“There’s always something to do.”
“The intelligent investor realizes that stocks become more risky, not less, as their prices rise – and less risky, not more, as their prices fall. The intelligent investor dreads a bull market, since it makes stocks more costly to buy. And conversely (so long as you keep enough cash on hand to meet your spending needs), you should welcome a bear market, since it puts stocks back on sale.”
In the final chapter of his landmark book on investing, ‘The Intelligent Investor’, Benjamin Graham cites the legend of an ancient king who charged the wise men of his time to provide him with a sentence that would always be in view, and which would be true and relevant in all possible circumstances. Their response: “This too will pass”. In other words, change – for the better, or for the worse – is always with us. It is an inevitable part of the human condition. Nobody who has lived through the financial and geopolitical events of 2022 could possibly take issue with the wisdom encapsulated in that brief phrase.
Benjamin Graham himself, “confronted with a like challenge to distil the secret of sound investment into three words,” offers the phrase “Margin of Safety”. In other words, when it comes to investment, concentrate on playing a sound defence. Avoid making obvious mistakes, the most obvious being overpaying for investments (or owning bonds at any point over the last five years, say ?), and the long term returns will take care of themselves.
To these two pieces of wise counsel we offer a third, and it comprises just two words. Capital Allocation. The best CEOs – and the best asset managers, for that matter – are masters of capital allocation, of stewarding their companies’ resources to where they can obtain the best possible returns with the least risk. This is consistent with behaviour that is entirely aligned with the interests of shareholders (and the best CEOs are invariably some of the largest shareholders of their own companies – they eat their own cooking). This is not just about squeezing the maximum returns out of a company’s capital. It also requires a focus on controlling costs that an outsider might regard as obsessive. Our favourite example is Tom Murphy of Capital Cities Broadcasting. Murphy realised that while you couldn’t control all of your revenues at a TV station, you could at least control your costs. He therefore deployed constant vigilance when it came to shepherding his company’s resources. Murphy was once asked to redecorate the tired old former convent building that housed the TV studio in order to project a more professional image to advertisers. He responded by painting the two sides of the building facing the road. The other two sides he left untouched.
So whatever other attributes a listed company might have, it helps enormously to have disciplined, shareholder-friendly management at the helm, ready and willing not only to say no to an acquisition at the wrong price, but also to refuse to spend money on expenditures that can’t be justified in a world of finite capital. Again to use an example from Capital Cities, Phil Meek, head of the company’s publishing division, ran an operation including six daily newspapers, several magazine groups and a stable of weekly shoppers, with just three people at headquarters, including an administrative assistant. Warren Buffett’s Berkshire Hathaway is run with exactly the same ethos, with just a skeleton crew at headquarters managing, and allocating, the company’s substantial resources and revenues. In her biography of Buffett with the same title, Alice Schroeder conjures up the image of ‘The Snowball’ – a constantly compounding profits engine, gathering momentum as it rolls downhill. Any capital expenditure that subtracts value from the enterprise also starves the business of the profit “snow” that it needs to continue its journey of expansion. A dollar frittered away today is worth perhaps ten dollars in future revenue. So don’t waste even a dollar. As the saying goes, look after the pennies, and the pounds will look after themselves.
While ‘value’ is somewhat objective, it cannot be assessed in any way without some recourse to price. So which metrics can we use to get a broad idea of whether a given stock offers the potential to be a great ‘value’ investment ? Stock price in isolation is a very crude tool. While we clearly want to buy great companies cheaply, a seemingly low stock price relative to a historic range isn’t enough. We need to assess how the company is performing as a going concern, not just as a share certificate whose price is shown on a screen.
Benjamin Graham warned that
“Investors do not make mistakes, or bad mistakes, in buying good stocks at fair prices. They make their serious mistakes by buying poor stocks, particularly the ones that are pushed for various reasons. And sometimes – in fact very frequently – they make mistakes by buying good stocks in the upper reaches of bull markets.” [Emphasis ours.]
It is difficult to go wrong by buying “good stocks at fair prices”. When Graham alludes to stocks “that are pushed for various reasons” he is politely referring to the malign workings of Wall Street brokerage firms, who are never happier than when promoting the new, new thing. But the last part of this warning is the most relevant today. Investors are running serious risks by “buying good stocks in the upper reaches of bull markets” – and it now feels that the market for so-called ‘growth’ has gone distinctly ex-growth.
Benjamin Graham recommended using the following valuation metrics to ensure that a potential investment offered that elusive ‘margin of safety’:
Let’s briefly look at each in turn.
Value investing is all about defence. Heavily indebted companies offer very little margin of safety, especially in a period, like now, when interest rates are starting to rise – and in this case from an ultra-low base. Many US companies have borrowed in the bond market in order to buy back their own stock. Those that have paid high multiples of book value (the net asset value of a company) to do so may well come to regret it. Whereas stock dividends are optional, bond coupon payments are obligatory. Fail to service your debts, and you run the risk of losing control of your company to your creditors.
Benjamin Graham’s second metric here, the current ratio, is another measure of safety. The current ratio is a measure of liquidity: it shows the current total assets of a company – both liquid and illiquid – relative to the company’s current total liabilities. Before selecting a company to invest into, you want to be as sure as you can that that company has enough cash and liquid assets to survive whatever storms the economy can throw at it. Given that we seem to be sailing into choppy waters, it helps if companies have plenty of liquid assets to tide them over if things get tight.
The third metric – positive growth in earnings per share – should be self-explanatory. You want a company to be growing its earnings. You want that company’s earnings to be higher today than they were five years ago. You also want to avoid companies that have incurred earnings deficits during the recent past.
A stock’s P/E, or its price / earnings ratio, measures the company’s current share price relative to its earnings per share. It can be calculated by simply dividing the market value per share by per-share earnings. If a company’s P/E ratio stands at 10 times, then for every share purchased it should take 10 years of cumulative earnings to equate to the current share price. All things being equal, investors will prefer to buy more earnings for every dollar they pay, so the lower the P/E ratio, the less expensive the stock.
A word of caution is required at this point. Earnings can be affected by one-off gains or losses, so it’s important to see the P/E as part of a trend, rather than taking one discrete sounding. This is why Robert Shiller uses 10 years’ worth of corporate earnings when constructing his CAPE ratio – it smooths out a lot of shorter term noise.
Another caveat. The management of a company can manipulate reported earnings in order to meet earnings expectations – and earn on the back of stock options. Investors should therefore treat reported earnings with a degree of healthy scepticism. For this reason we recommend using another metric as well to assess corporate profitability, namely Enterprise Value to Cash From Operations (EV/ CFO). More on this shortly.
Price / book is calculated by dividing the current share price by the most recent book value per share of the company. Book value offers a good – though not by any means perfect – indication of the inherent value of a company. Book value shows you the difference between the company’s total assets and its total liabilities, and is calculated from the balance sheet. If a company has total assets of $100 million and total liabilities of $80 million, its book value stands at the difference, or $20 million. If the company’s equity market capitalisation was $20 million, it would then be trading at 1 times book, and if its market cap. was less than $20 million it could be said to be trading at a “discount to book”.
One limitation of book value is that it will tend to discriminate between capital-intensive ‘old economy’ businesses such as railroads – which have lots of physical assets – and capital-light ‘new economy’ businesses such as software companies, where the company’s main assets go up and down in the lift all day. Book value therefore isn’t so useful for assessing the value of businesses with significant intellectual capital, but it remains valid for businesses with lots of solid assets.
Benjamin Graham’s last criterion – dividends – is another sanity check. It may take time for your discounted ‘value’ stock to trade up to a share price closer to its inherent worth. In the meantime, sit back and enjoy your dividend income. The return figures for income-generative stocks may also surprise you. For 200 years, the US and UK stock markets have delivered, on average, real annual returns of between 6% and 7%. (Clearly, some years have been negative, but on average and over the longer run, returns have been positive.) Of those 6% to 7% returns, compounded dividend income accounts for roughly 5% or so. In other words, if you don’t own dividend-yielding stocks, you are playing the wrong game.
Let’s pop quickly back to EV/CFO. Enterprise Value (EV) is the sum of a company’s equity market capitalisation and the value of its debt. Enterprise Value / Cash From Operations highlights the company’s cash yield on its invested capital, both equity and debt. Cash flow is simply a more honest form of earnings than the reported earnings figure – which, as we’ve seen, can be manipulated by less scrupulous management. Also, dividends can’t be paid from earnings – they can only be paid out of cash flow.
When you divide Enterprise Value by Cash From Operations, you’re effectively working out how many years it would take to buy the entire company using operating cash flow to buy up all its outstanding stock and pay off all its outstanding debt. If you turn a company’s EV / CFO ratio around (and calculate Cash From Operations divided by Enterprise Value), you get that company’s cash flow yield. Cash From Operations is a more useful valuation measure than simple profits because it’s unaffected by accounting entries like depreciation and amortization, or cash flows from activities relating to financing or investment.
The more of these metrics that you use, the broader your knowledge of a given company will be – and, in an ideal world, the closer you’ll be to identifying high quality stocks that also possess that elusive ‘margin of safety’.
We use the word ‘elusive’ for good reason.
Given the dismal yields currently available from bonds and cash deposits, investors have, understandably, herded into equities offering some semblance of yield. Investors have favoured the shares of mega-cap global consumer brands that offer the perception of being bulletproof by dint of their consumer franchises. This has led to a trend in so-called “expensive defensives”. Benjamin Graham recommended buying stocks trading on a price / book of less than 1.2 times and on a p/e ratio of less than 9 times. Now try finding any stocks with those characteristics in the markets today.
The sort of business we do happen to like is a diversified holding company for the little-known Boston-based Bresky family. They’ve made their fortune through a vehicle called Seaboard Corporation (stock ticker SEB on the New York Stock Exchange; ISIN code US8115431079; current share price at the time of writing $3954). Seaboard is the largest US pork producer and the company has food processing interests across North America and milling assets spread throughout the developing world, including regions with strong growth potential). They also have an international container shipping business, produce sugar and alcohol in Argentina, and process jalapeños in Honduras.
Our first reason for liking Seaboard is its track record. The management are great capital allocators. Shareholders have reaped their due reward: Seaboard shares have more than delivered the goods (see the price chart below). Our second reason is valuation – the shares currently offer a healthy cash-flow yield of over 19% and Seaboard’s share price currently stands at around just 1 times book.
The chart below, we think, is hugely instructive – and not just for investors considering purchasing Seaboard, but for all equity investors.
Seaboard stock (in white) versus book value per share of Seaboard (in green) and the S&P 500 (in purple), 1990 to 2022
Source and price data: Bloomberg LLP
There are three lines on the chart.
The purple line on the bottom shows the S&P 500 stock index. Over the last 20+ years, the S&P 500 has gone up by 1160%.
The white line shows Seaboard stock over the same period. Over the last 20 years, Seaboard stock has returned over 2970%.
Now consider the third line – the green line shows you the growth in Seaboard’s book value per share, over time. This figure is only reported four times a year, when the company releases its quarterly results.
What this chart shows, with crystal clarity, is that while growth in book value over time is relatively steady, the share price is anything but. In other words, while Seaboard management was quietly going about its business of value creation and sensible capital allocation, Seaboard shareholders were all over the place. At some times – 2007 is an obvious example – they were euphoric, and willing to pay a significant premium to book value to own the stock. At other times – 2008 / 2009 another obvious example – they were depressed, and only willing to pick up Seaboard stock at a meaningful discount to its book value. Meanwhile, the company simply kept on growing its intrinsic value.
So it’s entirely reasonable to expect a high quality company with disciplined, shareholder-friendly management, to grow its book value (or intrinsic value) over time. It’s also entirely reasonable to expect the company’s share price to track that growth in intrinsic value over the medium and longer term. But there are clearly occasions when shareholders (“the markets”) get carried away, and pay over the odds, just as Benjamin Graham warned. And there are similarly occasions when shareholders become unduly pessimistic and the shares offer a tremendous opportunity to patient value investors – provided the company and its underlying prospects haven’t changed. The most powerful returns will come to investors who a) recognize an exceptional business when they see it and b) have the discipline to strike when the iron is hot. Again, that requires a degree of patience. The Canadian value investor Peter Cundill wrote in his autobiography:
“The most important attribute for success in value investing is patience, patience and more patience. THE MAJORITY OF INVESTORS DO NOT POSSESS THIS CHARACTERISTIC.”
Seaboard stock already meets our criteria for investing – but truly patient investors might wish for an opportunity to buy it at even cheaper levels.
And the company has one other thing going for it. The jewel in Seaboard’s crown is its 50% interest in Butterball, the largest producer of turkey products in the US. Since Seaboard doesn’t have full control of Butterball, the holding is valued at cost at $356 million on the company’s balance sheet. On a fair value comparison with Butterball’s competitors, however, that holding in Butterball is worth perhaps $1.8 billion. Seaboard has a history of disciplined capital allocation, of increasing the efficiency of its operations and then often selling them on to a competitor. Were Seaboard to do this in the case of Butterball, its book value would increase by roughly 40%.
So while certain markets, and many parts of the US markets, appear overvalued, in the words of Peter Cundill, again,
“There’s always something to do.”
As you may know, we also manage bespoke investment portfolios for private clients internationally. We would be delighted to help you, too. Because of the current heightened market volatility we are offering a completely free financial review, with no strings attached, to see if our value-oriented approach might benefit your portfolio -with no obligation at all:
Tim Price is co-manager of the VT Price Value Portfolio and author of ‘Investing through the Looking Glass: a rational guide to irrational financial markets’. You can access a full archive of these weekly investment commentaries here. You can listen to our regular ‘State of the Markets’ podcasts, with Paul Rodriguez of ThinkTrading.com, here. Email us: email@example.com
Price Value Partners manage investment portfolios for private clients. We also manage the VT Price Value Portfolio, an unconstrained global fund investing in Benjamin Graham-style value stocks and specialist managed funds.
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