Thursday, December 14, 2006
Method of evaluating and selecting stocks (Part 2)
Again this is in response to Jojo, a fellow value investor, it's great to share ideas with someone who has a similar mindset towards investing, though may not be exactly the same in totality but the basic foundations are the same.
I too subscribe in total to Benjamin Graham basic notion of investing which is to find a dollar worth of business for 50 cents. This may be sniffed out in many ways, for instance, through the pure Grahamites method, or the improved method like how Warren and Charlie did.
Ok, I shall go part by part to elaborate how I select my business thus far. As to what I said earlier, I got to add that the ratios are just a trigger to consider investing in it. Well, PER and PBR are important triggers to telling you if a business is undervalued in a large part but it don't give you an idea of what the intrinsic value is.
The level of margin of safety is dependent on how confident an investor is to his valuation. Let's say if you are driving a 10-tons truck across a bridge over the Grand Canyon, you would feel you need a lot more in the way of margin of safety. But if you are driving over the Sin/Johor causeway, you need a lot less.
As for intrinsic value, I do not necessary base on that for my decision in investment. This is because if I can find a stock that is a great business and that it will survive, and have certain organic growth in the years ahead, and coupled with a valuation which is almost at its low for a long time, say, 10 years or more, I am sure the intrinsic value of its future flow of earnings at the present value today will be worth much more than the price that I pay today. Further, I got to add that I like to consider businesses which has a long history of getting good average return on shareholder equity.
Though I do not calculate the intrinsic value as always in all my purchases, I do have a method to calculate it. But the method is not simple and it is just an estimation though it is an all-important concept that offers a logical approach to evaluating the relative attractiveness of investments and businesses. To start, intrinsic value is the discounted value of the cash that can be taken out of a business during its remaining life. So what is meant here is really a long run for all the great businesses who has a great moat that has the durability to survive and grow its moat and more importantly, the durability of the moat. It is quite pointless to do an estimation of intrinsic value if the duration is 3 years, 5 years or such because you will not be able to see the effects of cash flowing in to make up for the price you pay at with such a short time frame.
And the inputs to the calculation of the intrinsic value is all important as well. And it has to be changed yearly when interest rates changes or future cash flows are revised.
And what importance intrinsic value brings to the table is it also helps to determine the fair amount of what you should pay irregardless of what is carried on the book or its book value at the point of valuation. In other words, book value by itself is meaningless as an indicator of intrinsic value.
Here's an example on how I calculate the intrinsic value for a business, I shall take this business called, USG, as an example.
In calculating intrinsic value, it is basically to compare between two options. In this case, we are to compare between investing in USG or to invest in risk-free equities like government bonds.
The process of estimating intrinsic value is firstly, to estimate the earnings that the business (USG) will receive over its lifetime or for the duration of the time frame you are willing to invest for (10, 15, 20 years or so on). Then once you manage to estimate the earnings for the duration, you must substract from that figure an estimate of what the investor would have otherwise earned if he had deployed it in some other securities like risk-free bonds. This will give you an excess earnings figure which must then be discounted at an appropriate interest rate back to the day you invested in. The dollar result equals the intrinsic economic value of the investment. This figure will then give you an idea of how much you should pay for at maximum and it brings you back to the old Aesop's axiom of "if a bird in hand is worth two in the bush."
Here's the exact intrinsic value that I calculated for USG and see if it makes much sense to you. But be cautioned that the outcome of it at the end is really dependent on two important variables, the current interest rate that I used at 5% for risk-free interest and the return of equity of the business at roughly about 26% historically.
A few months back, USG was traded at US$46.50. I used a time frame of 11 years. Then the book value of USG was about US$20, and by the year 2016, it is calcuated to be worth about $210. On the other hand, if I had opted to invest in bonds which pays 5% till 2016, the initial value of $46.50 would grow to US$75 by 2016. Obviously, at first glance, USG is a better investment but that is not the intrinsic value and it does not show you what the present value is for USG future value. So now, you got to take the difference between $210 and $75 and discount it back to today at an appropriate rate of say, 5% again. So the present value of the difference which is $135 is worth $82.90 today. So effectively, you are paying $46.50 for $82.90 of future cash flows.
I shall give another example that may make it much clearer in distinguishing the intrinsic value to the price that you should pay. I think some people like to value things too much by having the book value of the business or something as the yardstick but it isn't exactly a good way to do so.
You can gain a lot of insight from a college education. Think of education cost as its book value. And if this cost is to be accurate, it should include the earnings that were foregone by the student because he chose college over a job. Here is how it works. Firstly, you must estimate again the earnings the student will receive over his lifetime and then subtract from that figure an estimate of what he would otherwise have earned had he lacked his education. Again, the difference will give you an excess earnings figure, which must be discounted at an appropriate interest rate back to graduation day. This will then give you the intrinsic value. So the next question is if the parents of the student got his money (the cost of the education which is the book value) worth? Some students will find that the book value of their education far exceeds the intrinsic value, which means the parents or who ever paying for his education did not get his money worth. In other cases, the intrinsic value of an education will far exceed its book value, a result which proves capital is wisely deployed.
What we can glean from these 2 cases is clearly that book value is meaningless as an indicator of intrinsic value.
I am not sure if I describe clearly or I may have missed out any important point, which you may point out to me. I am extremely interested to learn more and improve on my method.
Aside from the intrinsic value, just as important, I can afford to hold businesses like these for many years or even throughout my lifetime because they have great business models which gives investor great returns if gotten at a fair price, or even better at a great price.
As for the value of USD, yes, it will definitely fall in the future because they are buying more than they are selling. So slowly, they got to sell away their assets and things like that and it will cause their currency to be worth lesser. Well, in any thing, there will be rock bottom or hit its bottom and then goes up again. So if my time frame for USG is 11 years, I really cannot tell if the exchange rate today of 1.55 will be worth more or less in 11 years but somewhere between now and then, it will probably be worth less. If I recall, in my poly days in mid 90s, SGD hit 1.42 to the Dollar, in 2002 it was at 1.82. I am no currency expert but if my time frame is long enough, I do not worry about the exchange rate of USD to SGD. Moreover, Singapore imports more from US than US imports more from SG, the only thing is SGD is pegged to a basket of currency which it is not easy to predict which direction it goes. I am pretty comfortable with the exchange rate for now which is probably at the middle between the bottom of 1.42 and high of 1.85 in recent 10 years.