Monthly Archives: July 2009

Are U.S. Stocks Still Cheap?

In an August 6, 1979 article in Forbes, Warren Buffett said we can think of the stock market as a kind of bond with a fluctuating coupon. That coupon is the earnings yield of the stock market which we calculate by dividing the earnings of the market by its price. If the earnings yield of the stock market is materially higher than that of the bond market, it may indicate that stocks are cheap.

In a December 19, 2008 letter to the shareholders of Longleaf Partners, Mason Hawkins, along with the fund’s management team, asked the question, “How Cheap are U.S. stocks?” To provide an answer, they compared the 5-year average earnings yield of the S&P 500 with the yield of the 10 year U.S. Treasury. They then compared this ratio to that of past bear market lows.

I have adopted their format as one the tools I use to value the overall stock market. This is not about timing the market, but, rather, assessing whether it is under or overvalued.

On Tuesday, July 21, 2009, the S&P closed at 954.58. This gave the S&P an earnings yield of 6.75%, based on its trailing 5-year average earnings of $64.43.

This is 1.91 times the 3.53% yield of the 10 year U.S. Treasury, which gives the S&P a yield advantage of 3.22%

Here is how the ratio of 1.91 compares with other bear market lows:

October 4, 1974 – 1.4 (S&P yield advantage: 2.7%)

August 12, 1982 – 1.0 (S&P yield advantage: 0.4%)

October 19, 1987 – 0.7 (S&P yield advantage: -2.3%)

July 23, 2002 – 1.1 (S&P yield advantage: 0.4%)

It is interesting to note that on March 9, 2009, which was the low point for the S&P in the first half of 2009, the S&P’s earnings yield shot up to 9.86%. This gave the S&P a yield advantage of 7.36% over that of the 10 year U.S. Treasury, and made the ratio swell to 3.94.

Here is a spreadsheet of the data I used.

Tomorrow, I’ll compare the S&P’s earning yield with that of high quality corporate bonds.

How to Use the Time You Devote to Investments

In his partnership letter dated February 11, 1959, Buffett wrote, “I make no attempt to forecast the general market – my efforts are devoted to finding undervalued securities.” This is very different from the approach we read about in the financial press and see on the cable business networks. It seems as if everyone has an opinion on where the market will be in the next six months. Of course, this would be nice (and profitable) to know. Getting rich in the market would be simple: get the latest six-month market forecast and place your bet, perhaps adding some leverage. The problem with this approach is that nobody can consistently do it.

Having said that, it is important to draw a distinction between market forecasting and market valuation. Market forecasting, as we’ve seen, is trying to predict the short term direction of the market. Market valuation is about gauging the level of overvaluation or undervaluation in the market. A value investor wants to commit capital when the market is undervalued and act with caution when the market is overvalued.

The takeaway should be clear. Instead of spending time reading and thinking about predicting the direction of the stock market, you want to spend the time you devote to investing finding undervalued securities. When Buffett had just finished Ben Graham’s course at Columbia, he took the Moody’s Manual and the Standard & Poor’s Manual and went through them twice. Evidently, this was more than 1,000 pages. When asked how he became so successful in investing, Buffett answered, “We read hundreds and hundreds of annual reports every year.”

In sales, they talk a lot about the Sales Funnel as a metaphor for the selling process. At the top of the funnel are all the unqualified prospects, in our case, the entire stock market. The salesperson’s job is to qualify all these prospects and take them through the sales process, i.e. contacting them, qualifying them, making a proposal, closing the deal. Likewise, the value investor must qualify prospective investments by researching and valuing them. For purposes of our discussion, the key insight is that, just like in sales, you need to keep your “idea” funnel full in order to find stocks that are worthy of investment.

To that end, the following is a list of sources that value investor Monish Pabrai uses to find new ideas. The list is from a February 2007 interview with Pabrai at The Motley Fool.

1. 52-Week Lows on the NYSE (published daily in The Wall Street Journal and weekly in Barron’s)
2. Value Line (look at their various “bottoms lists” weekly)
3. Outstanding Investor Digest (http://www.oid.com/)
4. Value Investor Insight (http://www.valueinvestorinsight.com/)
5. Portfolio Reports (from the folks who put out OID)
6. The Wall Street Journal
7. Financial Times
8. Barron’s
9. Forbes
10. Fortune
11. BusinessWeek
12. The Sunday New York Times
13. The Value Investors’ Club (http://www.valueinvestorsclub.com/)
14. Magic Formula (http://www.magicformulainvesting.com/)
15. Guru Focus (http://www.gurufocus.com/)

Pabrai said that, “Between all of the above, I have historically found at least three to four good ideas every year.” Note that some of these are paid services.

Happy hunting!

Microsoft Valuation by Richard Pzena

Richard Pzena is Founder and Co-Chief Investment Officer of Pzena Investment Management, LLC, which has more than $24 billion under management. Pzena uses a classic value investment approach.

The document contains detailed notes, courtesy of John Chew, on Pzena’s lecture to Joel Greenblatt’s Special Situations Value Investing Class at the Columbia University Business School. Pzena gives an overview of his approach to value investing. What follows is a detailed valuation of Microsoft. Pzena’s valuation is both qualitative and quantitative and highly instructive. It is a relatively rare detailed look at how a successful practicing professional value investor goes about valuing a company.

10 Reasons Why a Stock Can Be Undervalued

On Friday, July 17, 2009, I wrote that if you find a stock that you believe is undervalued, it is important to try to determine the reason for the undervaluation. As Buffett wrote about poker in his 1987 letter to shareholders, “If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.”

Interestingly, some value investors, such as David Einhorn of Greenlight Capital, invert this process. Rather than first looking for undervalued stocks based on quantitative screens, for example, low multiples of price to earnings or price to book value, they first identify areas of the market where undervaluation is likely to be present and then search for good companies within that undervalued sector.

Here is a partial list of reasons a stock may be undervalued:

1. The General Market is Down – This is generally the most obvious reason that a stock is undervalued and occurs when the macro view of the economy is poor. It is useful for investors to have some basic tools to value (not predict) the general market so they can prepare as the market becomes undervalued. (Look for future posts on this subject.)

2. The Macro View about a Particular Industry is Poor – A classic example of this was in the 90’s when the prospects of “Hillarycare” took down healthcare related stocks.

3. The Macro View about a Particular Geography is Poor – In the 1990-1991 recession, California’s economy was in bad shape after its real estate market suffered a large decline. This set-up a great opportunity in Wells Fargo’s stock which Buffett took advantage of.

4. There is a Severe Short Term Problem which does not Damage the Business Franchise – The classic examples here are Buffett’s purchase of American Express after a financial scandal in 1963 and his purchase of Geico in the late 70’s after it severely underpriced its insurance risk. In both cases, the problems could be fixed and, more importantly, they did not damage the competitive advantage of American Express’s brand and Geico’s low-cost structure.

5. The Company has Diversified away from its Core High-Return Business – In the 1980’s, Coke diversified into non-core low-return businesses such as shrimp farming and movie making which masked the gold mine they had in the core soft drink franchise. In 1988, when Buffett began to accumulate Coke at around fifteen times earnings, the stock was not overly cheap based on traditional valuation metrics, but this unwise diversification masked the degree to which the market recognized that Coke was a long-term wealth generating machine.

6. The Company Does Not Pay or Has Cut its Dividend – Buffett cites this as the reason that Commonwealth Trust Co. was undervalued when he bought it in 1958. It probably also contributed to the sell-off in high yield U.S. regional banks as they cut their dividends in 2008 to build their capital bases.

7. The Company is Not Followed – If a small company has little or no analysts following the company it may be undervalued because it is neglected. Nobody is getting paid to follow the stock and cheer it on.

8. The Company is a Spin-Off – This is another classic opportunity area. The new company may have excellent economics and prospects which were not understood or appreciated when it was part of its parent company. Joel Greenblatt’s book You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits provides a great overview of spin-offs.

9. The Company is Emerging from Bankruptcy – The market fails to recognize the value of a newly organized company free of its heavy debt burden or other legacy problems.

10. The Company is Too Complex – This is a favorite area of famed value investor Seth Klarman. If most investors don’t understand a given situation or they are unwilling to do the amount of work involved, it may make an undervalued situation available to astute value investors.

Summary of Buffett’s Investing Process from PBS Interview

I am a great admirer of Warren Buffett’s investing process. Here are some of his recent quotes from an interview with PBS on January 22, 2009.

“Any stock I buy I will be happy owning it if they close the stock market for five years tomorrow. In other words I am buying a business. I’m not buying a stock. I’m buying a little piece of a business, just like I buy a farm. And that doesn’t change. And all the newspaper headlines of the world don’t change that. It doesn’t mean you can’t buy it cheaper tomorrow. It may turn out that way. But the real question is, did I get my money’s worth when I bought it?”

“My greed quotient has risen as stocks have gone down. There’s no question about that. The cheaper something gets that you’re going to buy, the happier you feel, right? You’re going to buy groceries the rest of your life; you want grocery prices to go up or down? You want them to go down. And if they go down you don’t think gee, I got all those groceries sitting in my cabinet at home and I’ve lost money on those. You think, I am buying my groceries cheaper; I am going to keep buying groceries. Now if you’re a seller, obviously prices are higher. But most people listening to this program, certainly I, myself, and Berkshire Hathaway, we’re going to be buying businesses over time. We like the idea of businesses getting cheaper.”

“I spend 60 hours a week, thinking about investments and most people have got jobs and other things to do.”

“If you buy something with the idea that you’re going to do fine over 10 months, you may or may not. I do not know what stock is going be up 10 months from now, and I never will.”

“I‘ve had three times in my lifetime since I took over Berkshire when Berkshire stock’s gone down 50 percent. In 1974 it went from $90 to $40. Did I feel badly? No I loved it! I bought more stock. So I don’t judge how Berkshire is doing by its market price, I judge it by how our businesses are doing.”

“The most important investment lesson is to look at a stock as a piece of business not just some thing that jiggles up and down or that people recommend or people talk about earnings being up next quarter, something like that, but to look at it as a business and evaluate it as a business. If you don’t know enough to evaluate it as a business you don’t know enough to buy it. And if you do know enough to evaluate it as a business and it’s selling cheap, you buy it and don’t worry about what it’s doing next week, next month or next year.”

Here is a link to the video and a complete transcript.

Value Investing Conference Videos

The Darden School of Business and the McIntire School of Commerce at the University of Virgina sponsored the first annual Value Investing Conference on November 5th, 6th, & 7th 2008. There were some great speakers. Buffett’s biographer, Alice Schroeder, shared some great new insights, which are not in her book Snowball, into how Buffett evaluates and values an investment.

Here are the videos.

Why Knowing the Reason a Stock is Undervalued is Critically Important

When Buffett purchased shares of the Commonwealth Trust Co. of Union, New Jersey, he indentified the reason that was largely responsible for the depressed price of the company’s stock. It was because the company was not paying a cash dividend. Identifying this reason reduced the probability that there were other unknown or poorly understood reasons why the stock price was depressed which could have materially reduced the intrinsic value of the company and lead to a permanent loss of capital.

When I attended the Value Investing Executive Education course at Columbia, in June of 2007, our professor, Bruce Greenwald, stressed the importance of asking yourself, when you’ve identified a great bargain, why the market is making it available to you at such a great price. If you can’t answer the question, perhaps there are people on the other side of the trade who know something you don’t or who are smarter than you. This is why it also makes sense to look carefully at who else has taken a position in the stock or who has not taken a position in the stock. For example, it may be meaningful to observe that, even though newspaper stocks are selling at extremely low multiples, Warren Buffett and Rupert Murdoch have not stepped in and made purchases. What does it tell you when two of the savviest and knowledgeable media investors in the world have passed on stocks that you may deem to be a great value? This is not in opposition to the idea that an investor needs to do his own independent thinking. It is just another fact in the investment appraisal and a recognition that others may have access to more or better information than you do.

Value Investing Works

Before adopting a particular investing approach, it makes sense to ask if the approach has been successful over time. There is clear evidence that a value oriented approach will outperform over time. Buffett wrote about this outperformance in his 1984 article “The Superinvestors of Graham-and-Doddsville”.

I took a quick look at the performance of six prominent value equity funds vs. the Vanguard Index 500. The data compares the funds’ 10 year annualized returns and the data is through 7/15/2009. The data is from Morningstar. It is instructive to remember that most actively managed funds underperform the S&P 500.

Longleaf Partners: 1.32%
Dodge & Cox: 3.16%
Weitz Value: 2.50%
FPA Capital: 6.36%
Third Avenue Value: 5.83%
Sequoia Fund: 2.63%
Average: 3.63%

Vanguard 500 Index: -2.29%

Average Outperformance: 5.92%

These value oriented managers have added significant outperformance over the past decade in spite of the very challenging conditions.