Barnes & Noble (BKS) shares are down about 15% since reporting earnings earlier this month. The drop was due to a negative earnings outlook for fiscal 2010. Many times the market may overreact in cases like this or may not take into account other more positive factors regarding future prospects which would otherwise translate to a higher price paid for the common equity of the firm. This presents opportunity for the diligent value investor.

It can be interesting to look to the darlings of a sector for guidance as to which sectors have favorable prospects, but then to spend time thinking about and analyzing the laggards in the sector for actual buying opportunities. Being a contrarian leaves room to make money through capital appreciation whereas buying the all-stars may leave the investor vulnerable to overpayment. An investor who bought Wal-Mart (WMT) 10 years ago has actually lost money, even though the company itself has performed remarkably well. The growth prospects were all priced into the shares back then and the company would have had to exceed already optimistic earnings expectations for the performance to be translated into share price appreciation.

Amazon (AMZN), the apparent darling in the book merchant space, is trading on extremely high multiples (P/E of approx. 60 vs BKS’ of approx. 14) as a result of high hopes for growth in the electronic segment of the market, sales of physical books via the web store as well as electronic books via the Kindle e-reader. These expectations are obvious and are likely already priced into the company’s shares as a result. Of the 32 analysts who cover the company, 13 have a buy rating and only 2 recommend selling it. It’s hard to imagine much movement in share price if the company merely meets expectations, and not so hard to imagine what could happen if the company misses these expectations to the downside.

BKS on the other hand used to be the largest player in the book market but has since fallen out of favor with the market as its base of operations is largely the company’s 800 bricks and mortar stores. The share price is currently less than half of what it was in 2006, and as mentioned, has dropped significantly even within the past two weeks. It’s hard to see where the positive aspects of the company’s outlook are priced in, if they are. Another benefit for investors of the depressed share price is the current dividend yield of almost 5%. As brought to my attention via the Wall Street Journal is the fact that BKS will actually be partaking in the growth of the e-book market right alongside AMZN. BKS may even have an advantage thanks to its bricks and mortar locations as many shoppers have never even seen an e-reader, and a physical location gives BKS the opportunity of putting these devices directly in the hands of the consumer. Even more interesting is that while AMZN’s e-reader operates on a closed format (only the Kindle can read titles purchased from AMZN), the books sold by BKS operate on a shared platform known as ePub which will allow the purchases to be read on any device including laptops.  BKS has already begun taking steps to compete with AMZN as it has acquired an independent e-book seller and will also be launching its own e-book store shortly.

Based on the fundamentals discussed here, BKS seems to be a compelling value play. As always though it is important to arrive at an estimate of intrinsic value so that a purchase decision is based on hard evidence of a discount as well as the incorporation of a margin of safety. I’ll be valuing BKS in the next couple of days as well as taking a closer look into the financial statements and management’s discussion and analysis. I will be sure to share my findings here with the community. Until then, let’s take this to the forums for some discussion!

Return on assets (ROA), return on equity (ROE) and return on invested capital (ROIC) are the three most prevalent metrics used to obtain an idea of the returns a company generates, and to compare this return generation to the company’s peers. While important information can be learned from each one of these metrics, there are some significant differences between them.

ROA, calculated as net operating profit after tax (NOPAT) divided by total assets, shows the returns the company is able to generate relative to its entire asset base. While generally a good metric to use in comparing companies in same industries, this metric can be skewed when a company is holding lots of excess cash or assets for sale. These assets, while not expected to generate income are used in the calculation thereby causing the return on assets to appear lower than that which the company’s actual productive assets generate.

ROE, calculated as net income after tax divided by total equity (excluding preferred shares), demonstrates the percentage return earned on each dollar invested by the shareholders of the firm. This metric is very relevant when comparing companies with similar capital structures but outside of such a scenario it should not be relied upon. As Assets = Liabilities + Equity, the more debt a company has in its capital structure the smaller the equity will be as a percentage of total assets. Unlike the ROA metric, which remains stable throughout all capital structures, ROE can appear extremely high or extremely low when comparing a company to another employing a very different percentage of debt to equity.

My personal favorite of the three is ROIC, calculated as NOPAT divided by ‘operating net working capital plus operating fixed assets’. Operating fixed assets are any assets that are expected to contribute to earnings such as equipment, land (if not excess), goodwill, intangible assets, etc. Using operating net working capital, calculated as ‘current assets’ minus ‘excess cash’ minus ‘current liabilities’, also ensures that current assets that aren’t expected to generate earnings (such as excess cash) are not included in the calculation. This metric is my favorite as it gives a good indication of a company’s actual capacity to generate returns through utilization of its productive assets. Also, this metric can be used to compare companies employing varying capital structures. My main use of this metric is in comparing it to a company’s weighted average cost of capital (WACC), an estimation of the return expected by the debt and equity holders of the firm on a weighted average basis. The purpose of comparing the two is described in a previous article.

Dshort.com published an interesting article recently that calculated what is known as the P/E10 of the S&P 500. The P/E10 is essentially the current real price of the index divided by the average earnings over the past 10 years. Benjamin Graham created this ratio to be a more robust measure of the market’s value, as during times of extreme market fluctuation the regular trailing P/E is prone to somewhat illogical results. For example, the market currently shows a trailing P/E of 137.3, obviously due to the severely depressed earnings we’ve had this past year as well as to the recent run-up the market has seen in anticipation of future earnings. What is somewhat disconcerting is that the P/E10, while showing a more reasonable P/E of 19.1, still indicates the market to be overvalued in a historical context – the historical average P/E10 is about 16.3 while that of the trailing P/E is 15. This is even after the worst stock market decline in recent history; perhaps the stock market is getting ahead of itself?

Many of us will be watching for evidence of increased revenues this quarter, alongside hopefully increased earnings. Last quarter’s earnings may have met already decreased expectations, but much of the earnings came about by way of cost cutting rather than top line growth. Since businesses likely had a stronger call to action for cost cutting than ever in our recent history, I would be surprised if the majority didn’t trim all that they could as quickly as they possibly could. Going into this earnings season there likely aren’t too many avenues left to cut costs. If the consumer isn’t the heavy-lifter this quarter that the market is expecting, and if revenues stay flat or decline as a result, then there isn’t much hope for even meeting expectations this time around. I wouldn’t be too eager to see the effect such a disappointment would have, especially after the strong run-up we’ve just had in the markets since March.

Every time in the past that the P/E10 went from the 1st to the 4th quintile (quintiles divide the P/E10 into 5 groups with the 1st being the highest P/E group and the 4th being the lowest P/E group) it’s ultimately declined to the 5th quintile where it bottomed in single digits. In March, the P/E10 of the S&P hit the 4th quintile after a long way down from the 1st and we are currently back into the 2nd quintile where the market is looking expensive. If a drop to the 5th quintile was to occur, it would come about from either a decline in the S&P to below 600 or alternatively from a strong resurgence in corporate earnings. If Q3 earnings didn’t have you waiting in anticipation before…

As an aside, in the past these declines have lasted anywhere from 3 to more than 19 years. The current decline is in its 9th year. I wonder how long earnings can remain weak for until the market decides to take fate into its own hands. In this environment I wouldn’t bet on it taking its time.

The following article is based on the inaugural video lecture given to the new value investing class at the Richard Ivey School of Business in 2005. Mr. Irving Kahn delivered the lecture alongside his brother Thomas. Irving served as the second teaching assistant to Benjamin Graham at the Columbia University Business School and he has over 78 years of experience in the investment business. Irving and his brother founded their investment firm, Kahn Brothers & Company, in 1978.

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The Kahn brothers are firm believers that value investing is an art, not a science. In making this point they allude to an artist that paints masterpieces as this artist will surely have some poor paintings along the way. If value investing were a science then it would be replicable. One would be able to run equations in a machine all day and consistently right answers would emerge, but since it doesn’t work this way it has to be an art.

As value investing is more art than science, a value investor has the greatest chance of success studying industries that they understand. The Kahn brothers recommend paying attention to smaller cap and obscure companies, as these will offer the investor who takes the time to learn more about the company, than does the public, a chance for great profit. This means looking at places where the markets are not overpriced and where there are companies that will enable a value investor to truly benefit. Sometimes to find these opportunities one must be patient and not necessarily have their portfolio invested all the time. Ultimately, the value investor has to stay strongly contrarian, as sometimes not committing capital to the markets is the best thing to do. You don’t need all your money on the table all the time and if markets are high don’t invest. Be very selective and keep your standards. At the time of the lecture (2005), the Kahn brothers were not finding a general theme in which they invest that they can say to go and look into. They are very adamant that while occasional themes evolve, all they can say is that they maintain that very strict contrarian approach. If something is very popular and everyone is buying the same stock they are, they stand back and ask themselves what they’re doing wrong. Half the price of a common stock is probably current fashion so if you can buy what’s currently out of favor, you are well on your way to investing successfully.

The Kahn brothers have a few important factors that they keep in mind when evaluating a potentially undervalued company:

• The company should either be obscure or out of favor. It can be a big company that is not obscure though if it is very much out of favor.
• Their analysis is very much balance sheet oriented. They are not interested in companies with excessively levered balance sheets and they like companies with little to no debt.
• Management should be on the same page that the brothers are on. If management can own a lot of stock and are incentivized as shareholders that is a big positive.
• They avoid companies that have, in combination; volatile cash flows, are excessively levered and have management that are not too swift. This would be a very bad combination.
• The brothers are not so focused on the income statement initially. What they would ask is, what’s the earnings potential of the business? If it were run properly, if management succeeded in their plan to close a losing division, etc then what would be a reasonable earnings level? They check to see if the stock is cheap based on this earnings level and if they are confident that management can achieve this goal.
• The brothers really don’t care if a company is losing money and they actually would like a company to be losing money (although not hemorrhaging cash) because that knocks the stock down and presents some wonderful investment opportunities.

The newspaper seems to be a major source of investment ideas for the Kahn brothers. Thomas points out that the new highs and lows lists, and their relative size to one another, give a good indication of the direction of the general market. While shopping the new lows list doesn’t seem like a hi-tech, sophisticated way to invest it can actually bring forth some interesting ideas. Events that will also be presented in the paper are if certain companies are having problems and their stock tanks as a result, or if entire industries are affected by a current event. When you find a problem in a company or industry, pull out the financials, do some work and see if any of the stocks have gotten knocked down to where they are attractive. You must then decide if they are attractive investments. The value investing philosophy has nothing to do with what’s on TV (i.e. the talking heads) as the journalists are interested primarily in which stocks are moving.

Value investing will not go away. One may think that with so much information out there, and available to the public, that for instance standard value screens such as price/earnings and price/book may not be as effective. In reality however it’s not about opening up Yahoo Finance and looking at the latest data. The Kahn brothers have positions in some very complicated to understand companies. They also have a position in a company that hasn’t filed in a year. Institutions can’t hold this company and one can’t pull the latest data up online. As a result, if you’re confident that management is sound then this presents an interesting buying opportunity. You ultimately have to look behind the situation and you have to do your homework to get a leg up on other investors.

Once value is found, the brothers tend to ease into a position rather than to buy in all at once. They like to buy a small stake and get to know the company better. Frequently shares they buy will go down, so they will do their homework and see if they were right in their analysis but just maybe bought too early. If so then they stick to their convictions and they buy some more. Some of the brothers’ best capital gains have come from this process of averaging down. They warn to not be fooled by “snake oil salesmen” who advertise making money extremely quick. Most of the Kahn brothers’ investments have a holding period of 3 to 7 years, and sometimes longer. There comes a point, where as with a plant, the company begins to wither. Management may no longer be good, competition may be getting worse; you can see this in advance and make a profit. Personally I would sell an investment as it approached my estimate of intrinsic value, as there are likely other underpriced opportunities where I can put this capital to work for above average returns. This is even for companies that remain strong.

When it comes to placing a value on the notion of growth, the Kahn brothers don’t see a point. They want to grow their capital and don’t care whether it’s by way of a growth company or not a growth company or whether earnings are growing quickly or not, they just want their capital to grow. If a company has clearly defined, great prospects then it’s common knowledge already. How can one determine how many of these great prospects are already priced into the stock? The brothers don’t feel particularly comfortable paying up for those great prospects as they don’t have a way of figuring out what they’re worth. As a result of avoiding stocks like these, the firm has very successfully grown their capital over the years and can postulate that they’ve taken less risk than the overall market. Everyone is enamored with growth stocks, but how about just growing your capital with non-growth stocks? That’s alright too.

The markets MAY have started a long awaited correction today, but then again it’s impossible to tell for sure. Know the value in the companies you own, don’t panic sell, and use major dips in the market as buying opportunities.

By trying to time the market’s daily fluctuations you are playing a game that you can not win. This is how people end up buying high and selling low; the exact opposite of what you want to do. So please, have conviction in the companies that you own. If something material changes in one of your holdings then re-evaluate but otherwise do not let “Mr. Market” faze you. If anything, I get a little excited on days like today because it means we may finally have some more buying opportunities than we’ve had for the past couple of months. You should have a list of companies you would like to own, and then when the market finally serves them to you on a silver platter for the price you’ve wanted to pay for them, take it. If the market continues to drop, then buy some more. Over the long-term you WILL beat Mr. Market this way.

Stay strong my friends… we may have some exciting weeks ahead.

With so many companies to research out there how does one go about finding potential value stocks? Value investors tend to read a lot; Francis Chou has even been quoted as saying he reads upwards of 200 pages (newspapers, magazines, books, etc) every day. On top of daily reading it’s important to have a resource to go to when you are fresh out of ideas and need that next company to take a deep dive into. This is where stock screeners are useful.

The best stock screener I have found to date is ADVFN. It is completely free and can screen US, Canadian and UK equities. Also, it has more fundamental criteria available than I’ve seen anywhere else. If there are any other screeners you are aware of I’d be grateful if you posted them in the comments for the readers, although I challenge you to find one better than ADVFN.

Following are some of my favourite criteria to screen for as well as the constraints I like to place on each:

• Gross Margin: I like a gross margin of at least 20%, this ensures that the company has the ability to alter pricing in order to push through competition and difficult times.
• Inventory/Sales: Industry specific, but you don’t want the inventory turns to be too low, especially if you are placing a significant value on tangible assets – the longer the inventory sits for, the more uncertain its value will be.
• Net Cash from Continuing Operations: While GAAP earnings may be negative, these companies can still possibly be cash flow positive. I would be wary of any business that does not show positive cash from operations as they will just be eating into their cash asset and you can’t predict for how long.
• Current Ratio: Must be greater than 1 otherwise the company does not have the ability to meet its current obligations. In a market like this where funding is increasingly difficult to raise this is a situation companies should be trying to avoid.
• Price to Earnings Ratio: I like P/E to be less than the long-term market average of 15. This is a good indication that the company may be undervalued, but the specific industry also needs to be considered.
• Price to Book Ratio: I keep this under 2, depending on what I am searching for, just to screen out those companies that are most likely overvalued. There are companies that warrant a premium price/book but these companies will also have a high return on capital, so you will tailor your screen to look specifically for those.
• Price to Tangible Book Ratio: Interesting companies can be found if this criteria is set to less than 1. These will also most likely be companies in distress however so they should be approached with caution.
• Return on Invested Capital: You can set this to be below your estimate of average cost of capital to find those with turnaround potential. Another option is to set this variable greater than your estimate of average cost of capital and combine it with a screen for companies with low Price to Book in order to find companies that are likely trading below fair value.
• Long Term Debt to Total Capital: I set this to a max of 60% and then I evaluate based on the specific company I find. Some industries, those with steady cash flows, can safely service high levels of debt. Then there are those with more variable cash flows that should keep debt to a minimum. Over 60% however is likely getting close to the upper limit of safety for any company.
• Sector: If you want to incorporate a top down view into your investments then screening by sector can be a rewarding way to significantly narrow the options.
• Institutional/Insider Holdings: I usually don’t set restrictions for these variables but I do like having them available so that I can get an idea of share ownership. For example, when looking for stocks with turnaround potential I would be hesitant to invest in a company with low institutional and insider holding as no one has an incentive to get the job done.

We’ve had a lot of new visitors this week coming from various referrals on the web, and other sites where my articles are syndicated. I just wanted to take this opportunity and say welcome. It is my hope that you find this site to be a useful resource whether you are an experienced investor or just getting started. I recommend subscribing to the RSS feed (the orange button to the right) in order to receive the latest posts as they become available. Some articles, especially investment ideas, may be time sensitive and RSS is the best way to get them right away.

The articles and information on this site tend to be focused on the value style of investing as that is what I practice myself and is what I know best as a result. Very important however, especially if you are new to investing, is to pick a style/methodology, learn it well and stick to it. The worst losses in the stock market come from letting your emotions dictate your buy/sell decisions. That is when you are most likely to buy high and sell low; exactly what you do not want to be doing. As a value investor I have a lot of conviction in the value investment philosophy. I definitely do not preach it to be the only way to invest and there are certainly many very successful investors from other disciplines. Over the past few years however I have followed practitioners, read research and conducted some of my own studies. What I have learned is that there truly is a significant and persistent premium attributed to value investing over time and as a result this is the style I am practicing, preaching and most importantly sticking to.

The best place to get started on this site is by clicking on the “basics” heading under the topics to the left. This series of articles will give you a brief introduction to the investment methodology which I utilize. Just as there are many value investors out there, there are also many ways to practice value investing. The methodology I use, which I studied with Dr. George Athanassakos (Ben Graham Chair in Value Investing at the University of Western Ontario) while pursuing an MBA, is based largely on the teachings of Bruce Greenwald at Columbia Business School. A great resource for additional information on this methodology is Bruce Greenwald’s book – Value Investing: From Graham to Buffett and Beyond.

Please let me know either through the comments or via email (jonathan at jonathangoldberg dot com) if you have any suggestions for content that you would like to see here and I will do my best to accommodate. In the past I have posted investment ideas, summaries of lectures by notable value investors, market commentary and research findings (of which I admit may be the driest of the bunch i.e. last post). Speaking of research findings, while very dry my last post is an excerpt from a study I have conducted and the excerpt gives a great overview of some important studies which you can research on your own. For those of you that choose to skip that post I hope to have a more “user friendly” post in the future summarizing the findings as well as their applicability to you and your investments.

Look around, read previous posts and think about what you’d like to see in the future. And most importantly, subscribe to the RSS feed to the right of this page so that you are kept up to date with my posts as they become available. Oh yeah, and tell your friends to visit too!

I recently conducted a study with Dr. George Athanassakos. In the coming weeks I’m hoping to reformat it for publication in a journal. In the meantime please see below the abstract as well as an excerpt from the paper. Your thoughts would be very valuable.

ABSTRACT

In this paper we study the performance of value versus growth, and the resultant value premium, from 1951 to present. We look specifically at post-war recessionary periods in the United States. We are especially interested in the performance of value versus growth during a “credit crunch” such as the one in the current recessionary period. We find that (1) the only times during recessionary periods that one of either value or growth had positive returns, while the other had negative, were times when growth was negative and value was positive, (2) during both the current financial crisis, and that of the early 90’s, value suffered but performed no worse than growth and (3) there was a significant negative value premium in each of the 12 months leading up to the four most recent bear markets. This paper could prove useful to other researchers of the value premium as well as to practitioners who may be interested in developing a predictive model for use in the field.

EXCERPT

The value premium is the excess return of value stocks over the return of growth stocks. On the aggregate, and for research purposes, value stocks are usually described as those stocks with a low price-to-earnings ratio (or high earnings-to-price ratio). Value stocks can also be selected based on other metrics such as the price-to-book ratio. In practice, the value premium may have even greater significance when an aggregate basket is not used, but rather when specific equity selections are made. In this paper we set out to find how the value premium has performed during the current recession and what impacts a liquidity crisis may have had on value. In doing so we also determine the value premium for specific recessionary periods in the post-war United States and then draw implications from this for future research on the value premium.

A body of research is available demonstrating the significance of the value premium over long time periods (Lakonishok, Shleifer and Vishny 1994, Capaul, Rowley and Sharpe 1993) and in different parts of the world (Athanassakos 2006, Fama and French 1998). Athanassakos (2006) provides evidence for a consistently strong value premium over a 1985-2002 sample period in the Canadian market; a value premium that persists in both bull and bear markets as well as in recessions and recoveries.

There are two main causes of the value premium proposed in the body of research available today; these are the premium as a compensation for added risk and the premium as a result of errors-in-expectations. The most recent research available suggests that the errors-in-expectations theory is the likely cause of the value premium (Athanassakos 2006, Chan and Lakonishok 2004, Lakonishok, Shleifer and Vishny 1994). It is argued that markets are inefficient, evidence being from observations such as “The January Effect” (Athanassakos 1992), and as such there are times when certain equities are unduly overpriced or underpriced due to unrealistic future expectations based on historical returns.

In addition to research on the value premium over long periods of time, there is research available that has looked specifically at value stocks during periods of recession/expansion and bull/bear markets on the aggregate. Some of this research shows that historically the value premium persists during all aspects of the business cycle (Arshanapalli and Nelson 2007, Kwag and Lee 2006). There is also a body of research, however, which demonstrates that fundamentally value stocks are riskier during bear markets and recessions and that the value premium would be negatively affected during these times (Chen, Petkova and Zhang 2006, Xing and Zhang 2005, Black and Fraser 2003, Asness, Friedman, Krail and Liew 2000).

Kwag and Lee (2006) provide evidence that a value portfolio consistently outperforms a growth portfolio throughout the business cycle and that the benefits of value investing are even greater during periods of contraction than during periods of expansion. Arshanapalli and Nelson (2007) also provide strong evidence in support of this, showing that during the 1962-2005 period value portfolios suffered smaller losses during down markets than did growth portfolios. Their study also shows that investing in a high book-to-market portfolio during this time offered a significant value premium in addition to the downside protection that it offered in bear markets. This value premium was significant for all firm sizes. As a result, Arshanapalli and Nelson believe that the value premium doesn’t appear to result from bearing the additional risk these stocks may inherit during a recession.

While the aforementioned evidence provides a strong case for the performance of value over growth stocks during all aspects of the business cycle, value stocks have also performed poorly for significant periods of time (Asness, Friedman, Krail and Liew 2006). Black and Fraser (2003) provide strong evidence that the future expected value premium is negatively related to recently recorded GDP growth over long periods of time. Their research may contradict that of Kwag and Lee (2006) and Arshanapalli and Nelson (2007) in that it lends support to the view of the value premium as a reward for non-diversifiable risk associated with financial distress. They argue that value stocks are riskier during times of recession when investors least want to hold a distressed stock. The findings of Xing and Zhang (2005) provide support to this research as they find that the fundamentals of value firms decline sharply in recessions. While growth firms also experience a decline in fundamentals, the decline experienced is not as deep as that of value firms. The specific areas of underperformance during these times are in earnings growth, dividend growth, and sales and investment growth. It is proposed that as value firms generally have less flexibility than growth firms, due to a higher proportion of tangible assets, they are more susceptible to cost reversibility. As such, they conclude that value firms have a difficult time in smoothing negative aggregate shocks and are more affected by negative business cycle shocks than are growth firms. Providing further evidence to this research are Chen, Petkova and Zhang (2006) who demonstrate a countercyclical value premium, implying that value is riskier than growth in adverse economic times when the price of risk is high. They, like Xing and Zhang (2005) propose that as cutting capital is more costly than expanding capital, value firms don’t have enough flexibility when scaling down during negative business cycle shocks; value is therefore to be more adversely affected by economic downturns.

The previously mentioned research, regarding the demonstrated and expected value premium during negative business cycle shocks, is not unified in findings or expectations. Also, there has not been any research conducted on the performance of the value premium during specific negative business cycle shocks in history. While a significant body of research is available showing that value has outperformed growth in negative business cycles, much of the research points to evidence that value could be expected to underperform when the price of risk is high. This leads us to believe that during a financial crisis, such as the one present during the most recent recession, a significantly negative value premium could be expected. This paper studies a number of specific post-war recessionary periods in U.S. history, including the current one, in order to establish the periods where value did indeed underperform growth. We also provide a real situational analysis from these findings. Our research looks at value versus growth over a longer period than previously conducted research and delves into specific periods of time. To the best of our knowledge this has not been conducted previously. As practitioners believe that the outperformance of certain investment styles can be traced to economic fundamentals (Kao and Shumaker 1999), this paper also considers the macroeconomic indicators of the time periods that are being studied.

We find that it is difficult to make many connections between the realized value premium and the observed macroeconomic indicators in each period. This is likely due to most instances of the variation in the value premium being due to a standard deviation of the value premium that would be expected. There are a number of interesting and specific findings from our research that should greatly add to the study of the value premium in general. Firstly, all the instances where one of either growth or value had negative returns while the other had positive returns were instances where the returns of the growth portfolio were negative while those of the value portfolio were positive. These instances seem to be around situations involving a bubble in the equity markets. Secondly, it is apparent that value did not underperform growth in the most recent financial crisis. It seems that the returns of a value portfolio, while suffering, merely performed as poorly as those of a growth portfolio. This was likely due to a flight to quality across all financial assets and the same phenomenon can be observed during the 1990-1991 recessionary period, which can also be classified as a “credit crunch”. Lastly, and perhaps most interesting, is a persistent negative value premium observed in each of the 12 months prior to the most recent four bear markets. This trend goes back almost 30 years and, as a potential leading indicator, may prove to be the foundation for a predictive model in the future.

“We think shorting makes us better analysts. Charlie Munger says you really understand a company when you can articulate the negative scenario better than the person on the other side of the trade. We also think that from a business standpoint, if you’ve done all the work and conclude the negative scenario is most likely to play out, it makes a lot of sense to be able to short.”

- Ric Dillon, CIO & CEO, Diamond Hill Capital Management, Inc.

Buhler Industries (BUI) is a manufacturer of high-quality tractors and other related equipment for use in the agricultural industry. They are the only manufacturer of such tractors in Canada and one of four in the world.

The following screen brought this company to my attention:

• Return on Invested Capital (ROIC) greater than 10%
• Price to Book value less than 2
• 5-year earnings growth greater than 5%
• Debt to Capital less than 50%

What I was expecting to find was a company perhaps having a competitive advantage and that should be trading well above its book value but for some reason was able to be bought relatively cheap. BUI definitely wasn’t what I was screening for but I’m happy to have found it. The only reason it showed up on this screen was due to its turnaround performance in FY2008. After 5 straight years of declining sales and abysmal returns on capital, this company suddenly showed an ROIC of almost 17% in 2008 and reported its largest sales number since revenues started to decline in FY2003. This definitely warranted looking into further.

BUI is currently trading at a price/earnings (P/E) of 6.25, a price/book of 1.13 and a price/book (tangible) of 1.29. The company traded at an approximate average P/E of 18 over the previous 5 fiscal years. This definitely looks cheap but the question remains, is it unusually cheap or is the low price warranted? With a market cap of $136 million and no analysts covering the stock to my knowledge, there is definitely a possibility that this company is flying under the market’s radar only to be noticed at a future date.

Coming to BUI’s rescue in FY2007, the company’s worst reporting year since FY2000, was a Russian company by the name of Novoe Sodruzhestvo. This company’s reputation in Russia is, fittingly enough, that they acquire and transform factories. As is apparent from their track record, Novoe Sodruzhestvo lives up to their reputation. Even more fitting is that one of their previous acquisitions is the largest producer of combines in Russia. If you don’t know what a combine is, all that matters is that they are fixed onto tractors and used in agriculture. The Russians have already begun diligently working on their plans for BUI, which include introducing new products to the North American market as well as taking advantage of the Russian company’s distribution network in Eastern Europe. Over 160 official representatives of the combine manufacturer in Russia, Eastern Europe and Central Asia will support the distribution into new markets.

The results of the new ownership have so far been promising. The new owners restructured sales and production activity to be more efficient and reinvigorated the work force with some changes at the management levels. In addition, the Russian’s network overseas enabled the company to ship double the amount of tractors as in the previous year. There is room for improvement, which we can expect to see, as suppliers couldn’t keep up with the production level. The company has already begun improving their supply chain and efforts have been successful to date. Next year’s plans are to further develop the product to cater to client tastes, develop the dealer network through an aggressive marketing budget and more finance options, and to further improve the supply chain by finding replacements for weak suppliers.

Before even attempting to arrive at a value for a company it is important to understand the company and its assets as well as the strategic positioning and the current environment in which the company is situated. Only then can an estimate of fair value be arrived at with conviction. Prior to arriving at or relying on the following numbers it is helpful to read the company’s annual reports, most recent quarterly report and to visit the company’s website as well as those of its competitors. Obviously the more time and effort spent understanding the company and its industry, the better. The largest risk I see going forward is the strengthening Canadian dollar and the impact this may have on the amount of international sales and/or the conversion of those earnings into Canadian dollars. I believe this to be mitigated however by the company’s continuing operational improvements as well as by the margin of safety employed in arriving at an entry price.

Based on the current capital structure of 30.2% debt-to-capital and 69.8% equity-to-capital I found a weighted average cost of capital of 8.41%, using proprietary measures. With a ROIC (replacement value of balance sheet) of 4.02% in the last 12 months, earnings power value (EPV) would be expected to be below net asset value (NAV). EPV was found to be $5.65 per share with the major driver being normalized zero-growth free cash flows of $12 million. NAV was found to be $8.75 per share with the major drivers being hidden balance sheet assets (product portfolio and customer relationships) of $33.71 million.

If you would like to understand these numbers in greater detail please see my explanatory articles.

Remember, as value investors we do not want to project future growth unless a company has a sustainable competitive advantage and as such I do not project growth for BUI in my valuation. Rather I see the new management as knowledgeable, capable and as motivated to bring the company’s EPV in line with the competitive state of NAV. It is for this reason that I give an 80% chance to this being accomplished, which implies an intrinsic value of $8.13 per share for the equity.

Utilizing a 33% margin of safety, an entry price of $5.44 is recommended. At its current price of $5.44 this stock should be a valuable one to purchase and to hold onto for the long-term.

Francis Chou is the President of Chou Associates Management Inc., based out of Toronto. His funds, which were started as part of an investment club in 1981, won him the Canadian Investment Award title “Fund Manager of the Decade” in 2005.

The following is a summary of Francis Chou’s lecture, given to the Richard Ivey School of Business on August 19th, 2008.

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Mr. Chou began his lecture with some pointed questions to the audience. When you go shopping do you look for bargains? And when you find bargains does it make a good purchase and good financial sense? Presumably the majority of the audience raised their hands as Mr. Chou declared them to have the makeup of good investors (I did not attend this lecture in person and the audience was not visible on the video recording). He stated further that if you can take those principles from your everyday shopping experiences and transfer them to the stock market then you are well on your way to being a good investor. You do need to learn accounting however as it is the language of business.

Mr. Chou’s views on the pharmaceutical industry are that it contains good, strong companies with high returns on capital although a negative aspect is that it’s really hard to forecast the pipeline; you never know what new drugs competitors will be coming to market with in the coming years and which will be the blockbusters. To mitigate this risk he bought a basket of companies in the sector. Regarding allocation he says that if you are finding bargains in troubled industries you diversify, but if you are finding bargains in good companies then you concentrate.

The reason he saw the pharmaceutical sector as a good bet was because they were beaten down due to expiring patents. He saw this as a good opportunity to step in and buy a basket as there are sure to be new drugs coming through the pipeline in some of these firms, especially with the amount of R&D spend these companies expense. He foresees holding this basket for upwards of 5 years until there are significant events in the industry to drive the sector higher. He also mentioned that in a scenario like this, when you feel the whole sector has been hit and you want to diversify, an ETF is a good option.

As a side-note, when valuing companies Mr. Chou will never rely just on price-to-earnings as earnings can easily be manipulated. He likes to look at free cash flow multiples as well. And regarding evaluating the quality of management, he says to look at capital allocation over many years, not just one year. Additionally, numbers tell a story so you want to look at the numbers first and then evaluate management qualitatively as well.

The largest take-away for me from this presentation is the value of diversifying in certain industries, even as a value investor. I’ve always learnt that as a value investor you want to select the stock that is undervalued and have conviction in its true value, which mitigates the need for diversification and only risks minimizing your returns if you do. Mr. Chou points out a great example of an industry where you may know there’s value but you also have to realize the limitations inherent in making a selection as you never know which company’s laboratory the next blockbuster drug will come from.

Towards the end of his lecture Mr. Chou said something that I would like to reproduce here verbatim.

“If you believe in the value principles and you buy cheap just like you do in your day-to-day life and you think it makes good business sense, just do that in the stock market and you will be successful. The only difference in the stock market is that sometimes it plays on psychology; it plays on your own psychology, on your fears, your greed and sometimes when you buy a stock and it’s cheap it can get even cheaper. If you know what you’re doing and you know you’re buying it cheap and you have that courage to do what is right regardless of what the crowd is doing, there’s no reason why you should not be successful.”

He then went on to say, “And that’s what I did, I just stuck to my guns.” A great presentation by a great investor that should give us all the extra bit of conviction we need to stick to ours.

As mentioned in my basics course on value investing, the first step I take in valuing a company is discovering its net asset value. That is, the value per share of the company’s assets after accounting for (subtracting) all liabilities. If the company is healthy, and operates in a viable industry, the assets should be marked to their replacement value. These assets need to be replenished as they are used and any competitor wanting to enter the industry would need to pay fair market value in order to acquire similar assets. This replacement value is the normal case and would then be followed by an analysis of earnings power value, as discussed on this site previously.

What if the company is in trouble? Perhaps the company is in imminent threat of default and is not expected to continue normal operations into the future. Earnings power analysis is then useless as we can expect the company to liquidate its assets in order to pay debtors, with holders of common equity receiving the leftovers. In this case the assets of the company should be valued at liquidation value. We assume all assets are to be sold off to the highest bidder. Liabilities are then subtracted from the value of these assets to find what would remain for the holders of common equity.

As value investors, we don’t only consider companies that have long-term holding potential. Value investing is about buying an asset for less than it is worth. In some instances this may involve purchasing a company facing bankruptcy if the investor has conviction that the assets will be worth more to the common equity holder after liquidation than they can currently be purchased for, always including an appropriate margin of safety.

Valuing assets at liquidation requires a great deal of expertise and may require the services of an expert valuator. Keeping some things in mind, however, should assist you in arriving at a reasonable estimate when needed.

• Asset liquidity. The more liquid the assets are, the more likely they are to be sold at book value. For instance, cash is always valued at book value even in the case of liquidation. Marketable securities are another example of a highly liquid asset.

• Failing business vs failed industry. If the business being liquidated operates within a thriving industry then you can expect that there may be competitors willing to purchase the assets. In the case of a non-viable industry however, assets on the balance sheet are more likely to be sold at scrap prices.

• Asset specialization/customization. The pool of potential buyers shrinks the more specialized or customized the asset being sold. A warehouse that is just a stock space for storing items will have many potential buyers and will likely be sold at close to fair value (given a decent real estate market and enough time to sell). On the other hand, a warehouse that has been custom built and designed to house specific types of goods needing special care will likely be sold at far below replacement or fair value in the case of liquidation. It is important to keep industry conditions in mind though as even in the case of very specialized assets on the balance sheet, these assets could have a fair chance at being purchased closer to their replacement value if the industry is viable. In the case of a thriving industry, competitors will likely be bidding to purchase the asset in order to acquire the extra capacity on the market.

While valuing balance sheet assets at liquidation value can be a difficult task, keeping the above concepts in mind should assist you in arriving at a realistic estimate of their value. Best of luck, and as always I will do my best to respond promptly to questions and/or comments posted below.

Asked if anything was keeping him awake at night, he said there was not. “If it’s going to keep me awake at night,” Mr. Buffett said, “I am not going to go there.”

- The New York Times (Sept 7, 2009)

Options can be a very useful tool to boost your portfolio’s returns. While options can be very risky when used to speculate, this isn’t necessarily the case when using options backed by stocks you would like to own or which you already own.

Value investors looking for increased returns to their portfolios can employ two options strategies. One is selling covered calls, and the other is selling naked puts.

Being “covered” means that you already own the asset needed to fulfill the obligation of the call option if exercised. Your downside is limited as a result. A “call” means that the purchaser of the contract has the right to purchase the stocks specified from the seller at the exercise price (upon expiry if the market price is at or above the exercise price).

As a value investor you want to hold onto your investments until they approach your estimate of the intrinsic value. Depending on the situation this can take from a few months to a few years. By selling covered calls at your estimate of intrinsic value you receive the premium from the contracts and only need to sell the actual stocks if they reach their fair value by expiry. If this doesn’t happen you can employ the process repeatedly, generating a steady stream of premiums.

A “naked” option means that you are left exposed to unknown downside risk in the event that the option is exercised. A “put” means that the purchaser of the contract has the right to sell the stocks specified to the seller at the exercise price (upon expiry if the market price is at or below the exercise price).

By selling naked puts, the value investor is committing himself to purchase a security only if the market price at expiry is at or below the exercise price of the contract. If a security that you would like to own is currently trading at too high of a price then by selling naked puts you essentially earn a premium today and only need to purchase the stock if it reaches your entry price or below by expiry.

As shown above, the contract sold for a covered call should have an exercise price equal to or slightly below your estimate of intrinsic value and the exercise price of a naked put should be equal to your desired entry price. The last decision is the time until expiry, which is a personal choice. The longer the option has until expiry the more valuable it will be, but it also exposes the seller to the risk that something material may change within the company during this time. If a material event impacts your estimate of intrinsic value then you may be contracted to sell or purchase stocks at prices you no longer want to. As a general rule, puts can be sold for a long time out if you believe the company to be stable with changes to intrinsic value (on the downside) being unlikely. Selling calls far into the future however may cause you to hold onto a security well passed the time it reaches intrinsic value, perhaps causing you to miss a window of opportunity to sell if market fluctuations bring the price back down.

The risk involved in these strategies is that you may be either a) forced to purchase a stock for more than the market price (in the case of a put) or b) forced to sell a stock for less than it is currently trading in the market (in the case of a call). Either way, if you are confident in the intrinsic value you determined for the company then you are no worse off than if you didn’t sell options but rather purchased and sold the stocks according to your stringent entry and exit points. In fact you are better off, because with options you’ve earned the premiums.

Seth Klarman is President of the Baupost Group, LLC. His firm, founded in 1982, manages $15 billion for institutional and high net worth clients. His now out of print book “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor” sells for $1,200 on Amazon and $2,000 on eBay and has been stolen from most libraries.

The following is a summary of Seth Klarman’s lecture, given to the Richard Ivey School of Business on March 17th, 2009.

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Klarman opened his speech by pointing out that peoples’ investing temperament seems to be influenced by the state of the market when they graduated from school. As he said, “If you remember how cheap things can get, you don’t easily forget that lesson.” I attended this lecture in person while completing my MBA, and this statement had a direct impact on me as I would be graduating in one of the worst market climates in history.

In defining value investing, Klarman describes it as a risk averse approach. He says that it’s a series of principles and a way of thinking about investing that forces you to first focus on risk, and only then on returns. As the downside is where the pain is for most people, value investing protects against that first.

Klarman’s understanding based on research he has seen is that value investing via a mechanical approach (purely quantitative according to P/E, P/B, etc.) adds about 1% to 2% a year. He wonders, however, why anyone would trust a dumb formula when they can do even better through proprietary analysis and investigation. In doing so he can tell when some situations that look cheap (according to a mechanical method) aren’t in fact that cheap. As such, his firm’s approach to value investing is to follow the philosophy’s principles while relying on their own fundamental and detailed research.

Klarman’s approach to investing is based on three underlying pillars:

• Focus on risk before focusing on return. This is not risk in the form of beta or volatility but risk in the sense of how much you can lose if you do in fact lose. He mentions that beta or volatility risk is not really risk unless you must sell on the day the price happens to be low. This approach he describes is very different from wall street where reports tend to be written using single point estimates focusing on the upside, with rarely a mention of the various possibilities of potential downside risk.
• Adopt a view toward absolute returns. The world seems to focus on relative performance instead of absolute performance. This sticks most investment firms to the group of “ensured mediocrity” as many just try to lose less than their peers. In focusing on absolute performance, the thought to Klarman of losing any of his clients’ capital is unacceptable.
• Employ a bottom-up investment approach. Most of the world employs a top-down investment approach by analyzing the economy, interest rates, etc and then applying these findings to decisions to invest in certain sectors that should perform well in the relevant environment. Klarman does not know anyone with a long-term success rate in doing this. Macro forecasting is very difficult to do, and another issue is that even if you are right you must also be early or prices would have already moved to reflect your viewpoint. While Klarman will still think about the macro environment, he analyzes all his investments using a bottom-up approach.

More information about Seth Klarman as well as insights into the Baupost Group’s holdings can be found at GuruFocus.com.

Today was not a good day for the markets, to say the least. These daily market fluctuations don’t faze value investors though, due to the conviction we have in our investments’ true worth.

Recently I recommended an investment in Lockheed Martin Corporation (NYSE: LMT). Since it’s a high conviction investment of mine I tend not to follow the daily ups and downs in the share price. Rather I keep an eye out for any new press releases or industry news that may cause a significant change in the model. Today, however, I couldn’t help but notice that while the S&P was down by more than 2%, my investment in LMT was actually up 0.83%! Granted, this is a daily fluctuation that I already stated no interest in, but barring significant news one would expect a large-cap security like this to move along with the market.

I would like to believe that LMT didn’t suffer along with the rest of the market because it is one of the truly undervalued stocks in today’s speculative and possibly overvalued market. While we value investors don’t give notice to daily fluctuations in share price, it comforts me to know that we probably do have the upper hand when the market decides to go south.

“There’s a virtuous cycle when people have to defend challenges to their ideas. Any gaps in thinking or analysis become clear pretty quickly when smart people ask good, logical questions. You can’t be a good value investor without being an independent thinker – you’re seeing valuations that the market is not appreciating. But it’s critical that you understand why the market isn’t seeing the value you do. The back and forth that goes on in the investment process helps you get at that.”

- Joel Greenblatt

Lockheed Martin (NYSE: LMT) is a “global security company principally engaged in the research, design, development, manufacture, integration and sustainment of advanced technology systems and products.” LMT is in a sector that has been hard-hit twice in a short time span. As the markets were weighing the impact on defense stocks of a change in administration, the credit bubble burst bringing future government spend on the sector into question. LMT stock today is down 35% from its high of $120 (Q3 of 2008) while the S&P is down just 20% in the same period. This leaves LMT trading at around $75 with a P/E of 9.92, well below its long run average of 15. Throughout the current recession, LMT has remained profitable and has had no issues pertaining to credit.

The outlook for the industry is unpredictable at the moment as the recessionary environment is the priority of governments around the world. The United States government, the company’s largest customer is also currently occupied with ongoing concerns such as health care reform and energy initiatives in addition to programs to stimulate the economy. Longer term, large annual deficits and federal debt may have an impact on government defense spending. While the ultimate size of future defense budgets is uncertain, it is currently indicated that overall defense spending will continue to increase over the next few years but at a lower rate of growth than has been seen.

LMT’s customers are split as follows: 84% of net sales to the US government, 13% to foreign governments, 3% to commercial and other customers. The US government is a very stable customer, as they have a military reputation to uphold and they can print money. Despite all the talk about decreased government spending on defense, this will not be sustained long term as our world slowly returns to a multi-polar system. These developments will only bring an increase in defense spending as governments attempt to maintain their countries’ defence capability in the global arena. This is already demonstrated by the high level of negotiated backlog LMT has; approximately $80.9 billion, of which 58% will still be remaining after one year. Regarding the uncertainty of government spending going forward, LMT feels it is well positioned to take advantage of areas where the government has already indicated increased funding; namely intelligence, surveillance, and reconnaissance (ISR) support for the warfighter, cybersecurity, helicopter maintenance and training, and lift, mobility, and refueling aircraft. LMT provides a diverse product offering to the industry and is well positioned to take advantage of these areas of increased spending while other segments may suffer. This company may have been knocked for being in an industry with such an uncertain near-term future, but it is well positioned to thrive within it. Additionally, the company is pursuing a strategy that will see it “expand and complement our existing products and services by moving into adjacent businesses in which we believe that our core competencies will enable us to successfully compete.” Areas of opportunity the company foresees are “the need for more affordable logistics and sustainment, expansive use of information technology and knowledge-based solutions, and vastly improved levels of network and cybersecurity,” all national priorities. The company expects revenue growth to exceed the growth in the Department of Defence’s budget, as LMT’s revenues historically have not been dependent on supplemental funding requests (the requests beyond those for critical recapitalization and modernization programs) where cuts are most likely to happen.

The current debt to capital ratio of approximately 57% is high due to a reliance on one major customer – this affects the estimated equity risk premium. Using 60% as the long run target debt/capital ratio, 5.2% as the cost of debt (current yield to maturity) and 11.1% as the cost of equity (equity risk premium added to cost of debt), yields a weighted average cost of capital (WACC) for the firm of 6.41%. As a quick return on invested capital (ROIC) is 24.3% for the last 12 months, earnings power on an equity value per share basis (EPV) is expected to be significantly greater than net asset value per share (NAV).

A thorough valuation of LMT shows an EPV of $85.4 and a NAV of $48.5. This is in line with ROIC (replacement value of balance sheet) of 9.27%, which is greater than WACC. The competitive advantage which gives rise to the EPV-NAV discrepancy seems highly sustainable as it is based both on relationships (government connections) and capabilities (proprietary technology). Additionally, there are high barriers to entry in this industry as the government is generally a captive customer of LMT for upgrades, parts and service. It would be very difficult if not impossible for a competitor to take away market share from any of LMT’s existing products.

The value of growth plays a part in the valuation of LMT as the company has a stated goal of growth, both organically and through acquisitions, which will add value with ROIC being greater than WACC. The 5-year average growth in net-income of 20%, while likely not sustainable in the long run, lends credibility to assuming a long-run growth rate of 3%. Applying a value of growth multiplier to EPV at this rate of growth yields an intrinsic value for LMT of $108.5 per share.

As always, I recommend incorporating a margin of safety in order to account for sensitivity in my calculations. A reasonable margin of safety implies an entry price of approximately $76. As such, I believe LMT is a great purchase at its current price of around $75.

Insider selling to buying is at a new high as public company insiders are locking in profits from the recent market rally. Insider selling is currently more than 33 times the value being bought. At the same time the S&P is up almost 50% from the March 9th lows and trades at a trailing P/E of 18.5. It’s interesting that insider buying has been weak since April as insiders don’t seem to have jumped on board the rising market. This bearish signal sure doesn’t add any strength to whatever foundation the market rally may be built on.

As mentioned in an earlier article, there may be some volatile periods coming up in the markets. Insiders aren’t demonstrating the kind of confidence in their companies’ prospects that the rest of the market is; this may be a sign of the volatile periods ahead as the market reevaluates its views on future earnings.

If you find value in this market then buy it. But for those that are having trouble finding value in this inflated market, there is a possibility some of the buying opportunities seen during the March lows may come around again.

In my last post I talked about potential buying opportunities in the near future that you might want to be ready for. Part of being ready for a pullback in the market is to have your valuations and company knowledge on standby and ready for when you should take action. Not every company I value will be an immediate “buy”. As a matter of fact, most of a value investor’s time may be spent valuing companies that are not attractive opportunities at their immediate market price. I still see value in bringing these companies to your attention however; as once you do the work to value a company I definitely recommend keeping it on your radar screen. You’re done the hard part, now keep your model updated and wait for the right time to pounce.

If you’re a knowledgeable investor you can even profit off of the work you’ve done to value a company that you aren’t ready to buy. This can be accomplished through the writing of options, which will be discussed in a future post.

The markets have seen a run-up of over 40% since their lows in March. According to Bespoke Investment Group the S&P has reached its highest P/E since the end of 2004, due to a combination of market optimism without the earnings to support it. It may be getting very difficult to find value plays out there as a result. There may be hope yet though for those of you who wish you had jumped on the many opportunities back in March.

A recent article by my friend and professor Dr. George Athanassakos brings to light the oft spoken phrase – sell in May and go away. According to Dr. Athanassakos there is no reason to believe this year will be any different than what has been seen on average over the past 50 years. Even though the recent bull market has coincided with the beginning of the notoriously difficult May to October period “we are not out of the woods yet”, as Dr. Athanassakos says. Due to various market behaviors, which can be read about in the article, it may be time for institutional money managers to lock in their profits from the recent rally. He also points out that September and October are traditionally two very volatile months.

Supporting Dr. Athanassakos’ views is the fact that the consumer has some heavy lifting to do for earnings to catch up to the recently inflated price levels. That may be a stretch in the midst of consumer concern over high unemployment rates.

While many opportunities to invest in solid value back in March may have been missed, opportunity may present itself again sooner than you think. I wouldn’t go anywhere just yet.

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Due to reader requests I’ve now made it possible to subscribe to this site via email. While it would be great if you checked my site every day, this may not be the most convenient way to keep informed of new content as I don’t always post on a daily basis. The most convenient ways are to either subscribe to this site in an RSS reader or to conveniently receive new posts in your email on the days they are published. Both subscription methods can be found in the sidebar to the right.

Goodfellow Inc. (TSE: GDL) is a remanufacturer and wholesaler of lumber products and hardwood flooring. They have over 7000 customers, mainly in Eastern Canada and the United States. I found them by conducting a screen querying profitable companies trading below book value per share with a trailing P/E under 10. Running some quick numbers got me very interested in this little company as not only is it trading below book value but it is trading below current assets after subtracting all liabilities. I jumped on the chance to value this company as on the surface I thought it was a definite buy at this price.

I arrived at a net asset value (NAV) for GDL of $19.67 per share assuming a replacement value of the balance sheet. This took into account my estimation of the value of customer relationships as they seem to be very important in GDL’s industry and these were not previously accounted for as any sort of intangible on the balance sheet.

An earnings power value (EPV) for the company of $8.69 per share was found by extrapolating forward normalized earnings from the last 12 months. Normalized zero growth cash flows were found for the trailing 12 months and were then divided by the estimated cost of capital of 7.5% in order to obtain the value of a perpetuity with no growth.

The EPV well below NAV makes sense as GDL is currently returning approximately 5% on invested capital (replacement value of balance sheet). By comparing this to the cost of capital of 7.5% it is apparent that the company is underutilizing its assets. I like how management is focused on keeping costs down and on how management makes clear that capital expenditures are kept to the value of depreciation (essentially replenishment but not growth expenditures) – they are not trying to grow the company as this would only destroy value with the return on capital being less than its cost.

The current trading price of $7.90 per share seems to be based on the company’s earnings power minus perhaps the market’s own margin of safety due to the unknown prospects for GDL’s industry moving out of this recession. GDL mainly serves the housing market which has been decimated over the past 12 months and it is anyone’s guess what the prospects are for the industry.

The fact that GDL can be bought for less than its current assets, after satisfying all liabilities, has no implications for an investor. The company has a stable balance sheet, is profitable and operates in a viable industry – it is not going to be liquidated anytime soon. The only benefits an investor will see from this company are in the form of earnings to equity. As the shares are trading in line with EPV, buying shares in this company would essentially be speculating as to the prospects for the industry as a whole. If the industry picks up GDL will surely prosper. However if the industry prospects get even worse then you can bet that the company’s shares will move in lockstep.

As a value investor I refuse to speculate on the industry and would rather know that I am buying a company for below its true worth. I see no catalyst that may bring EPV closer to NAV as management seems content with the operations (except perhaps for the suffering top-line due to current market conditions). As such my intrinsic value for the company is $8.69 per share as found for EPV. Applying a satisfactory margin of safety implies an entry price of around $5.80 per share. As shares are currently trading around $7.90 I will be staying away from this company for now.

“So if the entire country became securities analysts, memorized Benjamin Graham’s Intelligent Investor and regularly attended Warren Buffett’s annual shareholder meetings, most people would, nevertheless, find themselves irresistibly drawn to hot initial public offerings, momentum strategies and investment fads. People would still find it tempting to day-trade and perform technical analysis of stockcharts. A country of security analysts would still overreact. In short, even the best-trained investors would make the same mistakes that investors have been making forever, and for the same immutable reason – that they cannot help it.”

- Seth Klarman

In anticipation of our first company valuation, the comments links are now active for all existing and future posts. I look forward to having some good discussion on this site about recommended companies and value investing topics in general. I’m sure many of you have thoughts on existing ideas or have new ideas to share and I encourage you to do so.

As mentioned previously, I am currently in the midst of a job search which I have been devoting a lot of my time to. As such, I haven’t had much time for screening potential investments never-mind conducting valuations on them. Thank you for your patience and for continuing to check this site regularly. I plan to start discussing specific companies on a regular basis sometime within the next week…

Until then please read my basics course on value investing and ask any questions you may have via the comments. Also, if you’d rather not check back here every day just subscribe with your RSS reader by using the orange link to the right. Until next time… have a great week and I look forward to your involvement either in the comments for each post or through email at jonathan (at) jonathangoldberg (dot) com.

All the best… JG

The methodology discussed in the basics course on value investing must seem like a lot of work to implement. Many of you may be wondering if it is even worth implementing when you have no doubt read the benefits of merely investing in pre-screened (according to P/E, P/BV, etc) value stocks. Dr. George Athanassakos, my mentor and Ben Graham Chair in Value Investing at the Richard Ivey School of Business (University of Western Ontario), has written a paper with two former students, Reyer Barel and Saj Karsan, on the added premium resulted in through the additional valuation work. In this paper they compare a basket of stocks selected merely using the “academic” method of screening for low P/E and low P/BV, and a basket of stocks selected using the rigorous and time intensive process which value investors follow.

Athanassakos et al find that there was a significant value premium attributed to the basket of low P/E and P/BV stocks as compared to a basket of high P/E and P/BV stocks. This has been confirmed by other research as well. What is unique about this paper is that there was an even greater and significant value premium attributed to the basket of stocks that went a step beyond the screening process and used a “valuation technology” to find the truly undervalued of the low P/E and low P/BV basket.

The methodology used in the study is the exact methodology that I learnt under Dr. Athanassakos so not only is the paper an interesting read but it is also a great way to obtain additional insights on valuation from an expert in the field.

The students that worked on this paper with Dr. Athanassakos have a value investing site of their own, Barel Karsan. The site is an inspiration for this one and it offers up very interesting insights into the philosophy and investing in general. While ramping up slowly due to my ongoing search for employment, I hope that one day my own site will live up to the one that inspired it.

Details on the paper are below and the paper can be found HERE.

What I have shown you in the basics course on value investing should only be considered as a first look into the philosophy and how to implement it. As you can imagine, every value investor has their own metrics, views and opinions when it comes to valuation and you will develop your own methodology with study and practice. A good place to start is with the book by Bruce Greenwald that I have mentioned previously. Now this is just a start.

My own serious studies in value investing began while working on a research paper with Dr. George Athanassakos at the Richard Ivey School of Business (University of Western Ontario), where he is the Ben Graham Chair in Value Investing. While at the school I also took his highly regarded and greatly subscribed to course in value investing. In this course we spent a number of intense weeks valuing many companies in different industries so that Dr. Athanassakos’ methodology would be second nature to us. On this site I will be sticking to the overview of the methodology that I have posted and will not be getting into the intricacies as our focus here will be about investment ideas. In order to learn the detailed aspects of valuation, that I use to arrive at these ideas, along with the toolkit to then go off and develop your own methodology I definitely recommend studying with an expert in the field like Dr. Athanassakos.

Dr. Athanassakos offers executive education seminars in value investing during the year. Details on these can be found HERE. He also teaches value investing to the MBA and HBA students at the Richard Ivey School of Business (University of Western Ontario).

I recently found an excellent interview with Bruce Greenwald that I recommend reading, especially if you’ve been following my basics course on value investing. Over the past few weeks I have been taking you through a brief overview of a value investing methodology. In this interview Mr. Greenwald does an excellent job of explaining the necessity of following such a methodology. He sums up value investing into three things; a search process and an understanding of the extent to which markets are inefficient, a “technology” for valuing what you are considering buying, and having discipline and patience.

“So I think of value investing as three things. A search strategy, which we talked about, which is where the low P/E, low market to book comes in. But it’s not all of it, by any means, even of the search strategy. A valuation strategy. And a discipline approach to taking advantage of the information that your valuation is telling you about and having a default strategy when it’s telling you it doesn’t look like there’s anything there.”

The beauty of this is that your valuation “technology” will enable you to have the discipline and patience that is required of a value investor. As he says, if you believe in your valuation and the stock you just purchased goes down, then you will buy more! In this way instead of getting caught up in the same behavioral mistakes that the average investor makes, you are taking advantage of a good deal turning into a better one as you cost-average down.

Mr. Greenwald also does a great job of explaining the importance of each step in the methodology that I have shown you, as well as the importance of the order in which they are performed.

“What you want to do is to have a technology that brings all the available information to bear, so you can cross-correlate the asset values with the earnings-power values, with your judgment about whether there’s a franchise here. That if you’re going to buy growth, you’re absolutely certain that the franchise is there so the growth is going to be valuable… And then, only then, looking at the growth.”

I highly recommend reading the interview which can be found HERE. Following is a brief biography of Bruce Greenwald as found in the Columbia Business School directory:

Professor Bruce C. N. Greenwald holds the Robert Heilbrunn Professorship of Finance and Asset Management at Columbia Business School and is the academic Director of the Heilbrunn Center for Graham & Dodd Investing. Described by the New York Times as “a guru to Wall Street’s gurus,” Greenwald is an authority on value investing with additional expertise in productivity and the economics of information.

Greenwald has been recognized for his outstanding teaching abilities. He has been the recipient of numerous awards, including the Columbia University Presidential Teaching Award which honors the best of Columbia’s teachers for maintaining the University’s longstanding reputation for educational excellence. His classes are consistently oversubscribed, with more than 650 students taking his courses every year in subjects such as Value Investing, Economics of Strategic Behavior, Globalization of Markets, and Strategic Management of Media.

This is the last part of the basics series on value investing. The series in its entirety can be accessed by clicking on the “basics” link under the topics section to the left. I hope this has lent a comfortable understanding of the value investing methodology. I can always be reached with questions or comments via email at “jonathan (at) jonathangoldberg (dot) com”.

In the coming articles I hope to introduce you to a wealth of value investment opportunities and insights to continue to further your education in the field (and to put some money in your pocket at the same time). If there are any companies you feel may be value investments please email me with your suggestions as I may do a complete valuation and analysis along with recommendation. In comparing my notes with yours we may both learn a thing or two.

I do not profess to be an expert in the field, as my learning is ongoing, so I welcome any suggestions for topics as well as additional insights into items which may have been discussed previously.

Subscribing to the RSS feed via the orange button to the right is the best way to stay on top of new articles as I do not plan on posting each day… and some days I may even surprise you with a second helping. Thank you for reading, please continue and enjoy the ride!

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Valuing growth is the least reliable aspect of a valuation. Whereas with the net asset valuation we are valuing assets the company currently owns and with the earnings power valuation we are extrapolating already realized earnings, in valuing growth we are forecasting what we think will happen in the future. It is this forecasting which is highly sensitive to assumptions as well as other behavioral biases. One of these behavioral biases is the fact that investors tend to overpay for growth; the average investor may jump into a stock that everyone likes (also known as “herding”) or assume that they know more about the the stock and its future than they actually do. As Mark Twain said, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”

As value investors we want this growth for free. Sure we are willing to consider a stock more favorably because of the potential for growth, but we won’t pay for something that we know to be so highly sensitive to assumptions. The most we are willing to pay for a security would be EPV (in the case of a franchise value with growth) – in such a case the value of growth is our margin of safety.

Unless a company meets the following two criteria there is just no way that value investors can consider it to have potential for growth:

1. Return on Invested Capital (ROIC) must be greater than the Weighted Average Cost of Capital (WACC), otherwise growth has no value.
2. The company must have a fully sustainable competitive advantage otherwise ROIC can not remain greater than WACC.

As mentioned in earlier posts, value investors like to make use of assumptions that they can be relatively certain about (i.e. last twelve months’ earnings, balance sheet valuations, etc). Even so, we know that nothing ever plays out as one would expect. As such, we make use of a “margin of safety”. This means that we will never buy into a security at its full intrinsic value (unless there are some pretty certain growth prospects which will be discussed in the next post).

Once the intrinsic value is calculated, an appropriate margin of safety is considered in order to arrive at an entry price. If the security can be had for less than this entry price it should be purchased.

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For those readers that are just joining us now, this is the 5th installment of a “basics” course on value investing. This is important preparatory reading, especially if you are very new to value investing, in order to understand valuations which will be discussed on this site. You can access the entire course by clicking on the “basics” link under the topics heading to the left. I also recommend subscribing to this site’s RSS feed by clicking the orange link to the right.

The next post will discuss the value of growth and will conclude the posts on value investing basics. There will definitely be more educational posts in the future but these 6 articles are the basics required in order to understanding an investment thesis on this site.

The intrinsic value (IV) of a potential investment is arrived at by comparing the results of the Net Asset Value (NAV) and Earnings Power Value (EPV) analyses.

If EPV is less than NAV then the intrinsic value for the company is derived from EPV and adds value for the probability of a catalyst taking place within the company that would bring the value of the company to its competitive state (NAV).

Earnings Power Value (EPV) is an estimate of the value of a company from its ongoing operations. The beauty of EPV, for value investors, is that the numbers used to calculate it are NO GROWTH free cash flows. No growth free cash flows just mean that we are only subtracting from cash flows the amount of capital expenditure required to sustain the business. By using no growth free cash flows we eliminate, to a great degree, attempts to predict future growth and as such arrive at a number which we can be fairly certain of; we are using today’s earnings, with the assumption that current profitability is sustainable. This isn’t to say that some companies can’t expect significant growth, but as value investors we refuse to pay for it.

Though we are using today’s earnings (today’s no growth free cash flows) in calculating EPV, we are normalizing these earnings to the business cycle. This eliminates the effects on profitability of valuing the firm at different points in the business cycle. Ideally, this means that we are considering the average operating profit (as a percentage of total sales) over 5-8 years. This average would then be applied to current sales. Other adjustments to be made to the current year’s cash flows would be to account for average expected one-time gains/losses.

The final step in calculating EPV is to divide the final cash flow number by the cost of capital. This gives us the present value of a perpetuity without any estimation of growth. That is your EPV.

Unlike net asset value (NAV) which is an equity value, the EPV result is the enterprise value of the firm; that is, adjustments need to be made to trim this down to equity value. In the investment articles on this site, EPV will refer to the equity value (per share) resulting from an EPV analysis.

“The investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons’ mistakes of judgement.”

- Benjamin Graham

Determining a figure for the replacement value of the balance sheet is the first step I take in arriving at the value I would pay for a company. This includes marking up land and buildings to current market values, adding assets and liabilities for operating leases, as well as adding intangible assets such as customer relations, product portfolio and licenses. Once complete, simply subtract the liabilities from the assets to find the net asset value (NAV) of the company. Dividing this by the number of shares outstanding yields the NAV per share.

This NAV is what you would expect an optimally performing company in the industry to be worth. All assets would be bid to their fair value in a perfectly competitive environment. That is, in a perfectly competitive environment an optimally performing company’s ROIC would be equal to its WACC.

Now in the real world the NAV of a company is not necessarily equal to its actual worth. There will be companies that are under-utilizing their assets (will be worth less than NAV) as well as companies that hold a franchise value (worth more than NAV as they are not in “perfect” competition). As such, the next step is to find the earning power of a company in order to arrive at a value based on actual cash flows. This will be discussed next.

Over the next couple of posts I will be providing you with the basic knowledge you need in order to understand my value investing methodology. Also, if you haven’t done so already you may want to subscribe to my RSS feed so that you receive the posts as they are published (link is to the right). Think of this as a mini-lesson in value investing. Enjoy!

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Return on Invested Capital (ROIC) is one of the first things I calculate in order to get a sense of whether or not management is taking the company in the right direction. ROIC is essentially the return that the company generates via its invested capital.

I just stumbled upon this video which was made by Columbia Business School. It features Bruce C. Greenwald – the Robert Heilbrunn Professor of Finance and Asset Management – speaking and lecturing about value investing. It is definitely worth the 5 minute viewing in my opinion, no matter what your level of knowledge. Always nice to see someone so passionate about value investing as motivation to stick to the discipline.

Over the following weeks you can look forward to insights and valuations on some stocks I have been following. I have had some interviews this week so didn’t have time to do such posts justice but I can’t wait to share my opinions with all of you.

As I’m in the midst of a job search I haven’t dedicated as much time as I would have liked to getting this blog started. I’m hoping to increase the frequency of posts as I am able. In the meantime you may consider subscribing to the RSS feed so that you automatically receive new posts.

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Market prices for fixed income securities can be volatile just like those for equities, especially for those bonds with longer maturities. As you may be aware, Benjamin Graham describes bargain issues as those stocks and bonds particularly worthy of a security analyst’s investigation. In terms of bonds these bargain issues are bonds that are deemed to be safe investments but which still sell at so low a price “as to offer a chance of considerable enhancement in market value”. This is why we want to find bonds of a higher quality which are trading at a discount to bonds of a lower quality. In most cases bonds would be trading cheaply because their safety is questionable but this is not always the case. As in equities, there are always a small number of cases where a security may be trading at a discount while still meeting strict investment standards. Fundamentals still reign supreme in fixed income though, so not only do you want a company that may have been battered by the market and investor sentiment (even if correlated with a higher yield on the fixed income security), but you want to be confident that your contrarian views are correct. The bonds are only valuable so long as the company is still in existence!

The concept of finding value in fixed income securities is relatively straightforward, but where do we begin to look for these bargains? If the equities of certain companies may have been negatively affected, creating value opportunities within the equity market, then perhaps the fixed income securities of these companies may be a good place to start. As there is no apparent systematic way to segment corporate bonds into value and growth categories, The Brandes Institute went back to a study they conducted on equities and then studied the bonds that the companies in the study had issued. Their main findings were as follows:

• There were more issuers with debt outstanding within the value companies.
• The bonds issued by companies within the value group delivered a better total return than the bonds issued by the growth companies over subsequent 3 year periods from 1990 to 2007.

What is interesting from the findings of the study is that one would assume the difference in total return to be merely due to the value bonds’ lower average credit rating and subsequently higher average spread. As such, The Brandes Institute compared the Lehman Brothers U.S. Aggregate Corporate A Index (a proxy for bonds of the growth companies which had a credit rating of “A” on average) to the Lehman Brothers U.S. Aggregate Corporate BAA Index (a proxy for bonds of the value companies which had a credit rating of “BBB+” on average). Over the same period as the study, these indices showed a difference in total returns of 14 basis points versus the approximately 69 basis point annualized total return difference between the value and growth bonds in the Brandes Institute study. The total return advantage for bonds of value companies therefore can not be fully explained by credit quality or yield spread.

It’s difficult, if not impossible, for a retail investor to build a bond portfolio with adequate diversification. Perhaps there would be demand for a fixed income ETF that invests solely in the fixed income of the low price-to-earnings universe of stocks, which is commonly used as a generalization for the universe of value stocks.

I do not recommend trying to time the market. Once again – I do NOT recommend timing the market. That being said there are benefits to knowing where we are in the business cycle.

From a value perspective what I look for first and foremost is the discount to a company’s intrinsic value that their stock is trading at. This card trumps all as the company that leaves you the greatest margin for error should outperform in the long-run. Assuming all else being equal, including the discount to intrinsic value, there are times when I would select one investment over another. Look at today’s markets for instance, we are most definitely somewhere around the trough of the business cycle. As the markets begin to improve we can expect a resurgence of inflation as demand returns and rates (which are now at historic lows) revert to the long-run average. At a time like this I would rather hold resource producers that will benefit from commodity price inflation. On the other hand, I would stay away from consumer goods manufacturers who will be susceptible to the rising input prices and may have competitive pressures which will keep them from raising prices to compensate. Financial companies would also perform poorly in an inflationary environment as rates rise and cut into their profits.

As mentioned before, this is only one of the many considerations that would go into comparing one investment option to another. If one company looks like the greater value play and has comparable long term prospects then the short term implications of the business cycle would not play a major part of the decision. This brings me to the next implication for this topic on value investing. When valuing a company it is a good idea to normalize earnings over an entire business cycle. As value investors we take a long term horizon and the value of a company relies in large part on profits that are expected many years into the future. As such, the next few years in the business cycle should not play much importance in the investment decision. It is important to make sure that you don’t “anchor” your future expectations on recent boom or bust years. By normalizing profits over an entire business cycle we enable our valuation to take a realistic long-term view of the profits a company can be expected to make without incorporating a bias from the most recent reporting periods. As long term investors we are concerned with the long-term path of the economy and not the short term booms and busts that give rise to great investment opportunities.

It’s pouring rain outside as I sit here and listen to the thunder and the occasional wail of sirens passing by… what better time for my first post! To introduce myself; I am a 25 year old student of value investing and, while I will surely get older and more knowledgeable, I will also always remain a student of this investment philosophy. Having been only formally introduced to value investing within the past year, at MBA school, I am already a devout follower in and believer of the philosophy. During the past year I have read countless journal articles and research papers on value investing – I have even valued a company or two (quite the understatement). The goal of this inaugural post is to start you, the reader, on the path of enlightenment. Following are a list of journal articles and working papers that I recommend you read in order to help you pursue a value investment methodology with the discipline that is required. If you are currently enrolled in a post-secondary institution then you can likely access the journal articles through your school’s library. The working papers listed can be found via the Social Science Research Network (SSRN).

1. Abhyankar, A., Ho, K., Zhao, H., Value versus Growth: Stochastic Dominance Criteria, Working Paper, 2006.
2. Arshanapalli, B., and Nelson, W.B., Small Cap and Value Investing Offer both High Returns and a Hedge, The Journal of Wealth Management, Spring 2007.
3. Athanassakos, G., Portfolio Rebalancing and the January Effect in Canada, Financial Analysts Journal, Vol. 48, No. 6, Nov. – Dec., 1992, pp. 67-78.
4. Athanassakos, G., Value vs. Growth Stock Returns and the Value Premium: The Canadian Experience 1985-2002, Working Paper, 2006.
5. Bauman, W.S., and Miller, R.E., Investor Expectations and the Performance of Value Stocks versus Growth Stocks, Journal of Portfolio Management, Spring 1997.
6. Capaul, C., Rowley, I., Sharpe, W.F., International Value and Growth Stock Returns, Financial Analysts Journal, Vol. 49, No. 1, Jan. – Feb., 1993, pp. 27-36.
7. Chan, L.K.C., and Lakonishok, J., Value and Growth Investing: Review and Update, Financial Analysts Journal, January/February 2004.
8. Fama, E.F., and French, K.R., Value versus Growth: The International Evidence, The Journal of Finance, Vol. 53, No. 6, Dec. 1998, pp. 1975-1999.
9. Kao, D., and Shumaker, R.D., Equity Style Timing, Financial Analysts Journal, Vol. 55, No. 1, Jan. – Feb., 1999, pp. 37-48.
10. Lakonishok, J., Shleifer, A., Vishny, R.W., Contrarian Investment, Extrapolation, and Risk, The Journal of Finance, Vol. 49, No. 5, Dec. 1994, pp. 1541-1578.