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Author: MrTompkins Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 20076  
Subject: WWJGII Date: 11/17/2012 9:09 AM
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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.

Matthew
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Author: stillwater9999 Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 12383 of 20076
Subject: Re: WWJGII Date: 11/17/2012 9:36 AM
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Are you only looking at large caps?

sw

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Author: MrTompkins Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 12384 of 20076
Subject: Re: WWJGII Date: 11/17/2012 9:58 AM
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Yes for now, but the process works for small & mid caps as well. I don't know that I would put the effort to have a small cap value group but it is possible.

Matthew

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Author: stillwater9999 Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 12386 of 20076
Subject: Re: WWJGII Date: 11/17/2012 10:20 AM
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Is the Boring Board you mentioned inactive (appeared to be when I looked for it)?

sw

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Author: MrTompkins Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 12388 of 20076
Subject: Re: WWJGII Date: 11/17/2012 10:53 AM
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The original board members left long ago.

http://boards.fool.com/boring-is-here-10000593.aspx

Here is post #1.

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Author: LeKitKat Big gold star, 5000 posts Top Favorite Fools Feste Award Nominee! Feste Award Winner! Old School Fool Global Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 12393 of 20076
Subject: Re: WWJGII Date: 11/17/2012 2:00 PM
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If it's not worth doing, it's not worth doing well.

Quote from the founder--well worth remembering

Hi Matthew

this is really great. Where are you getting the 20 quarter data? And are you putting a lot of the information in by hand? Do you think this system would be at all useful looking at annual numbers rather than quarters? maybe 8 years of annual data and 8 quarters? I ask because that's what I can easily get from 10K Wizard

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Author: MrTompkins Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 12394 of 20076
Subject: Re: WWJGII Date: 11/17/2012 3:37 PM
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Jean,

I probably have run through several dozen and I would say that stock splits are the number 1 issue that I have to adjust for. Other than that there are a few issues that I have had to correct manually.

If you want to capitalize operating leases or R&D or adjust for options then that would have to been done manually and would increase the workload. I would consider these exercises if you want to generate a discounted forward valuation(EVA, FCFF, etc.)

Otherwise everything is populated dynamically based on the ticker.

As for the data it is with the smf-addin by fellow Fool rharmelink and I use advfn.com for the information. Because it is dynamic you can pull information on any ticker so I have a basic template and then save the template for each ticker. I think that using a template customized for a specified sector/group might also make sense.

(For setup I have Fedora running Open Box and a virtual Windows Machine using Excel 2003 w/ the smf-addin. Using Google docs would be a great way to share some of the work but haven't had the time to figure out the best way to present it. Seeing is believing.)

Matthew

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Author: TMFHockeypop Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 12399 of 20076
Subject: Re: WWJGII Date: 11/18/2012 6:06 AM
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Matthew,

Have you tried running this idea through the Mechanical Investing Board? They seem to be the guru's of data and interesting results if I understand what you're trying to do.
http://boards.fool.com/mechanical-investing-100093.aspx?mid=...

bob
RYR Home Fool

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Author: MrTompkins Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 12403 of 20076
Subject: Re: WWJGII Date: 11/18/2012 10:43 AM
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Hey bob,

The mechanical nature is pulling data and creating a repeatable process. To be clear this is still a fundamental valuation process that is trying to emulate a low vol, high qual, value strategy. Currently I can screen for ~48 names that sit in both the S&P500 low vol index and the S&P500 high quality index. GMO has a high quality fund that has 13 of these holdings and a fair amount of others as well. My goal is to take the smallish pool of 48 names -- and be able to rank them in order of attractiveness so that I could create a portfolio of 25 names that are likely to outperform the SP500 both on an absolute and risk-adjusted basis. But at the end of the day its still a judgement call. From a portfolio manager perspective -- consider this a portfolio that is 100% invested at all times -- so no market calls or shifts to cash.

There isn't any backtesting or mechanical rules like using a 10-Month Moving Average or relative momentum screen. Hopefully this portfolio could sit in an open brokerage account and with little turnover be an attractive long-term port with tax efficiencies etc.

Matthew

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Author: RaptorD2 Big gold star, 5000 posts Top Favorite Fools Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 12479 of 20076
Subject: Re: WWJGII Date: 11/27/2012 11:02 PM
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It seems that all your goals might be met by simply building a screen in SI Pro, eliminating all the manual processes. This would also allow you to do a little bit of back-testing. Just an idea.

I also wonder if you've ever peeked in at the BMW board.

Personally I think you're on the right track with comparing current to historical price-related trends. After 8 years, I'm still working on my own 'formula.' :) Seems all of my past tools worked until, well, until they didn't. Anyway, SIPro sure saves a lot of time and drudgery.

Dan

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