blind stock valuation, cheap and interesting, fear and greed, growth investing, growth vs. value, investment writeup, reading, stock ideas, value investing, worship the spreadsheet
There’s one category of email I receive ’bout every second day. A typical example will thank me for the blog (yes, always good to hear!), stress they’re a regular reader, often cite a share we own in common, but then we reach the real meat – usually a somewhat impassioned plea:
Please tell me…where & how exactly do you come up with your ideas?!
All appear to be from genuine readers & investors – I certainly don’t think anybody expects some kind of get-rich-quick answer. [Though it gives a taste of how such a desire is so regularly exploited by the unethical & downright criminal]. I suspect this plea reflects a pretty common frustration for investors – where & how do I find new ideas…and how do I know if they’re actually bloody good ideas? Of course, I’ve no magic short-cut to offer here. My definitive answer’s still:
Read, read, read & then read some more…
I covered this ground in ‘Why I Read…’ (Parts I, II, & III – probably my most popular blog series ever). [‘Why I Write…’ may be a useful companion piece]. Looking back, I think these lines (from my final post) nicely sum up the challenge & benefits of reading:
‘I’m talking about territory where the greatest opportunities, and the greatest investors & traders, reside….For them, you can probably chalk it up to pure innate talent. For the rest of us, I think huge swathes of reading is the inevitable toll you pay to get there – however you go about it:
But reading annual reports will give you the figures. Reading non-fiction gives you the facts (& the right context). And most importantly, reading fiction allows you to recognize the fear & greed in yourself (& others), and enables you to see & imagine the world very differently.‘
Here, I thought I’d try place this into more of a day-to-day context. I’m not intending to discuss a reading plan here, or a daily reading link-fest. Yes, one might argue some sources are more useful than others, but I guarantee you’ll never know (in advance) which reading material will ultimately yield the greatest value. So you really do need to read as widely as possible… But what I’ll try do here is provide some insight into my journey from reading to an actual stock pick.
OK, to begin: What am I looking out for each day when I’m reading? Um, really nothing in particular… I’m often quite fearful of being swayed by noise & first-level thinking (see Howard Marks), so I prefer to let it all just wash over me & wait for the good stuff (like a decent investment theme) to gradually surface. But when I encounter new/unfamiliar companies, as I do nearly every day, I’m pretty methodical: I want to track all the cheap & interesting stocks I find! Right, so how exactly do I go about this?
Well, my investment process really boils down to just 2 Excel speadsheets & 4 sheets. The first spreadsheet’s my investment portfolio – I’ve already written a little about it (see Worship the Spreadsheet). The second spreadsheet contains the following:
Portfolio: This matches up with my portfolio spreadsheet, detailing a valuation & price target for each portfolio holding. [I include current share prices, so I usually rank by upside potential]. I also include leverage & some other basic price ratios, plus a target allocation for each stock. I’ve simplified this sheet over the past few years, as I now mostly rely on my published write-ups for the majority of my holdings. When I (fully) dispose of a holding, it’s usually demoted back down to Possibles.
Potentials: This sheet contains all my potential stock-picks – i.e. any stock I might purchase within (say) the next 6-9 months. It’s relatively select – but many still never make it into my portfolio. The format’s fairly similar to Portfolio, which reflects a research process akin to what you see in my posted write-ups. In due course, each stock is promoted to Portfolio (i.e. I bought it), or demoted back down to Possibles.
Possibles: The largest sheet…by far! A majority of the cheap & interesting stocks I discover initially find a home here. The only real escape’s an eventual promotion to Potentials. Again the format’s similar, but obviously more informal & abbreviated – from sheer necessity. Usually I just record:
Name, Ticker, Share Price, Target Price, Upside Potential, Valuation Summary, Comments
[If I’m focusing on stocks from a particular sector, or which reflect on a specific investment theme, I’ll group them together – this makes for easy reference & useful peer comparison.]
The blog already offers good insight into my research process (for Portfolio & Potentials), so we’ll concentrate on Possibles here. Now, I really need to define cheap & interesting..! At first glance, it seems like another expression of my recent ‘So, Growth…or Value?’ post. To some extent, it is – I prefer not to choose between growth & value investing, ideally I want to buy growth stocks (interesting) at a value price (cheap)!
Now, cheap is self-explanatory: None of us are infallible as investors & the market’s always unpredictable – the only sensible defence is to demand a decent margin of safety. Now, growth investors often cite a seductive argument – the compounding effect of a high growth stock is so great, it creates its own margin of safety. Sheer twaddle… High growth stocks are (almost) inevitably priced accordingly (or should I say richly) & are vulnerable to the smallest of hiccups. Clearly, they demand an even greater margin of safety! On the other hand, interesting can mean a lot of different things to different people. For most investors, it obviously means:
– Growth Stocks: I agree, I dream of owning some classic growth stocks at a decent price. But for me, interesting also includes:-
– Catalyst Stocks: These ideally offer the perfect investing combination – lower risk and higher IRRs (see ‘Catalysts – A Summary’, Parts I & II).
– Peer Stocks: Stocks which offer an interesting peer comparison, or even an investment alternative, to an existing portfolio holding.
– Theme Stocks: Stocks offering direct/indirect exposure, or a play on a specific investment theme – which I believe may offer superior/mispriced secular (or uncorrelated) growth prospects.
– Jockey Stocks: Identifying & investing alongside the best managers, investors & entrepreneurs throughout their careers is usually a great bet to make. [Bad management’s interesting too – if they fail to kill a (great) business, despite best efforts, what’s the potential when/if they’re gone?!]
– Geographic/Sector Stocks: Stocks which offer (possibly unexpected) exposure to a sector, a market, or a region.
– Uncorrelated Stocks: These offer alternative, or economically uncorrelated, exposure. Stocks which offer (relatively) uncorrelated returns vs. the market are even more attractive, but that much rarer. Finally, inversely correlated stocks (e.g. distressed asset/consumer plays) are another compelling portfolio hedge.
– Other/Unusual Stocks: A total mixed bag of stocks – those that grab my fancy, for whatever reason, plus stocks which offer exposure to a misunderstood, unique, or (potentially) disruptive business.
[NB: I’m covering the gamut of listed companies, funds & ETFs here. And stocks which overlap categories are often that much more attractive.]
This list illustrates why stock-screening’s often a fairly futile exercise. Most screens never produce what I’d ever describe as interesting stocks. Instead, they throw up a dreary succession of cheap stocks…which are destined to stay cheap forever, for very
good bad reason (bad management, bad business & bad finances). On the other hand, finding interesting stocks is far more of a treasure hunt… Yes, theme & sector stocks (for example) might permit a more focused reading list/approach, but you’ll mostly need to read far & wide to stumble across the most interesting stocks. But it’s always worth it, because:
Cheap is how you select a stock. Interesting is why you buy a stock…
But most of the time, there’s an obvious problem:
Cheap ≠ Interesting + Interesting ≠ Cheap
Yes, I’m really the king of the obvious statement – any decent investor knows this already: The real trick isn’t being smart enough to identify & invest in cheap or interesting, it’s having the iron will to demand both when making each & every investment. And that’s far harder than it sounds. Yeah, maybe it’s a breeze for a week, a month, a year – but how about fighting your natural (value, or growth) inclination, your boredom, your fear & greed, your itchy trigger finger, forever?! Sure, we all start out as Snow White – then we drift… For me, a rigid investment process has always been the solution. Quite simply:
I value every single new/unfamiliar stock I find!
Ulp, let’s take a breath… It’s not as bad as it sounds, the word ‘every’ is actually a flexible parameter! Investors should recognize their limits, in terms of available time, knowledge & experience – which defines their circle of competence & also their zone of comfort. If this means sticking with UK large-caps, for example, so be it – that’s your personal investment universe. [But remember, portfolio diversification’s an extremely valuable prize – one should always seek to expand that investment universe, but do it slowly & carefully. After much (painful & hard earned) experience, my own universe now encompasses most stocks I encounter these days]. And the payoff’s worth it…
Not to denigrate it, but once you reach a certain level of investing expertise, your in-depth research process is much the same for each potential stock-pick. But forcing yourself to snap-value a neverending parade of very different companies, business models, capital structures, management teams, etc. is the best way to test & expand your repertoire of stock/sector valuation metrics & techniques. Frankly, it’s the best (continuing) education you’ll ever receive as an investor. Plus it helps to hammer home a relentless discipline – no stock’s a buy, no matter how interesting, unless it first clears the valuation hurdle. Anyway, how else do you propose winnowing down that grab-bag of stock ideas you have – valuation provides a simple quantitative framework for homing in on the most promising candidates. And finally, relax…it really takes far less time & work than you think – practice makes perfect!
Typically, when I come across a new stock, I immediately check it on Bloomberg – this is simply a personal preference, there’s plenty of other decent sites. The Snapshot has all the basic corporate info/figures you need…but at this point, I try avoid looking at any of this! Because:
I prefer to treat each new stock as a blind stock valuation challenge!
OK, there’s method to this madness: As investors, we all suffer (un)-conscious biases for/against certain sectors, we tend to irrationally believe some companies deserve a premium irrespective of their financials, and we find it terribly difficult to buy a share that’s perhaps already risen (or fallen!) substantially in the past few years. And all too often, we fall into the trap of treating shares as pieces of paper to trade (trading sardines), rather than pieces of an actual business. Valuing a company blind – i.e. based purely on its financials – is a great way to avoid & ultimately eliminate these weaknesses.
[Approaching valuation in terms of total company value, rather than value per share, is also a useful little trick. Also worth highlighting: A company’s size is irrelevant to its valuation, that’s simply another bias. Investors who haircut small-cap valuations, often severely, risk tainting their overall valuation process. Setting a higher upside potential hurdle for small-caps is subtly different, but a far more effective approach.]
This means I head straight for a company’s financials – I want at least 5 years worth, ideally there’s a handy table in the latest annual report, 10-K, or IR presentation. The more consistent the revenue growth, the better – an erratic or negative growth trend should be valued far more conservatively. Earnings growth should be correlated with/superior to revenue growth – any marked divergence, it’s worth investigating. A focus on adjusted operating profit & net earnings is perfectly acceptable, as you’ll need to check them off against the cash flow statement anyway. Now, cash flow’s obviously volatile, so it’s worth averaging out good & bad years. If you see a marked (+/-) divergence, substitute operating free cash flow (cash from operations, less net PPE/intangibles) & free cash flow (operating FCF, less taxes/net interest) for adjusted operating profit & earnings within your valuation analysis. [This also exposes serial expensing of exceptional items. However, some leeway may be acceptable for high capex/intangibles investment, but only if it’s a high growth/high margin company]. I also check interest coverage, gross cash & gross debt. Net equity’s the only other B/S item I usually focus on – if it’s an asset-rich/heavy company.
Segment/divisional performance is the other key section of the accounts for me – the past two years is sufficient. If you’re an activist investor, this is where you’ll identify your ideal (potentially multi-bagger) stock-picks. What you’re looking for is a company with a hidden jewel in the crown – i.e. a high margin/high growth division, whose performance is masked by other divisions & corporate costs. Or perhaps the reverse – a dud division, whose sale might transform the company’s financials. Smaller companies are an excellent hunting ground, as a single bad division or excessive corporate expense can decimate overall profitability. [Say divisional profitability’s 4 million, while total corporate expense is 3 million…so, should the company’s valuation be a multiple of 1 or 4 million?! Now think about it from an acquirer’s (or an activist’s) perspective!]
In terms of valuation, the more metrics you employ the better (just average them out). It’s reassuring when you see different valuation methodologies confirm each other, while divergences demand more analysis. [Which may be an opportunity – divergent valuations can signal a misunderstood/mispriced company]. A target price/earnings ratio is probably the most common (& most dangerous) metric investors employ. For one thing, earnings are an obvious target for manipulation. Second, trying to pin an appropriate P/E ratio on a volatile (and/or cyclical) business is a fairly pointless exercise. Third, no P/E ratio may prove low enough for an over-indebted or declining business. Plus you never see private equity or corporate acquirers thinking in terms of price/earnings multiples! That being said, a P/E ratio works reasonably well for larger/more stable (blue-chip) companies – sticking with a PEG ratio of 1.0, or less, is sensible.
I much prefer to focus on (adjusted) operating profit margins & value the business in terms of a target price/sales multiple. These metrics are far less prone to manipulation, and this approach is a simple approximation of an acquirer’s perspective. [Acquirers care about revenue growth, operating margins & underlying cash flows – net earnings are irrelevant, as their capital structure & tax exposure may be wildly different than the acquiree]. I generally equate a 10-12.5% operating margin to a 1.0 P/S multiple, while higher margins deserve an expanding multiple (e.g. a 30% margin might deserve a 4.0-4.5 P/S multiple). [See my recent DCC write-up for further commentary].
I adjust my valuation for cash-rich, or over-indebted, companies. If a company’s financially strong, gross cash these days is a non-productive asset that could be returned to shareholders, or used for an earnings-enhancing acquisition. Surplus debt capacity’s also attractive, for the same reasons – I’m comfortable with interest expense up to 15% of EBITA. I’ll add gross cash, plus 50% of a company’s incremental debt capacity, to my P/S multiple. [Again, see The Great Irish Share Valuation Project, Parts I–IV to date, for recent examples]. For over-indebtedness, I’ll haircut my valuation by 100% of the company’s incremental debt (i.e. the debt reduction required to reduce interest expense to 15% of EBITA) – a clumsy but often effective measure of the operating/dilution/bankruptcy risks an investor faces with such a company.
Asset-rich/heavy companies – i.e. those depending primarily on fixed assets, property and/or investments to generate income/gains – are normally valued using a target price/book ratio. I usually equate an 8-12% return on equity to a 1.0 P/B multiple, and expand this multiple based on the consistency & level of return on equity. Again, excessive debt invalidates this approach (a reminder that banks are usually a ridiculous investment proposition!). A sum-of-the-parts valuation seems like a similar approach, but may actually incorporate all the valuation methodologies I’ve mentioned. Plus it lends itself to including alternative metrics – like % of AUM, $ per boe, $ per hectare, $ per subscriber, $ per MW, etc. Regardless of the metrics, I consider valuation a purely quantitative exercise, based almost entirely on past/present financials – whereas a company’s prospects & potential earnings belong to another entirely separate qualitative analysis.
At this point, I may check the major shareholders (for interesting investors), and the directors’ biographies (to see if I recognize them, or their prior corporate history). I’ll also return to Bloomberg for a quick review of the 5 year price chart. Plus I may scan the latest news & quarterly/interim report – but at this point, relying on the latest annual report is usually more than adequate for valuation purposes. Of course, I may keep reading if the company really takes my fancy – in reality, it probably takes me no more than a minute to absorb a quick summary of the company, what it does, and whether it’s actually interesting to me.
So now we reach crunch-time: If a company isn’t interesting, I normally won’t consider adding it to my Possibles sheet unless it offers (say) at least 50-75% upside potential – i.e. it’s cheap. On the other hand – if it’s interesting – I’ll happily add it to my Possibles, regardless of whether it’s over/under-valued. This may seem extraordinarily biased, but it reflects a simple reality:
Cheap stocks may never become interesting – fortunately, interesting stocks will almost inevitably become cheap…
As far as I’m concerned, stock-picking’s mostly a waiting game… I have plenty of holdings in my portfolio where I checked in on the stock literally every day for years, before I ever bought a single share! And there’s another very good reason to embrace patience – I’ve discovered many reasons over the years to regret diving headlong into a new-found stock, regardless of how cheap it first appeared. It’s a far better idea to get to know them first, have a look ’round their neighbourhood, and take ’em for a test drive. Go on, drink the milk…no need to buy the damn cow just yet! When it comes to good stocks, there’s really no such thing as familiarity breeds contempt…
So go ahead, I recommend you start work on building up your list of Possibles. Fortunately, it’s not a difficult database to maintain – use a data feed for updated share prices, or do it yourself on an ad hoc basis now & again. As for valuations, they generally change quite slowly, so refreshing them periodically (after the latest annual results, or when some interesting news grabs you) is probably more than sufficient. The mere fact you found & valued a stock, identified it as cheap and/or interesting, and added it to your list of Possibles, fixes it on your radar – these become the stocks that jump out at you each day when you’re checking market news & movers. Of course, you’ll also want to set aside time each week – to rank your Possibles (by upside potential), and to read up on & take a closer look at the most promising candidates. That’s not to suggest upside potential is the final arbiter – high reward stocks are often high risk too. Selecting stocks based on their quality, prospects & diversity is just as important, if not more…
Over time, like mine, your list of Possibles will keep expanding (as should your circle of competence). And in due course, you’ll arrive at a virtuous circle – each week, something cheap finally becomes interesting, and something interesting finally becomes cheap! 🙂 While I tend to become more or less enthused about the market, I honestly never run out of cheap & interesting ideas – for this very reason – because something new is always bubbling up towards the top of my Possibles selection. And you’ll also come to know these stocks like old friends, so it becomes a remarkably easy & compelling process to promote a stock-pick every now & again to your Potentials.
At that point, you’re really spoiled for choice… What a bloody great problem to have – how on earth are you meant to choose your next stock to buy, from such a cheap & interesting selection?! Well, lots more reading & research, of course… It’s time to knuckle down, go the last mile & finally nail down a:
Great Story, Great Stock, Great Price!
Good luck pulling the trigger… 😉
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You’re welcome, it’s us who should be thanking you!
I was indeed wondering in a general sense – just to try and get a handle on how you might handle with that technique a company that seems to really be shooting the lights out. It’s a nice approach to help with a bit of preliminary sorting.
Could I ask regarding your debt adjustments – I haven’t seen you make mention of operating leases as debt. Is that the sort of thing you’d only consider accounting for for something where it might only be integral and large-scale such as a supermarket estate or an airline?
Sorry for not replying ’til now. Actually my next post will includes a high margin/probably high growth recent IPO, if you want to take a look at another example – however, I’ve choked back my P/S multiple a little, reflecting one big concern I have…
I don’t come across operating leases v much…well, I should really say I don’t write about them v much. Mostly because I’ve never been that enamoured with retail – not because it doesn’t interest me, more because any decent retail’s almost inevitably over-priced (at least from a value perspective). [Frankly, I think ‘buy what you know’ is quite possibly the worst advice that’s ever been given to investors]. So I’ve never agonized over operating leases too much – one should obviously include them in any analysis, but I can think of pro & con arguments for actually treating them as debt. Anyway, a couple of the UK bloggers are the real experts here – far better to read up on their thoughts! But I have made adjustments when it came to Aer Lingus, for example – see here:
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Good Lord, Wex – what a superb post!
May I ask you a question on P/S multiples? I’ve been following your calculations and thought processes as you’ve been laying them out in the latest TGISVP – can I ask you what a couple of the highest P/S multiples are that you’ve ever ascribed to a name and why that was?
Keep up the great work
Thanks, Alex! Not sure if your question is in relation to TGISVP, or in general?
If you look back to last year’s TGISVP, I put a 4.5 P/S multiple on Tullow Oil (reflecting operating margins), a 3.5 P/S on Trinity Biotech (reflecting industry M&A multiples), and 3.25 P/S on Paddy Power (again, reflecting operating margins). More generally: As operating margins rise, my P/S multiples expand – I’ve actually evaluated & even bought shares in the past with a 4.5 P/S price target, based on 30% or so operating margins. I even remember, off the top of my head, setting a 7.5 P/S price target for a company with 50% operating margins…
That might actually surprise many readers here…that I was comfortable with those kinds of multiples! But they made perfect sense, based on the financials at the time. The reason you don’t see me buying such stocks here is mostly because such stocks are ridiculously over-priced 80-90% of the time, so I hardly ever get a chance to buy ’em!