Stock Evaluation 2 – Benjamin Graham method

In my first post, I talked about some of the rules that Benjamin Graham used to sort through the stocks to identify. Back in June, I used the decision criteria from “The Little Book of Value Investing.” I used these to identify seven potential stocks at the time, and saw which stocks matched the most criteria (shown in green)

 

OTEX TSN PAG LYB GILD SYMC ALK
Name Open Text Corp Tyson Foods Inc Penske Automotive Group Inc LyondellBasell Industries NV Gilead Sciences Inc Symantec Corp Alaska Air Group Inc
Dividend Yield 1.4% 1.4% 2.3% 3.7% 3.0% 1.0% 1.2%
Greater than $2B market value $8.81B $17.99B $4.40B $37.21B $91.62B $17.85B $11.96B
2-1 ratio of current assets vs liabilities 3.3 1.8 1 2.2 1.9 1.8 1.7
Positive earnings in each of last 10 years 5 5 5 5 5
Paid a dividend at least 20 years, raised over last 20 years No Yes Yes No No
Increase their earnings per share by at least 1/3, over 10 years Yes Yes Yes Yes Yes
P/E of 15 7.4 13.8 13 10.1 7 9.2 14.8
Price-to-book of 2.5 or less 2.52 2.33 2.51 6.12 5.43 4.52 4.18

 

The next step from there was to look through the stocks, get information and try and see which ones you understand. It does you no good to evaluate a company’s performance if you don’t really understand what they do. Warren Buffet is well known for not investing in technology, because he doesn’t really understand it. He understands Coca Cola, Geico insurance, etc. – so that is what he invests in. In this case, I understood OTEX, Tyson, PAG, Lyb and Gilead, so I chose to concentrate on them.

Graham had a formula for determining intrinsic value. Value = E * (2g + 8.5)  * 4.4/Y

  • E = current earnings per share, after taking out dividends
  • G = annual earnings growth – with 5 percent figured as a “5”. Typically for young, growth companies he used 10% growth, while using 6% for companies in a mature industry
  • 8.5 is the base P/E ratio for a stock with no growth
  • Y is the current interest rate, represented as the average rate on high-=grade corporate bonds

An example would be a company with a current earnings of $2.30, a growth rate of 10 percent, and a corporate bond rate of 6 percent. The intrinsic value is $2.30 * ((2*10)+8.5) * (4.4/6) or $48.07 per share

 

When I took the list above, using this equation, I came up with the following intrinsic value

Intrinsic Value OTEX TSN PAG LYB GILD
Earnings w/o dividends $0.75 $3.93 $2.69 $6.58 $7.13
Growth rate 10% 6% 6% 6% 6%
Bond yield 3.7% 3.7% 3.7% 3.7% 3.7%
Graham’s Value $25.42 $95.81 $65.58 $160.41 $173.82
Current Stock $33.48 $62.50 $51.88 $91.80 $72.06
Variance ($8.06) $33.31 $13.70 $68.61 $101.76

After this analysis I took the opportunity to look through Gilead’s annual reports. While their stock price had dropped dramatically, their overall economic position was strong, and they had a lot of excess cash. By the time I ended up deciding on the stock , Gilead had actually dropped to $66.46 (almost $6 less than my original analysis).  Using Graham’s numbers, it appears to have a tremendous amount of “up” (it had a P/E ratio of 7, or if inverted, a yield of 14%!). Since I purchased it in late June 2017, it has gone up to $83.27 (a 25.3% jump). Supposedly, based on it earnings, it could go as high as $173.82. I will have to keep track of it going forward.

In August and September, using the same concept, I’ve purchased TAHO (a mining company) and CSS (consumer products) both selling below book value, and seemingly underpriced. While I haven’t gotten a big “jump” on either (TAHO up 6% in 2 months, CSS up 2% in 1 month), they are both doing fairly well. I will keep them until they come close to their intrinsic value – which may be several years.

What systems do you guys use to pick stocks or mutual funds?

 

Mr.39 Months

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

Timing the Market – How would I have done if I followed it since I graduated?

Back at the beginning of the month (Aug 5th) I wrote about Stein & DeMuth’s use of long-term metrics and trends to “time the market” in the long term (i.e. over a 10-15+ year period). Unfortunately, their book was published in 2003, and while they kept graphs up on their website (   ) for a while, they stopped updating the graphs in 2015.

I wanted to do a “what if” analysis, where if I had followed their metric strategy from when I first graduated and started investing some of my salary (1987) to the end of 2016, a 30 year period. I would take $1,000 a year and invest it either in the S&P 500 every year (dollar cost averaging) or the S&P or AAA bonds, based on the “market timing” signal that Stein & DeMuth laid out:

  1. S&P 500 price vs. 15-year average (if above average, don’t buy)
  2. S&P500 P/E vs. 15-year average (if above average, don’t buy)
  3. S&P500 Dividend yield vs. 15-year average (if above average, don’t buy)
  4. S&P500 Earnings yield vs. AAA bond average (if bond yield is higher, go with bonds, not stocks)

Base Strategy

  • Whenever I got a “buy” for S&P 500, I put in $1,000 at the beginning of the year
  • Whenever I got a “don’t buy” I put in $1,000 in the average for AAA bonds
  • I adjusted for inflation
  • I ran the numbers for each of the 4 scenarios, for the 30 year period, including the great run up of stocks in the 90s, the dotcom crash, the low bond rates of the 00s, and the crash of 2008.

The results were very interesting.

  • Dollar cost averaging into S&P500: $60,691
  • Price metic: $65,576 (8.0% better return)
  • P/E metric: $67,583 (11.4% better return)
  • Yield metric: $67,133 (10.6% better return)
  • Earnings vs bonds: $66,034 (8.8% better return)

What this shows me is that, if you have the patience and long-term outlook necessary, using the metrics outlined by Stein & DeMuth appears to offer slightly better returns. In their book , they showed higher returns (20%), but that could simply have been the timing of the book – right after the dot.com crash.

I will probably continue dollar-cost averaging in my 401K and Roth IRAs across a spectrum of investments with my allocation. I will also probably use some of this timing strategy with my “funny money.” I’ll let you know how I’m doing.

Anybody out there with an interesting market timing strategy?

 

Mr. 39 months

Income investing – a basic portfolio of stocks, REITs and bonds

 

Intro

My father passed away in 2004, at the age of 70.  He was fairly frugal and had his investments set up to last for some time, so I inherited part of his IRA account (he had taken his pension/401K and gotten it put it into an IRA when he retired).

For those of you who have not had an “inherited IRA” – when you receive it, the IRS has you calculate your remaining years of life, based on your current age. At that time, the IRS tables said I could expect to live another 41.6 years, and so I had to pull out  1/41.6th of it. Each year, the number drops by 1, so the following year, I had to pull out 1/40.6th of it…..

I kept in with the same investment advisor for about a decade, and it grew as I was only taking out the minimum required. However,  in tracking I found they were always about -1.5% less than what I could have gotten from a regular diversified portfolio that I could set up. I made the decision in 2015 to take it away from them and invest it myself.

As one gets older, one starts to look at how to move from “saving for retirement” to spending your retirement money – and making sure it lasts for the remaining years. The traditional way that has been done is to setup your investments to generate income – through bonds and stock dividends. In the past, you could build quite an income portfolio with a mix of 6-7% bonds and 5-7% dividend stocks.

The issue has been that, with the low interest rates in place for the last several years, bonds have been returning very poorly (1% – 4%) and companies have not been paying dividends (the S&P 500 has been paying out about 2.2% dividends for the last year or two). What is a guy to do?

I picked up an interesting book, titled Yes, you can be a successful Income Investor by Ben Stein (Yes, that Ben Stein) and Phil DeMuth. The book was written  in 2005 (after the dot.com bust, but before the 2008 crash) but the concepts still hold up. They list a variety of income-yielding securities and then tell you how to combine them in a portfolio where you can get maximum yield for minimum risk. The concepts are followed in numerous articles on the web and in finance magazines as well.

The book covers three areas

  • Bonds (IOU’s from companies, you are loaning them money). They pay you back a set amount each year, and then the loan amount when the loan is due
  • Dividend paying stocks: Companies take a portion of the revenues and pay them out to shareholders on an annual basis. Depending on what price you purchased them at, this ‘yield’ can be somewhat high. This is in addition to any growth in share price of the stock
  • REITs (Real Estate Investment Trusts): Real estate companies that are created as trusts have special tax rules, but they must pass on a significant amount (90%) of their profits in dividends. This makes them good income producing stocks, but they can be risky (see 2007 real estate bust)

They end by providing sample portfolios with actual companies or mutual fund recommendations.  Some of the approaches are very easy (Just 4 mutual funds) and some are somewhat involved (3 mutual funds, 10 stocks, 20 REITs). Overall, it’s a good read, and provides an excellent basis for building your income portfolio.

For my portfolio, in an attempt to keep it simple, I chose to go with 2 bond mutual funds, 4 REITs, and 4 dividend paying stocks. I tried to stick to the book’s proposed 50% bonds, 25% REITs and 25% stocks. My plan was not to reinvest dividends, but to use them to rebalance the account, and to pull out at the beginning of each year when I had to take a required distribution (I am up to 1/29.6th).

For the bond fund, I chose to go with two vanguard low-cost index fund, one that represents the entire bond market (VBTLX) and one that represents intermediate bonds (i.e. 7-10 years) and it’s symbol is VBILX.

For the stocks, I looked at the Dow Jones and S&P 500 for high dividend stocks. I chose Verizon, Caterpillar and Chevron, as they were paying high dividends at the time. I also chose to invest in an ETF fund, in this case the iShares account for preferred dividend stocks, symbol “PFF”.

For the REITs, I started with the list provided by the Stein & DeMuth book, and whittled it down, based on yield, P/E ratio and general company health.

In 2016, they did well, with a dividend return of 3.7%, and capital gains of 6.9% (total of 10.6%). The stocks and REITs did very well, but the bonds pretty much stayed level. Not bad for a portfolio with 50% bonds.

For 2017, I traded out the Caterpillar (it had grown over 50% and my calculations showed there wasn’t much upside versus my new pick, Cisco). Other than that, I let everything ride.

So for early 2017, here is where I was.

% Symbol Name Current Shares Current Price  Current Value Yield Type Dividend
23.4% VBTLX Vanguard Total Bond Index 2814.3 $10.65 $29,972 1.80% Bond $552.47
26.9% VBILX Vanguard Int-term Bond index 3058.1 $11.24 $34,373 2.10% Bond $606.09
5.9% HR Healthcare Realty Trust 250.0 $30.33 $7,583 4.10% REIT $300.00
7.4% HPT Hospitality Properties Trust 300.0 $31.75 $9,525 8.40% REIT $609.00
4.5% O Realty Income Corp 100.0 $57.50 $5,750 2.80% REIT $249.96
7.1% UMH UMH Properties Inc 600.0 $15.04 $9,024 7.70% REIT $540.00
3.5% CSCO Cisco 150.0 $30.24 $4,535 3.72% Stock $168.72
4.6% CVX Chevron Corp 50.0 $117.77 $5,889 5.10% Stock $214.50
12.5% PFF Ishares Preferred 430.0 $37.22 $16,005 5.70% Stock $980.12
4.2% VZ Verizon 100.0 $53.39 $5,339 4.50% Stock $227.25
$127,994 3.48% $4,448.11

 

The overall yield provided is scheduled to be about 3.48%. Nowhere near the yields it used to be, but it gives you some idea of what you could expect this portfolio to ‘throw off’ in the years ahead. Note that this does not include company growth for the stocks and REITs, so you can hope (?) that this keeps pace with inflation.

I’ll report back periodically on how this portfolio is doing.

Kevin