Tag Archives: feeds

The Bright Side Of Volatility

Stock markets around the world have had a bumpy ride so far in 2016. The CBOE Volatility Index (often called the “VIX”), a measure of expected stock market volatility, has doubled since early November , and US stocks have fallen more than 10% since the start of the year. These kinds of changes can be gut-wrenching and can make it difficult to maintain a long-term perspective. But for some investors who are able to do so, there’s a bright side to volatility. If you’re periodically investing money, such as putting a portion of each paycheck into a 401(k) account, volatility isn’t necessarily bad. When markets fall you’re able to acquire more shares, giving you “more bang for your buck.” This concept is similar to ” dollar-cost averaging ,” where the average price you pay for an investment will be less than the average of the prices at each of the times you’re investing (because you’re acquiring more shares when the price is low and fewer shares when the price is high). Compared to if markets just blandly moved in a straight line, the ups and downs allow your periodic investments on average to go farther. Of course, there are a few caveats to this volatility fairy tale. First, it assumes that the market will end up in the same place regardless of how much volatility there is. This assumption is clearly sometimes false; stock markets would almost certainly be higher right now if the beginning of this year had been a paragon of financial tranquility. But over the long term it’s approximately true. Stock prices 20 years from now are unlikely to be massively affected by how much stock market volatility there was in 2016. Second, the potential benefits of volatility only apply if you have a long time horizon for your investments. If instead you need the money in the near future and markets plunge, the fact that you can then get more bang for your buck won’t do much good. Perhaps the most important caveat, however, is that you need to be able to stick to your strategy of periodically putting more money into the market. When the kind of turbulence that’s characterized stock markets this year arrives, it can be tough to invest money knowing that one wild day of market moodiness might eliminate a chunk of it. But those who are able to continue making periodic investments can benefit in the long run.

Financial Ratio Analysis: Sometimes Rules Of Thumb Do Not Work

Anyone who has ever tried to value a company has used some rules of thumb when conducting the financial ratio analysis. For me personally, these form a base upon which various screens and shortlists are structured. Looking for undervalued stocks can at times feel like looking for a needle in a haystack, and these rules of thumb can come in very handy to ease the screening process and get to the shortlist faster, so we can quickly commence the joyous process of reading the appropriate financial statements and conducting a deeper due diligence on each stock. So what kind of financial ratio analysis we are talking about? Which rules of thumb? Let’s start with some key valuation ratios. Insisting on a Low P/E Ratio may Cause You to Miss Greatly Undervalued Stocks Price/earnings ratio is one of the cornerstone ratios upon which many a screen is built. A typical value investor is very likely to add a P/E ratio filter in his or her screen. The rule of thumb that is used in this case is to keep your P/E ratio under 15. Some aggressive value investors (or more conservative, depending on your point of view) might filter out any stocks with P/E ratio above 10. The Problem There are cases where a company may see a temporary drop in earnings. This may be due to short-term difficulty, an unusual non-cash charge to the earnings, or for any multiple reasons. For example, an insurance company may face a large claims payout in a given year due to a vicious hurricane. This event is statistically not likely to be repeated every year and the company otherwise is healthy. This year’s earnings though are abnormally low, and hence, the P/E ratio is likely to be very large (Most sophisticated investors realize the short-term nature of this event and are unlikely to punish the stock price too much knowing that the earnings will recover quickly). Is this stock likely to be undervalued? Chances are, it is. Temporary distress creates opportunities. The problem is that a low P/E ratio screen will filter these opportunities out. The Solution A low P/E ratio screen still remains quite important. However, we would like to find these edge cases because most of the investors will not bother. While undervaluation is hard to find when the P/E ratios are higher, the ones that do exist are likely due to unusual situations, and can show a much larger profit potential. An easy screen to run is to create a screen with very high P/E ratios – let’s say 100 or more. One can also look at negative P/E ratio screens. With the stocks that these screens throw up, we will then go through them one by one and review their situation to find out whether an unusual situation exists (we will review these in detail), or if the stock is just normally overvalued with investor froth (we will ignore these). Insisting on a Low Price/Book Ratio may Cause You to Miss Some Outstanding Ideas Normally, value investors like to keep their Price/book ratio to be under 1. The idea is that there is enough equity in the business to justify the price being paid for the shares, so if something were to happen to the profits in the future, the stock price has assets backing it up and supporting it (so the likelihood of losses is lower). Other investors might be less conservative and will be okay buying a stock with P/B ratio up to 1.5. One should note that the nature of the business also dictates the correct P/B multiple one should be willing to pay. A service company, for example, that relies less on physical assets and more on human capital will sport a larger P/B ratio in normal course of business than a different company with a number of factories and equipment. The Problem It should come as a no surprise to anyone that the book value of the assets can be at large variance with what these assets will truly fetch in the market. Sometimes the book value is overstated, in which case we may consider a stock to be undervalued where as in reality it is not. Sometimes on the other hand, the book value is understated, in which case the stock may appear to be richly valued, even though in reality it may be a great investment. We also have situations where a company may have spent years destroying shareholder wealth to the point that the retained earnings and shareholders’ equity have become very small or even negative. If the business is now in a turnaround situation and the equity can be purchased at distressed levels, this may be a great investment. A very high or a negative P/B ratio will rule out these kinds of investments. The Solution We could screen for very high P/B ratios. Many of the stocks that come up will be anomalies that we will need to review in detail. In the past, we invested in TPL which carried almost a million acres of Texas land on its book at zero value since the land was acquired over 200 years ago and was fully depreciated by now. Given that the reason this trust exists is to monetize this land, its sole asset, it would have been curious if one did not wonder why it carried no real estate on its books, and why its P/B ratio was so high (21.52 at the time of writing). This case though does require looking into the books in greater detail. In case of high P/E ratios, the anomalies are normally easier to find and explain. Assets may be buried in the books for years inflating or deflating the stated book value, and unless we dig deep, we may never know the fact. Conclusion: Use the Rule of Thumb for Convenience, but Venture Outside the Box Occasionally So, if you miss some ideas, what is the big deal? There are many more, right? True. However, these many more ideas have a larger number of eyes already fixed on them. So, while you may find them, they may not have as great a profit potential as the stocks that keep under the radar for one reason or other. These two examples are how some stocks that may be undervalued continue to evade investors as they do not get caught in their screens.

If ROIC Is So Great, Then Why Doesn’t Everyone Use It?

That’s the question we get when we argue that return on invested capital ( ROIC ) does a better job of explaining changes in shareholder value than any other metric . Why do investors, executives, and the financial media focus on reported earnings and other metrics such as EBITDA that ignore the balance sheet? Why aren’t executives around the world adopting ROIC in order to boost returns? Anyone asking those questions should read the 1996 CFO Magazine article ” Metric Wars .” Back in the mid-90’s, ROIC-based models such as Economic Value Added (NYSE: EVA ) and Cash Flow Return On Investment (CFROI) were all the rage, with corporate giants such as Coca-Cola (NYSE: KO ), AT&T (NYSE: T ), and Procter & Gamble (NYSE: PG ) linking them to executive compensation and highlighting them in communications with shareholders. Fierce competition ensued, as a variety of consultants developed and marketed their own shareholder value models, all, at their core, based around the idea that companies need to earn a return on capital above their cost of capital. That revolution was short-lived. Coca-Cola and AT&T stopped regularly highlighting EVA in filings after 1998. Some of the consulting companies mentioned in the CFO piece no longer exist, such as Finegan & Gressle, while others like The Boston Consulting Group no longer highlight the same metrics. It would be easy to assume that ROIC-based models had their chance in the marketplace and failed because they weren’t good enough, but that would be wrong. The story of the “Metric Wars” shows that it was the marketing strategy, not the underlying model, which was flawed. The Consultant’s Concoction The lack of resources and technology available at the time required the proponents of these metrics to do many hours of manual work to provide the metrics for the client and its comp group. As a result, the firms wanted to differentiate their models or build barriers to entry around them so that competitors could not piggyback on their original work. Transparency was not in the consultants’ best interests. If everyone could see the inner workings of their formulas, clients wouldn’t have any incentive to pay big money for their model over a competitor’s. As a result, the various firms guarded their models and would attack a competitor’s formula as a “consultant’s concoction.” This was an understandable development, as the recurring revenue stream from a consulting client can be very valuable. Unfortunately, it also led to lot of significant problems for the ultimate end-users of that data. Excess Complexity: consultants needed to make the work seem really difficult so clients would not replicate and competitors could not decipher it. Lack Of Transparency: since each company’s formula was its bread and butter, they kept the details of how they were calculated hidden. It was hard for those on the outside to understand or trust the process. No Comparability: with no single standardized formula, it was impossible for companies or investors to benchmark results to their peers. Short Shelf Life: the analyses were only as fresh as the last engagement, and since the “proprietary” formulas could change from year to year, clients might not always have the most up-to-date analysis. Little Differentiation: While all the different consultant’s formulas had their own tweaks, they were based around the same basic idea. With so little fundamental differentiation, the various consultants spent a great deal of time and effort tearing each other down and nitpicking competing formulas, ultimately spreading more confusion. Add this to the tech bubble attitude of the late 90’s, when stock valuations became more about stories and potential rather than any fundamental research, and the work these consultants were doing fell by the wayside. Today, only Stern Stewart and Credit Suisse (which bought CFROI or HOLT in 2001) remain as survivors from the Metric Wars. Neither has had a ton of success monetizing their formulas since then, in part because they remain committed to their “concoctions” for consulting business, and also because they rely on inconsistent and limited data feeds that lack analysis of the financial footnotes or management disclosure and analysis. A Different Strategy What New Constructs does today is not so different from what Stern Stewart, The Boston Consulting Group, and others did 20 years ago. We’re working off the same conceptual framework and implementing many similar calculations. What’s changed is the level of rigor we put into building technology to gather high-quality data and build best-in-market models with scale. Our point of differentiation is the scale and speed with which we can build the models and provide analytics. Our highly educated and trained analysts leverage our proprietary technology to deeply analyze 10-Ks and 10-Qs in a matter of seconds on average. While we make thousands of adjustments in our models to close accounting loopholes and portray the true economics of the underlying business, every adjustment is not only 100% transparent but also overrideable by clients. Anyone can go to the Education tab of our website and get detailed explanations of the metrics we use, how we calculate them, and the various adjustments we make to accounting data. Our data is comparable across different companies, so anyone can easily use our screeners to compare profitability and valuation. During the Metrics Wars, the technology simply didn’t exist to create such a large database and deliver that much information without charging a prohibitively large fee to clients. Because of these limitations, those companies failed even though their underlying framework was sound. In the intervening years, the burgeoning financial punditry has helped propagate the myth that the market only cares about reported earnings. The rise of the E*Trade baby and amateur investors only furthered the focus on simplistic data points that could be easily calculated and consumed. More sophisticated fundamental research became harder and harder to find. Today, there is a noticeable gap for the many investors out there that want high-quality fundamental research. Most of the available research out there doesn’t attempt to assess the true drivers of value. Wall Street analysts lack the independence to deliver truly objective research, and what little truly high-quality research exists tends to be too expensive for the average investor to access. Our goal is to remove the noise that clouds the connection between corporate performance and valuation by providing an analytical framework that is intuitive yet rigorous. For over 95% of the world’s market cap, we provide apples-to-apples corporate performance and valuation metrics. We are ready to join the Metric Wars. Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, style, or theme. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.