Value investing is a somewhat broad term, but the concept is basically the idea of buying securities at a discount to “intrinsic value.” By doing so and by being willing to take a longer-term approach, the value investor is able to invest with a large margin of safety and also achieve better investment returns. It is important to understand that most buying and selling in stocks and bonds does not qualify as investing. Many market participants are traders or speculators focusing on short-term issues such as momentum, technical indicators and trend following. These activities can at times be profitable of course, but they don’t meet the basic definition of investing, which Benjamin Graham described in his investment classic Security Analysis 1934:
“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”
Securities such as stocks are fractional shares of an underlying business. To invest competently, one must start with an emphasis on the financial statements and also understand the strengths and weaknesses of GAAP (Generally Accepted Accounting Principles). One key difference between the way that most analysts evaluate securities and the way that we at T&T Capital Management (TTCM) invest, is that most analysts focus extensively, if not exclusively on earnings and earnings estimates in their analysis. This process entails, projecting earnings over the next quarter, year, or couple of years etc., and then comparing the analysis to consensus estimates. Once that analysis is concluded and it is determined whether the analysis is above or below the consensus estimates, it is necessary to put a multiple on the earnings to determine the appropriate price for the stock to trade at. For example, let’s say that you have a company like Procter & Gamble (PG), which you believe will likely earn $4 per share in the next 12 months. Historically PG has been a very high quality business with high returns on invested capital, adequate earnings growth and the company pays a dividend around 3% in this example. Historically a company like this might sell for 16-18 times earnings. In today’s low interest rate environment, where the 10- year Treasury until recently has been hovering around 2%, many market participants have shown a willingness to pay 20-25 times earnings for a company like PG, despite the fact that earnings have actually been quite disappointing.
The problem with this type of analysis and investing is that it only pays attention to the income statement and earnings, which can be highly volatile. In addition, the analyst is basically assuming the company doesn’t engage in investing or financing activities such as acquisitions, spinoffs, mergers etc. The reality is that most publicly traded companies do engage in these types of activities and these can be powerful ways of creating or destroying shareholder value. If you think of stocks as being fractional shares of businesses, there really shouldn’t be much difference in how you analyze public versus private businesses assuming you have a long-term time horizon. Most private businesses attempt to minimize GAAP earnings to reduce tax liabilities. Wealth creation is far more important to the private business owner than GAAP earnings, as often wealth creation grows tax deferred. Wealth creation can also be described as net asset value growth. As a company retains higher quality assets and reduces liabilities, the earnings power and resource conversion potential of the company improves. Berkshire Hathaway (BRK.A), Fairfax Financial (FRFHF) and the many entities of John Malone are all publicly traded examples of companies that focus on wealth creation over maximizing GAAP earnings. The analyst that focuses exclusively on GAAP earnings would have missed these incredibly performing stocks, which have built fortunes through investing in companies at extremely cheap prices and improving operations over the long-term. Warren Buffett, Prem Watsa and John Malone have created more value as investors and financiers as opposed to as operators of businesses, but the conventional security analyst doesn’t take any of these other activities into consideration when the focus is exclusively on earnings.
At TTCM, we take a comprehensive fundamental finance approach to investing. This process begins with a focus on the balance sheet where we determine the net asset value of the company. For companies such as banks or insurance companies with reasonably liquid assets such as most loans, leases, real estate etc., shareholder equity or book value is often a very good place to start. It may be necessary to adjust for goodwill or intangible assets if they overstate the value, so often we put more emphasis on tangible book value, which excludes those assets. For other companies such as exploration and production companies or technology concerns; discounted cash flow projections, replacement value, and sum of the parts analysis are usually good places to calculate the net asset value.
By focusing on the balance sheet first, the investor can be careful to ensure that he/she is investing in financially strong businesses. After extensively analyzing that balance sheet and the assets within, we at TTCM follow the free cash flow. Free cash flow is the amount of money left over for shareholders for dividends, stock buybacks, acquisitions and debt reduction. It is defined as operating cash flow subtracted by capital expenditures. While free cash flow generation is obviously highly desirable for investors, the use of that free cash flow in investment activities is just as, if not more, important. Many companies engage in activities that destroy shareholder value, such as overpriced acquisitions (see Hewlett-Packard’s acquisition of Autonomy), or stock buybacks when their stock is already overvalued. Sometimes these harmful activities are overlooked in a bull market when most market participants are only focused on upside, but as Warren Buffett always says
“it is only when the tide comes out that you see who is swimming naked.”
While some management teams have proven to be terrible allocators of free cash flow, others have been stellar. Some examples are Henry Singleton from Teledyne, Bill Stiritz of Ralston Purina, and Warren Buffett of Berkshire Hathaway. These managers proved to be tremendous investors and financiers, which caused their respective stocks to be some of the leading all-time performers in history under their respective leadership. They did this through a combination of accretive stock buybacks, intelligent acquisitions and attractive refinancing of debt when conditions were favorable. Most analysts that focus exclusively on items such as earnings and P/E ratios pay virtually no attention to this!
Bull markets are the result of corporate earnings growth and market participants’ willingness to pay higher multiples for common stock. Interest rates play an extremely important role in determining what multiples market participants are willing to pay, because the higher the interest rate, the greater the opportunity cost is to owning stocks. Conversely, the lower the interest rates are, the more willing market participants are willing to pay higher multiples on common stocks. The earnings yield is the inverse of the P/E ratio and it can be helpful to compare the earnings yield on the S&P 500 to the yield on the 10-year Treasury as an indication of the relative value between stocks and bonds. The earnings yield should almost always be higher due to the higher market and volatility risk on common stocks relative to Treasury bonds, so the wider the spread the more attractive stocks become. We haven’t seen a bear market in bonds since the early 1980’s, but depending on the degree of interest rate increases, both stocks and bonds in general could be due for a big fall.
So with all of this said, how does it relate to the current market environment? I greatly dislike when people focus on problems without offering solutions and I don’t intend on doing so with this article. By focusing on fundamental finance, we can identify undervalued businesses that can benefit from both improved earnings and higher valuations whether interest rates go up or stay low. This is the benefit of investing in individual stocks, where you know exactly what you own, as opposed to investing in index funds or mutual funds where you are basically investing in the market, or sectors of the market. Despite the S&P 500 trading at record high valuations, the majority of the companies that we own trade at discounts to our estimates of liquidation value, and all should see higher earnings and dividends three years from now if rates are higher or lower. Financials are benefitting from efficiency improvements as they continue to adjust to the new regulatory and political climate. Energy companies should benefit from higher prices in the coming years, as supply growth should slow and demand should pick up, as a result of lower prices and the corresponding reduction in CAPEX spending. While bear markets occur and they can take most stocks with them, over time it is the value of the businesses that matter; and if our companies, which we bought at large discounts to intrinsic value, begin to increase their intrinsic value over the next 3 years, we are not only unlikely to lose money, but we should end up doing quite well regardless of general market conditions. This is exactly what happened in 2000-2003 when the NASDAQ dropped 75% peak to trough, but many value investors did extremely well in individual stocks, because they weren’t invested in the overall market or tech stocks, which were outrageously expensive.
One example is in the common stock of AIG. After a nice rally so far this year, the stock trades around $60 per share. We started buying this stock for clients in the $20’s and we’ve added aggressively over the years to where it has been one of our largest positions at T&T Capital Management. We believe the stock is worth about $80 conservatively, which is right around 1 times book value. We believe that the company can grow book value by 10% per annum over each of the next 3 years, through improved earnings and stock buybacks from a low return on equity base. This would increase the intrinsic value of the stock to well over $105 per share if it occurs and AIG would earn considerably more money than this if interest rates were to rise, due to their massive investment portfolio. Of course in a bear market the stock might drop temporarily, but the growth in business value provides us with the large margin of safety and explosive return potential, on a stock that has already doubled over the last 4 years. I could write a whole book on these concepts, which have been inspired by the likes of Martin Whitman, Bruce Berkowitz, and Warren Buffett etc. The idea is just to continue to educate into our unique thought process and we believe that as market turns more volatile the long-term outperformance of TTCM strategies should accelerate.
P.S. In the effort to keep this as brief as possible, I didn’t even touch on our utilization of selling options to generate income, reduce risk and to manufacture cheaper entry prices into stocks. You can see more of how we do this at:
A Primer on Selling Cash-Secured Put Options