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Are You Really a Value Investor?

July 22, 2007 | About:
10qk

William Spetrino Jr

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After being away from the market for 3 days and visiting 25+ different businesses in Niagara Falls. It became very clear to me that some business owners had marketed their business intelligently and other businesses are really run poorly. I realized that investing is "much easier" than we make it. If you combine a great business (a ROC of at least 20% over the past 3 years and a ROE of at least 26% in the past 3 years) with a fairly priced stock ( 16 or less times last years earnings) and you combined these 2 traits with investors major advantage (being able to increase your position when the price drops) and then you sell position only when the ROC or ROE drop under 20 and 26 percent respectively over the past 3 years or the stock's PE is over 30. Logically you should be able to outperform the market and achieve great returns, Right? Let's see what we found.

Using the Dow Jones 30, 4 stocks out of 30 qualified from 2000-2006 and 1 more "qualified" in 2007. You can "test" this theory on any stock but since I am a "large cap" guy and am "too cheap" to purchase value line we will just study how this system worked since 2000. Altria (MO) was purchased after the annual report was issued EVERY year from 2000-2006 at an average price (post Kraft (KFT) split) of 49.08. During 2002 3 "average down" purchases which are "2 units” instead of 1 after a 15% drop from the original purchase. After each purchase your "reentry price is 85% of the last price. In 2002 those three 2-unit purchases had a basis of 38.62. The original purchase in 2002 was $53, after the three 2-unit "average downs" your basis is lowered to $40.67. Like Mae West said "too much of a good thing is wonderful". Today those shares are worth $93.67 (counting the KFT spinoff) and still "qualify" to be held.

The power of "averaging" down is illustrated in our next example. Merck was purchased originally in 2002 at $50.24 and was purchased the next 4 years at $50.24, $45.25, $34.25 and $35.75 respectively. Many gurufocus readers get "impatient" when their value plays don't "move up fast enough" and contemplate selling them. The 5 "1 unit" purchases "have a basis of $43.196 which with a 3 year average holding period is not very good. However here comes the power of "averaging down and adding to your position". In 2002 an average down was done at $42.70. 2 years later in 2004 3 "average downs" were done at $38.46, $32.69 and $27.78. The last purchase was done at almost 50% below the original entry point 2 years ago. How many of you would be "panicking" now? But a look of the previous 3 years ROC was almost 33% and the ROE was almost 40%. 2003 earnings were 2.92 per share. Your 3 "average down" purchases had a basis of $32.97 which is 11times last year’s earnings along with the "lights out" ROC and ROE levels. Having the "ballz" to not only not sell but increase your position separates the "men" from the "boys". (My averaging down of Altria which I have mentioned in other articles was responsible for almost 70% of my net worth today). Your original purchase price was $50.24 but after your "average downs" your basis ends up at $37.164.Your holding period was about 3 years. With dividends Merck ended up with an annual return of over 12% despite the fact the stock is LOWER now than your original purchase price 5 years ago. This stock is not presently a buy but since the ROE and ROC is still favorable the stock is still in our portfolio

The last 2 stocks were bought but sold after the ROC and ROE dropped "under our parameters. IBM (IBM) was bought in 2002 at $69.6 and "averaged down” at $59.16 a few months later (lowering our basis to $62.64). After the annual report came out in 2003 IBM's ROC 3 year average dropped under 20% and the position was closed out in 2003 at 80 dollars a share. Almost 30% in less than a year is a favorable return, although IBM is at an all time high. Keeping the stock would have made us less than 7.5% annually.

Pfizer (PFE) is the last stock that was purchased and is a "favorite" of many gurufocus readers. The stock was purchased first at $28 and then "averaged down" at $23.8. In 2005 it was purchased at $27.25 and averaged down at $23.16. 6 units total were invested at a basis of $24.86. In 2006 after the annual report came out Pfizer fell under the parameters for BOTH ROC and ROE and the position was liquidated at $24.50. With dividends this stock returned under 3% annually during a 1.5 year holding period. The stock is slightly under where we liquidated the position last year.

The total 39 units invested of $1553.12 turned into $2523.27 with an average holding period of about 3 years. With dividends included the patient value investor (oxymoron there) averaged over 21% annually compound return which is remarkable considering we bought large caps and all 4 stocks dropped a minimum of 20% at some point after buying them and 2 of those dropped over 40%. For you value investors out there consider this fact. Warren Buffett's billion dollar or more purchases of Coca Cola (KO), Wells Fargo (WFC), and Anheuser Busch (BUD) and Johnson and Johnson (JNJ) ALL qualified under these parameters. Just something to think about.

 So by combining a great business (ROC of 20% or more and ROE 26% or more over the previous 3 years) the "right price" (16 times last year’s earnings or less) and the ability and "ballz" to average down (2 units on each average down) you have the best of ALL 3 worlds. Sell ONLY when the stocks PE is over 30 or the 3 year average ROC is under 20% or ROE is 26%. In 2007 there has been only one selection. You guessed it, Johnson and Johnson. In the first quarter of 2007 Warren Buffett put in about $1.5 Billion and it is no secret Billytickets has put in every dollar he can raise at an average cost of $61.25.

 

About the author:

William Spetrino Jr
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 3.6/5 (25 votes)

Comments

roke6362
Roke6362 - 7 years ago
When you say ROC, do you mean ROIC? Or do you include all capital employed, including debt? What is your formula? Is it based on operating earnings or net income? Also, what do you mean by "1 unit", and "2 unit" purchases? It looks like you just average down at each 15% drop in price, and buy at every annual report if the PE, ROE, and ROC are still in the "zone".
billytickets
Billytickets - 7 years ago
Thanks for your feedback.I don't know value lines formula for ROC.The original purchases are done at one unit and once the stock drops 15% in the same year the subsquent purchases are made at 2 units.You are correct about when to average down and buy at annual report if still in the"zone"
intl444
Intl444 - 7 years ago
I sent the following to billytickets in response to his ressent article, and also decided to post it here for whatever it's worth.

I think that is a really great piece you wrote probably 2nd only to your book. However IMO the key sentence you wrote is "will you have the BALLZ to double up when necessary"? From my observation of the people that are on the guru board most are smart people, but probablywould not have the ballz to do it for the following reasons.Those that have shared their portfolio's most have only about 5% cash, and do not follow your ideas as put out in the book, therefore I doubt that they would sell any of their current holdingsto free up more needed cash if necessary.Also, I have noted that most do not have a concentrated portfolio of 5-7 stocks, but have 15-20 holdings which would make it very hard to sell --- most seem to have a problem with a sell dicipline, EG they buy at X price, but do not have any idea when they plan to sell and for what reasons. I'd bet that if you had not been suggesting the great bargin JNJ is how many would have been buyers on their own? When we chatted the other day you commented that many people who had purchased your book had a real problem figuring out the formula. Now if you need help figuring out the formula I wonder how many people really do the numbers on their own or do they rely on newsletters or other information's. Yes, investing is really easy if IMO you can read Value Line, and apply the numbers in those reports. Again I think is is a really great writing, and should make the LIGHTS go on for all that get the opportunity to read it, and understand how to apply it in their own portfolio's.

Keep sharing your idea's.
armeetofo
Armeetofo - 7 years ago
what is your sell discipline(s) then?
roke6362
Roke6362 - 7 years ago
Billytickets: When you say "1 unit" and "2 units", do you mean that, if your first investment is $1, then "1 unit" means $1 and "2 units" means $2?
hanzotutu
Hanzotutu - 7 years ago
I always feel it's so difficult to decide when and how much $ to average down. Following is what I am doing so far.

When I decide to open a position, I have a target amount for that stock, e.g., 3 units. Then I will use 1 unit to make the first purchase, and save the 2 units for possible average-downs later. There are two ways to determine when to average down: 1) TA tells you it's rebouncing from the bottom. 2) -7% from your last purchase price.

The problem for this method is what if the stock doesn't go down after your first purchase. The 2 units reserve is totally wasted then. Maybe use the 2 units to do some average-up?
armeetofo
Armeetofo - 7 years ago
average down is easy to say, harder to be done with real money, i'm not meaning to oppose author's opinion.

if holding i bought at $100, it went down to $50, it was 50% down, bear in mind it will take 100% gain to beat even.
billytickets
Billytickets - 7 years ago
Yes roke 6362 if the origonal purchase price was 50 dollars once it hit 85% drop ( 42.50) You would "double" your bet. (1 at 50$ 2 at42.50) would lower your basis to 45$. This is a basic advantage to investing

Armeetofo.when i first bought Altria at 40 I averaged down "2 units' at 34, 28.9, 24.55 and20.88 .the end result is that you have 9 units invested at basis of 28.495. so if the stock makes it back to 40 you have a return of 40.37% if it takes 2 years for that to happen your return is slightly 19% annually plus dividends. THIS IS WHY i ONLY invest in LARGE CAPS which meet my Strict" filters outlined in my book. Hope this helps.peace
armeetofo
Armeetofo - 7 years ago
billy:

that is why you are really a man!!!
JJINVEST
JJINVEST premium member - 7 years ago
I guess that's why you should always buy stocks ONLY if you are willing to average down if it goes down more. That will help you concentrate your portfolio, leading to better discipline and return.
billytickets
Billytickets - 7 years ago
JJinvest very TRUE statement do NOT own any stock you are not willing to "average down" on. One of the value investors BIGGEST advantages is BUYING down.WEB has done this BIG TIME with WPO and WFC and Interpublic AMONG OTHERS.

Armeetofo thanks for kind words fact is that EVERYONE i tell people to do is what I have personally done myself.as WEB says I "eat my own cooking"
ccyork
Ccyork - 7 years ago
billytickets Wrote:

-------------------------------------------------------

>do NOT own any stock

> you are not willing to "average down" on.

this is some of the best advice i've heard in a long time!

-- ccyork

JJINVEST
JJINVEST premium member - 7 years ago
how come my advice only gets 3.8 out of 5 with 11 votes! haha...

I am not that discipline myself. I wish I am.

I like down markets. It seems that my porfolio does better than the general market when it is down, but lags when it rallies. anyway, let's see if there is a big correction coming. I am wishing for one.
armeetofo
Armeetofo - 7 years ago
jjinvest

you discovered one, that is in bull market you buy indexs, you buy individual stocks in bear market, not bad uh?

but how do i know when? ha ha ha ha...
armeetofo
Armeetofo - 7 years ago
billy:

i do understand what you said, i love to learn how to deal with hard times, crisises and disasters. that's why you are a MAN!

do you mind to share how you were thinking and what you were doing when MO went down to $20?
billytickets
Billytickets - 7 years ago
armeetofo back in the"day".I did not have the "support system" that we have today at gurufocus. I was very nervous but knew the ROC and ROE was solid and the dividend kept coming in.

Obviously everyone was scared of the litigation. One day at a party I met a judge who will remain nameless and I asked him about the threat of litigation in the Engle case. He put down his cigar and laughed and laughingly said Judges want to work less not more. If any court let one smoker"actually" win damages and receive them the legal system as we know it would be "bomabarded" everyone who breathed in smoke( everyone would be suing) Added to the fact the US was 6 trillion indebt and the federal tobacco tax and settlement with the states was as big as it was my"theory" was that it would all "blow over". I just kept borrowing every cent i could to buy "big MO". peace
armeetofo
Armeetofo - 7 years ago
billy:

amazing!

again you are a MAN!, the judge was your support system at that moment.

happy investing.
billytickets
Billytickets - 7 years ago
Yes armeetofo I agree the judge made me see "reality". Remember Mr Market is here to SERVE YOU and not guide you. Learning to "take his punches" is a main trait in building wealth.
billytickets
Billytickets - 6 years ago
As far as the system in thsi artcile goes you would only put in 1 unit when it first "qualifies" and then 2 units if it drops 15% from there.

I personally really like this stock"besides" this formula and "sent it in" but the formula in this article does not buy more when it is moving sideways .when 2008 starts you check and see if the stock still qulaifies and if it does purchase 1 unit and again avaerage down "2 units" if it drops 15%.Hope this helps goatfarmer.peace
billytickets
Billytickets - 6 years ago
7 gurus in the forum have ALL bought stakes in Kraft including WEB Icahn and Peltz. BillyT has followed this company for 14 years and ANYONE who buys today is getting in"cheaper" than all these GURUS.I predicted WEB would buy Kft and if you dont own it and consider yourself a "value" investor BUY it now around30.65. Trust me the gurus are "averaging down" here.peace
armeetofo
Armeetofo - 6 years ago
i can't predict, but i guess warren will buy more on WFC, BAC, MCO or WM that related to subprime issues.
billytickets
Billytickets - 6 years ago
armeetofo Warren will wait for them to"drop again" as they more than likely will. Once it is announced he has bought a stock it spikes up like KFT did then retreats back>how many peopel got KFT for less than the Gurus did today?
billytickets
Billytickets - 6 years ago
How many people loaded up on KFT after BillyT's recommendation on August16th?

1) There are 2 kinds of investors ,those who did. 2) those who "wished" they did? Its still not too late
lzou
Lzou - 6 years ago
Billy,

I did partially. I mean I want to load it up but short of cash as I bought USB, WLP, DFS, HD and TX. And when I saw your suggestion, KFT is already more than 31.50. So, instead of buying the KFT stock directly, I bought some call options. So, sorry, it is not real long-term value investor approach. But, agree with your valuation and try to catch some short term profit.
buffetteer17
Buffetteer17 premium member - 6 years ago
"Once it is announced he has bought a stock it spikes up ..."

I sold off my BAC and bought COF today. I think COF has a bigger discount to IV and also more room for growth. Also it had spiked up recently, maybe a Buffett boost?

The thing to do is buy Buffett's picks before they are announced. Another reason it pays to think like him.
billytickets
Billytickets - 6 years ago
yes buffetteer17 but sometimes "anticipating" him may not be best: check this out:

Posted by: billytickets (IP Logged)

Date: July 8, 2007 10:22PM


as a long time follower of Kraft( the main reason I started buying ALTRia) there is only 12% of this stock in institutions hands and with Peltz buying it and Buffett "rumored to".( he owned nabisco bonds and general foods in 1980's but no confirmation yet). This company is a sleeping giant


Of course i anticipated his purchase in July but thestock was much lower ( over 10%) when i recommended it on this thread at 30.60 On Aug16th. BUD JNJ WMT KFT are 4 holdings that I bought CONSIDERABLY lower than WEB did. So "anticpating" him is NOT as impoertant as you and others may think. The important thing is to buy when the "public" is afraid. All my purcahses of stock in the past 14 years have been made within 2% of the 52 week low. That is the sign of the"true" value investor.peace

armeetofo
Armeetofo - 6 years ago
every one is good at buying stocks with bargain,

happy investing, guys!
billytickets
Billytickets - 6 years ago
Read my newest article about how to recession proof your portfolio and this article written by a TRUE value investor http://www.firsteaglefunds.com/firstEagle/fortune_world_according_to_eveillard_aug_07.pdf
billytickets
Billytickets - 6 years ago
Kraft is today at 33.46 now. Following the gurus like WEB Peltz icahn and buying them right=HUGE profits with SAFETY built in
billytickets
Billytickets - 6 years ago
Posted by: billytickets (IP Logged)

Date: August 16, 2007 11:57AM


7 gurus in the forum have ALL bought stakes in Kraft including WEB Icahn and Peltz. BillyT has followed this company for 14 years and ANYONE who buys today is getting in"cheaper" than all these GURUS.I predicted WEB would buy Kft and if you dont own it and consider yourself a "value" investor BUY it now around30.65. Trust me the gurus are "averaging down" here.peace

How many people here "loaded" up on this one?

billytickets
Billytickets - 6 years ago
I think we are going to find out soon that WEB has a LARGE position in this one.Any guesses to how large?
billytickets
Billytickets - 6 years ago
well perhaps WEB did not buy KFT or was able to delay his purchase. Billionaire turnaround specialist Peltz sees the value though and Rosenfeld seems"eager" to follow his proven plan of unlocking shareholder value. Also be careful trying to catch the "falling knife financials". If you are going to try make sure you average down every 15% Mamximum. Stay calm during these times of market unrest. Courage is not the ABSENCE of fear but is the CONQUEST OF IT. Now do you folks realize why consumer goods and pharmacetiucals have performed best in S&P from 1957 on? STay calm.peace

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