How can you identify individual stocks that are undervalued? How do you make a comparative analysis? And is it possible to time the market? In this third part of my summary of Security Analysis, written by the legendary father of value investing, Benjamin Graham, these are some of the topics that will be discussed. In the previous posts of this series, I presented differences between speculation and investing and talked income statements and balance sheets. They're not really prerequisites, but I strongly recommend that you read both of my previous posts of this series before continuing here. Back in 1940, when Benjamin Graham and David Dodd released the second edition of Security Analysis, stocks were valued at 12 times their yearly earnings on average. Today, the price of stocks is almost twice as high. But don't let that discourage you, it is still possible to be successful in the markets. Let's learn how!
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"The danger of paying the wrong price is almost as great as that of buying the wrong issue." According to Benjamin Graham, there are two different approaches to find undervalued individual issues in the stock market.
01. Using comparative analysis, which we'll get to in the next takeaway, and 02. Scrutinizing corporate reports as they go live.
One of the most successful investors implementing strategy 01 was Phillip A. Fisher, who was screening about 250 companies, before deciding to invest in a single growth stock. The most successful investor implementing strategy 02, is Warren Buffett, who famously reads about 500 pages of annual reports and the likes every day. Whichever strategy you choose to follow, you want to look for discrepancies between the intrinsic value of the company and its price. Mistakes in pricing individual issues are often caused by Exaggeration, Overs-implification, or Neglect.
Here are two types of situations when the market typically overestimates the true value of an issue.
Increases in Dividends: An increase in dividends is, according to Benjamin Graham, a favorable development for the stock. But not so favorable that it's justified for the stock to rise, say, $20, because of an increase from $5 to $6 in dividends. The buyer at a higher price is already paying in advance for 20 years of the extra dividends that he will receive with the new rate.
Mergers and spin-offs: Wall Street looooves it when there's a lot of action, but to be equally enthusiastic about merges as of spin-offs, is kind of hypocritical, as they are each other's exact opposites. You may have heard that 2+2 is said to equal 5 when it comes to merges, but did you also know that 5 divided by 2 equals to 3? Aaaaand ... Here are 2 situations in which the market tends to underestimate values.
Litigations: Investors are typically scared off when companies are threatened to end up in lawsuits. But often, the consequences aren't as significant as the drop in price indicates.
Financial Troubles: Don't buy companies that are likely to fall into financial difficulties. Buy those that already have. If you are going to follow this strategy though, Benjamin Graham advises you to be careful and diversify a lot, since many of the investments will go bust.
Takeaway Number 02: Comparative Analysis
Here, I will illustrate one of the methods of finding undervalued stocks by doing a comparative analysis of the world's four largest fashion retailers - Inditex, H&M, Fast Retailing, and The Gap. Remember that figures in these types of comparisons are only useful for wide and obvious disparities. Before we start out, I think a disclaimer is in place. With that out of the way, let's compare these fashion giants with one another. I've chosen to look at the following key ratios: Regarding earning power, I've picked: Gross Margin, Operating Margin, Net Margin, Return on Assets, Return on Equity, and Dividend Yield.
Gross Margin may be extra important to study in the case of retailers, as this reveals the mark-up that the company gets on average on products sold. We see that Inditex is way better than the others when it comes to margins from sales and that Inditex, together with Gap, are better at profiting from money in the balance sheet than the others. It's probably a good idea also to look at how these companies have been able to grow their sales. During a little less than a decade, we can see that Fast Retailing has outgrown the others, followed by Inditex, H&M, and lastly Gap. If the companies would have stagnated in their growth, I would be more concerned about Fast Retailing paying such a low dividend, but in this case, it seems the excess capital is being put to good use in the business.
Financial Stability, I've looked at the interest coverage ratio, the quick ratio, and the equity to assets ratio. The interest coverage ratio is a very important metric to consider when investing in bonds or preferred stocks, which we'll get you in the next post, but it's fair to say that all four of these companies pass Graham's tests by a landslide. Regarding the quick ratio, H&M looks quite weak, but considering the profitability of the company, I wouldn't be too worried. Inditex has the least amount of debt, which isn't just a defensive advantage. The company also has more financial muscles to make a bold offensive move than its competitors, by say, acquiring another company.
You also want to see that the executives of a company you invest in have Skin in the Game, in that they hold shares in the business just like you. The Ortega family of Inditex still holds about 59% of the company, the Persson family of H&M owns 46%, the Yanai family of Fast Retailing holds 44%, and the Fisher family of Gap owns 36%, so they all get a definite pass here.
Furthermore, Benjamin Graham suggests that one should look at Industry Specific Ratios, and for the fashion retailing industry, I'd wanna see a low or negative change in inventory valuation compared to the year before, high inventory turnover, and a lot of online sales. Fast Retailing increased its inventory by 59% from the year before, which is a red flag, and requires further research. The inventory turnover of the company is still okay though. So it's a sharp increase but from low levels. Regarding online sales, Gap stands out as the most successful adopter of this new trend. At this point, I'd probably say that Inditex looks like it's the best pic. It's not weak anywhere really, and it's also the strongest company in many aspects, but we're missing something ... Hmmm ... Oh! The Price. I've Picked Price to Earnings, Price to Equity, and Price to Sales for Comparison. Not too surprisingly, Inditex is one of the most expensive companies. Fast Retailing is even more expensive though, and one would be wise to ask himself, before investing in this company, if the market may be too focused on its current sales trend because, to me, the company doesn't set itself apart on any other account. Conversely, one would be wise to ask himself if Gap truly deserves to be valued at only 1/6 of Faust retellings earnings, or about 2/5 of its other two primary competitors. After this quantitative analysis is done, the investor must remember to confirm his beliefs from a qualitative standpoint. This activity is very time consuming though, which is why it's great to do a comparative analysis such as this one first to select specific companies for the time-consuming part. From this comparison, I'd obviously pick H&M to do a deeper analysis. How can one not want to invest in this Swedish crown jewel of a company?! Let's be serious. If I had to pick here, I'd investigate Inditex and Gap further for a possible investment.
Takeaway Number 03: Investing in stocks is the search for weakness
Investing in stocks will always be a bet on the future, but as Benjamin Graham expresses it: "The analyst must take possible future changes into account, but his primary aim is not so much to profit from them, as to guard against them." He suggests that you should find individual stocks that are attractive based on what they've already proven, not what they might prove in the future. imagine yourself buying a used car at the price of say $1,000. If the car does what a car is supposed to do for a couple of more years, this will turn out to be a bargain. Now you just got to protect yourself from the downside!
Here are some Red Flags to look for when investing in stocks that may spell trouble for the future.
01. Questionable Accounting Policies: I've said it before, but I'll say it again: "You cannot make a quantitative deduction to allow for unscrupulous management. The only way to deal with such situations is to avoid them."
02. Financial Trouble is Lurking: A rapidly increasing inventory, week earning power in combination with lots of current liabilities, rapidly increasing debts, etc. etc are all examples of this.
03. New Competition: Where investing in consumer-oriented companies, this can be quiet obvious sometimes. In 2012, I invested in a Swedish online casino and betting company named Betsson, and about two years later, the only thing you saw when watching commercials on Swedish television was online casinos. This was terrible news for my investment, which I eventually decided to cut loose.
04. Deteriorating Management: If you forgot about Warren Buffett's rule to only buy stocks in businesses that are so wonderful an idiot can run them, beware of deteriorating management.
05. Earnings with an Upper Limit: At times, companies have severely limited expansion opportunities. It can be because of market limitations or because of regulations from authorities, but whichever the case, avoid such stocks. If you're going to have a limited upside, you might as well invest in bonds instead, which we'll get to in the next post.
06. Convertibles and Stock Options: This can be quite subtle, but beware of companies that have issued a lot of convertible securities and stock options. If the company does well, and its total value increases (which is the only reason you'd invest in a stock, to begin with, right?) these securities will be converted into common stocks and dilute your returns.
Takeaway Number 04: Buy stocks that are valued below Net Current Assets
Let's return to the balance sheet to look at a specific method for identifying undervalued stocks. Benjamin Graham is famous for searching for companies valued below their net current assets, so-called "Net-Net" stocks. You get the net current assets of a company by taking current assets and removing all liabilities. Essentially, if a company is valued lower than this, it can be liquidated for more money than what you pay for it. The most common objection against buying a Net-Net stock is that it may continue to lose money, because, well typically they do lose money until the intrinsic value of the company is lower than the price that the investor paid. You see .. managers aren't always fond of the idea of liquidating the company, as it means that they are definitely going to lose their jobs. On the other hand, there are plenty of positive things that can happen that can change the situation in the opposite direction. Earnings can increase, perhaps as a result of the company itself improving or by an improvement in general of the industry. A competitor may decide to buy the company, and the managers may decide that liquidating the company is the best decision after all. To find Net-Net stocks is typically quite uncommon though during normal financial conditions.
In the midst of the bear market of 1938, Benjamin Graham noted that about 20% of all industrial companies had, at some point during the year, been valued below their net current assets. When I looked at data from 2018, on the other hand, I found that only 1.5% fulfilled these criteria.
Takeaway Number 05: Timing the Market
Is it possible to hit the ups and downs of the market with any reasonable accuracy? The following discussion won't give you an exhaustive answer to this question, but it will reveal how successful five different strategies, investing in the S&P 500 index would have been if they were applied during the last 50 years. Benjamin Graham and David Dodd discard any strategies of timing the market that isn't directly associated with fundamental values, so for this comparison, none of these strategies will be based solely on price indicators, such as for instance a swing trading strategy may suggest.
Here are the conditions. The primary thing you need to remember is that the five investors implementing these strategies, get an additional (Inflation-Adjusted) $10,000 each year. This is money that they've managed to save, earmarked for investing. Here's that disclaimer again ... Let's meet our five investors.
"All-IN" Anthony is the guy who simply invests everything in the stock market as soon as he gets a chance to, which, in our simplified example, is on January 1st each year.
Next up is "EARNINGS" Edward, who keeps some cash on the side if the average p/e ratios of the companies in the S&P 500 index are high compared to the last ten years.
"SALES" Sophie acts in a similar way, but she looks at the price to sales ratio instead of the price to earnings.
"BOND" Betty uses a variation of the method that Graham suggests in this book. She invests in stocks only when the S&P 500 p/e ratio is favorable compared to the yield of a ten-year US governmental bond.
Finally, we have "FIFTY-FIFTY FRANCES", who applies a strategy suggested in the Intelligent Investor. He tries to stay in 50% stocks and 50% bonds. if stocks have gone down, he will buy more of them to restore the equilibrium, and he will do the opposite if stocks have appreciated a lot in value.
1969 to 1979 Here are the results of these strategies during the first decade. At this point, the race is quite tight, and even though you can barely see him, Anthony is lurking there somewhere, and you can bet that he's all-in it, to win it.
1979 to 1989 Truly, this was a great time to own stocks. That's why many refer to this period as the "Roaring 80s". And none of the investors as much as flinched during the Black Monday apparently.
1989 to 1999 At the end of this decade, we're in full Dot-Com bull market mode and, it doesn't come as a surprise really that All-in Anthony is starting to create a gap between himself and the others. But can he sustain it?
1999 to 2009 "To speak of these prices as representing 'Investment Values' or 'The Appraisal of Investors', is to do violence either to the English language or to common sense, or both." Yep. This was the end of the dot-com bubble. Unfortunately, all the investing strategies took a hit in both the burst of the dot-com bubble and during the financial crisis, some more than others though. At the end of the decade, All-in Anthony is still in the lead, but it's no wonder that investors refer to this period as the "lost decade".
2009 to 2019 And the winner is ..... All-in Anthony! In terms of yearly returns, his strategy was able to generate, on average, about 1.5% more than Fifty-fifty Francis, and 0.5% more than the others. Over the course of 50 years, as you can see, this results in quite a significant difference in portfolio values. Strategies of this sort aren't without their flaws, unfortunately, as the future may not look exactly like the past, and because the methods require a considerable amount of human fortitude to stick with.
Time for a summary! Use a comparative analysis or scrutinize individual company reports to find undervalued stocks. When doing a comparative analysis, remember that only obvious disparities matter, and that it's mostly a tool to quickly reduce the number of companies considered for investment. The future is primarily something to guard yourself against. Weed out weak companies! Stocks valued lower than net current assets may represent true investment bargains, but you'll typically only find them during distressed financial conditions. It's difficult to time the market. An all in, the dollar-cost averaging strategy seems really tough to beat. The next time we will look at senior securities, and I know what you're thinking ... Yes, bond yields are historically low, but there are some special cases that are still interesting. Cheers!
Great information Regards Santosh Bhatt
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