Someone who reads my blog emailed me this question:
“I'm a retail investor in Hong Kong and like most markets internationally, equity markets here are… high. In such an environment, I'm in a bit of a dilemma. I'm still [finding] pockets of value based on asset value or earnings / cashflow, but these stocks are at or near historical highs in terms of [P/B and P/E]. Personally, I'm worried about the possibility that when an adjustment comes along, cheap stocks can become cheaper. As a value investor, what is one to do? Should I ignore the market and invest, or should I be more concerned about the [P/B and P/E] expansion and wait?”
When the market falls, cheap stocks will get cheaper. They may get a lot cheaper.
You can and probably should continue to buy stocks – even in today’s overpriced market. But, you should avoid buying stocks – even ones that appear to be a good value based on their absolute price-earnings (P/E) and price-book (P/B) levels – that are at or near historical highs in terms of EV/EBITDA, price-sales, price-earnings, and price-book. Always try to buy stocks that are cheaper now than they were in the past. I don’t mean a lower stock price. Often, I mean something more like the stock has gone nowhere for five years while sales per share have kept compounding at 6% a year – so now it’s cheap relative to the P/S ratio it was at in 2012 or 2013. That’s the kind of stock you should consider.
The riskiest behavior for value investors to engage in during a bubble is allowing themselves to get “crowded out” of good businesses. What happens is a value investor decides he will only pay a P/E of 15 or something like that. In bad times for stocks, it’s easy to find even great businesses briefly trading at 14 times earnings or less (for example: Omnicom had a P/E of 9 in December 2008). So, value investors can buy stocks that Warren Buffett (Trades, Portfolio) would like, Joel Greenblatt (Trades, Portfolio) would like, and which GuruFocus awards 4 or 5 stars in terms of predictability. Value investing is easy in “bad times”.
In normal times, value investing gets a little harder. But if most stocks are trading at 15 or 20 times earnings – whatever is out of favor will dip below that market wide level. So, value investing was really easy in 2009 and 2010. It got harder in, say, 2012 and 2013 in the sense that a value investor couldn’t just buy the best businesses around – he had to limit himself to looking at good businesses that were still trading at good prices. But there were always certain industries that were out of favor and certain counties too. About six years ago, I was able to put together a basket of Japanese net-nets with very little effort. In fact, I even limited my purchases to “better, safer” net-nets. I insisted they be profitable for 10 or more years in a row and that they have a negative enterprise value (sell for less than net cash) rather than just being a net-net (sell for less than NCAV). That was easy then. It’s harder now. Even Japan – like all other stock markets around the world – has been going up, up, up.
So, we are now in the point of the cycle (remember, this is a very old bull market – one of the oldest ever) where value investing is truly hard. A value investor’s “investable universe” has shrunk from almost everything in 2009 to still quite a lot in 2013 to now just about nothing in 2018.
The danger, like I said, is getting “crowded out” of quality stocks because you are focused on price. If you want to own 20 cheap stocks – in 2009, they could be 20 cheap and good stocks. Today, you can own 20 cheap stocks. But, you’ll hold some businesses that are on shakier ground. That’s not something I’m willing to do. However, I am willing to concentrate a lot in a handful of stocks (owning just three to five stocks at a time feels fine to me) and buying things very rarely (buying just one new stock a year feels fine to me). This adds risks to my portfolio that your portfolio doesn’t have. One bad stock can sink my portfolio in a way it can’t sink yours. But, it also makes my life a lot easier in avoiding fundamentally weak businesses in highly competitive industries. In the very last part of a bull market, that’s likely where a value investor is going to end up. Because the value investor wants a diversified portfolio of cheap stocks – he ends up lowering his quality and safety requirements till the average stock he holds is a more marginal competitor in a more highly competitive industry and has more debt than anything he was buying in 2009. The examples I gave of stocks I owned in 2009 -- Omnicom, IMS Health, Berkshire Hathaway -- show you that it was once possible to own leaders in an industry that wasn’t overly competitive – and yet get them at a bargain price.
It’s very hard to do that today.
I recently wrote a post where I said that I believe we’re in a bubble. And that’s true. I think stocks are in a bubble. And yet I’m 100% invested. If I can find things to do, then I do them regardless of whether the market is expensive or not. However, I only bought one stock last year and my top three positions are about 94% of my entire portfolio. So, I am saying – like the title of the great book about Peter Cundill – that “There’s Always Something to Do” (even in a bubble). But, I’m also saying that most weeks you just read and think and don’t buy anything. And then, maybe, once a year you buy something. And you might be able to find three really good things to own at once.
This is different than non-bubble years. There was a point in early 2009 (from about January till about the first week of April) where I was turning my portfolio over furiously, selling once cheap stock to buy an even cheaper stock. I thought Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) was cheap then, but I had to sell some of it to double my position in IMS Health (IMS) (this is the old IMS Health, before it went private and then public again) at an even lower price. You had stocks like Omnicom (OMC, Financial) and IMS Health trading at often something like 13% free cash flow yields while 10-year U.S. Treasury Bonds were at some like 3%. In other words, you were getting 10 percentage points above Treasury bonds before you factored in any growth in that yield. And, those industries were at a cyclically pretty low point – not a cyclically pretty high point. So, you could imagine a 13% yield plus a 5% growth rate or something. The math was telling you that you were going to make 15% a year or more in those stocks. Today, it’s difficult to find stocks where I really believe the math is telling me I might make 10% a year. At times like early 2009, I can buy one stock a month. At times like today, I can buy maybe one stock a year.
Last year, I literally bought just one stock.
But, we have to play the cards we’re dealt.
You could avoid the market entirely. I think that’s a mistake. But, I think you do have to be super selective. So, how can you become super selective in the stocks you buy during a bubble year like 2018?
We can attack selectivity from two sides. I recommend a “one a week” approach. Commit to learning about one stock a week in 2018. Research the stock. Don’t worry if you never buy a single one of these stocks. But, don’t stop learning just because we’re in a bubble. You can – if you fail to find anything – stop buying stocks because we’re in a bubble. But, never stop learning about stocks.
So, route No. 1 to finding good stocks is to start purely from the business side. This means look for truly “great” businesses. You want businesses with 4 or 5 stars on GuruFocus’s predictability ranking. Three examples are: Omnicom (OMC, Financial), Cheesecake Factory (CAKE, Financial), and NIC Inc. (EGOV, Financial). Cheesecake Factory invests pretty heavily in assets (a new location costs the company more than $8 million in property improvements). It earns a decent return on capital. Omnicom and NIC Inc. have businesses where returns on tangible capital will tend toward the infinite because the need for additional tangible capital in the business tends to be close to zero. So, if you haven’t researched companies like Omnicom (or any of the other big ad agency holding companies) or NIC Inc., put them on your schedule. It helps if the stock is at 15, 20 or 25 times earnings instead of 30 or 40 times earnings. But, that’s not a requirement. Stocks can fall a lot in price even during bull markets. Last year, Autozone (AZO) suddenly collapsed in price and then just as suddenly regained what it had lost in price. If you’d been prepared by having researched that company ahead of time – AutoZone is what Charlie Munger (Trades, Portfolio) calls a “cannibal” (it eats up its own shares) – then you could’ve jumped on that stock when you got a rare chance to buy it at a good price. AutoZone is today a nearly $800 stock that kissed $500 in price within the last year. You want to know about businesses like this ahead of time, so you can pounce when you get the chance.
I don’t recommend just looking at stocks that barely pass a screen. In fact, I’m not a big believer in screens. Value investors get in a lot of trouble when they think they can buy the No. 2 company in an industry at 13 times earnings when the No. 1 company is at maybe 19 times earnings. Is that value investing? If done over a huge number of stocks, it can be an effective sort of “mean reversion” bet I guess. But, that’s not how I think of value investing.
Value investing is about finding a big difference between the price you pay and the value you get. So, I recommend getting super selective by looking to find businesses where value is extraordinarily maximized or stocks where price is extraordinarily minimized.
The one screen I do recommend is simply working through a list of all stocks in various industries that GuruFocus ranks at 4, 4.5 and 5 stars of predictability. There are other ways to find potentially “great” businesses.
My own approach is to do a Charlie Munger (Trades, Portfolio) style “invert, always invert” and think of the two things that muck up long-term returns in a business:
- The need for owners to add more capital.
- The need to respond to competition (cut prices, improve technology, carry more inventory, etc.).
So, my advice for finding a good list of businesses to research next is to think of everything that:
- Requires almost no capital.
- Faces almost no competition.
NIC Inc. is a good example. I own BWX Technologies (BWXT, Financial) which faces no competition in its most important business. So, look for business that use almost no capital and have client retention rates of 90% to 100%. Ad agencies and (some) banks both qualify as far as retention rates. A “magic formula” type screen can help you find businesses that require almost no capital to run.
So, fill up your weekly research calendar with businesses that require almost no capital to run and/or face almost no competition. Then research them regardless of price. If you can research 20 of these in a year – odds are one of those 20 will fall in price by 50% sometime in the next year. That stock will have been a quality business – but not a value stock – when you found it. But, it’ll have become a value stock after you researched it. All you’ll need to do then is pounce.
The second method for selectivity is ignoring the question of business quality and looking just at “likely mispricings.” This is the Joel Greenblatt (Trades, Portfolio) in “You Can Be a Stock Market Genius” approach.
The one everyone knows is spin-offs. The stock I bought last year was a spin-off (actually, it was the “remain company” part of the spin). BWX Technologies (which I bought at a much, much lower price when it was a value stock – not today, when it’s quite expensive) was also a spin-off (actually, again it was the remaining business, not the spin).
Mispricings often occur with complicated businesses, messy businesses, businesses that have undergone change, and so forth.
Cars.com (CARS) is a spin-off of a spin-off. It was originally sort of a “captive” business (the major shareholders were newspaper publishers who were also customers of the company) that was then sold to Gannett (then a newspaper and TV company) and then Gannett became just a TV company (the newspapers were separated out) and the following year Cars.com was split off from that.
BWXT is another example of “messy.” When I bought into the stock it had three parts: the nuclear business (which I wanted to own), the coal business (which I didn’t really) and a money losing highly speculative future technology start-up. I honestly believe that if Babcock hadn’t been spun out of McDermott within five years before I bought it and hadn’t lost money on that modular nuclear reactor businesses (the speculative tech business) it wouldn’t have been so cheap. Certainly, we can see from what happened to the nuclear business and the coal (and other) businesses that investors were avoiding the nuclear business because it came with a coal business attached.
Look for mispricing situations more than screens. So, look for complicated situations like Bollore (in France) or Biglari Holdings (BH, Financial). If you look at a stock like Odet (this is a public company in France that owns a lot of Bollore which in turns owns a lot of other stuff – much of it publicly listed), you’ll see a lot of confusion in the press, among investors, etc. about Odet and Bollore and so on. It’s easier just to write about Havas, Viviendi, etc. than try to find out what parts of the Bollore extended corporate family effectively own stock in themselves and their “relatives.”
A lot of investors dislike doing this. Because, when you start, you’ll have no idea if Odet or Bollore or whatever is really expensive, really cheap, about fairly valued, and so forth. But that’s the point. There isn’t just widely available (like on GuruFocus) info on P/E, P/B and other ratios on Odet that is going to be meaningful. You need to do a sum of the parts calculation on your own.
Those tend to be the things that are mispriced. A classic example of this is a stock I wrote about in 2007. The stock was then called Rex Electronics. It is now called Rex American Resources (REX, Financial). The stock – in its last years of being Rex Electronics – was dirt cheap. And you knew – if you read what the company was saying and watched what it was doing – that it would re-allocate all its capital from failing electronics stores into ethanol. Nothing about either a failing electronics store or an ethanol stock got me excited. What got me excited was that I felt pretty sure the stock would be mispriced until it basically announced to the world that it was now officially an ethanol stock. (It did that, I think, about three years after I wrote that article).
Honestly, this is where you will find bargains regardless of what kind of market we’re in. Look for stocks that people think are something they aren’t. You’ve probably been reading in the news about stocks that suggested they are now bitcoin related and popped in price. Well, look for the inverse of that situation. Look for companies that are really changing on the inside but haven’t announced that to the outside world.
I’ll tell you a secret: In the earliest stages of deciding which stock to research next – I don’t look at a lot of numbers.
What I look at is the business model. I read about the franchised business model of Dunkin Donuts (DNKN, Financial) or Domio’s (DPZ, Financial), and I think: pizza and coffee – that’s pretty predictable. And franchising doesn’t require capital. So, it’s predictable and capital light – I’ll learn about it.
Likewise, with NACCO (NC, Financial), you had a cost-plus contract coal mine operator and a small appliance business yoked together. Even before I knew which business I was interested in (for me, it was the coal company) – I knew this could be something that’d be mispriced. And not just the second it was spun-off. It could easily take a year or more before each business model was really understood by enough people and communicated through analysts or value investors like those who visit GuruFocus and post on message boards for the narrative of the stock to take hold in a way it influenced the price.
If I think some people may not understand the business model behind a stock, I get really interested in analyzing that stock next. You should too.
The only way to be super selective during a bull market is to keep researching stocks. Do it constantly. Try to work through one new stock a week.
The best use of your time is to research stocks in two categories:
- Stocks that are immediately recognizable as great businesses.
- Stocks that are immediately recognizable as likely to be mispriced.
But here’s my warning: Those are two great categories to research. They aren’t two great categories to actually buy blindly. A great business can often be absurdly overpriced in a bull market. And a stock the market is confused about can be very mispriced in the sense of it being priced way too high or way too low.
It’s a lot quicker to find situations with a high probability of being mispriced than situations where you know which way the stock is mispriced. I felt Babcock and “old” NACCO were messy, complicated and just unattractive combos of different sorts of businesses – so I instantly thought they might be mispriced. But it took me a little while to try to figure out the intrinsic value and see if the mispricing was really there and if it was really the kind – too low a price – I’m interested in as a long-only investor.
So, this is just a suggestion about where to start your research process. And then you want to research as many stocks as possible (I suggest one a week). And you want to buy as few stocks as possible (I suggest never more than one a quarter). If you do this, you’ll always be saying “no” to at least 11 stocks for every one stock you say “yes” to. If you combine that kind of selectivity with looking at the stocks others aren’t – especially the weird, the less followed, the small or the recently spun-off, you should be able to find enough stocks to buy even in a bubble year like 2018.
Disclosure: Geoff is long NC, CFR, and BWXT.
