Good companies at cheap prices
Posted on August 26, 2009 by Richard Beddard
Filed Under Companies, Investing, Markets |
In practice
A random walk down Wall Street
How soon my ‘extended break’ ended. Now it feels like a mini-break and while I’m looking forward to resuming our discussions about the state of the market, and interesting companies, a bit of me is still in the middle of the Atlantic 
All I got from Bermuda (apart from happy memories and lots of pictures) was, predictably, a T-shirt. On the back it says “The drinking will continue until the economy improves”.
In New York, we took a random walk down Wall Street (see the picture) but back at work, research seems a better option than drinking, as often recessions are when shares are cheapest. To my irritation though, the authorities have declared the recession over and the market seems to believe them. Some of the opportunities have gone, at least for now.
The average long-term price earnings ratio is 12, by no means exuberant, but not as enticing as its low of 8 in March when the typical company was in absolute bargain territory (costing less than ten times its annual earnings (profits) per share averaged over at least five years).
Since averaging corporate earnings smoothes out the peaks and troughs of the business cycle it’s a truer method of measuring earning power (or typical profits) than a single year’s profit figure. Price earnings ratios calculated using many years of profits tell us whether companies are cheap or expensive compared to their earning power, or, since those earnings belong to shareholders, the return they might expect through dividends and/or a rising share price as the profits are re-invested in the business.
To make it easier to choose which potentially cheap share to investigate next, I’ve ranked my list of shares that are cheap, and financially strong, and despite the rising stockmarket, there are plenty of potential bargains. The data is from Sharelockholmes.com.
Because I’ve changed the format, here’s an explanation of the column headings.
10yPE
The ten year price earnings ratio is a measure of value. Assuming a company is as profitable in the future as it was in the past and an investor buys shares at a price of ten times its earning power, he should, in theory, get a return of 10% a year. That seems like a good deal. So long as the investor is fairly confident the company will still prosper, the share looks cheap. If the investor pays more, say 14 times earnings, the annual return will be lower (7%), a less good deal, unless the company’s prospects seem very bright. It’s easy to get carried away by a company’s prospects though and pay too much for a share, reducing the return. Buying shares on low PEs reduces that risk, and therefore increases returns.
10yCF
The ten year price to cashflow ratio is also a measure of value. It’s the same as the ten year PE ratio except instead of averaging accounting profit, it averages the cash profit made by the company. Ultimately the company needs cash to pay its bills so arguably cashflow is more important. Just as with the price earnings ratio, a low price to cash flow in an otherwise healthy company implies the shares are cheap.
FS
Piotroski’s F_Score is a measure of financial strength and helps us judge whether the company really is healthy. It’s like a credit score, rating companies highly if they are profitable, profitability is improving, they are paying off debt, consuming less cash as they operate and relying on their own profits to fund their business. Needless to say, unprofitable companies raising funds from creditors or shareholders score less well. Statistically companies with low F_Scores are more likely to go bust, and earn investors lower returns.
GG
Graham Gearing is a much blunter measure of financial strength. It compares what the company owns (its total assets) to what it owes (its liabilities – bank debt, pension liabilities and so on). I named it after Benjamin Graham, who invented the measure. Graham thought companies that owned more than twice what they owed (total liabilities are less than half of total assets) were financially strong.
The point of all this number crunching is to find unappreciated companies. Good businesses at cheap prices that the stockmarket should, one day, value more highly. But sometimes the numbers obscure important details. A company may have changed its business so radically that its past earnings history ceases to be relevant, or, like newspaper businesses today, it may face challenges that put its future profitability in grave danger. It’s assets may be cash, which we can value with certainty, or goodwill, an accounting convenience that could be written off in a note to next year’s accounts.
Sometimes data is simply wrong, and because some of it is reported only annually, it can be a year out of date, so the job of verifying the numbers and interpreting the story they tell remains.
Though a bit of me might still be in Bermuda, from today it’s business as usual.
In theory:
Imperfect Efficient Market Hypothesis
The Economist reviews Wall Street Revalued, by Andrew Smithers, which introduces ‘a coherent and testable economic theory’ that demonstrates markets can be valued. He calls it the Imperfect Efficient Market Hypothesis.
Talking of valuation, the author of three modern textbooks, Professor Aswath Damodaran, has webcasts of all 26 of his equity valuation classes on his website, and a mountain of data to mine.
And talking of datamining, here’s How to predict past US stock returns with 99% accuracy from butter production in Bangladesh and sheep population.
Megan McArdle says value investing might not survive Warren Buffett, Greenback’d says ‘phooey’.
Coming soon: Warren Buffett the cartoon.
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