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Investment Analysis Clubs / Value Hounds
|Subject: WWJGII||Date: 11/17/2012 9:09 AM|
|Author: MrTompkins||Number: 12381 of 22319|
I have set out on a mission to rank companies by a relative measure to create an attractively valued portfolio of ~25 firms. The idea is the combination of low volatility (low beta), high quality, and fair value – essentially WWJGII (What Would Jeremy Grantham Invest In). The kernel of the idea started with the paper Buffett's Alpha (Frazzini, Kabiller, and Pedersen) and to find a way to create a repeatable process. I work much better when the opportunity set has been greatly reduced (25 versus 2,500).
On the road here to hopefully a successful process I wanted to share some of my efforts to give back to the community but also for constructive feedback. I don't want to disappoint anyone here, but this exercise is more on valuation and corporate finance than finding the next 10 bagger (although they are not mutually exclusive! Also the focus is on large caps but the logic can and should extend to smaller capitalized companies).
A bit of background might be in order. My introduction (and appeal) to the Fool was mainly through the Boring board. One of the things I picked up from the Boring Board, Fool on the Hill, etc. was the concept of EVA. So the prism I look at the investment world is largely shaped by Buffett's advice to think of stocks as companies and the concept of economic profits and invested capital.
So the process is pretty straightforward. First I have to keep it simple because what I am doing – anyone with Excel (sorry LibreOffice won't cut it) can do. No Factset, Capital IQ, or Thomson Baseline required. Essentially I am taking the last 20 quarters of financial data and creating a recent history of how a company has been valued relative to its invested capital. (I am using 20 quarters of data because that's the most I can get via the web.)
Now a challenge is that you want to create a reasonable historical view of the firm to get an accurate market multiple. To do that I use the actual closing prices and use the average closing price (not adjusted for dividends) for the quarter to calculate the EV for the quarter. Therefore the rolling 20 quarter history is the EV at that time and is unadjusted for cash distributed to shareholders via dividends.
I am using the Enterprise Value-to-Invested Capital (EV/IC) multiple as my main tool for valuation. In other words I am not making calculations on ROIC, WACC, or IC growth. I would likely make forward estimates only if I was doing more due diligence on a specific firm. Based on my review of valuations from Morningstar, who I believe also values equity by first estimating value at the firm level, my implied value numbers are pretty consistent with the more involved forward projecting DCFs exercises.
As a reminder, a company that creates value will trade at a multiple greater than 1. A company that doesn't create value but doesn't destroy value should trade at a multiple of 1. And a company that destroys value should therefore trade at less than 1X its invested capital.
For instance the 10 largest utilities that make up the S&P 500 utility sector has traded at roughly .86X the groups invested capital. That doesn't mean you can't find value but that the sector based on this analysis indicates the industry itself doesn't create value. The actual range was from 1.1X (Dominion Resources) to .72X (Duke Energy & PG&E). Based on recent price data I calculated that this group was trading at ~90% of its implied value while M*'s fair value implied 88% of fair value.
Here is an example of the process using Wal-Mart (WMT)
5YR EV/IC Multiple: 1.9X
Implied Equity Value: $68.17
Current Market Value: $68.03
The implied value again is 1.91X the companies IC ($144.6B) net of its cash/debt position. As a reference check, M* recently (11/15/12) raised its fair value from $61 to $72. Not to be overly critical on M* but I get the sneaky suspicion that the analysts play some mark-to-market games with their values. Not always, but something that is likely a bias in their numbers and just the nature of the beast.
So what to do? Previously I noted that Intel looked interesting as a value stock based on its low current valuation compared to its normalized 5YR EV/IC implied value (as well as the dividend yield). Could we have profited from the same analysis with Wal-Mart?
I believe you could have. Wal-Mart has ranged over the past 20 quarters from 1.65X (Q3'11) to 2.18X (Q2'08). While purchasing Wal-Mart in Q2'08 in the mid-$50s has taken some time to create value – you did receive some value. The underlying capital, which creates incremental value due to its positive economic profits, grew at 4%-5% and you received dividends along the way. However purchasing Wal-Mart in the 2011 fall market swoon turned out to be the best time when the firm value was trading at 1.65X its invested capital.
And that is the crux of WWJGII and Buffett's Alpha in my opinion. The power of reversion to the mean on valuations based on normalized capital multiples using a low volatility, high quality company opportunity set. I believe you greatly increase your odds of solid returns when buying at reasonable to low market valuations. I would have never guessed that Wal-Mart could have made the run it did but based on the long-term averages – it makes a lot more sense.
I will wrap up with a thought on a real-time debate on Proctor & Gamble (PG). My implied valuation is $61.48 (which is 1.78X its 5YR EV/IC multiple). With P&G trading at $66.82 I would argue that it is not a buy at these levels. Therefore, if I had to chose between Berkshire Hathaway or Pershing Square on the better investment action – I would go with Berkshire.
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