But what is Value Investing?

This is obviously a beginning investor question. But weekends are for beginning value investors, since that is probably when they have time to investigate their investing strategies. In layman’s terms, Value Investing is about buying something for less than it is worth, whether its socks or stocks. Investors who use this form of analysis are called Value Investors. Famed value investors are Warren Buffet who began his career as a value investor and Sir John Templeton, Seth Klarman and Joel Greenblatt. But the Godfather of Value is Benjamin Graham.

Origins of Value Investing

Because of their 1934 book, Security Analysis, Benjamin Graham and David Dodd are regarded as the pioneers of value investing. This book provided the investment community with a concept of value investing, although it did not gain that moniker until later. The value duo chastised the investment community for being too short sighted. Oh, and obsessing about earnings. Some things in investing don’t change much. The real importance of Security Analysis is that it provided a set of criteria, what would later become the value investing criteria for individual stock selection.

Ultimately Graham says, “But in applying analysis to the field of securities we encounter the serious obstacle that investment is by nature not an exact science.” No kidding. That is why he developed the concept of a margin of safety. Investing, even value investing, is not precise so you need to have a buffer.

Graham’s 1949 book, The Intelligent Investor, was widely acclaimed with Warren Buffett cementing its reputation by commenting that it was,” by far the best book on investing ever written.”

How to value a Value Investment

So, how does one know if a stock is undervalued or not? As with most things in life, keep it simple. Value Investing is at heart a contrarian investing philosophy. We look for the out of favor, the unpopular and the beaten down to discover what is a bargain. Numerous directions can result in a value investing strategy. Here is one example.

The search begins by analyzing a company’s financial statements. From the balance sheet, calculate the book value, simply, total assets-total liabilities. Dividing book value by the number of shares outstanding on the balance sheet date, you arrive with a book value per share figure. Comparing the current stock price and book value per share gives an investor a good start in determining if the stock is undervalued or not. . I have written previously about a low price to book value investing strategy. Compare this ratio to the companies industry or the market as a whole.

Complications can arise. Intangible assets such as brand names, patents and trademarks come into play and can affect calculations, which is why  price to Tangible book is often used instead of the traditional price to book value.

Should I become a Value Investor?

It’s natural for a beginner to ask, “How do value investor’s performance fare against the market?” The weird part is that there is so much research showing that value investing is superior to “growth” or  technical investing that  you would think everyone would be a value investor. Fortunately, for you and I that is not true.

A good illustration is Warren Buffett’s article in 1984 titled, The SuperInvestors of Graham-and-Doddsville. Buffett challenged the ‘efficient market” theory and compared the performance of Graham and Dodd’s value investors against the market. He argued that if a large proportion of the winners belong to a particular group who practice value investing, their success is due to a winning strategy, not by chance as efficient market theorists assert.

In summary, value investing could be called by common sense investing, in a world where common sense is rare. . Look around chroma investing, it is free. There are not many better value investments than free.

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What is Low Price to FCF?

Two of the most important words in evaluating a company are Cash Flow. Old School Value Investors focused on Earnings. That is so 1950’s. I am not going to go into the details of Free Cash Flow. Please see the Chroma Investing Value Investing Terms FCF for a fuller explanation than I give here. The short version is that Free Cash Flow is what a company really has left over at the end of the year. It is the amount that you can turnover to investors in dividends, buy back stock, pay down debt or just let sit on your balance sheet.

Low Price to Free Cash Flow (P/FCF) is a measure that value investors find useful to analyze companies finances in relation to it’s current stock price. It is a stricter measure than the price-to- operational cash flow ratio as it backs out capital expenditures.  Here is the simple equation:

                                    Price to FCF = Market Cap / Free Cash Flow

A high ratio indicates that a company is expensive relative to its Free Cash flow. A low ratio shows that it is cheap in relationship to FCF. Like most of these value investing metrics you can reverse these and you will get the Free Cash Flow yield which is expressed as a percentage. With a Free Cash Flow yield, higher is better.

Simply put, Free cash flow is a measure of a company’s ability to generate cash, which is a starting point for stock pricing. Or as Warren Buffett said, “Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”

An easy formula for free cash flow is, FCF = Operating Cash Flow – Capital Expenditures. The numbers needed for the calculation are found on the Cash Flow Statement of the Financial Reports that a company issues in its 10K or 10Q.

How to use P/FCF in an Investment?

Let’s say you agree that using FCF can help you make your value investing decisions,  how might you go about it? Here are a few suggestions.

1. You can buy stocks in companies that are low in Price to FCF as compared to the market as a whole. That is you can compare the P/FCF of a company to that of the overall market. For example you could compare the FCF ratio of General Electric to the S & P 500. Although, I could not find this information on Standard and Poor’s own website.

2. You can compare Free Cash Flows to some arbitrary number, say 10 or 15. You may want to do this if you can come up with some historic norm for Free Cash Flow.  If you can review historical data of FCF over a long period of time, it is possible to come up with a normalized ratio. You could use that number as your comparison.  Again, this will be difficult since historic data for Free Cash Flow is difficult to obtain very far back.

3. You can buy a stock using P/FCF either as a solo investing criteria(not recommended) or in combinations with other factors. For example you might use FCF ratio with such metrics as low price to book, a high acid test ratio, high ROIC, etc.

4. You can buy a stock when a company has a Low P/FCF in relationship to its own 5, 7 or 10 year financial history. I always like to compare current ratios to historic ones to get a relative idea if this metric is cheap for this particular company.

5. You can buy the stock of a company who Price to Free Cash flow is low relative to its industry. In other words you take a look at Exxon’s FCF ratio and compare it to the oil industry as a whole to get a relative industry ratio.

6. You can buy a fund that specializes in Low Price to FCF. This may be an index mutual fund or an ETF. I don’t know of any pure play funds on Low P/FCF, since most value funds use a combination of factors, but perhaps there is one that has escaped my notice.

So, why is low price to free cash flow so important, that it is worth investing?

Importance of Low Price to FCF

Low P/FCF has been a good indicator in the past of what makes a successful investment moving forward. Let me give a few examples.

Peter George Psaras wrote a study called “Back-test showing the power of Price to Free Cash Flow in the Investment Process” where he back tested buying Low Price to Free Cash Flow stocks from the Dow Jones Industrial Average for 1950 to 2007. His criteria was simple: buy every stock that had a Price to FCF ratio less than 15 and sell it after a year. The results were remarkable. The performance was 22.77% on average over the 58 years. The average gain for the DJIA was only 7.82% for the same period.  Quite an outperformance

I asked myself the question, what does this mean right now? So I created a stock screen with Stock Investor Pro using data from last Friday August 5^th. Here are the companies passing the screen:

I am not recommending any of these companies, but it does give you some idea why some high profile value investors are interested in Microsoft, Pfizer and Cisco to name a few. Perhaps a few of these companies are worth some further research.

Other investing studies have used the less stringent  Low Price to Cash Flow ratio (P/CF). Let’s see if there was a similar outperformance.

Does Low Price to Cash Flow work in shorter time Frames?

In their study, “Contrarian Investment, Extrapolation and Risk, Josef Lakonishok, Robert W. Vishny and Andrei Shleifer reviewed all the companies on the AMEX and NYSE from 1968 to 1990. They divided up the companies in to ten selections called deciles by Price to Cash Flow. They formed portfolios that they kept for five years. What they discovered is that the lowest Price to Cash Flow stocks outperformed the highest  Price to cash flow stocks on average during a holding period of 5 years. The average return for the  low P/CF stocks was 20.1% per year and amongst the high P/CF stocks it was only 9.1% with cumulative 5 year return of 149.4% to 54.3%. Perhaps not as exceptional as the Psaras study, but significant none the less.

This is one of those studies that is useful only in the abstract. Realistically an investor is not going buy the lowest  10% of p/cf companies on any exchange.  But it does continue to show that when you are considering value investing metrics that P/FCF should remain in the toolkit.

Low Price to Cash Flow Internationally

All this may be well and good in the United States, but do these kind of value investing metrics work abroad? A Michael Keppler looked at this in his study “Further Evidence on the Predictability of International Equity Returns: The Importance of Cash Flow in Country Selection.” While he did not use FCF specifically, it is instructive. He found that from 1970 to 1989 in the eighteen countries studied that the lowest price to cash flow country indexes produced a result of 19.2% on average in local currencies compared to the highest Price to cash flow country indexes with a return of only 4.7 % in local currencies.

Since this was based on buying index funds this study has an actionable element. But it would require a little research. You don’t think I am spoon feeding you everything, do you? An investor could research index funds based on different countries stock markets. They would need to have P/CF information on each index (preferably FCF). Compare the indexes and pick a small basked of low cost to cash flow indexes.

If anyone does this research please report back.

Why does Price to FCF work as a Value Investing Metric?

No one knows for sure but here are a couple of my guesses.

1. Companies with low prices related to any value metric, Earnings, Book Value, Sales etc. are unpopular. Otherwise their price wouldn’t be low. Something is bothering the market, bothering it so much that it MAY be undervalued. Low Price to FCF investments are a contrarian investment by definition, and mostly people want to say they own Apple or Netflix, not Aeropostal or Microsoft.

2. Cash Flow may be more honest than earnings, a commonly used measure of a companies performance. As Damodaran said in his book Investment Fables, “Accountants measure earnings by subtracting accounting expenses from revenues. To the extent that some of these expenses are non-cash expenses … and because accrual accounting …does not always yield the same results as cash accounting, accounting earnings can be very different from cash flows.” (Italics are mine)

Having a healthy Free Cash Flow gives a company options. It is a sign of a financially sound company thriving in its industry. Free cash flow is often used for stock buy backs, dividend payments and in reducing debt.

Finding such companies is usually easier in a bear market ( like now) or when a company misses earnings, makes a mistake which leads to bad press, all of which can temporarily depresses its stock price. Investors finding such opportunities should, as they say, “strike while the iron is hot”.

Please come back each week as we write about various Value Investing Criteria to help you build your Value Investing arsenal. Add your comments if you have any thoughts about using  Low Price to FCF in investing. Finally, if you haven’t already done so, please sign up for email list (I promise I won’t spam you.) or like ChromaInvesting on Facebook.

Disclosures: I do not have any financial interest with aaii.com or Stock Investor Pro, but I am a paid member of the first and I have purchased the second for the past two years. I am making no recommendations on stock purchases or sales, just expressing my opinion on what I am exploring right now. I am not a professional investment advisor but a Film and television producer, thus everything here is for entertainment purposes only.

If you would like to download post you can here.

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ETF Defined

An Exchange Traded Fund (ETF) is similar to a mutual fund, but has similarities to purchasing stocks. The SEC says that ETF’s are “investment companies that are legally classified as open-end companies or Unit investment Trusts (UITs).” An open-ended investment company is one of the three primary groups of companies as described by the SEC. Unlike a close-end investment company, an open-end investment company can offer to buy back its shares from the investors.

A normal mutual fund is a pooled investment where the money from thousands of investors are joined together and invested in whatever the focus of a mutual fund is, such as equities, bonds or commodities. Conversely, a common stock is traded on a stock exchange. An exchange traded fund tracks a stock index, a commodity or pool of stocks, but is also traded on a stock exchange like a stock; the price variations occurring as people buy and sell the fund over the day.

 ETF – Good Value Investing Tool

ETF’s are very popular with value investors since they often have tax advantaged status. That is you don’t pay on the capital gains with the ETF only when you sell your investment. In the current law if you sell after one year that means long term capital gains which as of this writing is only 15%. Another reason ETF’s should be popular amongst the value investing crowd is that unlike mutual funds Exchange Traded Funds can trade at the same price as a stock Trade. Both TradeKing and Zecco charge $4.95 for an ETF trade the same as an individual stock.

ETF the Nitty Gritty

An ETF often represents a set of stocks. For example the SPDR 500, the oldest ETF follows the Standard & Poor’s 500 Index, which is an index of the 500 largest companies in the US. ETF’s portfolio would not change over the course of their lifetime and that means that investors are aware what they are investing into. If an ETF says that it is investing in energy stocks, then it is investing in energy stocks.

An ETF’s price is determined by their daily trade volume which is not the case with other funds. Because of the inherent benefits of Exchange Traded Fund, they are widely used as a preferred mode of trading across the globe with more than a few hundred Billion dollars having been invested in various funds across hundreds of indices.

ETFs do not sell individual shares to investors like Mutual Funds., large blocks of shares known as creation units are issued. The creation units are not purchased by the investors in cash, rather they are purchased in the form of a portfolio of shares which would represent the portfolio of the ETF. Investors after purchasing the creation units can either sell the shares in the secondary market or sell them back to the Exchange traded fund.

Another difference between a Mutual Fund and an ETF is that Mutual Funds have their Net Asset Values computed at the end of a trading day based upon the values of their holdings; they constantly trade in the market to reflect a better price. However Exchange Traded Fund gets their prices determined by the push and pull of the market since they follow a fixed basket of stocks.

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 1. Do your own research

While a blog, stock screener or newsletter may give you a good idea to investigate, you should not rely on anyone else’s analysis. You may not realize that their investing bias is different than yours or that that some of their financials have errors or even have typos. There is a lot of information that can kill a good idea. Make sure you have tried to kill your good idea before you invest your cash. Benjamin Graham and Joel Greenblatt have different ways to getting down to the value investing highway. You will need to chart your own. This does not mean you have to read every 10K or 10Q, but you need to have a methodology for your value investing research.

2. Have a margin of safety

There are numerous ways to value a company or analyze whether or not you should buy it. Whether you use Low Price to Book, Discounted Cash Flow or  some other value investing metric, Graham’s concept of Margin of Safety never goes out of style. You will often be  wrong in your analysis and having a margin of safety will help protect your downside risk. Preserve your capital first, accumulate capital second.

3. Know when to sell

Before you buy an equity you should have an exit strategy. If you believe a stock is worth $30 but is trading for $15, your exit strategy might be to sell when it reaches $30. Or it might be to reevaluate the company and see if the fundamentals have changed and to recalculate the companies value. Make sure you know when you will sell if you are wrong about your investment idea. Will you sell if a stock drops 20% or 50%?

4. Don’t be a trader

Don’t buy and sell too often. This is vital. It is one of the chief reasons that a value investor can lose money or trim profits. Their is a lot of research that shows that not just indivdual investors suffer from this problem, but professional money managers as well. Value Investing is not day trading or weekly trading, it is a long term strategy that seeks to arbitrage the present market price against the higher long term value of a company.

5. Don’t buy hot stocks

Value Investing is fundamentally a contrarian method of investing. If the crowd is buying it, you should avoid it. This will help you avoid investing in bubbles like the current bond market.

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The confirmed speakers are

Bill Ackman, Pershing Square
Leon Cooperman, Omega Advisors
James Chanos, Kynikos Associates LP
Adam Weiss and James Crichton, Scout Capital Management
Alexander Roepers, Atlantic Investment Management
Joel Greenblatt, Gotham Capital
Guy Gottfried, Rational Investment Group
Michael Kao, Akanthos Capital Management
Whitney Tilson & Glenn Tongue, T2 Partners

I can say that Michael Kao and Guy Gottfried were both very popular speakers at the last Value Investing Congress I attended in May. I am also curios to hear Jim Chanos speak, since he is a legendary short seller. Finally, Whitney Tilson is always good for the T2′s long and short actionable idea. If you decide to go be sure to use my Value Investing Congress discount coupon N11CI4

If you would like more information about this Value Investing Conference, or any other, please go to my Conference page which has the most up to date information on Value Investing Conferences.

Disclosures: I am a media sponsor of  the Value Investing Congress.

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Studies have shown that individual investors often under perform even when they invest superior performing funds. The reason is easy to understand. They buy high and sell low. When a fund manager has been doing well they buy in often at the top of that funds price and when he is doing poorly, they sell, selling at the worst time because the price is low.

The problem with this thinking is that the top performing managers will under perform the market, and sometimes badly. In the article, it speaks about Bruce Berkowitz of Fairholme Capital, and that one of their funds “fell 12 percent through June 9, ranking it last among 870 diversified U.S. stock funds with at least $500 million in assets.” The S & P 500 during the same period gained over 3%. Berkowitz was named Morningstar’s fund manager of the decade and here is dead last, opportunity anyone? In a theoretical sense it would be great time to invest in the Fairholme Fund. A manager with a great track record is getting hammered, so you might want to jump in now.

But herein lies the problem for me. Fairholme Fund has 74% of its equities investments in Financial Stocks. And I don’t trust the entire industry. It is too opaque to evaluate well, and nearly impossible to value assets, and what is on and off balance sheet. The fund seems overly risky to me. So, while I do believe trolling in the murky waters of the currently poor  performing fund managers should be part of the standard value investing bag of tricks. You still have do your due diligence and ask why is this beaten down, in the same way you would ask of a company who’s share price is in the toilet. Sometimes there are good reasons for the relatively cheap price.

You could easily say, dude, the man has outperformed the market in a really bad decade. And you would be right. But was he lucky? Was he taking risk that wasn’t apparent? He seems to me to be doing it now.

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• What is your Investing Edge?

The Value Investing Congress West was more than a month ago. It is a value investing conference worth attending. If you want a great set of notes go to Ben’s Inoculated Investor to get them. I took notes too, but his are better than mine. I am at heart a contrarian, not just in investing but much of life. So the lesson’s I learn are often different than other persons. The most important things I learned were not the actionable investing ideas, which there were several. No, I walked away with simple conceptual ideas, some of which I already knew, some I learned for the first time.

Value Investing Lessons

The first lesson was an idea from the Charlie Munger oevre that Rhaul Saraogi of Atyant Capital spoke about. The idea is to always invert the problem. I took it as always invert. Always. Don’t assume anything. If someone tells you an investment is great, ask why it wouldn’t be. There was a speaker that was  young and energetic, obviously bright, and his investment thesis was about a real estate company in Canada. Many people were very impressed. Initially, so was I. His “story” was great. Until I asked one simple question of his proposal (which was not answered at the conference) When the real estate market tanks in Canada, what then? There have been soaring real estate prices in parts of Canada (I am most familiar with Vancouver), which looks suspiciously like a bubble to me. What if there is a correction. Then the company could implode. “Invert, invert.” The story was compelling, the analysis seemed not to allow for the obvious downside risk. This is not a criticism of the Value Investing Congress, which I found to be extremely valuable, but of our process. We want to believe. We don’t want to invert.

Through June 29th you can save $2100 off the fall Value Investing Congress in New York, which is in October 17& 18th. It promises to be truly kick ass. Joel Greenblatt, Bill Ackman and Jim Chanos are just a few of the high profile speakers they will be have. It is sort of like a rock concert for investors. If you are interested in getting the Chroma Investing discount click here.

If you would like more information about this Value Investing Conference or any other, please go to my Conference page which has the most up to date information on Value Investing Conferences.

Disclaimer: I am a media sponsor of the Value Investing Congress.

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In the original version of his book Greenblatt proposed a very simple idea. Simple does not mean dumb. It means simple to understand, but also intuitive. Its appeal was that even I could understand it at first glance. I will distill this down to my target audience: small and beginning investors. The idea was to take the universe of stocks with a market of $50 million or more and grade them based on two criteria. I told you it was simple. Greenblatt makes adjustments from the standard ideas he represents. You can read either version of the books appendices to understand his thinking in this regard. The first criteria is Return on Capital (ROC) or precisely as Greenblatt defines it: EBIT/(Net Working Capital+Net Fixed Assets). The second is Earnings Yield or in the Magic Formula: EBIT/Earnings Yield. Higher is better in both cases. In true mechanical investing form, the idea is to take the grades on these two criteria and sum them giving you a total number. Rank the top 30-50 companies and buy a limited portfolio of these companies. Sell the losers a day less than a year, Hold the winners a day past a year (for tax reasons).

The reason I was initially awed by this was that Greenblatt said that his extensive back testing had shown that it averaged more than 30%/ year from 1988-2004. A staggering return. I recently read the updated version and an interesting thing happened since 2004. The returns have declined. A lot. It now stands at only 23.8% from 1988-2009. The last five years have been so weak that it dragged down the return for the previous 16 years. So the question I proposed in my title. Does the Magic Formula work? The real answer is I don’t know. I sure would love for it to work. It would sure make my investing decision easier. But as Greenblatt himself said the Magic Formula’s period’s of under-performance will scare people off from using it enabling it to continue as a viable investing strategy.

I am of two minds. The first is that I am distrustful of back testing. What has worked well in back testing has not always worked out as well in the light of real money investing. The second is that it is also hard not to recognize the powerful influence of mean reversion. It is hard to know if the the Magic Formula theory’s returns are declining because of mean reversion. But one must consider it apossibility. A final thought on the Magic Formula. If the mean reversion applies to the MFI theory in and of itself (instead of as measured against other investment strategies) then now would be an excellent time to buy into the strategy because it is likely to return to its former glory.

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I have meant to post on  James Montier’s concept of investing risk ever since I first read Montiers writings. He gets risk in a way that the uber-smart quants sometimes fail at. He recognizes that risk is not an equation or number, it is a concept.  Much of this post refers to his Clear and Present Danger; The Trinity of Risk, but I will refer to other of his writings as well. You really should read Montier directly.

For anyone who follows in the Graham school of investing, or this blog, you know that first and foremost is preservation of capital. Montier begins in this tradition,  “Graham saw risk as the Permanent loss of capital.” Amen. We as investor’s often spend way too much time chasing the return and not examining the downside. That is the risk.

Montier divides investing risk into what he calls the trinity.

The first aspect of this trinity is valuation risk. Simply stated the risk that you will screw up the valuation of a company and over pay for the stock. Montier says, “buying expensive stocks leaves you vulnerable to disappointment.”This is classic value investing. Don’t overpay. There are lots of metrics to keep things cheap.

Montier suggests that we should return to works of Graham and make sure we are not buying a stock with a P/E greater than 16. He quotes Graham, “We would suggest that about 16 times is as high a price as can be paid in an investment purchase of a common stock? Although this rule is of necessity arbitrary in its nature, it is not entirely so. Investment presupposes demonstrable value, and the typical common stock’s value can be demonstrated only by means of an established, i.e. an average, earnings power. But it is difficult to see how average earnings of less than 6% upon the market price could ever be considered as vindicating that price.”

The second aspect of the trinity is business/earnings risk.

Again Montier defines the term by quoting Graham, “Real investment risk is measured not by the percent that a stock may decline in price in relation to the general market in a given period, but by the danger of a loss of quality and earnings power through economic changes or deterioration in management.” When a company suffers an earnings drop, or an outright loss the price of the stock can drop substantially.

The trick in assessing Earnings risk, is to figure out whether or not an earnings set back is temporary or permanent. If you get this wrong you will end up with a value trap instead of a good deal. Again Montier has a metric. Instead of just looking at Price Earnings alone, he suggests that you look at the ratio of P/E to the ten year average P/E. To minimize earnings risk this ratio should be less than two, perhaps considerably.

The third of three is Balance Sheet/Financial Risk. Montier again uses Graham to define, “The purpose of balance-sheet analysis is to detect? the presence of financial weakness that may detract from the investment merit of an issue.” According to Montier most investors are smitten with earnings and only look at balance sheet risk when something goes awry. Obviously, with the emphasis on NCAV stocks on this, we often start with balance sheet risk.

Montier uses a metric that readers of this blog will recognize, the Altman Z score. Interestingly, he uses the standard manufacturing equation in his evalution, but I will tweak Montier, if I may, and refer to the non-manfuacturing Z-score.

T1- Working Capital/Total Assets

T2- Retained Earnings/ Total Assets

T3- Earnings before Interest and Taxes (EBIT)/ Total Assets

T4- Market Value of Equity/Book Value of Total Liabilities

T5- Sales/Total Assets

The revised Altman Z score is Z= 6.56T1+3.26T2+6.72T3+1.05T4

The score should be above 2.6 for non-manufacturing, non financial companies to minimize balance sheet risk. If it is below 1.8 watch out. For manufacturing companies refer to the original Altman Z score.

Now you can put all this together. But ultimately, Montier sums up best when he argues  “that risk is really a notion or a concept not a number. Indeed the use of pseudoscience in risk management has long been a rant of “(his).

Look at a range of factors that make up investment risk and take appropriate action.

What do you think comprises investment risk. Am I missing anything?

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