I’m thrilled that you have decided to join me on this new wealth-building journey as we profit from undervalued, lower-risk investments that still possess a strong upside potential.
I’m particularly excited to get started with you because I truly believe now is the right time for value investing. That might surprise you since the market has been dominated for quite some time by high-flying biotechnology, social media and tech stocks. This is because too many investors make decisions largely based on whether companies will beat earnings estimates in the next quarter.
That strategy worked in past years because the market was undergoing a strong run after the 2008 financial crisis and even reached an all-time high. However, you may have noticed that a lot of these high-fliers have been hit pretty hard in recent bouts of selling, especially with the recent pandemic. After a decade of profits, pumped up first by the Federal Reserve’s quantitative easing, and now by the biggest corporate tax cuts in a generation, there are signs of froth in the market. Now, momentum plays are no longer such a smart bet. Instead, investors are rotating into stocks that are trading at lower valuations — precisely the kind of stocks we’ll be investing in.
While I don’t think the overall stock market is in a bubble, certain segments (like biotech and social media stocks) sometimes reach valuations approaching bubble territory. Many of these stocks were gobbled up by hedge funds and momentum players, not because of their long-term prospects, but because they just kept going up. As we all know, that can’t last forever. An old expression on Wall Street is, “The trend is your friend until it ends.”
And when it does end, it can be painful.
Keep in mind that in many cases, we’re not talking about a temporary loss in value due to a market correction. Rather, many of these insanely valued stocks are headed for a permanent value impairment. They just don’t have the fundamentals to support their baseless valuations, even after a correction like the one the market suffered in early 2018. Let me say that I am a balanced investor, and growth stocks have a legitimate place in a well-balanced portfolio. But value investing is clearly very effective in building wealth as it offers less risk (and less stress), especially as valuations become irrational and things get dangerous.
While many investors are losing their heads, now is the time to keep yours by making investments with a solid framework in mind. That’s where value investing can really prove its worth. Since there will always be undervalued stocks in any market condition, we can stay invested in a rational and sustainable way without taking on excessive risk.
Here’s another reason why value investing is right for so many people. I hear from a lot of investors who missed some or all of the market’s run over the past decade because they were too burned from the losses in 2008 and early 2009, to feel comfortable jumping back in. However, since we still have cash to put to work, value investing offers an excellent approach for those who are done with steep losses. We will focus on stocks that offer a “margin of safety” — a tried-and-true principle of value investing. To give you a better understanding of what exactly value investing is, and how it can build wealth for you, let me share a quick overview of the strategy and its very famous roots. Then we’ll talk about how we will use it to our advantage.
A Valuable History
Value investing often conjures up images of mature, sometimes quite ordinary, companies that sell for cheaper prices than the overall market. While it’s true that most value stocks have low metrics, there is a lot more to this strategy than just numbers. Value investing is a combination of art and science, and it begins with a mathematical principle that is taught in the first lesson of every Finance 101 course:
The value of an asset (i.e. a business) is the present value of its future cash flows. As value investors, we will aim to scientifically value a company based on real numbers and realistic projections — the exact opposite of the wild assumption (i.e. hope) that a company will grow at 20% forever. In other words, instead of jumping blindly into what’s “hot,” we’re using solid data and analysis to more accurately identify a company’s future value.
How do we do this? Believe it or not, until the time of the Great Depression, there was no systematic method to analyze and determine a company’s value — even though the stock market had been around for decades! This lack of knowledge and discipline helped drive much of the speculation that occurred before the 1929 market crash that would usher in the Great Depression.
Then, in 1934, Benjamin Graham, the father of value investing, changed the game by publishing a book called Security Analysis. For the first time, a scientific framework was available to analyze and value stocks. Security Analysis became the bible of value investing, and remains so for value investors to this day, with the sixth and most recent edition coming out in 2008, nearly 30 years after Graham’s death.
The story doesn’t end there. Mr. Graham also taught his methods in a popular class at Columbia Business School. One of his students was so impressed by what he had learned that he offered to work at Graham’s investment partnership at no cost. While he was turned down at first, the student would eventually work at the partnership for a few years until it was dissolved in 1958. That young student, named Warren Buffett, then struck out on his own. He went on to be Graham’s intellectual successor and the greatest investor of our time. Graham was so influential in his life that Mr. Buffett eulogized him as a man who planted trees that other men could sit under. We’ll aim to sit under those same trees.
Buffett refined Graham’s original methods and turned them into modern-day value investing. This was necessary because Graham’s preferred method of investing — buying stocks that were selling for less than their liquidation value — had become impractical. This was in the 1940s and 1950s when the stock market remained spooked by the 1929 crash, and there were plenty of opportunities to buy shares in such companies. However, valuations rose as investors regained confidence in the market. Eventually, there were only a handful of stocks trading at such a discount.
Buffett added qualitative methods to Graham’s quantitative approach and began to seek out the bulletproof franchises with large “moats” that dominate his current Berkshire Hathaway portfolio. Mr. Buffett believes — and I agree with him — that if a business is solid and keeps generating cash, the stock almost has to go up over time. Those are the kinds of businesses to invest in.
Our Approach
The Graham/Buffett approach provides the groundwork for the strategy we’ll utilize here and in Value Authority. We’ll also need to add a few refinements that my analysts and I have developed. For starters, we have one nice advantage in the fact that we have the flexibility to invest across all market capitalization sizes. Since Mr. Buffett has to invest billions of dollars, he is forced to stick with large-cap companies. The same is true with many large mutual funds. While this can be limiting, we will not be restrained by those limits. Instead, we can cast a wider net to find opportunities in both large and small stocks.
As our recommendations list pivots to embrace new names and takes a profit on those that have reached their potential, we’ll talk much more about the specific characteristics that I look for in a value stock. As I do want to give you at least a quick overview of our methodology before we get started, here are six important keys to keep in mind:
1. Valuation: We’re looking for stocks that sell at a discount to either the market as awhole or their particular sector and still have room to run. In particular, I look at price-to-earnings (P/E) ratios, price-to-free cash flow ratios and enterprise value to EBITDA (earnings before interest, taxes, depreciation and amortization). Stocks with lower valuations not only have upside potential but also have lower expectations. This means they will be better rewarded when earnings are good — a positive surprise — and less susceptible to sharp selling if they disappoint. Because they are already discounted, they present what Benjamin Graham called a “margin of safety” and produce less of a downside risk.
2. Strong balance sheets: Quite simply, companies with lower debt are safer and have less earnings volatility as they do not have fixed interest-rate payments that cannot be adjusted the way operational costs can. These companies hold their value better during bear markets and in times of economic distress, like what we saw in 2008 and 2009. Specifically, I like to see a company’s debt be no larger than 50% of its total capitalization.
3. Consistent earnings: Companies that produce a steady stream of earnings over time are eventually recognized by the market. They can also attract the interest of financial buyers, such as private equity firms, and eventually achieve a profit for shareholders. You will frequently hear me say that a company is a candidate to be acquired.
4. Improving returns on invested assets: Every asset that appears on a company’s balance sheet, with the exception of cash and accounts receivable, becomes an expense at some point. When a company’s assets start growing faster than revenues and operating income, it could be a sign of trouble. As each dollar invested brings a diminishing return, growth is likely to slow or even portend a decline in earnings. We’ll avoid those potential value killers by looking for improving returns on invested assets.
5. Free cash flow relative to earnings: Cash builds shareholder value by allowing a company to invest in productive assets, reduce debt, pay a dividend or buy back stock. So, no surprise here — we want to own companies that generate a lot of free cash. While lots of investors like to focus on earnings, and rightly so, they have to be aware that certain accounting practices can make earnings look a little different than what is expected. Thus, a company’s earnings don’t always present the most accurate picture.Since you can’t fake free cash flow, which is the money left over after you subtract operating costs, we won’t just look at P/E ratios. After all, P/E ratios do not tell you how much actual cash the company is generating relative to its stock price. We can learn that by focusing on price-to-cash flow.
Oil stocks are good examples of how focusing on P/E ratios alone can get you in trouble. Oil stocks look inexpensive on a P/E basis, even though their figures provide a different picture when we look at how a prospective investor evaluates the company’s price-tocash flow. The problem is that oil companies need to invest heavily to keep their current levels of production intact. As a result, their capital expenditures are well in excess of depreciation, and they don’t get much in the way of unit growth despite their investments. As an example, Exxon Mobil (XOM) had a net income of $32.6 billion and a free cash flow of only $11.3 billion in 2013, as the cost of finding and drilling oil had risen significantly. XOM then had to borrow money and eat into its cash balance to finance its dividend and share buyback programs. Then, the stock was crushed when oil prices plunged in 2014. When analyzed this way, its reported profitability overstated the true economic returns of the company. In some ways, XOM could be considered a more expensive stock than Procter & Gamble (PG). This is because even though PG has a higher P/E ratio, the company also aims to convert 90% of its earnings into free cash flow.
6. Companies likely to grow their earnings: All that said, earnings are still critical. We won’t just look for undervalued stocks; we want catalysts to drive future value. Stock prices follow earnings in the long run, and even value stocks need earnings growth to do well. Our focus on a company’s improving return on assets and free cash flow is a great starting point for finding companies whose earnings will grow. I then add more qualitative factors, including potential changes in market share, the overall strength of franchises, technological changes that might impact the company’s industry or products and more.
As you can see, identifying solid companies that are undervalued and likely to move higher, requires a detailed analysis that goes far beyond simplistic P/E ratios or other valuation metrics. While those can be important, we’re also looking for companies that are solid cash generators or in the early stages of a significant turnaround that has not yet been appreciated by the market. We will not buy stocks based on their current popularity or rumors without an in-depth valuation analysis. We’ll leave the speculation to others.