Friday, July 13

Value Investing in uncertain times


Introduction

This summary analyses the effectiveness of investor tools, support services, methodologies and hedging strategies to facilitate wise investing in today’s volatile market. The outline will have particular appeal to direct investors in the stock market or other asset classes and for those either managing or contemplating managing their own super fund or investment portfolio. Topics include valuing listed entities, other asset classes combed and evaluating research sources. There is an underlying theme to sage investing since the same methodologies can be applied to most asset classes. Many come under the heading of uncommon common sense whilst some aspects will have more of an appeal to those who like to do a lot of analysis. Either way my aim is to be sufficiently broad so that it’s helpful to a wide range of investors albeit there is more emphasis on equities.

However it is important to note this summary is very general in nature since one cannot know or take into account individual circumstances. If necessary, anyone contemplating any form of investment should consult a licensed professional who will be able to take into consideration individual circumstances and investor risk profile.
     
A lot is made about philosophy and the link to the humanities claiming it has nothing to do with business or investing.  But the broader definition of philosophy is – “A set of ideas or beliefs relating to a particular field or activity; an underlying theory”. That is what I propose to pursue with this summary on the basis that value investing is a theory that believes prices will ultimately always follow value    
 The equity market in Australia

When you acquire shares you become part owner in a business not a market.  

By the equity market we are talking about owning shares. It’s important to note at the outset that when you acquire shares in a company you become the part owner of that company to share in the profits from dividends and increases or decreases in the share price. Hence you own a share of that business and not a share of an equity market since ultimately future values are dependent upon the individual returns.

Equity market

The overall market is rarely in a consolidation phase but rather long periods of the so called bull market (sentiment is   optimistic) are punctuated by bear periods where doom and gloom depress prices. But regardless of the cycle there will always be good underlying businesses for the patient investor. Of course, one could opt to simply invest in an indexed fund which mirrors the index, but the objective of value investing is to achieve superior returns to the index.   
          
The average bear market in Australia since WW2 has lasted about 5 years as we enter our fourth year in what could be described as a bear market stock prices have fluctuated within in a band up to 40% below 2007 highs. No one can say for sure when their will be a recovery accepting for certain there will be one eventually- with a rebound of renewed optimism.  Even so, some sectors are struggling sectors continue to be plagued by downgrades.     

On a more negative tone markets could stay stuck in this band as a consequence of continuing shocks from abroad for many more years to come.    

2.00 -A conservative approach underlies value investing

2.1 Keep enough in reserves to avoid forced selling  

A good starting point is to ensure one remains in a strong position 
and avoids any forced selling at temporarily depressed prices. 

Ideally you aim to be on the other side of the transaction as the 
astute investor investing in undervalued stocks. Ultimately prices 
always catch up with value – but not always in logical sequence so that the market prices will continually overshoot or undershoot fundamental values. This applies equally to other asset classes and especially to property when one wants to avoid the spectacle of the “liquidation sale”:      

Individual circumstances will vary but assuming you’re already in 
receipt of an income stream it’s a good idea to have sufficient cash or liquid assets to be able to draw on these reserves if necessary during any unexpected prolonged downturn.  This goes to the heart of good investing - buy when sentiment is low at depressed prices to unlock outstanding value but don’t be afraid to offload at the other end of the spectrum when they overshoot.  Always have enough in reserve to allow you to adopt this conservative stance. 

2.2 -The dangers of gearing (borrowings)   
Excessive gearing was possibly the single most important feature that helped bring on the onset of the global financial crisis and when you added this to trading in leveraged derivatives the explosive mix brought about counterparties going into bankruptcy. Gearing (borrowing to buy securities) or buying into products which are already geared magnifies the losses as well as the gains. Be careful you understand what products do and make a distinction between investing and speculating.

Generally speaking in Australia gearing is prohibited within you self managed super fund to buy securities except for installment warrants. An installment warrant is a derivative and when purchasing warrants whose underlying security is shares you receive all the dividends as if you owned the securities. Installment warrants are issued by Investment Banks who purchase the underlining security, which is held in trust for you until such time, at your option, you purchase the security by paying the final installment at the expiry date.  Warrants are essentially the equivalent of a loan to buy shares, upon which you pay an initial installment and the balance at your option at expiry. The Investment bank issuing the warrants recovers their interest margin and protection costs within the issuance cost for the warrants.  Buying a warrant does not afford you any form of protection that can apply to other forms of derivatives. You cannot write options over warrants but you can buy and trade put (option to sell) and call (options to purchase) warrant options.      

3.00 -Valuing a listed security

3.1 Introduction

Value investing implies choices based upon a value criteria- to determine a risk reward margin and the selection process to identify those reaching this hurdle. In Australia where we have about 1800 listed securities its apparent we are going to need some form of supportive research.            

3.2-Equities 

The risk reward margin is the level of return one would expect over non risky alternatives such as government guaranteed deposits or government bonds.  But before any consideration is given to entities that qualify one needs to weed out any securities considered an unacceptable risk. The degree of comfort an investor wishes to impose will vary – but excessive debts levels, a management or director record of poor governance, industries considered unethical or unsustainable have added elements of risk.  On the positive side entities with a low level of debt and prior good track records for earnings able to fund growth and pay dividends might pass our filters.     

Having eliminated those of unacceptable risks one needs to set a minimum return. There will ways be turnaround stories and start ups with current poor returns.  But given a choice, it’s less risky to invest in an entity that has already a proven track record with equaling appealing future prospects and sound governance.         

The investors expected rate of return is a subjective decision but generally a useful guide is around the 10- 12% mark which is the so called cost of capital. In other words this is the minimum return investors seek under new issuances based on the risk reward scenario.  For the sake of the exercise I will use the figure of ten percent.

In determining value an analyst would typically discount expected future returns using the discounted cash flow method which is in effect compound interest in reverse – in this case using the 10 % discount rate as a reference point.  But to initially illustrate my point I will revert to the more easily understood concept of the commonly used price earnings ratio- the multiple that earnings represent to its share price. Let us assume we are confident this current rate after will continue in the future in the examples provided in our table.   

An illustrative table below indicates preferences for A over B whilst C fails our criteria.     

Table 1
Shares
Earnings 
Share price
Value
Diff
Multiple
A
4.00
35
40
5
8.75
B
2.20
20
22
2
9.09
C
1.50
20
15
-5
13.3

Another easily calculable methodology is to value an entities capital per share on the basis of that expected rate of return.  

All that is needed is to know the total number of shares on issue, shareholders funds and the profit after tax expressed as a percentage of shareholders funds. All of these figures are usually widely available and included in annual reports. The capital per share is a calculation as the total of shareholders funds divided by the average number of shares on issue and multiplied by a factor to find our value.      

The actual securities price then can be compared with this valuation based on this factor where 1.00 equals 10% as our benchmark. If it was 12% then a return of 12% would represent the benchmark factor of 1 and so on.  So if the return is 15% the factor on a benchmark of 10% is 1.5 and so on.

You discard any entities that earn less than 10% or those whose price includes a greater factor that your valuation.  In other words the share price multiple is too high to ensure you’re able to achieve your ten percent return on your outlay.             

An illustrative example is as follows which indicates D meets our criteria whilst E and F on face value fail   :
Table 2

Capital per security 
Earnings 
Return 
Factor
Stock Price 
Value
Difference
D
18.00
2.70
15%
1.50
20
27
7
E
10.00
2.50
25%
2.50
30
25
-5.
F
1.00
.28
28%
2.80
3.80
2.80
-1
        

3.3 Dividend yield and effect of undistributed profits on valuations 

In the earlier tables we have assumed all of the profits after tax have been paid out in dividends which are clearly rarely the case. In the example provided  in  table 1 if half of the earnings were paid out in dividends a dividend yield would be half the earning rate to yield a dividend rate of either 5.7%, 5.5 % and 3.7% respectively for A, B and C but increasing to 8.1%, 7.8%  and 5.4%  if 100 % franking was available. The important point to note is under examples an A and B we have a grossed up dividend yield that already gives us around 8% and there remains undistributed profits to build up further incremental value so long as those returns can be maintained.
This is because the remaining funds in the business (those not paid out in dividends) are earning at a rate that exceeds your benchmark to justify you paying a higher multiple than was illustrated in the previous examples.    
This obviously only applies where your benchmark rate is exceeded – in this case 10%. 
It is crucial to understand the concept of value and to be able to determine the merits or otherwise of securities that will potentially make up your underlying investments.  An excellent source for further reading is Roger Montgomery s book entitled “Value able” - second edition. Roger also provides an on line facility called Skaffold ( click here to visit) which covers all Australian listed entities with pertinent information inclusive of an assessment of their intrinsic value.
 
Roger's book can be purchased by clicking here.    
He's also on facebook at His facebook also has an events section which covers all the tv and radio appearances.
Roger is also speaking at the Trading and Investing Expo, find the webpage by clicking here.  

3.4 Property


The Australian property market is made up of many different 
markets and the sage investor will apply the same principles to 
determining value as was illustrated for securities. What is apparent 
is there is no such thing as bargains since properties are usually 
widely advertised and recent prices are easily ascertained from 
recent history. The idea you can pick up bargains that no one else 
wants is a hope and not a strategy.   
The first point to make is that to achieve value an investment 
property will need to have both a good rental yield and a healthy 
future capital gain. In determining likely future appreciation in rents 
and values the investor will need to impose criteria and rule out 
unacceptable risks. Boxes that might need to be ticked could 
include such things as the proximity to public transport, educational 
and health facilities, median income level, the attitude of councils 
to planning and growth, employment opportunities and whether or 
not the region is supported by growth industries to underpin future 
value.  One needs to determine the key market drivers to future 
value which underpin renter appeal and support growth in prices.

3.5 Interest bearing securities
Interest rate security pays either a fixed or a floating rate of return 
either as interest or dividends.
This class of security has increased in value as larger corporates 
have become more dependent on the debt market to raise capital to 
fund their operations. The debt market comprises of both senior and 
subordinated notes and for those prepared to take on an element of 
risk corporate bonds offer attractive income opportunities with 
recent issuances carrying rates in excess of 7%. Typically they will 
offer low volatility with the prospect of modest capital appreciation 
in any period where we are likely to see declining interest rates.  
The hybrid market as the name suggests are in effect an interest 
bearing security which exhibits both the characteristics of equity 
and of a bond. Hence Preference shares are hybrids which rank 
ahead of ordinary equities but pay dividends and will be redeemed 
at their face value at some future time.
Convertible notes on the other hand are convertible at a future 
point of time into equity but during their issuance period pay an 
interest rate like a bond.  

When assessing these issuances ones need to do the same valuation 
as investing in equities to identify strong financials which underpins 
their value.  

3.6 Other assets classes

 Hedge Funds 
Hedge funds have captured investor interest due to the relatively poor returns over the past few years but little is known about their activities as you can’t be sure about what trades they have entered into. There is no definition of a Hedge Fund which may use both leverage and derivatives to magnify returns regardless of whether or not the market is up or down. However some will also aim to both hedge individual stock exposures and reduce volatility. 

Typically they will have clients from institutions and high net worth individuals.

Hedge funds attempt to earn absolute returns of 15% or more by 
uncovering miss pricing and unlocking value through quality 
research. They don’t provide the certainty of regular income which 
may be important for many investors.

However many of the tools available to the Hedge Fund Manager 
can be accessed by the value investor even adopting a conservative 
approach. Derivative can provide modest hedging and additional 
income and let me provide a number of risk minimization strategies 
and their solutions:

Alternative Investments - Derivative Securities

What is a Derivative?

A financial instrument derived from the value of an underlying security. An examples of derivatives include options. 
An option can be sold by one party to another offering the holder the right, but not the obligation, to buy (call) or sell (put) a security at the strike price at future date.

Buying Options
Options are called either putts or calls. When you purchase an option, you pay a premium to the option writer. Options are complex securities that can carry significant risks.
Buying a call gives you the right to buy a stock from the writer at a specific price during a specific period of time, while buying a put gives you the right to sell the stock to the writer.

You would purchase a call if you expect the market price of the 
stock to rise and purchase a put if you expect the price to fall. 
Hence a call is similar to a long position in a stock, increasing in 
value as the stock's price rises. A put is similar to a short position 

that gains value as the stock's price declines.

Selling Options
The motivation to sell (write) options is to earn a premium. Most investors who sell options hope the purchaser will not exercise those rights. The safest form of option writing is via  a covered call because the worst outcome would be to have shares already owned called away. A much riskier choice is selling naked options.

A naked option is an option for which the buyer or seller has no underlying position in the stock. A writer of a naked call option does not own the stock on which the call has been written. Therefore, if the stock rises and the holder of the call decides to exercise the option, the writer of the naked call will have to
buy the stock at the higher price and sell it at a loss to the option holder.
Using derivatives to help protect portfolio and earn additional income.
Hence options are derivative and can be used for a variety of purposes. They can be used as a Hedging instrument and to earn additional income from your share portfolio. 

As a hedging instrument

Buying an American style put option (an option to sell) over a security or index gives you the options (but not the obligation) during the period of the option to exercise the option if the price falls below at agreed strike price in consideration of the premium paid.

Writing covered calls   

Call options are options to purchase at an agreed future price (strike price). The term covered calls is commonly used to describe an option writer and seller of a call who also owns the stock. Writing covered call generates income     

Before using options it highly advisable you undertake an educational course so you know what you are doing.      

  4.00 Research sources   

By now it’s become apparent one needs support to be able to undertake the analysis to determine value.      
Continued consolidation in Australia of financial services has reduced the numbers of independent research firms,   advisors and brokerages who are now more likely to be aligned to major financial institutions adding to the risk they aren’t always responsive to a client’s interests. Apart from that, brokers, financial advisors and analysts livelihood is dependent upon finding reasons to buy or sell when sometimes the best decision investment decision is the one not made at that time. Nevertheless there are a number of independent and well researched advisory groups and software available.

There is such a wide spectrum of opportunities one would be reluctant to make any recommendations.   

There are a number of sources which can arise from the more 
sophiscated credit scoring platforms, the research arms of 
independent brokers and from financial planners or other sources 
which match your investment philosophy. 

5.00 Diversification – helpful or a distraction? 

A great deal of attention today is given to the value of 
diversification to counteract volatility and create the notion that if 
you spread your wings you’re buying protection. But if you’re 
struggling to assess values in one asset class adding in new 
unfamiliar ones won’t help you one iota. Diversification in itself is 
not a panacea to reducing risk. But understanding the inherent risks 
and being able to value a security will enable you to do this.

Conclusion  
The best person to look after your investments is you – but you need to be passionate and do a lot of homework. 
Realizing  you can’t do it all yourself you also need to find trusted sources of support

3 comments:

Mercutio said...

This is a fantastic piece. I'll have to save & read a bit more of it later.

A preliminary 'Thank you' here.

I tend to trade the volatility, and of course, there is commensurate risk.
I got bit by that last year.
Up 30% the one year, then down 70% the next.
A series of mishaps; heavy in uranium when the Japanese crisis hit; two Chinese companies with accounting scandals; a Canadian oil sands speculator bankrupt after the financing of a lease fell through; wind power subsidies expiring, etc.

From what I saw earlier in the year, this should have been a bumper year for corn. And then the drought hit the midwestern US. Dismal.
Beef shorting and high on the long.

Odd that weather can still make such drastic changes in our markets, as technologically advanced as we are.

Of all things, coal looks good these days. Two companies I watch are well below a third of their standard pricing.

From my own experience, I have Headwaters (HW) on a watchlist. They sell recycled waste products as construction materials. The general trend follows construction in the US.

Lindsay Byrnes said...

Thanks Mecutio - have been tied up doing some voluntary tutorials at the University of the 3rd Age on value investing and only just now are responding to my blog.

Best wishes

here are my golden rules

Firstly establish security value since price follows value.
Don't invest in a sector simply to diversify if no value exists.
Small caps less liquid and fall heaviest when markets panic.
Keep sufficient cash to tide you over= 3 years.
Don't worry over only having 5-6 stocks that represent value – be patient- wait for value to emerge.
If a stock sours sell it – hope is not a strategy.
But you could write several “covered calls” close to the money to recoup some of your losses before selling.
Don't fall in love with your stocks – they need to earn their keep and values will continually change along with market sentiment.
Don't be afraid to sell when they are overvalued.
The past is a barometer but not a catalyst for the future.
Hold few stock and spend more time researching – don't rely on diversification as end unto itself.



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