstate the future growth prospects of a business. The primary idea here is that you want to determine if the factors that led to the past growth are still in place, and, if so, how much growth potential is left. If you can’t figure it out, you can’t value the stock, at least not its future growth prospects. It still may be worth considering if the stock is so undervalued that it is cheap even if you factor in zero growth going forward.

I’ve added the following stocks this week:

Alliant Techsystems Inc. (ATK)

Rockwell Collins, Inc. (COL)

Lockheed Martin Corporation (LMT)

Markel Corporation (MKL)

Berkshire Hathaway Inc. (BRK.B)

Fairfax Financial Holdings Limited (FRFHF)

U.S. Bancorp (USB)

CIGNA Corporation (CI)

Laboratory Corp. of America Holdings (LH)

Lincare Holdings Inc. (LNCR)

UnitedHealth Group Inc. (UNH)

Computer Programs & Systems, Inc. (CPSI)

Techne Corporation (TECH)

Here’s the updated Watch List for September 21, 2010.

Tip: Don’t forget to utilize the link to GuruFocus in column U. It’s a quick way to see who is buying a stock.

The author of this blog is NOT an investment, trading, legal, or tax advisor, and none of the information available through this blog is intended to provide tax, legal, investment or trading advice. Nothing provided through these posts constitutes a solicitation of the purchase or sale of securities/futures. The data and information presented in this blog entry is believed to be accurate but should not be relied upon by the user for any purpose. Any and all liability for the content or any omissions, including any inaccuracies, errors or misstatements in such data is expressly disclaimed.

My Watch List plus Selected Valuations – September 14, 2010

I have updated my watch list for September 14, 2010.

The following companies have been added to the list:

ConocoPhillips (COP)

Exxon Mobil (XOM)

Ecolab (ECL)

NewMarket Corporation (NEU)

Praxair, Inc. (PX)

Sigma-Aldrich Corporaration (SIAL)

In addition, I have made some changes to the watch list. I have simplified the valuation methodology.

The valuation is now the sum of the current earnings yield and a simple projection of the expected growth in earnings. The current yield is based on the consensus estimate for the current year’s earnings (EPS estimate for the current year / current price).

The expected future growth rate equals 60% of the growth in EPS over the past ten years. The use of 60% is an attempt to be conservative, particularly given the challenges to the U.S. and global economies.

If a valuation sparks your interest and the company is within your circle of competence, you should research whether the factors that produced the growth over the past ten years are still in place and if the company’s position is weakening or strengthening. Where ten years of EPS data was not available, I tried to select a reasonable proxy and note it in the Comments column.

I have added valuations for stocks that are within 5% of their 52-week low or have an earnings yield that is greater than 8%.

In addition, I have added the consensus estimate for 2011 EPS to give some context to the EPS projection. I have also added the five-year average P/E to give additional context.

I stress that this watch list should only serve as a dashboard to keep you focused on areas of opportunity. These valuations are overly simplistic and should only serve as a catalyst for your own deeper analysis. I suggest calculating the earnings yield using normalized “Owner Earnings” as the numerator and also looking at the ratio of EBIT to Enterprise Value.

(The following was previously posted but provides important background information on my watch list.)

You will notice that the majority of the stocks on the watch list are categorized as a “Good Business”. That is intentional as the fourth tenet of my investing blueprint is Buy Good Businesses. I want to have an active dashboard where I can easily track all these good businesses and zero in on the ones that Mr. Market is making available at a cheap price. The basic screen for Good Businesses was inspired by Buffett in his 1987 letter to shareholders.

Experience, however, indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago.  That is no argument for managerial complacency. Businesses always have opportunities to improve service, product lines, manufacturing techniques, and the like, and obviously these opportunities should be seized.  But a business that constantly encounters major change also encounters many chances for major error.  Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise.  Such a franchise is usually the key to sustained high returns.

The Fortune study I mentioned earlier supports our view.  Only 25 of the 1,000 companies met two tests of economic excellence – an average return on equity of over 20% in the ten years, 1977 through 1986, and no year worse than 15% [emphasis added]. These business superstars were also stock market superstars: During the decade, 24 of the 25 outperformed the S&P 500.

To be categorized as a “Good Business”, I am looking for businesses that pass these Fortune tests. Given the severity of the recession, I might include a company that is close but not quite there. As you can see from the study, not many companies pass these stringent tests. If you are fishing in this pond, at least from a quantitative standpoint, you have eliminated many sub-par companies. Note that 24 out of 25 of the stocks that passed the Fortune screen outperformed the S&P over the decade preceding the study.

This approach for the watch list was also inspired by Mason Hawkins who said at a 2005 lecture at the Ben Graham Centre for Value Investing at the University of Western Ontario that he and his team revalue the top 200 businesses in the world every week to see if they are available for less than 60% of value.

By way of review, the other categories are as follows. The categories may be added to or evolve over time.

  1. Special Situation – restructuring, spin-off, bankruptcy, divestitures, etc.
  2. Book Value Aristocrat – exceptional book value growth over the past decade
  3. Strong Moat – evident durable competitive advantage
  4. Guru Purchase – recent purchase by a notable investor

The author of this blog is NOT an investment, trading, legal, or tax advisor, and none of the information available through this blog is intended to provide tax, legal, investment or trading advice. Nothing provided through these posts constitutes a solicitation of the purchase or sale of securities/futures. The data and information presented in this blog entry is believed to be accurate but should not be relied upon by the user for any purpose. Any and all liability for the content or any omissions, including any inaccuracies, errors or misstatements in such data is expressly disclaimed.

My Watch List plus Selected Valuations – September 6, 2010 (Value Line Issue 2)

I have updated my watch list to include companies from Value Line Issue 2. I have added valuations for companies that have an earnings yield that is greater than 8%. It is important to read the entire post to understand these valuations.

You need to scroll to the right to see the valuations.

My Watch List – September 6, 2010

By way of review, I am primarily focused on tracking companies that have averaged at least 18-20% return on equity over the past ten years.

Here are a few features of the watch list.

  • If a stock is within 10% of its 52 week low, the cell will turn yellow. If it is within 5% of its 52 week low, the cell will turn green.
  • If a stock is within 5% of its 52 week high, the stock’s cell will turn red.
  • Earnings yields of 8% or greater will turn green. These are the stocks you want to pay attention to. As time permits, I will add valuations for all stocks with an earnings yield greater than 8%.
  • If the total return – capital gains plus dividends – exceeds 15%, the cell will turn green.

Valuation Methodology

  • These valuations are very simplistic and are based on a linear projection of trends of the past 10 years.
  • The valuations should be viewed as a starting point for your own work. If valuations were as simple as doing a linear projection of past trends, as Buffett has pointed out, librarians would all be rich.
  • The primary question you need to ask yourself is whether the past conditions that produced the company’s historical results can be expected to continue into the future.
  • Although I try to be accurate, I make no representation or warranties as to the accuracy of the data. My source data is from Value Line. You should always check the data from the original sources, i.e. 10-K’s, 10-Q’s, etc.
  • These are not stock recommendations.
  • The valuations do not show an estimate of the company’s intrinsic value, rather they show the total return that is discounted in the stock’s current price if it rises to the projected target price within the next five years.
  • If nothing else, you can invert the expected total return and analyze all the component variables and their attendant assumptions required to achieve it.
  • Where the historical median P/E was greater than 18, I capped it at 18 to be conservative. I show the actual median P/E in the “Comments” field.

Here is an explanation of the various data points used in the calculations:

  • Return on Incremental Equity – Past 10yrs – (Net Profit 2010 – Net Profit 2000) / (Equity 2010 – Equity 2000). This metric attempts to measure how profitable the company’s equity investments were of the past decade.
  • % Net Profit Reinvested in Equity – Past 10yrs – (Equity 2010 – Equity 2000) / Total Profit 2000-2010. This measures the amount of the company’s net profit that was reinvested in the business.
  • Expected Growth Rate to 2015 – (Return on Incremental Equity – Past 10yrs) x (% Net Profit Reinvested in Equity). This attempts to project future earnings growth as function of the level of reinvestment and its profitability.
  • CAGR Shares Outstanding – 10-year trend of the number of shares outstanding
  • Net Profit 2015 – (2010 Net Profit) x (1 + Expected Growth Rate to 2015)^5
  • Median P/E – Median P/E ratio over past decade

The author of this blog is NOT an investment, trading, legal, or tax advisor, and none of the information available through this blog is intended to provide tax, legal, investment or trading advice. Nothing provided through these posts constitutes a solicitation of the purchase or sale of securities/futures. The data and information presented in this blog entry is believed to be accurate but should not be relied upon by the user for any purpose. Any and all liability for the content or any omissions, including any inaccuracies, errors or misstatements in such data is expressly disclaimed.

My Watch List – August 31, 2010 (Value Line Issue 1)

I have completed my review of Issue 1 of Value Line and have added a number of stocks to my watch list. I will begin to selectively add valuations as time permits. I will generally focus on those companies that are either near new lows or that have a high earnings yield.

You will see that my valuations take the form of the total return (capital gains plus dividends) that is discounted in the current stock price based on today’s closing price. Please note that these are simplistic valuations based on the extrapolation into the future of the companies’ past performance, including net profit, return on equity, rate of reinvestment, share repurchases and average dividend yield, which may not be indicative of future performance. You should always do your own research.

You will notice that the majority of the stocks on the watch list are categorized as a “Good Business”. That is intentional as the fourth tenet of my investing blueprint is Buy Good Businesses. I want to have an active dashboard where I can easily track all these good businesses and zero in on the ones that Mr. Market is making available at a cheap price. The basic screen for Good Businesses was inspired by Buffett in his 1987 letter to shareholders.

Experience, however, indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago.  That is no argument for managerial complacency. Businesses always have opportunities to improve service, product lines, manufacturing techniques, and the like, and obviously these opportunities should be seized.  But a business that constantly encounters major change also encounters many chances for major error.  Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise.  Such a franchise is usually the key to sustained high returns.

The Fortune study I mentioned earlier supports our view.  Only 25 of the 1,000 companies met two tests of economic excellence – an average return on equity of over 20% in the ten years, 1977 through 1986, and no year worse than 15% [emphasis added]. These business superstars were also stock market superstars: During the decade, 24 of the 25 outperformed the S&P 500.

To be categorized as a “Good Business”, I am looking for businesses that pass these Fortune tests. Given the severity of the recession, I might include a company that is close but not quite there. As you can see from the study, not many companies pass these stringent tests. If you are fishing in this pond, at least from a quantitative standpoint, you have eliminated many sub-par companies. Note that 24 out of 25 of the stocks that passed the Fortune screen outperformed the S&P over the decade preceding the study.

This approach for the watch list was also inspired by Mason Hawkins who said at a 2005 lecture at the Ben Graham Centre for Value Investing at the University of Western Ontario that he and his team revalue the top 200 businesses in the world every week to see if they are available for less than 60% of value.

By way of review, the other categories are as follows. The categories may be added to or evolve over time.

  1. Special Situation – restructuring, spin-off, bankruptcy, divestitures, etc.
  2. Book Value Aristocrat – exceptional book value growth over the past decade
  3. Strong Moat – evident durable competitive advantage
  4. Guru Purchase – recent purchase by a notable investor

Here is My Watch List for August 30, 2010

The author of this blog is NOT an investment, trading, legal, or tax advisor, and none of the information available through this blog is intended to provide tax, legal, investment or trading advice. Nothing provided through these posts constitutes a solicitation of the purchase or sale of securities/futures. The data and information presented in this blog entry is believed to be accurate but should not be relied upon by the user for any purpose. Any and all liability for the content or any omissions, including any inaccuracies, errors or misstatements in such data is expressly disclaimed.