Tag Archives: fn-end

Should You Look For Value In Cash Flows?

Most deep-value investors look at the balance sheet and P/E multiples when they are hunting for bargains, a strategy taught by the godfather of value investing, Benjamin Graham . However, what strategies like these fail to take into account is cash flow. Glen Greenberg and Donald Yacktman are two respected value investors, both of whom invest not just with asset value in mind but also cash flows. This strategy has yielded results. Greenberg’s fund, Chieftain Capital Management achieved a compounded annual growth rate of 25% from 1984 through 2000, the S&P 500 achieved a return over 16% over the same period. Annual returns through 2010 were 18%. Greenberg uses a DCF model to make his investments but rather than the traditional DCF method, in the style of Graham, Greenberg looks for a margin of safety before investing. This margin of safety is a hurdle/discount rate of 20% for all potential investments when computing the DCF. The rate was lowered to 15% in order to reflect the interest rate environment. (click to enlarge) Adjusted cash flows Meanwhile, Yacktman uses an adjusted cash flow figure to value securities. Yacktman equates the forward rate of return with a company’s free-cash yield . He calculates this yield by computing the FCF, then adds in the cash he believes the business can generate through growth and adjusts for the effect of inflation. That figure is then divided by the stock price. Using this adjusted cash flow figure, Yacktman compares the stock’s forward rate of return with yields on long-term Treasuries. The wider the spread, the deeper the discount and the more attractive the stock is to Yacktman. DCF valuations for forecasting free cash flows: Not clear cut The use of a DCF valuation places less reliance on current market valuations. Instead, it emphasizes the full-information forecasting of free cash flows over a multi-period finite horizon. In comparison, PE models are dependent upon the fact that current earnings measures are good proxies for value, placing emphasis on current, not future value. Moreover, DCF calculations allow for the choice of an appropriate finite horizon, estimation of growth beyond the horizon, and in its standard implementation, estimation of an appropriate WACC and of the value of non-equity claims on the firm. In other words, the valuation is more comprehensive and provides a long-term valuation of the company that it not dependent upon wider market valuations. That being said, there is some evidence to suggest that price targets calculated using a P/E multiple, are more accurate that price targets computed using a DCF analysis. A study entitled “ Does valuation model choice affect target price accuracy? ” found that DCF models are used to justify higher price targets by optimistic analysts. Additionally, a study entitled, Valuation Accuracy and Infinity Horizon Forecast: Empirical Evidence from Europe , published within the Journal of International Financial Management and Accounting 20:2 2009, found that when calculating a DCF forecast, analysis’ tend to factor in an “ideal” long-term growth rate, which is just above the WACC: …Therefore, using this ‘‘ideal’’ growth rate leads to the determination of ‘‘ideal’’ Target Corporation (NYSE: TGT ) prices that respect the long-term steady-state assumptions… Therefore, it’s easy to conclude that if a DCF figure is used to calculate a price target, or identify value opportunities , a suitable, conservative set of figures should be used to compute the DCF in order to prevent optimistic forecasting. Disclosure : None.

Our 10 Investing Rules For 2015

In 2015, investors should be more skeptical of expert market analysis, and be humble in their approach to new investment opportunities regardless of their past success. Investors should be diversified beyond stocks that Wall Street currently loves, and be wary of investing in overpriced dividend growth stocks. Investors should prepare a list of potential investments as an inevitable correction may finally occur in 2015. Investors should focus on alternative financial media to support their investment decisions, and focus on their entire portfolio’s performance. Investors should broaden their mid-cap stock exposure and strategically invest in out-of-favor dividend stocks with potential to become classic dividend growth stocks. As 2015 rapidly approaches, set forth below are our rules for investing in stocks for 2015. Many of the rules are perennial rules that will always stay with us, and should stay with most investors throughout their investing activities. Some investing rules for 2015, however, are more specific to the current investing environment of: 1) historically low interest rates that are likely to change in the near term; 2) investors engaging in riskier investments given such low interest rates; and 3) desperate search for income causing many dividend growth stocks to be vastly overpriced. With this in mind, below is a set of rules we will be following in 2015 as we make modest adjustments to our portfolio. 1 – Be Skeptical of Pundits and Experts The overall stock market has had an extraordinary run since the dark days of 2009. Most analysts and market pundits predict market indexes to advance further in 2015. We, however, remain skeptical of expert opinions about the near-term future of stocks and the market indexes. Why? The market has had an extraordinary run, and all good things must come to an end or at least take a rest. Although market indexes have advanced strongly since 2012, we have been highly skeptical of the strong surge in the overall market indexes. In our effort to add stocks to our portfolio during such period, we focused on and purchased only stocks that were out-of-favor, including Coach, Inc. (NYSE: COH ), FMC Corporation (NYSE: FMC ) and Patterson Companies (NASDAQ: PDCO ). 2 – Be Humble when making new Investments Since the market advance began in 2009, many institutional and individual investors have experienced significant returns on investment. In addition, there are pockets of the stock market where stocks are clearly overpriced, such as certain dividend growth stocks. With great success comes human nature to begin to think of oneself as invincible. A successful investor with many successful investments in their past begins to think they too are invincible. The current bull market has made many individual investors feel like geniuses when their success is part smart stock picking, part the actions of the U.S. Federal Reserve’s low interest rate policy and part luck. With that said, leave the arrogance to the professional traders and be humble when you are making changes to your stock portfolio. Over time, the stock market tends to humble all investors on a periodic basis. 3 – Be diversified An individual investor that chooses to invest in individual stocks should focus on being diversified throughout multiple industries. If an individual investor wants to own 40 stocks, then, for example, such an investor should own a few of each of the following types of stocks: 1) food stocks, 2) industrial stocks, 3) pharmaceutical stocks, 4) software stocks, 5) utilities, 6) consumer non-discretionary stocks, 7) consumer discretionary stocks, 8) chemical stocks, and 9) technology stocks. An investor should never overweight their portfolio with one or two stocks, no matter how much Wall Street, the financial media and individual investors love the stock. We are constantly amazed at how many investors overweight their portfolio with Apple, Inc. (NASDAQ: AAPL ) stock. No matter how wonderful you think AAPL is as an investment, one day the company will stumble and fall for a period of years. When AAPL does stumble you will not want to be overweight on the stock. Stay diversified. 4 – Be wary of overpriced dividend stocks The last several years have been extraordinarily kind to dividend growth stocks and any investor in such stocks. Now, however, is the time to turn more cautious on this crowded trade. The success of dividend growth stocks over the last several years has been due in large part to the U.S. Federal Reserve’s ultra-low interest rate policy to boost the sagging U.S. economy. The Federal Reserve’s policy has forced many investors to take on more risk to provide income. With banks providing near zero interest rate returns on bank accounts, investors have flocked to dividend growth stocks. With the Federal Reserve indicating that interest rates are set to rise in mid 2015, investors should begin to look more skeptically at dividend growth stocks to avoid overpaying for such stocks. 5 – Develop a List of Potential Investments Whether overall market indexes are hitting new highs or new lows, we believe there are always opportunities to invest in individual stocks in the markets. With that said, we prefer to invest in out-of-favor stocks when the overall market corrects more significantly. Therefore, we have a list of about 50 or so stocks that we are interested in under the right circumstances. Most of such 50 stocks we will never buy as such stocks will never reach a price that we believe is fair for the stock. There will be, however, instances where we will be able to buy a few of the stocks on our list each year. The purpose of such a list then is to provide us with a rough guide of what we can add to our portfolio when the stock market unexpectedly provides us with the opportunity to make a well-timed purchase of an out-of-favor stock that we believe in. 6 – Be prepared for a market correction We believe that the lack of a correction in the last few years has made investors complacent and feel invincible. Investors have forgotten what a severe correction looks like. For us, a severe correction tends make us feel that all we felt we knew about the stock market has been thrown out the window. A severe correction makes us look at our stocks in disbelief as they drop in multiple point increments day after day to levels we never thought imaginable. The feelings of being an investor during a severe market correction (such as the 2008-09 correction) are quite humbling. Being prepared for a correction means for us to: 1) stick with the investments we have, 2) not panic, 3) continue to reinvest dividends, 4) make new investments, and 5) stay calm. A more experienced investor sees a market correction as an opportunity rather than a tragic permanent event. 7 – Seek out alternative financial media discussions Anyone who has read some of our articles knows that we hold Wall Street, analysts and mainstream financial media in very low regard. Much of the financial news coming out of the most mainstream of news sources engages in loud headlines that send out signals of extreme euphoria or extreme pessimism regarding overall markets and individual stocks. We believe that such extreme headlines serve to confuse individual investors and push them to make rash buying and selling decisions. Apart from our favorite mainstream financial news source, Barron’s, we believe all other mainstream financial media should be viewed in an extremely skeptical manner. We also believe that the shouting headlines of mainstream financial media is what has driven many individual investors to Seeking Alpha for more rational discourse on overall markets and individual stocks. Aside from Barron’s and Seeking Alpha, we believe individual investors should seek out investing information from secondary sources. There are paid sources such as Morningstar, which we believe are very valuable to the individual investor and are worth the subscription fee. In addition, we believe that investors should conduct Internet searches for the companies they have invested in or are interested in investing in. Local newspapers, technological newspapers, industry journals and highly respected blogs are valuable sources of information for individual investors and can give greater clarity to an individual investor about what a company is really about. 8 – Focus on the whole of your portfolio We once told another investor that our portfolio of stocks was similar to a parent’s children. If a parent has 4 children and 3 have done well in school and are bound for excellent colleges, but one child is struggling in school, the parent will feel like a failure. Well, of course, a good parent wants all of their children to “succeed.” Our point is, however, that focusing on a minority of underperforming stocks in an overall portfolio prevents an individual investor from understanding and appreciating the successes of their portfolio. Just as children can reach their potential at different stages of their life, so too can stocks appreciate and perform well in varied periods. An individual investor with a portfolio of 40 to 50 stocks will recognize that individual stocks will perform well over multi-year periods, but will also move sideways or downward for multi-year periods as well. Over the long term, even the most successful stocks have their sideways and downward trading periods. Once an investor accepts that not all of their stocks will perform well every single investing year, the sooner they will accept that they do not need to trade in and out of stocks constantly. 9 – Seek out Mid Cap Stocks The vast majority of our stocks are “mega-market capitalization” companies with market capitalizations ranging from $40 to $50 billion to hundreds of billions of dollars. While “mega-market capitalization” stocks do have a place in an individual investor’s portfolio, lately we have come to appreciate owning stocks of companies in the $4 to $15 billion dollar market capitalization range. In particular, we focus on dividend paying mid-cap stocks that are out-of-favor with takeover potential. Mid-cap stocks offer greater share price appreciation, lower outstanding share counts and takeover potential. Our recent purchases of COH, FMC and PDCO fit into the mid-cap category that we are beginning to favor as an addition to the mega-market capitalization stocks that form the majority of our portfolio. We now believe that up to 25 percent of any individual investor’s portfolio should be comprised of such mid-cap stocks. 10 – Increase dividend income stream through strategic purchases Our final investing rule for 2015 is a rule that we have been following for many years. Now, however, as we indicated in an earlier rule, dividend growth stock investing has become a crowded trade, which makes us wary of investing in many dividend growth stocks. With that in mind, an investor must alter their dividend investing approach to adapt to the current market climate. Instead of focusing solely on the current yield of a stock and the length of years a company has raised its dividend, an investor should focus on a company’s recent dividend history and the potential for dividend growth in the company’s upcoming years. To use a baseball analogy, instead of trying to buy an expensive free agent baseball player with extraordinary past performance, look for a lower-priced minor-league baseball player at a more reasonable price with potential. A company with a 5-year history of dividend increases, a 1 percent dividend yield, and the potential to increase dividends for years to come is likely a better choice today than the most highly publicized (and overpriced) dividend growth stocks. In the current market climate, individual investors need to think differently about dividend growth investing and increasing their dividend income stream.

The Liquidity Curse

Is the liquidity premium turning into a discount? Traditionally, investors have been willing to pay a premium for stock liquidity. This premium appears to be turning into a discount. Could this phenomenon last? Historically, market participants have been willing to pay a premium for liquidity. In the equity market, in the hypothetical situation of two otherwise identical stocks, the one with the better trading liquidity would be expected to command a premium over the less liquid stock. In other words, everything else being equal, a stock that is easier to trade (one with better liquidity, i. e., more trading volume) would be expected to be awarded a higher valuation multiple than the less liquid alternative. Frequent readers are well aware that I am a strong fan of Warren Buffett. He has repeatedly noted how perverse it is that investors treat stocks so differently from real estate, simply because stocks are a much more liquid investment. Paraphrasing Mr. Buffett, he recently remarked how absurd it would be if a homeowner liquidated his or her home just because a neighboring home was sold at a discount versus its fair value. Homeowners do not track the theoretical value of their homes on a daily basis, and their investment psychology is not affected by the price fluctuations in their homes anywhere near to the extent that they are when they see the price swings in their stock holdings. Thus, Mr. Buffett often reminds us that, in the short term, the equity market functions as a voting machine, whereas in the long run, it is more like a weighing machine. That is one of the key reasons behind the success of long-term equity investing. In the long run, the stock market weighs the cash flow generating ability of the underlying equities, whereas in the short term, fads and popularity tend to determine the price at which a particular stock trades at specific point in time. The implied discrepancy is what often creates wonderful buying opportunities in very desirable equities for the long term. How could trading liquidity ever be a bad thing? In the short run , better stock liquidity can certainly work against a stock price. Particularly in severe market-wide corrections (or if a specific stock is heavily owned by leveraged traders), a liquid stock may suffer disproportionately in the short term as traders take advantage of the relatively high liquidity to raise cash. This is when particularly attractive entry points are often created for long-term investors, but also why I advocate that such investors never use margin debt to increase their exposure to stocks. Owning stocks on a leveraged basis does potentially expose market participants to a sort of ‘liquidity curse’. One may receive a margin call and be forced to liquidate a particular stock in a sudden market correction. But other than that, trading liquidity should always be considered a positive characteristic in a stock, in my view. Still, and perhaps because investors seem to be increasingly shunning volatility, it appears almost as if the historical liquidity premium may be turning into a discount, and that the liquidity curse may be becoming more widespread and more of a permanent feature across equities! Much has been written lately about the millennials. The so-called millennial generation does seem generally less open to equity investing than previous generations were at the time they were in the age range of millennials today. Having seen their parents go through the burst of the TMT bubble and the global financial crisis may have traumatized millennials enough to generally shun investing in publicly traded equities, at least for the time being. That said, investing in private equity seems much more currently popular. This is reflected both in the staggering valuations now prevalent in a number of late-stage venture investments, as well as in the growing popularity of ‘crowdfunding’. More investors than in the past, perhaps bolstered by young people including millennials, seem to be increasingly comfortable tying up their funds in illiquid investments. Equity is equity, and that which is not traded in the public markets is almost by definition riskier than publicly traded stocks, even everything else being equal. Thus, it would seem as if more people are choosing venture capital and private equity at the expense of the public markets, at least implicitly preferring trading illiquidity. One hypothesis I have for this phenomenon is that it is less traumatic for those investors not to know exactly how much a particular equity investment they own is worth at a particular point in time, just as is the case in real estate.