WS: BUY STOCKS LIKE STEAKS, II (04 Oct 2006)

The beauty of value investing is its logical simplicity. It is based on two principals: What's it worth (intrinsic value), and don't lose money (margin of safety). These concepts were introduced by Benjamin Graham in 1934, and they are as relevant today as they were then.

Graham began as a credit analyst. When bankers make a loan, they first look at the collateral the borrower has to pledge to secure the loan. Next, they look at the borrower's income for paying the interest on the loan. If a borrower earns $75,000 a year and wants to take out a $125,000 mortgage on a $250,000 house, that is a pretty safe bet. It is not so safe a bet if someone earning $40,000 a year wants to borrow $300,000 to buy a $325,000 house. Graham applied the same principles to analyzing stocks.

Stocks are not unlike houses. When you apply for a mortgage, the bank sends an appraiser to value the house you want to buy. In the same way, a value analyst acts like an appraiser trying to estimate the value of a business. It is in this concept that Graham's definition of intrinsic value originates. It is the price that would be paid if a company were sold by a knowledgeable owner to a knowledgeable buyer in an arm's-length negotiated transaction.

Few investors, individual or professional, pay much attention to intrinsic value, but it is important for two reasons: It enables investors to determine if a particular stock is a bargain relative to what a buyer of the entire company would pay, and it lets investors know if a stock they own is overvalued. The overvalued part of the equation is even more important if you want to avoid losing money.

At year-end 1999, the price of Microsoft stock peaked at US$58.89. In the seven years leading up to 1999, Microsoft's earnings per share had increased 775% from 8 cents per share to 70 cents per share. A terrific company with a stellar record of growth. However, was it worth 84 times earnings at the end of 1999? Apparently not. Over the next six years through 2005, Mocrosoft's earnings per share grew 87% to $1.31. While this is still an enviable growth rate, it is far less than the growth the company enjoyed in the 1990s. The result was that by the first quarter of 2006, Microsoft was trading at less than half its share price on 31 Dec 1999, and its PE ratio had declined from more than 75 times to 20 times earnings. Investors who bought Microsoft in late 1999 own shares in a great company, but they may have to wait years to get their money back.

The August 2000 issue of Fortune magazine, included an article titled "10 Stocks to Last the Decade." The recommended stocks (which were described as "Here's a buy-and-forget portfolio" that would let you "retire when ready") were Broadcom, Charles Schwab, Enron, Genentech, Morgan Stanley, Nokia, Nortel Networks, Oracle, Univision, and Viacom. Lowenstein found that by the end of 2002, these 10 stocks had suffered an average loss of 80%. And even after a market rebound in 2003, the aggregate loss was still 50%. Maybe you could retire if you don't mind eating cold beans out of a can and living in a tent.

Why is intrinsic value so important? Don't stock prices just fluctuate up and down having nothing to do with their intrinsic values? It is true that stocks will from time to time sell for more or less than intrinsic value. Some investors like to play the market by juming on trends in stock prices. This is called momentum investing. If a stock is rising, they like to buy it hoping they will know when to get out before it falls. However, this type of investing may require a knowledge that is more divine than earthbound.

Intrinsic value is important because it lets the investor take advantage of temporary mispricing of stocks. If a stock is selling for less than its intrinsic value, chances are this will ultimately be recognized and the market price will rise to a level more indicative of the company's worth. Or the company may choose to sell out at its intrinsic value, or a corporate raider may come along and try to take it over at a price that reflects something closer to its intrinsic value.

If a stock is priced way over intrinsic value, it may become vulnerable to the "king is wearing no clothes syndrome." This is what happened in the spring of 2000 when the technology, media and telecommunications bubble burst. Investors realized that a lot of those new age Internet stocks never had a chance of developing into real businesses with real profits that would justify their lofty stock prices. The result was a dramatic downward revaluation of many of those "had to own" stocks.

The consequences of the stock market revaluing overpriced stocks is often what Graham called "permanent capital loss." If the stock price of a mundane company declines, which it often does, you have the comfort of knowing that it is still worth much more than you paid for it, and someday the price is likely to recover. If a stock is grossly overvalued and its stock price crashes, history shows that it is unlikely it will regain its former inflated value. Does the investor who bought JDS Uniphase for more than $140 per share, only to see it crash to less than $2 per share, think he will ever see $140 per share again? History says no. This is permanent capital loss. And it has happened numerous times over the years.

How do I determine intrinsic value? There are two broad approaches to determining intrinsic value. The first is highly statistical and involves a set of financial ratios that are good indicators of value. By observing the financial characteristics of stocks that perform well, we can construct a model for a good, cheap stock. This method is not unlike the way GEICO (auto insurance) screens for good drivers. It gathers data on drivers with good records and drivers with bad records to create a profile, or model, of what good drivers look like. If GEICO only issues auto insurance policies to drivers between age 35 and 55 who live in the suburbs but take public transportation to work, who have no children of driving age, and who own and drive a multi-air-bagged Volve, the company will have to cover fewer accidents than other companies that insure teenage boys who drive sports cars. A similar model can be derived for stocks.

The other approach to determining intrinsic value, I call the appraisal method. This method involves making a company-specific estimate of what the stock would be worth if the company were sold to a knowledgeable buyer in an open auction. It is very much the same process you would follow to sell your house. You would call a few local real estate brokers whose knowledge of recent sales in your neighborhood would guide them to a suggested listing price for your house. This is what a company board of directors often does when they vote to sell their company, only they employ brokers who go by the fancy title of investment bankers. The bankers look for recent acquisitions of companies in the same or related industry to guide them in appraising a particular company.

In a perfect world, all stocks would sell for their intrinsic value. But it is not a perfect world. That is good. It creates investment opportunities. Stock prices, for many reasons, trade for more or less than intrinsic value-- often far more or far less. Most investors are driven by emotions that run the gamut from extreme pessimism to jubilant optimism. These emotions can drive stock prices to the extremes of overvaluation and undervaluation. The job for the smart investor is to recognize when this is happening and to take advantage of the emotional swings of the market.

To be continued...


Credits: Much of this article, with modification, is extracted from The Little Book Of Value Investing by Christopher Browne, 2007.

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