Where the value is…

It’s here! In the UK!

Bad news for US investors. According to Robert Shiller’s cyclically adjusted PE (CAPE) stock market prices are back in the most expensive quintile. US stocks are nowhere near as expensive as they were in 2000, say, but for more than 80% of stock market history since 1881 they’ve been lower [click for a larger, sharper chart]:

As the chart below shows, investors haven’t done well when prices are high [click to enlarge]:

Soc Gen Analyst Dylan Grice, whose reports I’ve culled for this blog says:

If history is any guide, those investing today can expect a whopping 1.7% annualised return over the next ten years.

So what’s a hapless investor to do? Well, he could sit on his hands and wait, perhaps years, for prices to fall, or go hunting for companies that appear cheap, even though the market in general isn’t.

Grice goes hunting, using Stephen Penman’s Residual Income Model¹. He only gives us a glimpse of how the model works:

…all I really do is assume that a company which earns only its required return is worth no more than its book value. By capitalising expected excess returns (defined as RoE less required return) onto book value I arrive at an intrinsic value which I can compare to the market price.

In other words, if an investor is to buy shares in a company he must cover his costs: the interest he’d lose by not investing in so-called risk-free government bonds, and compensation for the extra risk of investing in shares. This is the required return (also known as the cost of capital). Anything earned on top in the future is a bonus, and adds to the company’s intrinsic value now. The word intrinsic differentiates the price an analyst puts on a company’s shares, from its market price.

Grice, who uses consensus analyst’s estimates of future earnings, says it works. Companies with high intrinsic values relative to the market price do much better than companies with low intrinsic value to price ratios (IVPs).

Aggregating IVP ratios can tell us if markets are cheap or expensive. So what do market IVPs tell us now? The value’s here, in the UK, the only country in Grice’s survey where intrinsic values exceed market prices [click to enlarge]:

Estimating future profits and calculating intrinsic values, is a step further into the dark art of financial analysis than I’m currently prepared or able to go. But Grice’s conclusion is, to a degree, supported by my calculation of the UK market’s long-term PE (a similar measure to Shiller’s CAPE), which suggests that the UK is not cheap, but it’s not expensive either.

Globally, the value is hiding in companies exploiting natural resources [click to enlarge]:

For example, Grice says:

…integrated oils are cheap. True, they always seem to be. They’re too big and have gone ex-growth. But the long-term growth numbers I’ve used for them (e.g. Royal Dutch Shell) are actually negative so they allow for this. And if we overpay for strong growth, mightn’t we underpay for weak growth? According to Factset, Integrated Oils have been one of the best-performing sectors over the last 15 years returning 12.3% annualized, against 8.5% for the World.

Here’s a full list of larger companies worldwide with an estimated intrinsic vale higher than their market prices [click to enlarge]

Six of them:

1. AstraZeneca
2. BP
3. Kingfisher
4. Royal Dutch Shell
5. Vedanta
6. Carnival

… are listed in the UK.

I have a shorthand way of finding cheap companies, the long-term PE, a close relative of Shiller’s CAPE, which I marry to measure of financial strength. It’s relatively rare for successful multinational companies to be cheap according to this measure, and I don’t profile the ones that are, because I think generally:

1. There’s more value in smaller stocks, and…
2. …They’re too complex for an individual to appraise in, say, a day!

But here’s a list of the big UK listed companies that have recently appeared in my Thrifty 30 shortlist:

1. AstraZeneca
2. BP
3. Royal Dutch Shell
4. Unilever
5. Vodafone
6. Xstrata

Notice any similarities?

-

Footnotes

1. Described in full detail in Penman’s excellent textbook: Financial Statement Analysis and Security Valuation.

-

Stupid goodwill

UK Value Investor reckons the FTSE 100 is 15% under fair value.

In 2003, Professor Jeremy Siegel argued market PE ratios should be higher than historical norms because: “…We can avoid crises such as banking collapses, great depressions and double-digit inflation. We also have a much more liquid market. Transaction costs are much lower. We have a favorable set of taxes on equities.” I wonder if he’s still confident about that PE ratio.

Aswath Damodaran breaks goodwill down into ‘stupid goodwill’ and ‘smart goodwill’. Are you feeling smart?

Judging by Unilever’s share price, ceo Paul Polman has had a flying start, but, he says: “I’m not driven and I don’t drive this business model by driving shareholder value. I drive this business model by focusing on the consumer and customer in a responsible way, and I know that shareholder value can come.” To understand why, see John Kay’s book, Obliquity.

Why should we learn from Robert Rodriguez about the sub-prime crisis? He “… Actually did the careful, detailed work and… figured out, in real time, the dangers of what was transpiring,” says Jeff Matthews, inspired by Robert Lowenstein’s book, The End of Wall Street.

A wonderful chart [pdf] of over a hundred years of the Dow Jones Industrial Average.