nodoodahs commentary

[victor]

Hi all,

Bill, you are my hero.

I liked very much your commentary The Art of Value Investing.

And, for “education purposes” I liked the Chicken as well.

But few questions arise from that commentary:

1. What about PB?
As a value investor 2.28 doesn’t look like a super-bargain. Does your screen consider the BV as a filter?

2. The dividend yield.
As I understand, the company prefers to retain the earnings in order to finance its expansion (pay-out ratio below 0.3). But, anyway, from a value investor’s eye, do you feel fine owning a stock that yields a mere 1.1%?

3. Once the stock is in your radar, what does it trigger your buy order?
I mean is it price, change in the financial statements, your mood, ...?



Finally, I find really useful a couple of links you recommended, I mean:

http://www.tweedy.com/library_docs/papers/what_has_worked_all.pdf

http://webuser.bus.umich.edu/Lundholm/mywebs/valuedog/Piotroski_Value%20Investing.pdf

Any other useful links/docs for a value investor wannabe?

Well, one last question. I don’t like to pay for data. I use to work with reuters, yahoo finance and msn.money (ordered by preference). Any advice about that? Any known supplier of screens for European equities?

Feel free for not to answering if your time is scarce.

Thanks Maestro
Victor

[nodoodahs]

Really nice Motley Fool article on Price/Book.

http://www.fool.com/news/commentary/2005/commentary05101313.htm?source=eptyholnk303100&logvisit=y&npu=y

How to Use the P/B Ratio
By Philip Durell (TMFAdmiral)
October 13, 2005

The price-to-book (P/B) ratio is widely associated with value investing, and in fact we use it as one of the metrics on our Motley Fool Inside Value scorecard. Like the price-to-earnings (P/E) ratio, a low P/B ratio isn't always indicative of an undervalued company. Conversely, companies with a relatively high P/B ratio are not necessarily overvalued. P/B is a useful measure for comparing firms that have negative earning; those businesses can't be compared using the P/E ratio. Quite simply, far fewer firms have negative book values.

The P/B ratio is calculated as follows:

P/B ratio = market capitalization / book value of equity
(Market capitalization is often abbreviated as "market cap"; book value is often abbreviated as "BV")

Market capitalization = shares outstanding * market price per share

Book value of equity = book value of assets - book value of liabilities

So therefore, P/B = market cap / (BV of assets - BV of liabilities)

The book values of assets and liabilities are easily found on the balance sheet. The book value of assets is usually classified as "total assets." You may need to do some arithmetic to arrive at the book value of liabilities (it may not be quite so obvious on some balance sheets), but it includes all current liabilities and long-term obligations. The book value of equity is often broken out for us under the heading "Shareholders or Shareowners Equity." In my experience, most financial websites are fairly accurate with P/B ratios.

What we can deduce from a low P/B
In absolute terms, a P/B ratio under 1.0 is considered low (there are some variations that I'll explain later). Generally speaking, a low P/B can indicate:

That assets are overstated on the balance sheet. In this case, we should avoid the company because it may be destroying shareholder value. Ford (NYSE: F) is a good example of this. According to MSN Money Central, Ford's P/B was 0.72 in 1997, and its book value per share was $25.54. Today, Ford's P/B is 1.30, and its book value per share is down to $7.66. During that time, the share price has fallen from nearly $50 to less than $10. Clearly, Ford had other problems, but the low P/B certainly did not indicate value. At Inside Value, we generally look for companies that have been increasing book-value-per-share over a number of years because -- as Ford's plight shows -- the share price often follows the book value per share.

That the company will generally have a poor return on equity (ROE) and poor return on assets (ROA). If earnings are negative, there will be a negative ROE and ROA. Of course, if there is a solid management team that is turning around the company's fortunes, then we may have an interesting value proposition. When I first recommended MCI for Inside Value subscribers, it certainly fit that mold.

That the industry at large has a low P/B. Certain industries have low P/B ratios, generally because they are cyclical or because the companies generate relatively low ROE. Hurricane Katrina reminds us that insurance companies typically have low P/B ratios because of the cyclicality of that industry. "Hard insurance markets" (i.e., those with higher premiums) form after a major disaster. This attracts new capital in the short term, when investment returns can be very good. After a while, however, competition increases and the market softens. It's important to find insurance companies that maintain discipline in a soft market. Otherwise, they'll take on risks that are not adequately covered in the premiums. Eventually, claims will roll in, along with underwriting losses, and the book value will be reduced.
P/B has a buddy
ROE is a useful companion metric for P/B. This is no surprise; after all, the "B" in P/B and the "E" in ROE are one and the same -- they're both symbols for book value of equity.

A high ROE normally accompanies a high P/B ratio because investors naturally bid up the price of a company that gives them a better return on their equity. Similarly, companies that have high earnings growth rates generally have high P/B ratios -- investors expect the book value of equity per share to grow.

However, if a high-growth company has a high P/B ratio and low ROE, that growth may not be translating into shareholder value. This could portend a collapse in share price.

Even if growth rates are average, a company with a high ROE will generally have a high P/B ratio. Consequently, I always screen for ROE and P/B. The difference between the company's ROE and its cost of capital is important. The wider the spread, the higher the P/B ratio (the higher it should be, at least). Even when comparing P/B within an industry, there may be discrepancies that have nothing to do with valuation.

Best use of P/B
P/B is best used for asset-heavy companies, such as financial institutions, manufacturing companies, and other capital-intensive industries. Companies with a regular inflow of new assets, such as capital expenditures in the case of DaimlerChrysler (NYSE: DCX) or more cash in the case of JPMorgan Chase (NYSE: JPM), are likely to have book values that at least relate to market values (e.g., at around 1.2 for the P/Bs of Daimler Chrysler and JPMorgan). In both cases, a lower-than-average P/B ratio compared with past years may indicate a value opportunity. Comparing it to the S&P 500 average P/B of 2.84 (according to Barra) is meaningless as a measure of value.

P/B distortions
Distortions in P/B (and ROE, for that matter) arise because book value of equity is more an accounting measure than an economic measure. Here are a few natural distortions to watch out for:

Companies that have very long-lived assets (like real estate) still on the balance sheet at original cost (i.e., the book value) will have understated assets and, therefore, an understated book value (remember, book value of equity = assets - liabilities). All other things equal, the effect will be an increase in the P/B ratio, as the reported "B" is lower than the real value of the equity. In this case, you might miss an undervalued company by simply looking for low P/B ratios.


Service companies, and those that rely on intellectual property (IP), are not capital-intensive, and they do not have significant assets recorded on the balance sheet. A good example is Microsoft (Nasdaq: MSFT). At the end of its 2004 financial year, Microsoft had $94 billion in assets, with a full $60.6 billion in cash and equivalents, $10 billion in other current assets, and only $22 billion in longer-term assets. Nearly all Microsoft's IP was developed in-house and is not capitalized on the balance sheet -- and it can't be, because IP must be expensed on the income statement under U.S. generally accepted accounting principle rules.

Recent acquisitions will generally increase the book value and lower the P/B because the new assets go on the balance sheet at the full price paid. In the unlikely event that Microsoft acquired Oracle (Nasdaq: ORCL) and all of its IP for $70 billion in shares, the full $70 billion would be recorded on the balance sheet as an asset. The amount in excess of Oracle's $11 billion book value ($59 = $70 - $11) would show as goodwill.

A serial acquirer of other companies will almost always have a high book value, which may artificially lower P/B. However, a huge part of the book value will be in goodwill or intangibles. In this case it is prudent to subtract goodwill from book value, resulting in a "tangible book value." We can then calculate the more meaningful "price-to-tangible-BV ratio."

Recent write-offs will reduce the book value of equity. Companies typically say that this is a non-cash charge, yet in a real sense it reduces the value of shareholder equity. It may not show up in the P/B ratio because as companies reduce the "B" via write-offs, investors reduce the "P" via a lower stock price.

A company that has a history of buying back a large number of shares (in excess of covering dilution from employee stock options) will have a lower book value. All of the shares bought back go into what is called "treasury stock" at the full buyback price, and these are subtracted from book value. The original shares are recorded at par value, which is usually as low as $0.10 to $1.00 per share. A good example is Inside Value newsletter pick Anheuser-Busch (NYSE: BUD), which in the past four and a half years bought back 140 million (15%) of its shares. Book value is just $3 billion, yet the company has almost $15 billion in treasury shares. Without any buybacks the book value would be around $18 billion. A really good indicator here is that both the P/B and the ROE will be extraordinarily high. For Anheuser-Busch, P/B is 11.7 and ROE is 75, which are extraordinarily high and of little use in assessing the value of the company. To overcome this, we can use a BV adjusted for share buybacks. This would reduce the P/B to 2.0 and the ROE to around 13.
Foolish final thoughts
That's just a brief look at the P/B ratio, and I've only touched on a few of the wrinkles associated with it. P/B is a very useful measure of value, but as with other valuation metrics, it should not be used in isolation.

Philip Durell heads up the Fool's Inside Value newsletter service. To date, his picks are outperforming the S&P 500 by a margin of 4.43% to 0.20%. If you'd like to join Philip on the search for undervalued stock opportunities, you can sample his service for 30 days for free. There is no obligation to subscribe.

Philip Durell does not own shares of any company mentioned in this article. JPMorgan Chase is a Motley Fool Income Investor recommendation. The Motley Fool has a disclosure policy.
_________________
I haven’t seen a beatin’ like that since somebody stuck a banana in my pants and turned a monkey loose.

[nodoodahs]

Hi Victor,

I just got back from vacation and will be a little slow getting into the swing of things again, sorry.

Suggestions are certainly welcome! I plan on mixing it up a little bit, maybe some heavily-traded stocks and my opinion on them, maybe some unconventional takes or opportunities, etc. Also if I write about opportunities I find attractive, I will try to focus on those that are less well-known if possible. I think I'm pretty quick to point out what I don't like about some stocks, perhaps too quick.

I learned a lot from reading the more fundamentally-based "bear" sites, and from reading material about and by short-sellers. IMO if you can figure out what makes a stock a good short (from a fundamental basis), reverse the metrics and you've found a safe investment! Eliminating the bottom 1/3 of the stock universe pretty much guarantees you'll beat the index, long-term. That's why I focus so much on the fundamentals and the ratios, invest pretty much exclusively in stocks that have a history of profits, etc. I do wind up missing the occasional turn-around or pharma rocket, but I also wind up missing a lot of duds.

You’re right in that SAFM has a PB that’s “high” from a traditional value viewpoint. It is only slightly below average for its industry according to http://biz.yahoo.com/p/343mktd.html . I think both PB and PE ranges vary somewhat from industry to industry, and I choose to use PE based on my belief that PB is more impacted by an industry’s relative capital-intensity than PE is (which may be a mistaken belief). I don’t screen for PB in general, but I try to buy stocks with PB lower than their competitors’ and if the PB were well out of range to the high side, I would certainly investigate further. I think a PB-based approach, or one that favors PB more than PE, is just fine and will work, but I choose to use PE more regularly from personal preference. Sometimes I will screen for deep discounts and limit to PB < 1.00 or look for high relative cash to share price, but that’s not where I make most purchases.

I think we have to consider the size of the company and the history of dividends. What is important for a small-cap (nearly micro-cap) stock is that the dividend has been paid pretty regularly since 1990, has been increasing in the last four years, and they will pay special dividends on occasion at the end of their fiscal year based on results (see 2003 and 2004). I don’t think a dividend is necessary for a stock to be a value and I don’t screen for dividends, but I usually wind up with a high average yield from the stocks I buy.

My buy decision for values is based entirely on capital availability. I’m a small investor! When I find a bargain, and become convinced that it’s either (1) better than some other investment I own or (2) better than money in the bank, I buy it then and there. I might be better off trying to time entry, but for every example of something I mistimed, I can find a counter-example of something I shouldn’t have waited on.

Some links.
http://www.brandes.com/NR/rdonlyres/9D4985FA-F2A2-4FD9-9900-2BC2F73CA4EA/0/ValuevsGlamourUSpaperFinal0705.pdf
http://www.mises.org/journals/scholar/Leithner.pdf
http://www.informit.com/articles/article.asp?p=170894&seqNum=3&rl=1
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/valn2ed/book.htm

I’m at a total loss for free data on European equities not traded in the U.S. Sorry!
_________________
I haven’t seen a beatin’ like that since somebody stuck a banana in my pants and turned a monkey loose.

[HenryTo]

Hi Victor,

Suggestions are definitely welcomed - thanks. Please feel free to post on this board or email me at hto@marketthoughts.com anytime you want.

Your point is well-taken - and like Mr. Pete Richardson mentioned before, no one has a monopoly of ideas - and this is one of the reasons why we started this discussion forum. Hopefully, the traffic will continue to grow going forward.

I am continuing to find ways to bring in guest commentators, although I do not have anyone else lined up at this point. Peter has previously mentioned that he may like to do another one - and so I will ask him again to see if he is interested.

As of this time, I am still trying to find out more about the hedge fund industry and trying to see what the implications may be on the broader economy and on investing in general. Any insights into the hedge fund industry will be a very important piece to the stock market puzzle going forward.

That being said, I think we will see some volatile times (relative to the last 21 months) in the stock market during the next 12 months.

Take care,

Henry

[victor]

Hello Henry,

Are suggestions welcomed?

I’ts a great idea to bring guests to Marketthoughts.
Sincerely, I think you (Henry) write too much. Your analysis are sharp and accurate. But you are “forced” to write twice a week about the boriest stock market in years. You fill my screen with the latest Market Vane reading which is up 0.01% in the year and it is expected to move another 0.002% before Christmas. I mean, when there is nothing to do, the better is do nothing.

That’s the reason because I actually enjoyed your “off-topic” writtings about six sigma, copper or the world is flat.

That’s the reason I welcome new guests.


And now, time for express my wishes:

“Our mission is to educate readers about the stock market and the economy beyond the headlines.”
Henry To

I want to be educated.
I would like to know which books do you read, how you get the data, which software you use, how you analyze that (the math stuff), and not only your conclusions.
So, Bill, don’t give me every Wednesday the “Hot Stock Pick of the Month”. Just show me how you screen the stock universe, what you like about that stock, and more important, I think, what do you don’t like, what you are afraid (think GM).

Best regards.
Victor

[HenryTo]

By the way, another important thing I had forgotten to mention.

Bill actually started his vacation earlier today and will be traveling from now till next Tuesday - so I am guessing you won't see much of him in the upcoming days unless he finds access to a computer.

Henry

[HenryTo]

Victor,

I had forgotten to mention one important thing in the intro to Bill's commentary - that he will actually be writing a commentary on an individual stock the first Wednesday of every month. That way, you can take a break from me - as well as get insights from Bill regarding potential value plays out there - which some people have consistently asked for.

Nice seeing you here,

Henry