Wednesday, August 12, 2009 2 comments

Newbie Thoughts: My investing process

This post was going to be about Lemark's 10 year financials but it was getting too long so I'm chopping it up in two. This one will briefly outline my investment process. I'm not a very good investor so if anyone has tips or suggestions to improve, feel free to let me know.

My Process

I'm more top-down than bottom-up as you know, and this is true even if I am interested in a specific company. Assuming I'm fine with the industry/sectory/country/etc, the first thing I usually do is to look at a P/E ratio and P/BookValue and quickly figure out whether I'm interested in something or not. I usually don't pursue a company if its recent (say TTM or trailing 3 year) P/E ratio is above 15 (this doesn't apply to cyclicals or distressed companied with really low earnings.) I view high P/E companies as being too "growthy" for my taste. However, in some special cases, I might add them to my watchlist (an example is Amazon (AMZN)).

I Target Low P/Es

Generally I only look at companies with P/E ratios around 10, irrespective of bond yields. Some professionals invest based on the bond yield. For instance, they compare the earnings yield, which is the inverse of the P/E, against the bond yield. In that scenario, high P/E can be attractive if bond yields are really low. Theoreticaly I believe that is the correct approach. For instance, Japanese stock market had P/Es between 20 and 50* all throughout the 90's. Some of it was due to low earnings so the P/E is misleading but even adjusting for that (or looking at other valuation measures), the valuations were high. One of the reasons the market never marked down Japanese stocks down to, say, a P/E of 18, is because bond yields were very low. If you were a Japanese investor, a P/E of 30 (earnings yield of 3.3%) is not so expensive when bond yields are close to 2%. However, I personally don't follow that thinking and rarely ever take the long bond yield into account. My reasoning is that, I am a global investor and I am willing to go to other countries if the stocks are expensive (even though they are cheaper than bonds.)

Anyway, coming back to my investment process, I stick with low P/Es for the most part. As anyone that has ever done deep-value investing or contrarian investing of any sort knows, distressed companies trading below P/Es of 10 tend to be risky (non-distressed companies at low P/Es are not risky e.g. many smallcaps and microcaps trade at P/Es under 10, almost perpetually.) Although true measure of risk is not valuation—the cheaper something is, the less risky it is, as Buffett would say—newbies like me can't properly distinguish between something that is risky and something that is undervalued. So, although value investors may disagree with me, I think low P/Es (except for cyclicals) are indeed risky. So, it's tough to figure out if the market is right about the prospects of a distressed company trading at low valuations (again, note that this is very different from a non-distressed, microcap, that is trading at a low valuation.) I feel that, if you do invest in a distressed company with a low p/e, you are betting against the market!

Business Environment

The next thing I do is to think about the company's business and read up on recent news stories or magazine articles on it. Listening to an earnings conference call or two, is also helpful to understand the business.

I am a big fan of management presentations. You may find presentations given by management at conferences on the company website. These presentations tend to be very biased and very bullish but it does quickly give an overview of the industry. Typically the conference presentations, which are directed at analysts and institutional investors, go over the company's business, its brands and various assets, its products, and so forth. Even if you could care less about these presentations, you might want to quickly flip through the slides and see if there is any data that may be useful to you. Sometimes, the slides contain data that is very expensive for a small investor to obtain (an example would be market share data from an industry research firm—these can cost $10,000+ per report).

Depending on the company, I also check out competitors. Some companies, especially the small ones, may not have direct competitors so it can be tough to find relevant information. Sometimes, it's difficult to research competitor information for various reasons so I spend more time on this later. Although Lexmark has many competitors, such as Canon, HP, Xerox, Epson, Ricoh, Kodak, and so on, it takes some effort to find information on the competition. For instance, HP is probably the main competitor but it is a conglomerate so one can't simply look at HP's financial statements or listen to its conference call to figure out how their printer business is doing. If you look at, say, HP's margins, it is irrelevant; you have to dig into HP's printer division only.

After that, I look at the financials.

Long-Term Financial History

I think the proper thing is to read the annual reports for a few years. I actually don't do this. Instead, I look at a summary of 10 year financial history. The flaw with this method (as opposed to reading the official annual reports) is that the data provider may make mistakes. It may also compute some numbers—say free cash flow—differently from how you would. The advantage of 10 year summaries is that you can quickly get a feel for the company without digging through countless annual reports. It also saves you from tabulating them yourself since the sources I use have them in an easy-to-read format.

There are several sources that provide 10 year financials in summarized format:

  • Sell-side research from S&P, Reuters, etc sometimes contain reports with 10 year financials. It depends on the research firm and this may be freely available from your discount broker. For instance, I have free access to S&P reports (I don't really like them that much though :( ).
  • If you have access to it, or are willing to pay for it, Value Line provides a nicely laid out 10 year history. If you want some samples, Value Line provides free reports for the Dow 30 companies and you can check them out here.
  • GuruFocus also has 10 year financials. Type in the ticker symbol at the top and click on financials. Here is the page for Lexmark. GuruFocus financials are mostly free, except for the 10 year valuation ratios (P/E, P/BV, P/S, etc). I don't subscribe to GuruFocus so I don't have access to the 10 year valuations :( Ever since I gave up on DCF, my whole valuation methodology has relied on P/E (and other) multiples. So the lack of 10 year valuations makes GuruFocus somewhat limiting for me.
  • The site I usually use for 10 year financial is Morningstar. Thankfully, it's free and it provides access to 10 year P/E ratios. As an example, here is the 10 year income statement for Lexmark. I also have access to Morningstar analyst reports through one of my discount brokers (not sure if they will continue this service) and I also rely on that if Morningstar covers that company. Overall, the Morningstar website is my main site to get summarized 10 year financials.
  • If you have a good library system (especially if you are in a big city or still in university), you may also have access to some stock market database service. These days you can even access them from home, with proper library authentication. I'm in Toronto and it has one of the largest library systems in the world (second to New York in North America I believe) so I have access to a lot of info. In particular, I have access to Mergent Online. This provides 15 year financials for most companies in the world. I use this for foreign companies (I used it a lot when I was looking at Japanese companies.) ... Libraries will generally have some of the sources I mentioned above in printed form (like Value Line). If you are only researching one or two companies, you can just head over to the library and photocopy the Value Line report if you want. Although nothing came of it, I actually did that once. I was researching Owens Corning (OC) and I went to the library and photocopied a page from an old (I think it was 1999) S&P Guide. Owens Corning came out of bankruptcy and all the free data providers only had financials for the new Owens Corning. I wanted to look at the original Owens Corning so I looked at the S&P Guide report from 1999 which covered the prior 10 years. I did this because I wanted to see how Owens Corning, which is somewhat similar to USG, behaved in the prior housing bust in the early 90's. I decided not to invest and that turned out to be a good move. If the housing bust does not drag on for decades like Japan, then companies like USG and Owens Corning are going to be spectacular investments at some point.


Key Measures

With the 10 year financial data, I don't always look at the same financial measures for all companies. I'm just learning as I go and I can't say there is anything that is more important than another. I think the importance of a particular piece of financial data depends on the circumstances surrounding the company.

When I was investing in Ambac, which will likely be a 100% loss for me, I primarily looked at its book value growth in the past. I actually didn't spend much time on the 10 year financials for Ambac because it was dominant in all measures. For instance, Ambac had the highest profit margin in the S&P 500 in 2006 (or maybe 2005). In hindsight, those numbers were so good because they were "fictitious" profits. By that, I don't mean they were illegally concotted by management; I am not accusing anyone of any wrongdoing. Rather, the profits posted looked so good because future liabilities were under-estimated and you can't tell this from the financial statements**. This is the problem with insurance companies (I worry about this with Montpelier Re (MRH), my other holding, as well.)

In the case of Lexmark, I started off by looking at its long-term ROE. Although the business fundamentals look questionable (declining brand strength, loss of margin due to generic ink cartridge replacements, etc) Lexmark is one of the few that I have run across that has an ROE above 15%, even after profits started weakening and without much boost from debt. I don't think ROE will go back to what they were 5 or 10 years ago but it's still quite impressive. (if you don't like ROE, you can also use ROIC which is somewhat similar.)

Then I started look at long-term P/E and P/BV for Lexmark, to gauge how the market valued it in the past. (if you want to account for debt***, which the P/E overlooks, you can also use something like Enterprise_value/EBITDA.)

After that I looked at the 10-year sales, profits, and free cash flow. The future is unlikely to be as good as the past. So the goal is to try to figure out how bad things can get. I'll go into more detail when I write up about Lexmark but the major risk is the declining sales. In the first two quarters of 2009, sales have dropped as much as 20%! That's a huge drop! But then again, the company says they were altering their product mix and switching their strategy so it's not clear how much was due to the shuffling of the products.

Many investors use DCF and try to figure out what the future cash flows will be for future years. I gave up on DCF a while ago because I didn't know what the hell I was doing. The numbers were so sensitive to your estimates that you could come up with almost anything. These days, rightly or wrongly, I simply try to estimate one number! I try to come up with an average, normalized, long-term earnings per year or free cash flow per year and apply a multiple (I usually use the simplistic formula suggested by Benjamin Graham and apply a p/e of 8.5 for zero growth companies; and usually 10 to most companies.) I prefer to use earnings because I generally 'think in P/E terms' but free cash flow is better for some companies. In the case of Lexmark, it doesn't matter what you use because the earnings and FCF have been somewhat close to each other in the last 5 years.

Macro or Industry Research

If there is something I learn from looking at the 10 year financials, I may do more macro or industry research. Some investments depend a lot more on some macroeconomic scneario, while others don't. For example, after looking into Owens Corning, I came to the conclusion that its fate depends on the housing market. So I spent some time thinking about that.

Conversely, situations like Lexmark don't seem to require much research on specific industry or macroeconomic topics. I recall some news article that suggested that printer sales will contract until 2012 or something like that but that's just some analyst forecast that can just as likely be completely opposite. I think Lexmark's fate will largely be determined by company-specific events. Yes, a booming economy will help but it started declining even when the economy was strong.

Annual Reports

I'm sure this is opposite to many out there, but I usually read the annual reports last. Reading this last can be dangerous because the consolidated 10 year financials I rely on may be misleading for some companies. I do it this way, and I don't recommend you necessarily follow me, because I find annual reports very boring and time consuming. I can quickly figure out how much I like a company by looking at the simplified 10 year financials.

The advantage of reading annual reports first is that you won't accidentally cross off companies due to misleading 10 year financials. You can probably also find more "gems" by reading annual reports first. For instance, you may cross a company off your list because its profits look poor when you look at the simplified 10-year financials; but that company may have "hidden assets" (say real estate purchased long time ago and recorded at cost; or say the profits look bad because money is being diverted to R&D or advertising and the company is developing a moat) that is only visible if you read the official documents.

The annual reports and official filings also describe the company in more detail so, reading them first may save some time researching the industry.

You can generally find the latest annual reports, quarterly reports, etc on the investor relations portion of the company website, or at SEC's EDGAR (search for company filings and type in the ticker symbol.)

Finally, Figure Out A Valuation

Last step is to come up with a final figure for what the company is worth. Quite frankly, this is my weak spot and I don't know what I'm doing. I usually just apply a P/E multiple between 8.5 and 10 to what I think the company's long-term normalized earnings is (sometimes I use free cash flow instead with a slightly higher multiple.) Because I tend to look at distressed or low p/e stocks, I think a p/e multiple less than 10 is usually appropriate. I don't usually follow companies that trade at higher valuations, and have higher growth or stronger moats (the only exception for now is Amazon, which I will buy if its P/E hits around 20).

If the company is a cyclical, I like to apply a P/E multiple of around 5 or 6 on peak earnings. Conversely, you can apply a higher P/E on trough earnings. Whatever you do, don't apply a peak P/E on peak earnings unless you have reason to do it (check this post to see why it may not be a good idea.)

Final Word

It is very important that you don't blindly follow anyone you read—either on a blog or even in a nicely published book you purchased. This certainly goes for anything I say. I'm just a newbie and don't have a good record so you need to figure out if what I say makes sense, in this post or any other, and whether it is applicable to you.

My investing strategy and tactics keep changing so, although I have been investing for around 5 years and have dealt with 27 securities, my skills are weak. I'm weaker than someone who pursued a single strategy (say value investing or momentum investing) for the full 5 years. For my life-time, I have one major failure (Ambac), one moderate failure (Takefuji), one minor failure (Delta Financial) and several dissapointments.

So far, I would say that I have a lot more to learn, especially on financial statement analysis. I don't think I will ever be a true value investor—it's not me and I'm more interested in macro topics—but I would like to improve my valuation skills.





FOOT NOTE:

* Article accompanying that Japanese P/E chart can be found here.

** I didn't know Ambac's profits were overstated so much but I did realize that liabilities would make or break this company. So I spent most of my time on their annual report and thinking about potential macro scenarios. In a simplistic sense, all that essentially mattered for Ambac was the housing default rate (things like credit card defaults, auto loan defaults, etc mattered too but they were a small component.) Although I was bearish on housing for many years, I thought housing prices won't fall more than 20% in aggregate. Needless to say, housing fell more than that and all the bond insurers are likely insolvent. Actually, for those not familiar with the housing story, it's a bit complicated, but I also made a huge error with Ambac's HELOC and CES exposure. Although many say that CDOs and CDO-squareds brought down Ambac, I actually think the HELOCs were the major problem. A lot of the CDO principal payments are way into the future (20+ years from now) but HELOCs weren't. ContrarianDutch also suggested, after I invested so do not construe this as a criticism, that HELOCs or maybe the CES (don't remember exactly) were recourse loans in places like California. It didn't matter because I already invested but it gave some comfort. But I missed something big. I didn't realize that a lot of those loans were frauds. Not only did the—to use one of the popular stories a few years ago—strawberry picker from California who clearly couldn't afford the home end up defaulting, he also dissapeared and was nowhere to be found. The mortgage lending companies also started dissapearing (mostly through bankruptcy.) In the grand scheme of things, I'm not sure who is going to end up with the losses. The bond insuers will attempt to void the fradulent insurance so banks and private investors may end up with more losses. I completely missed discounting for the fraud, liar loans and so on. One good thing about commercial real estate, which also had a bubble, is that fraud, lies and deceit, seem not to have occurred. So, hopefully, market participants discounted the risk a bit better than most investors dealing in the residential real estate world.

*** I don't have a theoretical background, although I did take some finance courses in university, and I haven't read too many books on fiancial analysis—have never read Graham and Dodd's Security Analysis either :(—so I don't really know what is theoretically more appropriate: using metrics with debt, or without. The simple answer is probably that each is better for different situations. But if you had to use just one, which is better? It's not clear to me if ROIC is superior to ROE and if EV/EBITDA is superior to P/E. I almost always use P/E and ROE but always check to see if the debt seems mangeable.

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2 Response to Newbie Thoughts: My investing process

Sriram
August 13, 2009 at 4:49 PM

Have you looked at q-ratio? It may not work for individual stocks. But was just curious.

http://www.amazon.com/Valuing-Wall-Street-Protecting-Turbulent/dp/0071387838/ref=sr_1_1?ie=UTF8&s=books&qid=1250196528&sr=8-1

Sivaram
August 13, 2009 at 8:52 PM

I haven't read that book but I am familiar with the Q ratio. I looked at it near the March low. Back then, it seemed that the market was not cheap, but it wasn't that expensive either.

As you implied, the Q ratio isn't useful for individual stocks but can be useful for the overall market. If anything, it provides an additional data point to make your judgement. 

I'm more macro-oriented than pure value investors, so I do think about the market valuation (you can might want to read some of my "market valuation" posts if you are interested). The measures I tend to look at to determine market valuation are the following:

short-term P/E
10-year cyclically adjusted P/E (CAPE)
stock market capitalization to GDP
Q ratio


The market  seems to move mostly based on the short-term P/E. But I rely on the CAPE as my main measure.

All the measures seem to indicate that the market is not cheap. The thing I don't get is why Warren Buffett said stocks were attractive* back in September or October. The market clearly wasn't cheap at that time, based on my read of the situation.


(* Buffett did limit himself and only said that stocks will outperform cash, which isn't much of a bold call. But even then, there is a risk that stocks may underperform cash if we end up stuck in a mild deflation.)

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