Selecting Shares That Perform 4 – Value investing, Emerging markets, Contrarians & Stars

Selecting Shares That Perform

Today’s post is our fourth and potentially final visit to a book recommended by a reader – Selecting Shares That Perform, by Richard Kock and Leo Gough.

Way 7 – Value investing

We have four more Ways to try to get through today.

The first of these is value investing, whose most famous disciple is Ben Graham. (( Buffett started out as a value investor, but now buys high quality market leading firms with defensible competitive advantages ))

  • There is a lot of academic support for value investing, though like most approaches, it does not work all of the time.

Value investing operates on four principles:

  1. The value of the company – and therefore of its shares – can be calculated from its financial characteristics.
  2. The market value of shares is affected by supply and demand, hope, fear, fashion and animal spirits.
  3. Thus the price of a share may be above or below the “intrinsic value” of the share.
  4. Sooner or later, the price will revert to the mean (the intrinsic value) before typically over-shooting in the opposite direction.

So we can buy when the share price is lower than the intrinsic value, and sell when it is higher.

  • Luckily not all investors believe in this approach, otherwise share prices would closely track intrinsic value.

There is also a valid criticism that value investing relies on data from the past, and the future may well be different.

  • But the past, including the possible extrapolation of existing trends, is all that we have to go on.

There are four practical objections to the approach:

  1. It’s hard work, and needs skill with numbers and accounting as well as an introverted, analytical personality.
  2. It can produce the wrong answers for long periods.
    • For example, it can view the whole market as overvalued for years at a time, even as prices press higher.
  3. It therefore requires a long-term perspective.
  4. It is somewhat contrarian, and therefore requires strength of character.

Value investors are sceptical, and always look for flaws and downsides.

  • They are glass half-empty people who don’t jump on bandwagons.
Value rules

The main problem with value investing is that the valuation rules that Graham developed don’t apply well to modern markets, where valuations are much fuller.

Originally, Graham had three rules:

  1. Adjusted net assets
    • Buy when market cap is two-thirds of “net quick assets” (assets minus stock, plant, property, goodwill – essentially just cash and debtors)
    • Sell when market cap is 100% of adjusted net assets
  2. Earnings yield
    • Buy when the earnings yields (the reciprocal of the PE ratio) is twice the yield on quality bonds
    • Unless total debt is higher than tangible net worth, in which case avoid.
    • So if corporate bond yields today are 3.75%, we need an earnings yield of 7.5%.
    • This equates to a PE of 13.3. (( Some investors use the government bond yield, which under today’s low-interest rate conditions is much more favourable: the 10-year gilt is at 1.1% this morning, giving us an earnings yield target of just 2.2% – that would support PEs up to 45! ))
  3. Dividend yield
    • This needs to be two-thirds of the high quality bond yield, or 2.5% pa today.
    • Many stocks would pass this test.

Graham also had three selling rules (any one of which could act as a trigger):

  1. A gain of 50%.
  2. The dividend was suspended.
  3. A period of two years.

Most modern value investors use a more relaxed variation of PE value, price to earnings or price to book value.

Value rules #2

After Graham’s death, a second set of rules was published in 1977, from which one value and one safety rule needed to be passed.

The five value rules were:

  1. Earnings yield twice the high quality bond yield
  2. Dividend yield two-thirds of the high quality bond yield
  3. PE less than 40% of its highest value in the previous five years
  4. Market cap below two-thirds of tangible book value
  5. Market cap below two-thirds of net current assets

The five safety rules were:

  1. Total debt less than book value
  2. Total debt less than twice net current assets
  3. Current ratio (current assets over current liabilities) of at least 2
  4. Earnings growth of 7% compound over previous 10 years (( Happily, thanks to the Rule of 72, this basically means that earnings need to be double what they were 10 years ago ))
    • When inflation is high, real earnings growth of say 3% pa should be used instead
  5. Two or fewer earnings falls of 5% or more in past 10 years
See also:  Selecting Shares That Perform - The Lessons
Stock market cycles

In general, value investing will give you buy signals in bear markets and sell signals in bulls, which is good.

  • But both signals may be premature.

In particular, extended bull markets will have you sitting in cash while the market rockets up.

  • It’s tempting to suggest that a “relative value” strategy might be substituted when valuations are high, but the best performers in bull markets are often the most “overvalued” shares.

Value investing is one of the simplest and best strategies in theory, but it is not simple to implement for anyone other than a long-term pseudo passive investor.

Way 8 – Emerging markets

I have some difficulty in seeing an allocation to emerging markets (EMs) as a Way of investing.

For me, emerging markets are just another geographical division of stocks, and they form part of the top-down asset allocation process.

  • I expect their returns to be only moderately correlated with returns in my home market (the UK).
  • Therefore I will allocate some of my equity exposure to EMs, just as I will to the US, Europe and APAC.

The authors present EMs as high growth in comparison to developed markets.

  • Despite the maturation of China, and the breakdown in the globalisation movement, this remains broadly true.
  • But economic growth does not always translate to stock market growth, and in particular to growth in those sectors of the market that are accessible to foreigners.

Most of this chapter reads like economic history, and we can skip most of the detail.

It’s hard to see why anyone would want to avoid an EM allocation, but I’m not sure that putting money into any particular region is the road to investing success.

  • Most investors will have a 5% to 15% allocation of their net worth to EMs.

The authors mention investment trusts and ETFs as ways of investing in EMs, and I agree with them.

Way 9 – Contrarian investing

Contrarian investing involves going against the general market opinion.

  • Value investing is a form of contrarian investing, as it involves buying companies when they are unloved.

Way 9 is more concerned with big-picture, macro contrarian investing.

  • Examples cited include Britain leaving the ERM in 1992, and foreign investors pulling out of Indonesia in the 1990s.
  • Possible future scenarios that the authors think might be worth backing (( At the time of writing, in mid-2013 )) include an EU / Euro / Eurozone collapse.

It’s important to remember that macro contrarian opportunities don’t come along every year.

  • You need to keep some powder dry to take advantage – keep at least 10% of your portfolio in cash.

This approach is clearly not for everyone, as it involves constant political and economic monitoring.

  • The authors recommend using an investment diary to record your thoughts on scenarios as they develop, and to check back on why investments did or did not work out.
  • You need to develop your own “axioms” and test them against the world.
Way 10 – Star businesses

I think we’d all like to invest in star businesses, so the question becomes how to identify them, and in particular, how to identify them early enough so the prospect of decent future returns is reasonable.

The concept of the star business comes from the famous “two by two matrix” invented by Boston Consulting Group (BCG).

  • One side of the matrix covers market growth rates (fast and slow) and the other covers market share (high and low)
  • Firms (and divisions of firms) are divided into stars, dogs, question marks and cash cows.

So stars are doing well in a market niche that is itself growing (at 10% pa or more).

  • Cash cows have good share, but in a stagnant market.
  • Question marks are in a good market, but don’t dominate.
See also:  Selecting Shares That Perform 2 - Rainmakers, Winners & Specialisation

Compounding is key here.

  • Growth rates of 20% or 30% pa compound up extremely well over a decade (more than ten times).
  • Coca-Cola grew at more than 10% pa for a century.
  • McDonalds’ grew at more than 10% pa from 1948 to 1990.
  • Xerox, IBM, Microsoft, Google, Apple and Facebook are other examples.

Unfortunately, 95% of businesses are not stars, and stars are hard to find.

  • Many are not quoted on a stock exchange until long after they become stars.

By then it might be too late.

  • Google was launched with $1M in 1998, but by the time it listed in 2004, it was worth $23 bn.

The authors recommend that you focus on unlisted firms, which obviously means that this approach is not for everyone.

  • The authors even go so far as to recommend taking a job in any star that you find.
  • They also recommend joining networks of Angel investors.

One of the authors put £500K into Betfair and came out with £26.4M

  • But by the time of the stock’s IPO, most of the growth was behind it

The things to look out for are:

  1. Rapid growth
  2. Market leader in a niche
    • Make sure that it is a defensible niche that can’t be easily supplied by bigger firms in the wider market
  3. A new, innovative way of doing business
    • Betfair is a good example here
  4. Potential higher margins
    • From either higher prices or lower costs
  5. Cash generation
    • Either now or in the near future
    • Revenues should increase faster than costs

If you find a star, hang on until:

  1. Growth in the niche falls below 10% pa, or
  2. Another firm overtakes your star as market leader in the niche, or
  3. Markets are high and your firm’s PE is very high (PEG less than one)

And that’s it – we’ve reached the end of the book.

  • It’s been a decent read overall, best treated as a tasting menu of the various ways in which people have succeeded as investors.
  • For me there isn’t enough detail on any individual method to take you very far.

Here’s a quick summary of the Ten Ways:

  1. Follow the Smart Money (Rainmakers)
    • A decent approach, and easy to implement through guru screens
  2. Good Businesses (Winners)
  3. Specialisation
    • I have no interest in this approach, and prefer to blend successful styles together.
    • I also can’t see specialisation as something to be learned from a single chapter in a book.
  4. Earnings acceleration (Growth)
    • The authors propose a very complicated system for identifying growth shares
    • I think this method is only suitable for investors who can get out before the growth phase ends and the stock falls back from its extended valuation
  5. Outsider information
    • This is another smart money strategy, but one that involves more leg work.
    • You need a particular combination of extravert and analytical personality traits to pull this one off.
  6. Good companies (Buffett)
    • A nice approach in principle, but difficult in practice
    • Not many companies stay “good” for decades, and only a minority of them are listed in the UK
    • Unilever, Reckitt Benckiser and Diageo qualify, but that’s a small portfolio
    • You might think of combining this approach with a tilt towards Family Firms
  7. Value Investing
    • This has been difficult to pull off for the last 30 years
    • If you have the right personality, it could be very rewarding
    • For most investors, a semi-passive (factor) approach to value would work best
  8. Emerging markets
    • This is part of asset allocation, not stock selection
    • It’s a good idea, but for different reasons that those given by the authors
  9. Contrarian investing
    • This is the big-picture, top-down, macro counterpart to value investing
    • Again, you need a specific personality type to prosper
  10. Stars
    • A very attractive idea, but increasingly one that needs to be implemented through early stage companies
    • Access to the best firms will be limited for most private investors

We’ll leave it there for today.

  • I’ll be back in a few weeks with a new book.

Until next time.

Mike is the owner of 7 Circles, and a private investor living in London. He has been managing his own money for 40 years, with some success.

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Selecting Shares That Perform 4 – Value investing, Emerging mark…

by Mike Rawson time to read: 7 min