Monday, July 7, 2014

Selling cheap to buy cheaper

I apologize for the lack of recent posts, in many ways it' a bit unusual.  I started this blog in 2010 and became serious about blogging during 2011.  Since then I set a goal of posting twice a week.  If you look at my post history you can see a giant gap over the last few weeks.  We took a nice long summer vacation and I decided to abstain from posting while away.

We drove from Pittsburgh down to New Orleans to visit my brother, his wife and our new nephew. Then we headed over to Pensacola for some time at the beach.  Before this trip I hadn't spent any time in the Deep South.  It was really nice, we had a great experience.  We had some good food, relaxing days, and I was even able to meet up with a reader for coffee, which was awesome.  While away my inbox filled up and I kept my eyes off the market.

Now that I'm back I want to get back into my two posts a week routine; here's to starting!

A friend emailed me recently musing about buying when the market is falling.  It might sound like a strange topic to discuss when markets are soaring higher, but it's always good to be prepared.  My friend asked my thoughts on selling cheap stocks to buy cheaper stocks in the midst of a downturn.  In his view this is the ultimate act of a investor.  The ability to ignore emotions and sell stocks that at other times would be considered extremely attractive for stocks that one deems are even cheaper.

If an investor wants to have the ability to sell a cheap stock and purchase a cheaper one they must have some sense of potential value.  Is a stock at 50% of book value cheaper than a stock at 60% of book value?  Not necessarily.

Some investors (the disciplined ones) keep spreadsheets of all of their holdings and what they feel is the discount to intrinsic value of each holding.  The investing cowboys, of which I am one, tend to play it a bit more loose.  No spreadsheets are necessary, just a rough gut feel of when a stock is getting a bit frothy.  My own process works as follows.  I will initially research a stock and often will write a post about the stock.  The purpose of the post is to help formulate my thoughts on an idea, and to preserve a record of my initial thinking.  If I like the stock I make a purchase and usually forget that I even own it.  I don't follow the news for stocks, or set alerts.  I will check my entire portfolio on  a semi-regular basis.  I check each stock for news or activity and then go back on ignore mode.  If during my check I notice a stock that's run up significantly I will look for news, and evaluate if I need to sell out of the position.

When considering my investments against each other I like to look at what I consider their potential value.  This is the stock's undervaluation plus their business value.  In Security Analysis Benjamin Graham discusses selling a stock after three to five years if it hadn't reached intrinsic value.  I want to walk through an example of how I calculate potential value.  Let's take a stock at 60% of book value that's earning 3% on equity.  Many readers bash stocks I pick with low returns on equity, but maybe understanding how I view things will help to clarify why some of these low ROE companies can be good investments.

Take the example of a stock that has a book value of $10 and is selling for $6.  The company earns $.30 a year, or 3% on equity.  If the stock reaches its intrinsic value in five years, our maximum holding period, the investor would earn 19% a year.  Between year one and five the company grew their equity at a paltry 3% a year.  Five years of 3% book value growth equals $11.59 in book value at the terminal date.  If an investor held the entire five years, and the stock rose to book value they'd realize a gain of 93%, or 19% a year over their holding period.

The above example shows how even poor companies that don't earn their cost of capital can result in significant gains if the company's market price eventually reverts to intrinsic value.  Of course nothing is guaranteed, and not all investments drift up to what a reasonable investor might consider intrinsic value ever.  At times management is directly opposed to shareholders and works to keep the value of the company low.  Other times there are structural factors that keep the value of a company low forever.

If one believes in the concept of mean reversion then this theory holds.  The key variables to the equation are the company's intrinsic value, and the time period of the holding.  If a short time period is used then potential returns increase.  If a longer period is used then potential returns decrease.  There are a few investments I hold where I've figured that even with a 10-15 year holding period my potential returns could be well above 15% a year.  It's situations like that where I'll potentially hold a stock for a decade or more.

So what does the idea of potential valuation have to do with selling cheap stocks to buy cheaper stocks?  It's the only way I can think of that one can rationally rank investments in a way that lets them compare two potentially cheap investments.  I mentioned above that a company at 50% of book value might not be cheaper than one at 60% of book value.  If the company at 60% of book value is earning 8% on equity and the one at 50% is earning 2% the company selling at the initially higher price is cheaper overall over the same holding period.

When a stock appreciates towards what I might consider a fair value I will go through this exercise to determine out what the potential return is for the stock going forward.  My personal hurdle rate is 10-15% a year.  My hurdle probably seems low for most readers, but if I can earn between 10-15% a year for the next 30 years I'd be extremely satisfied.

In a downturn an investor could use the above system to classify all of their investments.  Then evaluate new investments against the set of current investments.  A company with a potential return of 20% a year could be sold to purchase a company with a potential return of 30% a year.

The caveat with this system is that in a downturn it's hard to know what past numbers could be repeated in the future, and secondly you need to invest in companies that will survive.

I want to come full circle and answer my friend's question.  I agree that selling what's cheap to buy what's cheaper is the ultimate test of emotions.  An investor in that situation is facing a portfolio that's  losing value, and they are out of cash if they're in this situation.  They need to ignore their gut and trust the numbers, sell companies with low expected returns and purchase ones with higher expected returns.  I don't know what different in potential return is meaningful, but I think it's an individual preference.  Based on the potential error from estimated time ranges I wouldn't be exchanging stocks for a few percentage point differences in potential returns.  But I would exchange something with a 15% potential annual return for something with a 30% potential annual return.

In my own portfolio I like to keep 5-10% in cash at all times.  I feel this gives me the ability to act quickly on a new investment idea should I come across something attractive.  I haven't found my cash levels to be correlated with the market levels in generate.  I'm currently floating closer to the lower end of my cash cushion, whereas a year or two ago I was closer to 15% in cash.  As opportunities become available I take positions.  And if the opportunity has a potential annual return of 10-15% I will seriously consider a place for them in my portfolio.

10 comments:

  1. Nate,
    When will the next issue of your subscription be out?
    Thanks
    Don

    ReplyDelete
    Replies
    1. Don,

      It'll be out this Friday after the market closes. Thanks!

      Nate

      Delete
  2. Glad to see you're back to your regular posting schedule. Always enjoy reading your articles, thanks!

    ReplyDelete
    Replies
    1. Thanks, looking forward to getting back into the rhythm of things!

      Delete
  3. Why would you think a company earning 3% RoE should be worth its Book Value? At that rate, the company is destroying shareholders' value by earning significantly less than the cost of capital.

    ReplyDelete
    Replies
    1. Would like to hear other opinions on cost of capital.

      Cost of capital, in my opinion, is really too theoretical to be of much use.

      The way I'm currently choosing to think about cost of capital is in the creditworthiness of a company as compared to the cheapness or lack thereof in an investment. The higher the financial or business risk the higher the cost of capital. The higher the price paid for any business the lower the cost of capital to the business.

      Using the definitions I just laid out: An over-capitalized bank (low ROE) that could net someone 10-15% a year would probably have a low cost of capital if this bank wanted to raise funds in the future or attract new depositors.

      A company that consistently earns a high Return on Investment has a lower cost of capital and a company that is trading at a significant discount to book value or asset values has a low cost of capital.

      What is the cost of deposit capital to a bank? Since the equity investor gets the benefit of this cheap source of funding is cost of capital is lower, therefore banks, insurance and float generating companies have a lower cost of capital.

      Delete
    2. If the company isn't raising capital to grow the business, then cost of capital may not matter. Assume the company is running the business for cash and retaining the earnings in the bank. They aren't trying to grow the business. In that case, the company should probably trade around liquidation value if/when they decide to close up shop. If the company in the example paid out all of their earnings, the yield would be 5% at $6. 20x is a rich multiple for this type of business. However, 10x earnings and a 10% yield implies an intrinsic value around $3. If they decided to liquidate, an investor might make an acceptable return.

      Cost of capital would be more relevant if they were raising money to grow the business. That would be ludicrous and value would be destroyed rather quickly.

      Delete
  4. Its always a pleasure to read your posts. Your method sounds very familiar to me :).

    ReplyDelete
  5. Hi Nate, interesting post. You seem to assume that book value equals intrinsic value of companies. Disregarding the difference between balance sheet value and market value, this isn't really true.

    If a company has BV of $100 and earns $3 per year like in your example, they are earning sub-standard returns on capital. Think of a junk-rated company issuing a 10y bond with a 5% coupon when their libor+CDS would indicate that they should pay 6%. The intrinsic value of this bond is not 100, it's around 90, and that's where it'll trade.

    The difference with a company is clearly that you have the optionality that they'll start earning highr returns or liquidate the company, thereby realising the value. This potential clearly has a value, but only if that was 100% certain could you argue that intrinsic value = BV.

    If markets were efficient you'd argue that companies earning sub-par returns on equity would be driven towards higher returns, just as high-ROE companies are driven towards lower levels. In reality this isn't true though, and purchasing a company below BV should include some thoughts wirth regards to future ROE.

    /Charles T

    ReplyDelete
    Replies
    1. Book value does not = intrinsic value necessarily but in many cases (notably with financial companies or holding companies) book value or NAV is pretty meaningful.

      The profile of the bank mentioned could be a very interesting acquisition for another banking institution or represent large potential growth if the reason for the bank having low ROE is that they are overcapitalized. If this bank has similar earnings power taking into account differences in capitalization then the low ROE company is a much superior investment. So I would make the argument that an overcapitalized bank has greater safety as well as greater ability to increase earnings than a small bank with a ROE already in the 8-9% range.

      Delete