Value Investing – part 1

Stock Evaluation – Benjamin Graham method

In my ongoing quest to look at finances and improve my financial performance, I’ve done a lot of reading on value investing. The general concept of value investing is that you can, with some accuracy, determine the intrinsic value of a stock.  However, the stock market is often based on emotions, and a stock can be selling for less than its intrinsic value (due to bad news and overreaction, general lack of knowledge of a certain company’s performance, or the stock not being in a “sexy” industry.

I worked for a company in 2000 that was in automotive (i.e. not a “sexy” dotcom in 1999 -2000). Very well run, great numbers, but only trading at $1.68 a share. Once the dotcoms blew up, people starting looking for other companies to buy and found ours. Over the next seven years, it went over $140/share (taking into account splits). While we did great work at this company, even I don’t think it was worth a 833% rise in value.

The key for a value investor is to find these “diamonds in the rough,” purchase them, and then have the patience to wait till they jump up. If you can judge the intrinsic value, it may take the market a year, or 5 years, but eventually you will be rewarded.

Note that this is the exact opposite of the “efficient market” theory that rules Wall Street at this time – the belief that information is known to all, and therefore the market is correctly priced, each day. These investors tend to emphasize hot growth stocks. However, if everyone had total knowledge, why are there always sellers and buyers for a share of stock, with both of them thinking they made a good deal?

One of the earliest proponents of the value theory was Benjamin Graham, and most of the big value investors are disciples of his teachings (Warren Buffet and many others actually took classes from Graham and worked for him).

In looking through books authored by Graham, liked The Intelligent Investor, or other value investors, they ended up with a process to evaluate and pick value stocks:

  1. Learn to understand a company’s basic financial documents (balance sheet, earnings statement, cash flow)
  2. Use simple metrics (I will show Graham’s ten values) to weed out the majority of non-value stocks
  3. Once you have identified a list of candidates, use some additional rules to weed out those value-type stocks that don’t match your goals, or who are questionable
  4. Invest and show patience while you wait for the market to agree with your valuation.

I won’t go into details here on how to reach a company’s documents. There is a wide variety of information on-line, but here are some, in case you need them:

  1. Reading a balance sheet 
  2. Reading an earning’s statement
  3. Reading a cash flow statement

For step 2, Benjamin Graham (and other value investors) used a series of ratios to weed out the stocks that did not meet their value objectives

No Criteria Measures
1 Earnings to price (the inverse of P/E) is double the high-grade corporate bond yield. If the high-grade bon yields 7%, then earnings to price should be 14% Risk
2 P/E ratio that is 0.4 times the highest average P/E achieve in the last 5 years Risk
3 Dividend is 2/3 the high-grade bond yield Risk
4 Stock price of 2/3 the tangible book value per share Risk
5 Stock price of 2/3 the net current asset value Risk
6 Total debt is lower than tangible book value Financial Strength
7 Current ratio (current assets / current liabilities) is greater than 2 Financial Strength
8 Total debt is no more than liquidation value Financial Strength
9 Earnings have doubled in most recent ten years Earnings Stability
10 Earnings have  declined no more than 5% in 2 years of the past 10 years Earnings Stability
If stocks meet seven out of the ten criteria, it is probably a good value, according to Graham. If you are income oriented, recommended to pay special attention to items 1 – 7

Graham’s criteria from Value Investing for Dummies

In my next post, I’ll explain how I used these criteria to identify a group of stocks, and then did further research in order to pick one for my “fun money” account. You’ll get to see how I did there.

 

Mr.39 Months

You’ve got to have hobbies – part 3

Sorry for me not posting over the weekend. I was out again, hiking on the Appalachian Trail, this time in Connecticut.

As I’ve said before, I belong to a club that does outdoor events (kayaking, biking, etc.) and a group of seven of us went over the weekend to backpack the AT. It was a total of 12.5 miles (6.5 miles on Sat, 6 on Sun) with a stay at the shelter.

I really love taking these trips to the outdoors, and I look forward to the opportunity, once I hit my FI goal, to do more of this.

I hope everyone had a great weekend!

Mr.39 Months

Good post on what to do with the credit breach at Equifax

Its been a topic of discussion among the folks I talk with, and its a real cause for concern among many people.

This article goes over some good steps you can use to help remove/reduce the potential for loss. It pretty much breaks it down into:

  1. Finding out if your information was exposed
  2. Getting a free year of credit monitoring (but be careful & read the fine print. You may be giving up your right to sue Equifax)
  3. Check your credit reports often (you can check each of the three sites – Equifax, Experian and TransUnion once a year for free).
  4. Consider placing a credit freeze on your files
  5. Or consider placing a fraud alert on your files
  6. File your taxes early (so frauds can’t cheat you out of your money)

No matter what, keep an eye out for thieves on the net. They’re out there, and its just smart financial sense to be ready for them.

Mr. 39 Months

 

Do Natural Disasters Improve a Country’s GDP?

There has been some discussion on the internet this last week about the positive effects on the country’s GDP after a Hurricane hits a particular area. The activity that GDP measures (rebuilding, supplies, etc.) get a “boost” of spending when a site is rebuilding, but the GDP measure (which many folks use as shorthand for the economy) isn’t really built to measure this sort of thing.

The Econoproph wrote, back in 2011 (after Hurricane Irene): What will show up in GDP measures after the natural disaster is a perverse reaction in the months after the disaster.  This comes because of the re-building activity that comes after the disaster.  Repairing buildings, cleaning up, rebuilding all require paid services, building supplies, labor, etc.  These transactions will show up in GDP measures in the months/quarters after the disaster as an slight increase in total GDP.  But it’s a deceptive increase in total GDP because we aren’t really significantly better off.  We’re just getting back to the condition before the disaster.  GDP counts the fixing, but not the damage done.  This is why we sometimes hear commentators say that a “disaster is good for the economy”.  It isn’t really.  It’s good for GDP, but that’s not a perfect measure of the economy.  The mistaken idea that damage or disasters are good for the economy is what economists call the Fallacy of the Broken Window. It was first explained by Frederic Bastiat.

 All this activity is doing is getting us back to “0”, which isn’t that helpful. It would actually be more helpful if we had spent the funds on hurricane damage preventive measures in the years prior to. One just has to look at New Orleans (which saw a massive rebuilding since Katrina – but which has leveled off). It hasn’t really recovered to where it was, and it has lost a decade of potential growth while rebuilding.

One other part that will affect the GDP is the price of oil and gasoline in the country. As we work to get Houston back on-line (and potentially other areas depending on the Hurricane season this year), folks have already seen the price of gas go up 20% or more in their local area. This will have a net drag on GDP growth, and the economy, as funds are diverted to purchase gas that could have been used elsewhere.

I’ve got family in Florida, and my prayers go out to them, and to all the other folks in TX, FL and other states affected by the Hurricanes this year.

 

Mr. 39 months

Interesting info on re-balancing investments

Was listening to the Stacking Benjamins podcast this morning and they had an interesting bit of trivia.

Apparently, July was the lowest amount of trading within existing accounts for 401Ks/403bs/IRAs. What this basically meant is that folks were not re-balancing their investment accounts (selling their high winners and buying losers to get the allocations back in line).

Those that were trading were selling mostly out of bonds and into foreign stocks and S&P 500 – which has been the big winners over the last 6 months. In other words, they were selling low and buying high!

While I only rebalance 2x a year (Jan & July), I definitely trade to get back into my allocation, selling high and buying low.

What do you do when you make trades within your account?

Mr. 39 months

 

 

Monthly update – Sep, 2017

Keeping it rolling, only 34 months from Financial Independence!

After a great month for July (+$14,373), my August wasn’t exceptional. I started the month with $926K of invested assets (not counting savings), put $4,108 into my various accounts (401K, Roth IRA, brokerage), but ended the month at $928.6K, a 0.2% drop. For the year, all total, I am still up around 7.1%.

Bonds and REITs are up, probably because folks don’t expect the US Fed to raise rates for the rest of the year. My stock Index funds are down a bit. One of my “value” stocks that I purchased, Gilead (Stock symbol GILD) is up 10% for the month. I bought it because it was selling at a low P/E, and matched 5 of Benjamin Graham’s seven value indicators. Its up over 24% for the year, so a big win for me.

At the same time, using the same logic, I bought a lot of Tahoe enterprises (miner stock) that hit 5 of Graham’s points, and was selling below book value (i.e. the stock was less than what you’d get if you liquidated the company). So far, it’s dropped 10.6% for the year, primarily due to legal troubles. Still, the concept of value still holds, and if I have patience, it should still bounce back up (it has been on an uptick the last 2 weeks).

For September, I plan on putting my investment money into my bond mutual fund. I want to get my allocation more in line there with a 33% REITS/ 33% bonds/33% stocks plan. This will call on me to probably buy bonds each month for the rest of the year

 

Hope your August was fun and fulfilling!

 

Mr. 39 Months.

Book Review – Yes, You can Supercharge your Portfolio by Ben Stein and Phil DeMuth

Most people remember Ben Stein as the teacher in “Ferris Bueller’s Day Off” or from his show “Win Ben Stein’s Money.” However, he is also an accomplished economist, with a degree from Columbia and the valedictorian of Yale Law School. He worked in the White House in the 70s, and has written articles on finance for Barron’s and the Wall Street Journal.

Phil DeMuth was valedictorian of his class at the University of California, and has a master’s & doctorate degrees. He is a registered investment advisor and president of Conservative Wealth Management in Los Angeles. He has also written extensively for the Wall Street Journal and Barron’s.

This is the Fifth and final book in the author’s five part series on finances. In the previous four they showed how to use long-term trends to “time the market” in the long term (10 – 15 years +), how to set up an income producing portfolio in these low-yield times, how baby-boomers can still retire even after the dotcom crashes through using the right steps, and finally, how millennial and Gen Xers should be saving, investing and living their lives responsibly throughout their lives (their 20s, 30s, 40s….). This final book goes through a series of steps that anyone should take when designing their savings and investing strategy, so that it meets their short and long-term goals and they can move towards the life they desire.

Most of these steps are not unfamiliar to folks in the FIRE community. As laid out in the book, the six steps are:

  1. Evaluating your needs before deciding on your investments (what are you trying to accomplish, what are your current assets & liabilities, what are your short term and long term goals, etc.). You shouldn’t just invest in something, you should figure out what you want to accomplish first.
  2. Your whole portfolio matters. Often folks develop their investments over a period of time (bonds from grandparents, start an IRA at graduation, 401K at 3% match from work, buy some stocks from a friend who is a broker, etc.). An individual needs to consider all of their investments in one “pool” and make decisions based on that (some items are preferable in a tax-advantaged account, some not, etc.)
  3. Take on risk intelligently. Your stock may have gone up 15% last year, but based on the high risk you took on, it really should have gone up 30%, to compensate (maybe the much safer investment which made 14.5%). Its here they start getting into the use of Monte Carlo simulation to help with investment decisions.
  4. Diversify. Don’t put “all your eggs in one basket” or you faith in 1 or 2 stocks. There is a wide variety of investment options (stocks, bonds, ETFs, mutual funds, precious metals, real estate, etc.). They go up & down at different rates, and carry different rates of risk. By diversifying, you can reduce risk while keeping investment returns strong. It also makes it easier to sleep at night. Stein and DeMuth are big fans of modern portfolio theory, and demonstrate how a series of investments can earn good returns with reduced risk.
  5. Use the Monte Carlo Simulator to test drive your portfolio. The book covers the use of the Monte Carlo simulators at www.quantext.com or www.financialengines.com to test out the portfolio. Many of us are familiar with Monte Carlo simulators (see my sidebar for links). The simulators help you see your chances of reaching certain goals with the portfolio you selected. This really is the meat of the book, as it shows in detail how to analyze your portfolio strategy in order to optimize it.
  6. Do a Portfolio Reality Check. Look at the portfolio in terms of your current life situation (do you have debts you should pay off first, etc.), does the portfolio make sense, will you be able to sleep easily with the results. Take this opportunity to revisit goals and then act.

Other Topics Covered

  • Farewell to Bonds? Here the authors cover the use of low volatility stocks with low correlation (i.e. stocks that don’t move much, and don’t move with the market as much) in the place of bonds. They show it across time periods when stocks didn’t do well (2000-2002) and did well (2003-2006). In both, when compared against a 60% bond and 40% stock portfolio, they did well.
  • Hedge funds? Use of specific hedge funds to “hedge” against losses and obtain higher returns
  • Investing for Income: Most of these topics were covered in their previous book, but the general idea is to use dividend stocks, bonds, and REITs to generate respectable income (instead of having to cash in growth stocks).

Overall, I think it’s a good book, and could be useful for those interested in doing the research to “bump up” their returns.

I would rate in 25 stars out of 5, primarily because most of the topics were covered in the previous 4 books.

 

Mr. 39 months

Good post on retiring early on $500K in investments on Early Retirement Extreme

Guest post from Debbie M at the website Early Retirement Extreme

Good article on how she is breaking down her expected spending and how she plans to get there. Great to see folks showing how they can retire on less than $1M (which seems to be everyone’s drop dead amount in the mainstream media).

Go Debbie Go!

 

Kevin