The ideal method to maximize return is buying low and selling high at the right time with investments that have quick recovery time frames. Ideally, all the cash proceeds from a sale should be immediately reinvested into new opportunities. Often, this is not the case. When the respective markets such as the DOW, S&P 500 or the S&P Composite 1500 experience highs, it is difficult to find good quality investments at low prices. This is further hampered when a value investment fund has limited options. In order to provide ample opportunities for reinvestment of cash, value investment funds require at least five pools of industries and a minimum of 40 stocks. The ideal fund will have around eight pools of potential investments with no less than 60 potential securities.
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Fast is fine, but accuracy is everything. – Wyatt Earp
Churning refers to agitating. It is commonly used with the dairy industry to refer to the process of turning liquid cream into butter. The churning process breaks down the fat membranes allowing the fats to join together. In effect, churning means to work the liquid into a solid. With investing, churning has two different connotations. The first is the more common negative connection to brokers getting their clients to buy and sell frequently in order to increase overall commissions for the brokerage. The positive connotation is rarely used and it refers to working one’s portfolio of investments to maximize overall return. That is what this lesson is about. How does a value investor work their portfolio to maximize overall portfolio return?
The ideal method to maximize return is buying low and selling high at the right time with investments that have quick recovery time frames. Ideally, all the cash proceeds from a sale should be immediately reinvested into new opportunities. Often, this is not the case. When the respective markets such as the DOW, S&P 500 or the S&P Composite 1500 experience highs, it is difficult to find good quality investments at low prices. This is further hampered when a value investment fund has limited options. In order to provide ample opportunities for reinvestment of cash, value investment funds require at least five pools of industries and a minimum of 40 stocks. The ideal fund will have around eight pools of potential investments with no less than 60 potential securities.
The current Value Investment Fund on this site has the following pools and respective stock selections within each pool:
. Real Estate Investment Trusts Insurance
Railways (Residential Rentals) Banks Fast Food Non-Health Care Military Contractors
Union Pacific Essex Property Trust Comerica Bank McDonalds Travelers Huntington Ingalls Industries
CSX UDR (United Dominion Realty) Bank of America Restaurant Brands AllState Lockheed Martin Corp.
Canadian National Equity Residential Wells Fargo Starbucks Progressive Raytheon Technologies
Canadian Pacific Avalonbay Communities JP Morgan Chase Jack In The Box Cincinnati Insurance Northrup Grumman
Kansas City Southern Mid-America Apartment Communities Fifth Third Bank YUM Brands Old Republic General Dynamics
Norfolk Southern Corporation American Homes 4Rent CI A Bank of New York Wendy’s L3Harris Technologies
. Dominos Pizza
. Shake Shake
This particular investment fund has six pools with 37 various stock selections. Even with this many selections, the Fund still has times where it holds large amounts of cash for extended periods because all of the respective opportunities are priced in excess of intrinsic value. The key is to have a large enough selection so that at any given time, one or more of the opportunities has a market price below intrinsic value allowing an investor to reinvest cash earned from the sale of securities. In effect, the cash is always invested and working to improve the overall fund’s return.
There are two key requirements to successfully churn an investment fund. The first is selection; i.e. ensure a diverse portfolio of opportunities such that at any given moment there are always opportunities to buy. Secondly, understanding how timing impacts returns on investment. When an investor understands how these two requirements interact with each other, an investor can take advantage of this knowledge and successfully manage and churn a good return (remember a good return means annual returns above 30%).
As always, a reminder is required here. Value investing is not about getting rich quickly, it is about creating a methodical buy/sell program that generates good returns year after year with very little, if any, risk associated with the capital invested.
Pools of Potential Investments – Selection
A common risk reduction tool with securities management is diversification. Here, the professionals discuss specific types of risk associated with actually owning the respective securities. The goal is to reduce volatility and correlation risks such that no one single investment will expose the owner to a significant loss. The results are interesting, with at least 18 different security positions, a portfolio manager reduces this risk by 90%. Having 30 different positions, improves risk reduction to 99%.
However, with value investing, the goal isn’t really volatility. After all, value investors are buying the the respective security at less than intrinsic value; therefore, the chance the particular investment will go lower and stay low for an extended period of time has already been practically eliminated. The risk value investors are seeking to eliminate is that with a portfolio of securities to choose among, that all the respective opportunities are all above intrinsic value. In effect, there are no opportunities to buy low. Value investors need one or more of these potential opportunities to drop below intrinsic value and acquire some margin of safety such that a purchase can be made to utilize excess cash. Thus, how many stocks must exist within the selection pool such that there will always be opportunities to buy and therefore the portfolio rarely has cash which earns a pittance return in comparison to capital gains.
Simply stated, how many different securities must exist in the overall portfolio such that there is ALWAYS an opportunity to buy low. Thus, when a sale of an investment is made, the cash proceeds are immediately reinvested in a new opportunity.
Furthermore, the ideal situation provides more than just one or two opportunities to buy. Value investors want to see several potential investments below intrinsic value such that one or more of the securities provides a greater margin of safety when purchased. Then the value investor reinvests with the security with the greatest potential to recover quickly and earn an outstanding return on the investment. The end result is constant agitating of the portfolio to maximize overall return for the portfolio.
So how many potential investments must exist to always have continuous opportunities to buy? Remember, value investors are only interested in the top 2000 publicly traded companies and all of them must have good histories of operations and earnings. With top corporate operations, the market rarely allows the securities’ price to drop below intrinsic value. Thus, these attributes make it difficult to find opportunities to buy low.
If a value investor could, obviously having two thousand plus opportunities is ideal. This would indeed provide continuous occasions to buy low such that the cash will always be at work. However, it is unrealistic. It takes about 20 to 30 hours of work during the initial phase to learn about an industry and then another eight to 10 hours to analyze each potential member within that pool. Once the initial work is completed, it takes about four to eight hours per year to maintain the analysis for a pool of five to eight members. In effect, it requires about five hours on average per year for each potential investment to conduct initial analysis and then maintain that analysis. If a value investor has a pool of 50 possible individual securities, then on an annual basis, this investor would need to spend around 250 hours of work to maintain the analysis necessary for intrinsic value, margin of safety and of course market recovery price.
To make matters worse, 50 possible individual securities would mean about seven to nine pools of investments (six to ten potential stocks in each pool). Learning about and understanding seven to nine industries will add another 200 hours of work per year.
The end result is that it is ideal to have several hundred potential investments with their respective value points (intrinsic, buy and sell); but, it is unrealistic to think that any single individual can realistically expend the resources necessary to develop and maintain such a diverse portfolio of pools of industries and of course each pool’s individual members.
What is the minimum required?
Based on experience and some supporting input from Graham and Dodd (Security Analysis), a value investor needs at least 60 potential investments spread over no less than eight pools of industries. The only possible way to have such a diverse portfolio is if the value investor participates in a club whereby each member establishes and monitors a single pool industry and provides the information to fellow club members. This in turn, allows all members access to a diverse portfolio of pools of industries and a broad base of potential investments.
Churning with value investing is the ability to maximize returns to the maximum extent possible. This requires a large pool of potential investments. Not only is a wide selection pool required, the investor must select those available investments that have faster recovery time frames over those with longer recovery periods.
Churning – Timing of Investments
Churning refers to continuous utilization of cash into investments with the best recovery cycle such that the entire investment portfolio is growing at the fastest rate possible. In order for this to be possible, a value investor must be able to time the purchase at a low point below intrinsic value. In addition, preference must be given to those investments with faster recovery time frames over investments with slower or extended recovery periods. Thus, timing involves buying at a low price and giving preference to those potential investments with faster recovery cycles. Each of these two attributes are explained further.
Buying Low
Value investing uses the term ‘Margin of Safety’ to refer to buying the security at a good price. Margin of safety is typically a percentage of value below intrinsic value. Of course, intrinsic value is the securities’ real value, i.e. the maximum value which a reasonable investor would pay to own the respective rights the security provides. In effect, intrinsic value is a ‘Fair Value‘ for the investment. When a value investor purchases this investment for less than intrinsic value, it affords additional risk protection that the particular investment’s market price will go lower and/or stay below this price for an extended period of time. Think of margin of safety as an insurance policy.
Margins of safety are calculated depending on several attributes. Companies with strong current asset weighted balance sheets have a lower margin of safety because of the liquidity afforded current assets over fixed assets. Liquidity refers to the ability to unwind the business in a reasonable time frame. Whereas fixed asset intensive operations require deeper margins of safety due the market’s understanding of fixed assets and the unease of turning a fixed asset into cash. In effect, it takes much longer to liquidate fixed assets over current assets which in turn requires a greater margin of safety when buying fixed asset intensive companies.
There are other contributing factors affecting margin of safety, they include:
- The Respective Industry
- The Industry’s Financial Model
- Economic Factors (Inflation, Interest Rates, Unemployment, GDP, Growth, etc.)
- Federal Compliance and/or Restrictions
With this site’s Value Investing Fund, the following pools have these respective margin of safety ranges:
. Pool Balance Sheet Margins of Safety Range
Railways Fixed Asset Intensive 9% to 19%
Fast-Food Mixed 5% to 35%
Banking Current Asset Intensive 4% to 14%
P&C Insurance Current Asset Intensive 3% to 8%
REITs Fixed Asset Intensive 8% to 18%
Military Contractors Fixed/Intangible Intensive 5% to 12%
Overall, current asset intensive pools start with lower margins of safety and tend to top out with a margin of safety that will rarely exceed 15% to intrinsic value. Whereas, fixed asset intensive models start out higher and top out at more extremes to intrinsic value. This reflects risk associated with liquidation of assets. The greater the risk to liquidate in a shorter window of time, the more important it is to reduce this risk by increasing the margin of safety.
Thus, when buying low, the value investor should wait until the margin of safety price is reached by the market prior to purchasing the security. As an example, Union Pacific’s intrinsic value is currently $197, the Railways Pool has determined that an appropriate margin of safety for Union Pacific is 9% or about $18 against intrinsic value. Therefore, Union Pacific’s current buy price is $179 per share. The risk the price will drop lower than $179 exists, but as the price continues to drop, other forces kick in to minimize its continued downward spiral. For example, the dividend yield at $165 per share is 2.85% which is extremely strong. At $150 per share, the dividend yield increases to a rarely found 3.15%. Furthermore, the deep selloff of Union Pacific during the mid February to late March 2020 driven by the COVID pandemic identified a maximum market price reduction for this company of around 37% against its prior peak market price. Again, this sudden price drop was against current market price which had just recently reached the highest ever recorded for Union Pacific just prior to this drop. Thus, buying Union Pacific at a 9% discount against an intrinsic value which is commonly much lower than the market value provides adequate protection against a market price that will continue to drop dramatically lower than this preset buy price and acts as a very defensive position that this deep discount price will stay low for an extended period of time.
The idea of buying at such a low price is one of the four principles of value investing. The buying low is the best risk reduction tool available to any investor. In addition, buying low generates greater returns once the security is finally sold. To create great disparity between the buy price and the sale price begins with buying low. The lower the buy price against intrinsic value, the greater the absolute return on the investment once it is sold.
One last note related to buying the security below intrinsic value. With a typical portfolio of 60 to 80 potential investments, only about two to three investments will be at these low prices. Remember who we are talking about here. These are top 2,000 companies with very stable history of earnings and performance. There may be other driving forces that may have more than three out of 80 potential investments whereby the current market price is dramatically lower than their respective intrinsic values. These include economic recessions/depressions, industry wide issues (new federal compliance requirements, resource availability, consumer attitude towards the industry’s product/service, and/or competition). But the more common scenario is only two to three out of 80 potential investments. Thus, which one does the investor choose to buy low?
Recovery Time Frames
The second attribute of timing related to churning of one’s portfolio of investments is the recovery time period. This is the common time frame for a company to have its securities’ market price recover to a prior peak price. Obviously, the shorter the time recovery period, the greater the annual return on the investment. This is key for any churning function of any portfolio. Ideal recovery time frames are three to six months. Some investments will have longer recovery time frames, in some cases up to three years.
Thus, preference is given to those potential investments with shorter recovery time frames allowing the investor to sell upon recovery and begin the churning process all over again with this new inflow of cash into the portfolio.
As an example, here is the Banking Index over the last three years. Notice the time period from one peak to the next. Once the stock is purchased as some point within that cycle at a deep discount to intrinsic value, the recovery time frame is anywhere from two months to nine months. As an example, if an investor bought banking during March of 2020, they would have and to wait until early February of 2021 to sell their investment and reap their reward. This was eleven months, which is slightly longer than the expected nine months maximum. It doesn’t change the absolute dollars earned, it only changes the annual return on the investment due to the longer time frame to complete the recovery cycle.
Other industries take much longer to recover. Look at military contractors:
With military contractors, recovery time frames are much longer; short time frames are about one year and extended time frames are just longer than two years.
As a value investor, each investment will have its own recovery time frame. Give preference when buying to the investment that has shorter recovery time periods over those with longer recovery time frames.
In the sophistication phase of this program, the value investor learns about how to calculate the various inclines found with a security’s market price. Those investments with steeper price declines and recovery periods are given greater preference over those with shallow inclines.
The reality for the attribute of recovery is that as value investor, you will rarely have to address this as a part of your decision model. Odds are that you will only have one potential investment in your portfolio of investments to invest excess cash. Without a large portfolio of at least 60 or more potential investments, most likely you will not have anything available when you have excess cash to churn. If your portfolio of potential investments is less than 30, it is very likely you will have to sit on cash for extended periods of time while waiting on the market or a particular industry to falter providing the value investor with an opportunity to buy low. Remember, value investing’s fourth principle, patience.
Summary – Churning
With value investing, churning refers to maximizing the use of cash in the portfolio. To properly churn the investment portfolio, the value investor must always have one or two investments waiting for the cash investment. In order to to do this, the portfolio of potential investments must be vast and diverse. A typical portfolio of 60 or more potential investments will customarily provide two to three opportunities to buy low. If this exists, the value investor will always prefer the investment with the shorter recovery period for market price recovery. The key is to maximize the overall return of the portfolio by having as much cash invested as possible and optimizing the portfolio by selecting securities with faster recovery time frames. Remember the primary tenet of business, buy low, sell high. Act on Knowledge.
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I think it is an immutable law in business that words are words, explanations are explanations, promises are promises – but only performance is reality. – Harold Geneen
Monitoring performance is the single best tool to ensure success with value investing. Comparing results against expectations provides the basis for good decisions. In business, this is known as the feedback loop. In effect, a variable input is changed, results are recorded, compiled and reported in a understandable format. Any unexpected results are analyzed and input changes are implemented. The pattern is repeated. The end goal is to generate continuous improvement. With business, improvement is stated in the form of profit; with investment funds, it is stated in the form of percentage of return on the overall invested capital. Thus, managing an investment fund is just like operating a business; the goal is to improve overall performance.
Throughout this series of lessons in Phase One of the program, it has been stated and reiterated several times. The goal of value investing is to generate returns that far exceed the returns of several indices. A value investor should expect at least a return on their investment in the mid-twenties as a percentage per year. The real goal is to generate 30% plus with returns. If the investor does their research properly and adheres to the four principles of value investing, achieving 30% plus per year on average is doable. But without monitoring performance of the fund, an investor cannot make the necessary timely adjustments to achieve the annual goal.
There are three different levels of monitoring with an investment fund. The primary level includes the decisions and status of the respective buy and sell points for each transaction within the investment fund. Here, the goal is to ensure that each respective company level purchase is adhering to the respective parameters of their pool’s buy/sell model. How is each position performing? The next level is at the pool level. Similar to the respective investment level activity; at the pool level, the goal is to understand how the pool is performing against the initial conception for the upcoming period of activity. Is the pool of similar investments complying with or meeting the goals set at the beginning of the investment year?
The final level is for the fund as a whole. Here, the idea is to understand how each of the respective forms of realized earnings is performing against total earnings (realized and unrealized). Furthermore, it is important to break down progress against anticipated areas of anticipated revenues including dividends, options and finally gains from the sale of actual securities.
Throughout this lesson, the investor will refer to this spreadsheet to understand how this works. If you are a member of this site’s program, the spreadsheet is a simple download using your password. For those readers that are not members, you will have to refer to the screenshots provided along with some examples included here in the lesson. The key is that the formulas are built into the spreadsheet for members making it a lot easier for them to understand and to use this spreadsheet for their own personal purposes.
Monitoring Performance – Primary Level of Data
With value investing, it all starts out with creating the industry model. This table of information provides the basis for the buy and sell decisions an investor will set as the standard of performance. The model itself has it own set of building blocks which are covered in Phase Two of the membership program. Those building blocks have their own respective concepts, formulas and spreadsheets to use. Those resources are provided with their respective lessons.
The value investment industry model is the outcome. This is the guidance piece of the overall puzzle. To illustrate, here is the railways pool model. There are six publicly traded railways in North America. Each has their own current market price, book value, and intrinsic value. Review all six for these respective dollar amounts.
This fund model has several interesting key points.
- At the time of this lesson creation, every single one of the potential investments in the railways pool is at or near their historical peak price. This lesson was written in late March 2021, thus the Prior Peak Price column actually reflects current market prices for the individual companies. More interesting is that on Monday the 22nd of March, Kansas City Southern jumped another $25 per share do to an announcement by Canadian Pacific to buy and merge with Kansas City Southern. Even as a combined company, their volume of revenue ton miles will still be less than one-half of Union Pacific. This is why Union Pacific is marked as the standard bearer.
- Market price on 10/22/2020 indicates the market price as of the start of the fiscal year for this respective pool of potential investments. Prior peak price merely represents the most recent peak in price for the stock during the current fiscal year.
- Optimum buy price is the current year’s desired purchase trigger. The optimum buy price reflects the margin of safety desired from intrinsic value.
- Intrinsic value in the railways industry is calculated using a modified discounted cash flows formula (covered in Phase Two of the program).
The model is the most important part of the industry pool. When developing the model, the investor typically discovers patterns about the individual companies and uses those patterns to finesse the model. In this case, this particular pool of investments typically have excellent results. The problem is that having opportunities to purchase low occur infrequently. Over the last two years, a total of seven opportunities to buy low have existed. Each opportunity was recorded and every single one of them performed greater than than the model predicted.
To date, in Fiscal Year 2021, there have been two opportunities to buy low, both transactions generated outstanding gains. Look at the results:
Notice how the annualized return for Norfolk Southern far exceeded the expected annualized return the model sets. Norfolk Southern’s transaction far surpassed the expected due to its short turn around time of only 13 days. Union Pacific’s transaction almost hit the usual 90 day recovery and this is why its annualized return was only slightly better than what was projected at that time.
One last note, Norfolk Southern’s purchase at $202.49 per share was only at about 1% margin of safety and not the desired 10%. The investment pool manager decided to make the purchase just under intrinsic value because there were no holdings at all during this last week of October. The pool had not held a single investment in over a month. Once one of the potential investments finally had a share price below intrinsic value, the pool’s decision maker decided that owning Norfolk Southern for a smaller overall projected gain was worth the risk. Furthermore, four of the other potential investments were indicating recovery which meant that the likelihood of Norfolk Southern continuing to decline to the margin of safety buy price was unlikely. It turns out that Norfolk Southern’s share price only dipped to $198 before it rebounded and cleared its prior historical peak. Thus, intrinsic value is the worst case scenario to buy the respective potential investment.
With each full transaction (buy and sell), the pool’s overall value should begin to increase. In addition, any investment currently in a ‘hold’ status waiting on recovery after purchase requires monitoring. Thus, a second level of monitoring is required. This is the industry pool level.
Monitoring Performance – Industry Pool Level
At the pool level, monitoring performance is about tracking the status of the respective investments in that pool. The current status is compared against the goal. The idea is to understand how the pool stands in relation to the overall objective. When the investment is made for a particular member of that pool, it is then included in a current portfolio of investments and updated weekly to identify progress towards the projected recovery point.
To illustrate, here is the report for the Real Estate Investment Trust Pool of this site’s Value Investment Fund.
Take note of what this report reveals:
- The pool’s current cumulative value is well ahead of schedule, it is currently five months complete and all of the respective investments are either on schedule or ahead of schedule of their respective target earnings. For example, with four months to go, Equity Residential is tracking almost in-line with the desired outcomes. This is a reflection of the quarterly reports. There are two more quarterly reports to go before then end of July 2021. It is conceivable that the market price will hit the target price of $81 per share when the 1st quarter report for 2021 is posted at the end of April 2021. If that report identifies normal earnings, then the market price will soar. If tenant payments are still an issue tied to COVID, then the price will not hit that target price of $81 until after the 2nd quarter report.
- If all investments hit their respective targets by the respective goal dates, the respective return on investment will exceed 52% not counting dividend earnings during this period.
To augment the current status report, a second report is also included on the same page in the spreadsheet. Dividends earned and expected during the holding period are quantified and reported. This is an example of the report for the REITs Pool.
Take note, already fiscal year-to-date the REITs Pool has earned $666.66from dividends and is expected to earn another $1,711.96 if the respective investments are held through their respective anticipated recovery dates.
Add this cumulative $2,379 to the anticipated gains and this set of investments should earn a cumulative $39,224, a 56% return on the $70,000 basis. This is well in excess of reasonable return guidelines for value investors.
The pool is tracking very well towards it end goal. By Mid-April, the first quarter dividends will post, adding another $666.66 to realized returns.
Remember, dividends are not the primary purpose of value investing. It is about earning respectable gains within a reasonable period of time. Dividends are just icing on the cake. Overall, auxiliary sources of income such as dividends, interest and the sell of PUTs typically increase the return about 10% above gains. Thus, if a fund earns a total 35% return in one year, about 3.5% is sourced from these auxiliary sources. Gains will typically represent about 90% of the total return over time.
The final level of reports sums up all the respective pools onto one tab in a spreadsheet.
Monitoring Performance – Investment Fund Level
At the investment fund level, the format is a summary presentation of each of the individual pool’s current status tied to the existing investments. In addition, a second section reveals realized gains from each pool. A third section identifies the auxiliary forms of earnings fiscal year-to-date including dividends, sales of any options and interest. The summary line indicates total unrealized gains, realized gains and current balance of the investment fund. This section of the investment fund level will also identify the current positions along with any dividends receivable and cash balance.
The following is an illustration of how this site’s Value Investment Fund is presented to members for learning purposes.
VALUE INVESTMENT FUND
Status Report – 03/24/2021
Current FMV Unrealized
Industry Pool Investment Basis Net of Fees Gains/(Losses)
Railways -0- -0- -0-
REITs $70,000 $92,214 $22,214
Banking 40,000 41,889 1,889
Sub-Totals $110,000 $134,103 $24,103
Realized Gains
Railways $7,298
Banking 3,677 Realized
REITs -0- Earnings
Sub-Total $10,975
Dividends Earned
Railways 204
REITS 667
Banking 409
Sub-Total 1,280
Sale of PUTs
Railways 3,361
Sub-Total Realized Earnings Fiscal Year-To-Date $15,616
Receivables (Dividends/Broker Amounts) -0-
Cash Account 5,617
CURRENT DOLLAR BALANCE – VALUE INVESTMENT FUND $139,720
INITIAL INVESTMENT BASIS 10/22/2020 $100,000 $39,720 (Realized & Unrealized Gains)
When reading this report, remember, realized earnings are reinvested into other potential securities. In this, $10,000 of the earnings have been reinvested as the cost basis up in the industry pools section reveals a current cumulative investment of $110,000. The Fund started out with $100,000. The difference is in the form of cash; with most reports the difference will be in the form of receivables and cash.
Thus, this fund has increased in value by $39,720 through the first five months of activity.
Summary – Monitoring Performance
Monitoring performance of a value investment fund is essential for several reasons. First, it is important to compare results against the designed buy/sell model for each respective industry pool. Secondly, understanding the current fair market value of each industry pool and the dollar value of each holding within that pool allows the investor to understand how the respective investments are tracking against the goals set forth. Finally, an overall picture informs the investment fund manager about the current status of the fund overall, where it has earned its gains and other sources of net realized earnings. This allows the investor to compare the fund’s status against the respective goals set out at the beginning of the year. Act on Knowledge.
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“The big money is not in the buying and selling … but in the waiting”. – Charlie Munger
Setting buy and sell points for any investment security determines the investment’s final return. If the buy is made too early while the security is falling in price, the value investor loses out on not only additional margin upon the sale of that security, but also reduces their margin of safety associated with the intrinsic value point. It is similar on the other side of intrinsic value. If sold too soon, the value investor leaves money on the table. Thus, setting the buy and sell points are important decisions for every investment.
There are tools available to determine these two values. In the simplest of statements, the easiest rule to follow is the Pareto Principle; commonly referred to as the old 80/20 rule. This rule basically states that roughly 80% of all outcomes are within 20% of a focal point. With security pricing, this principle is simply that 80% of the value changes will occur within 20% of intrinsic value. Therefore, if a security’s intrinsic value is $80, then the probability is that 80% of the maximum change in value will happen within 20% of the core value. Therefore, the buy is approximately $64 and the sell point is $96. Almost certainly, this rule isn’t pure with security investing. The conception is that if the end results are beyond this 20 percent under and over the intrinsic value point, the value investor must have additional financial support and a lot of history with the security to validate expanding the buy and sell points beyond 20% fluctuation. This does not mean that the buy and sell points are exactly 20% deviation from intrinsic value; it merely states that there is an 80% probability that the buy and sell trigger points are within 20% of intrinsic value. The key point here is that if you can find 20% deviation on both sides of intrinsic value with high quality securities, then you have an excellent potential for a good return.
This lesson first introduces a basic model to illustrate and reinforce setting the respective buy and sell points. This model emphasizes an important aspect of price change. The angle of change affects the return on the investment. The steeper the price change, the shorter the time period for the change. The shorter the holding period for any investment, the greater the return on the investment. This is illustrated with a chart in this section of the lesson.
Once the basic principle of the price angle is understood, it becomes straightforward with creating formulas to determine the preset buy and sell points. This lesson introduces three quick and simple tools to assist with setting these two points around intrinsic value. The first formula is the price to book ratio converted into dollars. The second tool is the adjusted prior dip or peak price point. The third, and highly restrictive, is the price to earnings ratio.
Lesson Three explains how fluctuations exist not only in the market as a whole, but with the economic sector, the industry group,and the respective investment securities of each company. Some companies experience wild fluctuations in bursts over extended time periods. Others have stable low variances.
A perfect example of a highly stable minimal variance security is Coca-Cola. Review Coke’s price fluctuations over the last ten years.
Other than the aberration circled in red driven by the sudden market decline in Feb/March of 2020 (COVID market decline), there is a steady incline with the market price for Coke’s stock. As the line moves along the time spectrum, there are lots of small peaks and valleys including some built-in high points to low points. For example, look at the middle of the 2014 – 2016 grid block. Right in the middle the price peaks to $37 and by around November of 2015, the price bottoms out at $32 a share.
It occurs again in early 2016 with a peak just above $40 and a dip to almost $35 by late 2016. Thus, in a nine month period, Coca-Cola’s share price deviated a total of $5 (approximately 7%) in a single direction. Without deep changes, at least 12% changes in a single direction, a value investor will find it very difficult to create enough delta with price deviation to justify the investment if a reasonable return is desired (more than 30%). Only during the sudden steep drop in March of 2020, where the price changes 35% is there an opportunity to earn a good return. Coca-Cola is just that high of a quality of stock. It is considered one of the top 10 stocks to own if you can buy it when there is a sudden and dramatic dip in its market price. The closet similar dip occurred back in 2008 – 2009 time period during the housing market collapse. Thus, Coke rarely has a significant price dip nor a dramatic increase in value.
This illustration emphasizes the importance of understanding a security’s pattern. Two questions must be answered. First, are there frequent enough changes over time? Secondly, are these changes dramatic enough to warrant inclusion in an investment pool of funds? The first section below provides a model of price change and time period involved when developing potential investments.
Setting Buy and Sell Points – Basic Model Required
The ideal value investing model would have a straight line intrinsic value with a predictable security price fluctuation with at least a 20% change in both directions within a one-year time frame. This would allow for an above average annual return. Look at this stock’s price change over a course of a single year. 
On the first day of the year, both stock and intrinsic value start at the same point, $35. The determination to purchase and sell is 20% below and above the intrinsic value point. Thus, the buy is made at $28 per share and the sell occurs at $42 (120% of $35).
The price dips to $26 on 05/28/2021. However, it hits $28 around 04/23/2021. Since value investors use computer orders to buy and sell, the stock is purchased on 04/23/2021 at $28 share. At the same moment, a transaction fee is imposed of $1 per share. Thus, the total investment is $29.
Over the next month, the price continues to drop and reaches the low point on 05/28/2021 and begins to swing back towards intrinsic value. On 07/02/2021, the price crosses over the $28 dollar point and continues to climb to $35 on 07/30/2021. The model’s rule is to sell at 120% of intrinsic value, $42. It finally hits $42 on 09/17/2021. The computer generated order completes the sale and charges $1 for the transaction fee. Thus, the value investor nets $41 on the sale. The original investment is $29 (buy price of $28 plus $1 transaction fee). The gain on the sale is $12 ($41 minus $29). The original investment is $29, therefore the return on the investment is 41.3%. The holding period is 149 days, almost half of a year. The effective annual return is 101%.
This particular model is a ideal dream. The buy point is well below intrinsic value and the stock’s price recovered quickly from its low of $26.
A common concern/question raised by students of value investing is: ‘Why not buy the stock after it dips past $28?’ Their point is that, if the stock were purchased at $26, the return on the investment would be $14 on a $27 investment (buy price of $26 plus $1 transaction fee). The final return would equal 51.8%; the effective annual return would be dramatically greater than the 101% from the above example. There are two benefits from this; first, the financial gain is greater on a smaller investment and the time period to complete the full transaction is 35 days shorter. Therefore, the actual and annual return is greatly superior.
There are two problems with this thought. First, the student assumes that the price will continue to drop when there is a good chance that the price dips to $28 (recall the 80/20 rule) and then begins to swing upwards. The idea to continue waiting means a lost opportunity. Secondly, value investors exercise computer orders in order to reduce their time commitment with constantly monitoring the market. Imagine monitoring eight or ten different stocks waiting for a good price to buy. One of the benefits of value investing is reduced stress, a direct result of proper planning. Computer directives are a part of planning. Value investors adhere to the old adage: ‘Proper planning prevents poor performance’.
This is why this program teaches that value investors will earn good returns; in order to earn great returns, there must be dramatically more risk assumed and increased time invested with monitoring and research.
The above model is an example of an ideal potential investment opportunity. The perfect model would have greater dispersion from the intrinsic value point at higher frequency (more often). Imagine, having a model that allows for 30% deviation from intrinsic and the fluctuations occur within four months, i.e. the 30% dip to the 30% peak transition in four months. Thus, based on a $35 intrinsic value, the dip to $24.50 ($35 * 70%) would only take about 45 days; the buy is made for a total investment of $25.50. The market price recovery accelerates to $45.50 (130% of intrinsic value) in four months and the stock is then sold netting $44.50 ($45.50 less $1 for the transaction fee). Total gain is $19 on a $25.50 investment which equals a return of 74.5% or an annualized effective return of more than 220%.
Take note, steeper deviations along with shorter time frames dramatically increase the return on one’s investment. It isn’t a slight increase, it is substantial.
These types of models just simply don’t exist with highly stable top 2,000 companies. This is why it is explained in Lesson 14 to design at least three sets of pools that allows a value investor to create multiple models. From Lesson 3, market fluctuations are primarily driven by economic wide pressures, then industry wide factors. The goal is to have three or more industries (pools) with varying models such that the deviations are predictable. This then allows for easier setting of buy and sell points.
Go back to the core four principles of value investing. Principle number one is to seek risk reduction. Highly stable, top 2,000 companies practically eliminate risk associated with investment. Additional risk aversion is fulfilled by buying the security below intrinsic value. An investor can indeed find securities with dramatic deviations around intrinsic value and high frequency fluctuations. These are commonly found with small-cap investments. The trade-off with investing in this part of the market is significantly increased risk. Thus, value investors AVOID small-cap investments, a direct result of risk aversion. It is superior thinking to earn good returns with minimal risk than to increase risk dramatically for potentially a few more percentage points with gains.
When developing a model, try to find and use an industry wide model as the base for the pool. For example, this is the railways index published by Dow Jones and is comprised of all six North American railroad companies.
The least differential of extremes occurs with the center circled zone. On 04/28/2019 the index peaked at 2,512 and four months later on August 18, 2019 it dipped to 2,177, a 13.3% decrease. The key is that there is a pattern of differential values with railroad stocks. There appears to be an annual repetition with highs and lows of more than 13%.
For explanation purposes, assume the intrinsic value of the index fund is 2,300 in 2019. Thus, this would indicate a dip in this time period of approximately 5.4% and a recovery of approximately 109% of intrinsic value.
Many of you reading this will question why this would meet the suggested minimum differential of at least 20% of intrinsic value as the mean value. Therefore, based on this requirement, the only valid differential occurs in 2020 and there isn’t enough frequency to warrant inclusion of railroads as an industry pool of potential investments. The argument is reasonable. The response is really informative.
The index fund is comprised of six railroad investments. During the 2019 cycle period, each of the six had their own distinct cycles. To illustrate, here is a table of values, peaks and dips for each of the six railroads in this index fund.
. Time Period 04/28/2019 thru 08/18/2019
Name Peak Price Lowest Price Differential %
Union Pacific $179.20 $162.45 10.3%
Canadian Pacific $246.27 $216.73 13.6%
Kansas City Southern $125.34 $112.05 11.8%
Norfolk Southern $206.70 $169.85 21.7%
Canadian National $95.37 $88.59 7.6%
CSX $80.52 $64.41 25.0%
Within these six investments, both Norfolk Southern and CSX railroads drove the average price differential of the index fund. Thus, out of the six, two of the investments are potential value investment opportunities. Again, the respective intrinsic value for each investment is required in order to determine if indeed there is opportunity with that investment.
The point of the above exercise is that the industry index reveals cycles of ups and downs. Secondly, these differentials are for the industry as a whole. Reviewing the individual investments will identify actual opportunities.
With a core model developed for the industry and then with each member of the respective pool, the next step is to set the buy and sell points. A popular tool use is the price to book ratio.
Setting Buy and Sell Points With the Price to Book Ratio
The price to book ratio is one of the most popular value investor tools used to gain a quick understanding of any company’s financial market profile. As a company gains trust and proves its stability (remember, stability of earnings is considered the number one factor with valuation), its price to book ratio will begin to increase.
The price to book ratio is defined as the market price per share against the book value per share. The book value is the shareholder’s equity section divided by the number of shares outstanding (sold and held by shareholders). Thus, if the market price is greater than book value, the result is a positive relationship. It is not uncommon for market price to be less than book value and yet the company is still a great operation. In some instances, it is possible for the book value to be negative; yet the investment is considered high quality. A good example of this is McDonalds Corp. McDonalds book value is almost $9 negative per share; yet, it is one of the top 10 most stable companies in the world.
There are circumstances when book value is less than market price with high quality companies. But, in general, investors look for positive price to book values. The higher the ratio, the more likely it is time to dispose of the investment. In order to determine potential opportunity, the value investor must first recognize or determine the normal expected price to book ratio. Here is an example:
Essex Property Trust is a real estate investment trust with over 60,000 units along the west coast of the United States. In early 2021, its book value was approximately $98 per share. Its market price ranged from $240 per share to $265 per share during the first two months of 2021. Thus, its price to book value ranges from 2.45 to 2.70. The intrinsic value of Essex Property Trust is calculated to be $255 per share or approximately an intrinsic price to book value of 2.60:1. Thus, with this particular investment, it is expected and reasonable to have book values ranging from 2.1 to 3.1 (20% deviation from the intrinsic price to book ratio of 2.6).
This is not unreasonable with REITs. With banks, ratios greater than 1.5:1 are just unheard of with that industry. To illustrate, here is Bank of America’s price to book ratio for the last 14 years.
Not once in 14 years has Bank of America’s price to book ratio exceeded 1.5:1. Bank of America is considered one of the top five banks in the United States. It is a well respected and well run organization.
The point here is this, THERE IS NO UNIVERSALLY CORRECT PRICE TO BOOK RATIO STANDARD. Each industry is different and as a value investor, you must recognize this and accept it as a value investment standard to follow. If you ever hear someone say that the price to book ratio is high and that it is common to sell at 2 or 3 to one, that individual is not sophisticated when it comes to investments. THERE IS NO PRICE TO BOOK STANDARD. Price to book ratios have normal ranges within each industry.
This same principle exists with the buy side tied to price to book ratio. Many so called professional investors state that buying at less than book value is the same as value investing. IT IS NOT! It is not uncommon for the price to book ratio to be less than 1:1 with several different industries, for example, insurance companies. The Travelers Insurance Company have had eight of the last fourteen years with the price to book ratio at less than 1:1 and Traveler’s is a DOW Jones Index member.
The goal of this exercise is to first understand the industry’s normal price to book ratio range and then each member within your pool of potential investments within that industry. Keeping with Essex Property Trust, here is Essex’s price to book ratio over the last 14 years.
Notice that Essex’s price to book ratio dipped below 1:1 back in 2009. This is a direct relationship to the entire economic recession driven by the mortgage crisis that started in the 2nd half of 2008. The price to book goes over 3:1 in the middle of 2019 just prior to the COVID market collapse in February of 2020. With a 3.2:1 ratio and a book value back then of $94 per share, the market price was just over $300 per share.
Remember from above, intrinsic price to book is 2.6:1. Thus, looking at this graph, an excellent buy price is when the price to book drops to 2.4 or 2.3:1. If the current book value is $98, then a good buy price is $225 to $235 per share. Looking at the trend line, the sell point is 2.9 possibly as high as 3.0:1. Thus, a reasonable sell price if book value is $98 per share is $285 to $295 per share.
The key is to pay attention to current book value as it does improve from one quarter to the next. Remember, value investors only purchase high quality, top 2,000 companies. Since stability of earnings is essential to belong in this group, book values should increase quarter over quarter. There are exceptions to this rule; but in general, book value should improve with each quarter’s financial report for your investments. Since book values improve, the market price for the respective stock tied to price to book ratio should also improve quarter over quarter. Thus, the market price standard this quarter will most likely end up less than the desirable amount in the forthcoming quarter.
There is a lot of emphasis on book value in one of the lessons during Phase Two of this program. That lesson teaches the value investor on how to read the equity section of the balance sheet and derive book value. It also explains how share buy-back programs impact book value along with other circumstances that impact book value. Understanding book value and how to monitor this important pricing mechanism is essential as a value investor.
Another tool used to set buy and sell points with a particular investment is the prior peak price point of the security. This particular tool places emphasis on setting percentage changes in order to determine buy and sell points for stock.
Setting Buy and Sell Points Using Prior Peak Price
An alternative to the price to book ratio method is using the prior peak price tool. This approach is based on an assumption that the market price for high quality securities will always be on an upward incline, similar to the DOW Jones Industrial Average. Thus, if a particular company’s stock price hit a new peak, at some point in the future, it will surpass this peak price. In effect, buy at deep discount to the most recent peak price and then simply sell once the security’s price surpasses the prior peak price.
Thus, in order to to earn good gains, the value investor only needs to find securities with adequate differential between the peak prices and dips in market price within a short period of time. Here is an example with Norfolk Southern Railroad.
Norfolk Southern has a distinct incline. Within this incline are multiple points of peak price and a corresponding deep price discount. Here are the four obvious cycles:
- Jan 2018 – price peaks to $150.88 and dips to $135.78 in March of 2018 – 10% change
- Sept 2018 – price peaks to $180.50 and dips to $149.54 at the end of Dec 2018 – 17% change
- April 2019 – price peaks to $204 and dips to $174 in August of 2019 – 14.7% change
- Jan 2020 – price peaks to $208.21 and dips to $146 in March 2020 – 29.8% change
In a course of two years, there are four full cycles of at least a 9% decrease in value from a prior peak. This site’s investment fund took advantage of three of these distinct cycles to earn excellent gains. This site set the price decrease to 12% of the prior peak and the sell point to 103% of the prior peak and reaped good gains for each full cycle.
The key is that there is a definite pattern with this particular company and recovery from a trough point along the price spectrum is short in duration and always surpasses the prior peak market price. Why? This company is highly stable and provides weekly updates to its key performance indicators. In effect, it is highly stable and a well run company. Any negative deviations are simply the result of an industry wide issue or some kind of temporary falling out of favor from the market as a whole. This same pattern has existed for the last 20 years. With this site’s railways pool, this particular company is an automatic buy at a 12% dip in market price to prior market peak price and then sold at 103% of prior market peak price.
An important critical piece of the formula is the intrinsic value line. The line should have a similar incline as the market’s trend line over time. Do not allow the separation of the intrinsic value from the market’s trend to deviate more than 5%. A greater than 5% deviation will cause greater disparity with price fluctuations and will require a deeper discount with market price to protect against a protracted recovery period. In effect, deviation from normal warrants additional security to protect the investment and increase the final reward for this additional risk.
This particular method is only appropriate with investments that clearly demonstrate a pattern as Norfolk Southern’s share price illustrates. Furthermore, it is of the utmost importance to validate that the company is well managed and that it isn’t suddenly changing its operational standards or product/service lines. With railways, changing the model is difficult if not impossible. Thus, the highly stable pattern exists.
One last important note related to this particular method of buying and selling securities. Sometimes the prior peak is an anomaly. Be careful, look at the historical pattern, the prior peak should be on the incline path; in effect, it was predictable. If the prior peak is a spike that is more than 15% off the predicted high, gain an understanding of the underlying forces that cause this abrupt increase. If the underlying factors are permanent, it is possible that the market is elevating the entire industry due to a change in the industry or the economic sector. A good example are pharmaceuticals in late 2020. Worldwide governments started negotiating contracts with them to provide vaccines. There does not seem to be any reason to believe that this will not continue as new vaccines will be required each year to keep up with the variants of this virus. Thus, pharmaceuticals have been elevated to a higher tier of overall value in the eyes of the world economy.
To counter this, an example of stock that has had a sudden increase in market price is Tesla. There is no industry, company wide nor economic justification for this doubling of stock price in six months. In effect, Tesla’s $800 per share market peak in price is unjustifiable and quite simply, unreasonable to maintain or continue increasing along the same incline. It simply does not make sense.
A third method of setting the buy and sell points is to base the values on earnings per share.
Setting Buy and Sell Points Based on Earnings
Throughout Phase One of this program it has been reiterated many times in the lessons and in articles about particular investments that stability of earnings is the number one factor related to value for any company. Stability of earnings refers to three required characteristics of a company’s earnings.
First, the earnings must be positive for an extended period of time. The more history of positive earnings, the greater the reliance on the company to earn a profit in the future. An extended period of time does not mean five or even seven years. It means positive earnings for a complete economic cycle within the industry the company operates. For most industries, this means at least a dozen, possibly as many as twenty years of continuous positive earnings.
Secondly, the historical earnings pattern must be growing from one year to the next. A good example is Canadian National Railway. Here is Canadian National Railway’s earnings per share over the last fifteen years.
The increase in 2018 is a direct result of the change to the United States tax rate from 34% to 21%. The company elected to include deferred income into that year’s income and pay the tax at a much lower rate as allowed by law.
For this company, earnings per share per quarter are consistently on an incline over time. The last three quarters reflects the impact from COVID (quarters 2, 3, & 4 of 2020).
This graphical depiction validates stability of earnings. This is the ideal pattern for any publicly traded company.
Finally, the company must demonstrate positive earnings during a recession. Since stability of earnings is based on a full economic cycle for the respective industry, from the graph above, Canadian National demonstrates this twice in this fifteen year depiction. Back in 2008, which is depicted at the seventh and eight marker (notice the slight decrease with these two earnings per share indicators), a recession started in North America. A second recession exists during the last half of 2020 driven by COVID, notice the last two markers in the above graph. Canadian National continues to earn positive earnings per share during two distinct economic recessions.
Stability of earnings is the most critical factor in deriving value.
When setting a buy and sell point for any stock, earnings per share can be used to determine these two points. A popular ratio used to assist with this outcome is the price to earnings ratio. In theory, a company should hold steady with its price to earnings ratio (P/E). As its earnings increase, the market price per share should increase in a similar pattern as if the two units of measurement had a correlation rate of a natural price to earnings relationship. A good example of this is Amgen Inc. Amgen is a biotechnology company and a member of the DOW Jones Industrial Index. Take a look at its earnings, price per share and its P/E ratio.
Other than the anomaly in 2018 due to the tax code implications on earnings, the P/E ratio remains relatively stable even though the stock price increases. There is a good correlation between the increasing earnings and the stock price keeping the P/E ratio stable. Notice that even though the earnings dip due to the taxation recapture, the stock price did not drop in a similar pattern. This is because investors were well aware of the tax implications when Congress passed the Tax Act in December 2017. However, if the market price for a share remains stable and the earnings practically collapse, it does indeed impact the P/E ratio. The result was a tripling of the ratio outcome.
However, this isn’t true for all companies. Amgen is one of the few that actually adhere to the correlation theory for price and earnings. Other market forces including industry issues can cause the P/E to fluctuate even though the company continues to prove its ability to earn profits with consistency and improvement over an extended period of time. Take a look at Canadian National Railway’s P/E ratio over the same time period as the above earnings graph for Canadian National.
The P/E ratio fluctuates and its pattern is not level. This is how value investors can take advantage of the P/E ratio and set buy and sell points for a stock security.
How is this done?
To start, the value investor must know the intrinsic value. With this value, an intrinsic based price to earnings ratio can be calculated. As with all intrinsic formula calculations, use no less than five years look back to determine an average.
For Canadian National, the average annual earnings were $4.57 adjusted to exclude the tax benefit in 2018. The historical average P/E for the S&P 500 has been 15:1. With railways, an intrinsic price multiplier is 18:1. Using this ratio as the mean, Canadian National’s intrinsic average would be $82.26. Over the last five years, it has traded for a low of $48 and high of $116.
If an investor wants to add additional security with their investment, they would simply lower this ratio to 17:1. Thus, whatever the average five year earnings are, a buy is set for any price less than 17:1 and a sale is conducted at 23:1 or higher.
With Canadian National Railway, the current buy price using this method is $78 per share and the sell is set to $105. As of the writing of this lesson, the current market price for Canadian National is $108 (02/17/2021). During the past 12 months, the low has dipped to $66 per share and its high reached $116 per share.
Each quarter, this buy/sell trigger formula is recalculated to reflect the impact of the most recent earnings. However, the intrinsic value earning multiplier never changes; refer back to the correlation theory of market price to earnings.
* Caution
For those of you interested in reviewing Canadian National’s quarterly or annual financial reports, please be aware, their financial statements are in Canadian dollars, also known as the ‘Loonie’ named after the national bird, the loon. Thus, you must convert their financial information to US dollars in order to compare against other years or companies.
Summary – Setting Buy and Sell Points for Financial Securities
This lesson’s primary principles are as follows:
When setting up or designing buy and sell values for any financial security, a core industry model must be created and used as the standard to follow. Each industry will have a their own value differential around a core intrinsic amount. In addition, this model will identify a common frequency for these maximum and minimum price fluctuations. With this model in hand, the value investor can then proceed to create a unique buy/sell model for each potential investment within that pool of similar investments.
Value investors may use one or more of three very popular methods:
- Price to Book Ratio – as stated multiple times, each industry has their own average price to book ratio and a corresponding corridor of values tied to the price to book ratio. Remember, there is no universal standard for price to book ratio. In some industries, it is normal and acceptable to have price to book ratios less than 1:1.
- Prior Peak Price – highly stable, top 2,000 companies have a strong history of stable earnings; their respective securities price will also improve over time. A good method is to discount a prior peak price with a substantial discount, buy at this discounted price and then resell once the prior peak price is surpassed at a reasonable point, like 103% of prior peak.
- Price to Earnings Ratio – since the market typically prices stock tied to earnings, it uses a price to earnings ratio to determine value. A value investor determines the intrinsic value multiplier and uses the average of at least the last five years of earnings adjusted each quarter and then determine the current buy and the corresponding sell price based off this single multiplier number.
Good value investors will use all three tools to establish a limited range (corridor) of buy and sell points and adjust these two points each quarter as each company releases their respective financial updates. Act on Knowledge.
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“Courage taught me no matter how bad a crisis gets … any sound investment will eventually pay off.” — Carlos Slim Helu
An investment fund is a collection of capital from one or more individuals and is used to purchase financial instruments of various companies or other funds. The most common types are brokerage funds that allow incremental purchases from members. These funds are often dedicated to a certain group or type of investment with similar attributes. Some funds are dedicated to stocks from only small-cap companies. Other funds focus on a sector or industry within the economy. For example, there are utility funds, real estate funds and retail based funds.
The primary goal of a fund is to restrict the purchases of financial instruments to a certain investment group or type believing that this group or type is dynamic enough to earn a good return for its members that contribute the capital to buy rights to companies.
There are two forms of investment funds. The first form is an open fund. This means that it continuously allows new investors into the fund and its capital basis can expand over time. Most brokerage funds are open as they are used with many retirement plans. The opposite of this is a closed fund. Here, a preset sum is invested and the fund grows off this limited capital investment. Ownership of the fund may change as a member has the right to sell their respective position in this fund.
This site’s investment fund is a closed fund. It is owned by the site and does not allow others to join. Only the activity of the fund is documented and reported on this site to demonstrate how value investing works and how it continuously grows the investment. Furthermore, the fund’s respective information is available to club members. They have the right to use the information for their own investment fund.
When a value investor creates their fund, they utilize pools of similar investments in their fund to enhance the fund’s overall performance. It is encouraged to have at least three pools of investments in a fund and no more than six pools. A well designed fund uses the attributes of the respective pools to reduce risk, improve overall performance and minimize the holding of cash. The following three sections cover these three pooling benefits and how they achieve the overall goal of value investing.
The club’s Value Investment Fund consists of five pools of investments. Each pool is a set of companies in a similar industry. All potential investments belong to the top 2,000 companies traded in the market. The three pools and their corresponding members are:
Railways Real Estate Investment Trusts (Residential Rentals) Banks Fast-Food Insurance (P&C)
- Union Pacific Essex Property Trust Comerica Bank McDonalds Travelers
- CSX UDR (United Dominion Realty) Bank of America Restaurant Brands AllState
- Canadian National Equity Residential Wells Fargo Starbucks Progressive
- Canadian Pacific Avalonbay Communities JP Morgan Chase Jack-In-The-Box Arthur J. Gallagher
- Kansas City Southern Mid-America Apartment Communities Fifth Third Bank YUM Brands Old Republic International
- Norfolk Southern Corporation American Homes 4Rent CI A Bank of New York Wendy’s
- Shack Shack
- Domino’s Pizza
There are no less than 30 potential corporate investments. Each pool has its own dedicated set of resources, spreadsheets, formulas and supporting documentation in their respective section of the website. You must be a member of the club to gain access. It is encouraged for members to create their own pool and have that pool validated by the facilitator and in a forum of other members. Once completed, that pool may be posted to this site with the creator’s permission. If you desire to have your pool posted here, you will be considered the expert for that pool; any interactions with fellow club members related to that pool is controlled by you.
Investment Fund – Risk Reduction
As explained and illustrated in Lesson 14, pools of similar investments reduce risk primarily driven by a requirement to have comprehensive understanding of that industry. It is difficult for a single individual to have a comprehensive understanding of more than five industries due to the extensive time commitment required. When the investment fund has several pools in it, the overall risk factor can be further reduced just by the sheer volume of selection of potential investment options. In effect, intrinsic value for each company in each pool can be set one to three percent lower for all potential investments as there are often several potential investments at or near their intrinsic values at any given time. To illustrate, this table identifies at least five of the above 18 potential investments that are below, at or near their respective intrinsic values. Today is January 22, 2021 and the DOW Jones Industrial Average is at or near its all time high of 31,250. At closing, the DOW is at 30,998.
. Values
Railways Intrinsic Market
- Union Pacific $180 $206.93
- CSX $67 $87.64
- Canadian National $84 $106.06
- Canadian Pacific $225 $339.26 *5:1 Stock Split in the Summer of 2021
- Kansas City Southern $135 $217.58
- Norfolk Southern Corporation $205 $244.22
Real Estate Investment Trusts (Residential Rentals)
- Essex Property Trust $255 $243.45
- UDR (United Dominion Realty) $42 $39.11
- Equity Residential $67 $61.56
- Avalonbay Communities $158 $164.73
- Mid-America Apartment Communities $98 $134.18
- American Homes 4Rent CI A $23 $31.25
Banks
- Comerica Bank $44 $62.16
- Bank of America $26 $31.55
- Wells Fargo $34 $31.90
- JP Morgan Chase $104 $133.79
- Fifth Third Bank $22 $30.90
- Bank of New York $42 $41.93
Of the 18 potential investments, five are currently trading on the market at less than intrinsic value. With such a wide array of potential investments and so many at less than intrinsic value, a value investor can easily adjust the buy point two to three percent less than intrinsic value and still have plenty of potential investments available to select for purchase. This further reduces risk as risk aversion is strongly correlated with intrinsic value. Any difference between intrinsic value and market price below intrinsic value is considered additional margin of safety.
Of the three industries, two are having difficulties right now and are frowned upon in the market. Banks are out of favor due to the impact of the pandemic and some historical misleading of the public. The pandemic also affects the REITs industry, specifically the apartment complex holdings which the above pool holds. With several different pools in the portfolio, there is always opportunity to buy a good investment and at the same time, one or two investments are doing well with their market price. For example, this site’s investment fund purchased Norfolk Southern back in October when the intrinsic and market value at that time was $204 per share and sold them 13 days later at $231 per share. Right now, railways are performing well and all of the potential investments in that pool are at their all-time highs. Thus, it will be several months before this industry sees any significant decrease with their respective market values approaching intrinsic value. This industry wide ‘UP’ is offset by the two other industries in the ‘Fund’. Thus, opportunities exist at all times. The best part is that opportunities always exist at or near intrinsic value which greatly reduces risk for the entire fund.
Investment Fund – Improves Overall Performance
Enhancing overall performance of an investment fund is essential to improve the cumulative return. Improving overall performance starts with selecting highly defined pools for investments. To augment performance, ensure that the respective pool’s economic cycles are different. Some industries experience market fluctuations that are extended; others have quick frequencies of highs and lows. Having a mix of market price cycles allows a value investor adequate opportunities to buy low and sell high with less volume of potential investments.
It is important to note certain drawbacks to this concept. Awareness of these drawbacks forces the value investor to pay attention to market conditions and utilize preset computer orders to ensure proper timing and return. To assist in understanding, the following three subsections explain the drawbacks of extended, desired and shorter market cycles. In the next section, this lesson covers how to maximize return utilizing pools and how their respective market and economic cycles impact value investing.
Extended Market Fluctuations
When a stock’s market fluctuation cycle exceeds one year, this is considered an extended cycle. In effect, the most recent low and high exceed one year and in some industries can approach three years in duration. The most common industries that exemplify this cycle period are high fixed asset based companies with long lives that earn revenue on a consistent basis. Examples include real estate based operations, shipyards, and publicly traded toll road operators. Companies like this are highly focused and rely on large initial capital outlays to purchase the necessary long-lived assets and associated intangibles (worker skills, logistics, market position). In return, they receive a consistent and reliable source of income. Their profitability is tied to their ability to efficiently produce their product or provide the service.
For illustration, here is Huntington Ingalls Shipyard’s stock price over the last five years. Notice the distinct extended low price of stock and the cycle time between these lows.
The deep lows occur every 15 to 18 months. The unique high stock prices also occur in between the distinct low points. Naturally, this isn’t a permanent pattern but it does illustrate how this company has an extended cycle time for distinct highs and lows related to stock market price.
Furthermore, large companies like this earn consistently improving revenues over their respective lives. The next exhibit illustrates how Huntington Ingalls has a pattern with continuously improving revenue over time.
As a value investor, this type of pattern is greatly beneficial. The key is to understand how to take advantage of this pattern and earn excellent returns. Since it is impossible to accurately time the respective deep highs and lows, an alternative method must be utilized. Assuming the investor has done their due diligence with calculating intrinsic value and the corresponding reasonable market recover price, what can a value investor expect as a return on their investment. Let’s walk through this.
Assuming a reasonable intrinsic value of $190 per share and a market recovery price of $230 per share, what would be the respective return on the investment over the first two cycles?
Looking at the share price line, the price dips to $190 in about April of 2017. The buy is then made. In November of the same year, the stock peaks suddenly to $240 passing the sell point of $230 within a couple of weeks. Thus, the transaction earns $40 (sold at $230/share less basis of $190/share) over an eight month period. In effect, the return on the investment equals about 30% on an annual method. In November of 2018, the price drops past the $190 buy point and the stock is purchased again. It looks like the price rises past $230 a share in November of 2019. Thus, the next cycle earns $40 per share over a full 12 months. The annual return on the investment approximates 21% due to the longer recovery period.
Two key important points of interest here. First, although the full economic or market cycle is extended, the actual buy/sell period is significantly shorter. Value investors are not holding the stock from one low point to the next. At some point, the stock price recovers before it dips back to another low. Thus, a long extended cycle does not mean a long holding period for the value investor. It just means that the opportunities for investment exist in a long cycle, the actual full transaction is completed within this cycle. Secondly, the shorter time period between buy and sell points dramatically improves the annual average return on the investment. This is explained in Lesson 3 of this series. This important principle is elaborated more in Phase Two of this program (development series).
Extended cycles are riskier for investors due to the possible long extended market recovery period from a low purchase price. If this cycle extends into two and three years, the return on the investment drops below 10% annually. Therefore, it is important to pay attention to these cycles and how they can impact the performance of the investment portfolio. The ideal pool would have shorter cycles and greater differentials between high and low stock prices.
Desired Market Fluctuations
The ideal stock investment is one that has a recurring pattern and is not influenced by the general economic situation nor industry conditions. It would have a perfect sinusoidal waveform of ups and downs and its frequency would be every six months. See Lesson 9 and its explanation of cycle patterns. The respective peaks and troughs would also have enough differentiation that acting on the respective investments at proper buy points and sell points generates more than 35% annual returns.
This ideal set of conditions in a single or a set of similar stocks does not exist in the market.
However, there are industries that happen to have reasonable cycle patterns that occur every six to twelve months allowing an investor the opportunity to earn good gains with each transaction. The key is that the industry itself may not have this cycle, but this cycle will exist with one of its potential investments or moves from one company to another within the pool membership. Finding an industry with this type of action generates not only good returns but greatly reduces risk.
Ideal changes would be more than 20% from one extreme to the other within a three month period; thus, it would fully cycle every six months or so. Changes less than 20% from one extreme to the other makes it difficult to earn a reasonably effective return due to transaction costs. Here is an example.
XYZ Company experiences market price fluctuations from $89 to $111 twice a year. To protect the fund, the value investor selects $93 as the buy price to ensure acquisition of stock at a good price and sells at $105 per share to protect against the inability of the market cycle to fully reach the prior peak price. Assuming a $1 per share transaction fee, the actual investment is $94 and the net proceeds are $104. Thus, the actual realized gain is $10 per share on an investment of $94. Assume the market cycle is pure with two full cycles per year. The buy is made as the stock heads towards the low of $89 and sold as it heads towards the peak of $111. The effective holding period per completed transaction is approximately 90 Days. Thus, each year, $94 is invested to get a cumulative return of $20 (twice a year, each time earning $10). The actual return is 21%, the effective annual return is 42%. Look at this graph for the illustration of timing of the buy and sell points.
Thus, $94 is invested for 90 days each twice a year, Mid-March to Mid-June and Mid-September to Mid-December. Again, there is a 20% market price change four times a year, two declines and two recovery periods. This allows two full opportunities to buy low and sell high. With market price fluctuations of 20%, an investor can expect about a 40% return on their investment. If the market price fluctuations are less than 20%, and the cycle is similar, an investor cannot reap the rewards given the risk factors involved.
Therefore, it is important to understand that there are two critical aspects of market price fluctuations. First, the ideal situation would allow for TWO full cycles per year and secondly, the price change must be at least 20%.
It is also important to note that in order to get an effective 42% return per year, the value investor would need a second company that has similar pattern but shifted by 90 days in either direction. Thus, upon the sale of one stock, the opportunity to buy exists with the other stock. This keeps the capital invested full time for the entire year.
The drawback for ideal market price fluctuations is they just simply do not exist. If it did, everybody would follow this pattern which would change the pattern. This is why as a value investor, you must find an industry that has at least a 20% price fluctuation change from peak to lows and with frequency on a regular basis. It doesn’t have to be perfect; it just needs to be common and if common among the industry membership, the greater the chance to improve overall performance for the investment fund.
With the current Club’s Investment Fund, the railways pool provides these ideal market fluctuations on a regular basis. NO, it isn’t perfect, but the pattern does exist and given the six companies in the pool, there are enough frequent opportunities to earn good returns. Again, value investors are not looking for great returns; great returns require UNACCEPTABLE RISK. Value investors are looking for good returns with minimal risk. The railroad fund is used as one of the examples to illustrate finding an ideal pool of similar investments that have predictable patterns and earn good returns with minimal risk. This is covered in detail in Phase Two of the membership program on this site.
The continued drawback for both the extended and ideal cycle patterns is that cash is held during certain times while the fund waits for the proper buy point to materialize. Therefore, a value investor’s fund needs more frequent opportunities in order to ensure as much capital is invested as possible. Thus, a good investment fund will also have a pool of investments that have high frequent peaks and lows in order to exercise available capital during interim periods of time.
High Frequency Market Fluctuations
Since it is so difficult to find companies with ideal stock price fluctuations, value investors turn to the opposite of extended market price based pools and utilize pools with more frequent ups and downs to improve overall investment fund performance. In general, high frequency pools experience a complete cycle within a few months. The respective industries typically are popular with consumers and often the respective companies introduce new products in order to compete. If you were to review their balance sheets, the respective companies have greater portions of their current assets as a ratio of total assets. Thus, their risk factors are slightly higher than longer term and single focus entities. Furthermore, the intrinsic value tends towards book values for these companies. Price to book ratios rarely exceed 2:1 and often the price to book is less than 1:1. Examples of industries that have more frequent fluctuations include those industries in the financial sector, construction and transportation sector.
The drawbacks to these companies are two-fold. First, the difference between the peaks and lows within the cycle rarely hit more than 12%; thus, there must be greater attention to current key performance indicators that create value. Secondly, as market fluctuations increase in frequency, risk increases. Thus, it is essential to ensure an accurate calculation of intrinsic value to prevent losses. In general, value investors must utilize a greater safety margin (buy at less than intrinsic value, typically in the 80% or less range of intrinsic value). Worse, when it comes time to sell, the sell point is set lower than prior market peaks in order to ensure capture of gains and prevent the risk of sudden reversal of price increases forcing the value investor to hold the stock for longer periods of time to wait for proper recovery of stock price.
All of this affects the return on the investment. To further reduce gains, the cost of transaction fees impact overall gains and lowers the final return on the investment.
To illustrate, take a look at Lennar Corporation’s stock price fluctuation over the last six months. Lennar is one of the top five home construction companies in the United States. In this case, Lennar’s book value on 11/30/2020 was $61.24. Intrinsic value was calculated at $75 per share for 2020. Thus, the buy point is $75 per share. The reasonable market recovery point (sell point) was set for 8% higher than intrinsic value. Thus, the buy point is $75 and the sell point is $81. Assuming a $1 transaction fee per trade, the net gain equals $4 per full cycle on a $76 investment (the intrinsic value point plus $1 for the transaction). Thus, with each full cycle, the gain equals 5.3%. Take a look at Lennar’s stock price chart over the last six months.
In this case, the value investor is waiting for the price to drop to $75 after it peaks at $81 per share. It peaks to $81 at the end of September 2020; peaks just past $84 in Mid-October 2020. Then drops to $75 per share on 10/26/2020 (see gold cross-hair). The buy is made on this date. The price recovers to the sell point of $81 on January 20, 2021(see gold cross-hair).
The full cycle is completed in 88 days, not quite one quarter. Thus, the cycle generates a 5.3% return on the investment in 88 days for an annual return of 21.8%.
Notice how this more frequent cycle but less disparity between buy and sell doesn’t generate the desired annual return of more than 30% on investments for value investors. It is good, but not at the level wanted. So why include pools of investments that have market characteristics like this if the end goal is to generate 30% or more return on capital in the investment fund?
Investment Fund – Maximize Return
With a well designed fund, maximizing earnings annually is the goal. With a set of diversified pools, timing of investments and utilizing all the available capital increases the overall return. As illustrated above, finding ideal pools with perfect market price fluctuations is unrealistic. Fund managers must combine the positive attributes of extended and frequent market price changes in order to ensure all the capital is put to work. It would seem that the easiest path would be to simply use all the capital with a single investment if that particular stock is bought at a very low price to intrinsic value with adequate margin of safety. The problem is that there is no guarantee of market recovery in a reasonable period of time. Therefore, it is prudent to diversify the portfolio. Diversification requires additional patience while waiting on other possible purchases.
During this temporary waiting period, it is beneficial to put this available capital to work by purchasing an investment from a more frequent cycle pool of investments. The return isn’t as lucrative as the extended cycle investments; but, it puts to work the available capital to earn some return.
The ideal fund will have investment pools composed all three types of market fluctuations. The most difficult type to find is the ideal cycle pool of investments. This site’s fund currently utilizes a railways pool as its ideal pool, but at the time of this lesson production, this particular pool has all six of the potential stocks at or near their respective all-time highs for stock price. In the interim, the available capital is invested in the banking pool which carries the more frequent cycling attribute necessary for an investment fund.
Overall, the extended cycle time pools of investments provide outstanding gains and high average returns. The ideal pool of investments will sometimes experience highs and this can go on for many months. The void is filled with investments that have faster cycles and although not as financially lucrative as the other two pools of investments, the faster cycle pool provides a good safe haven to invest the available capital during the waiting period.
This whole design goes back to the business investment concept of diversification. Diversification reduces overall risk but the associated cost is an overall lower return. In the long run, this design of the investment fund ensures good returns with low risk. Remember from Lesson 1, the goal of value investing is to have solid stable good returns with minimal risk involved. This is why this investment method never espouses high returns (>40% annually) but does persistently advocate for good and reasonable returns – greater than 20% annually but more than 25% per year is the goal. Act on Knowledge.
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Being a Navy SEAL and sniper taught me all about risk management. Take away all the risk variables under your control and reduce it to an acceptable level. The same fundamentals apply in business. Brandon Webb
Value investors utilize pools of similar companies all belonging to the same industry in order to reduce risk, create accurate buy/sell models and manage their portfolio of investments in their investment fund. It is essential that all potential investments in a pool have similar attributes including market capitalization, comparable operations, indistinguishable balance sheet relationships and reporting formats. As explained in Lesson 11, all the members of the pool should have similar key performance indicators.
It is impossible to single handily manage hundreds of potential investments and design/build a separate buy/sell model for each company. To simply and efficiently create an investment portfolio, value investors create a group of five to eight very similar companies in the same industry. This is referred to as a ‘Pool’. Since this pool is dedicated to a particular industry, the investor can appreciate the research and due diligence required to understand the industry’s terminology, operational standards and performance outcomes. It is the most efficient use of time.
Most value investors can only manage one or two pools of similar companies. However, one or two pools is insufficient to maximize a value investment portfolio. Thus, it is best to turn to a club whereby several pools are available to the investor. In effect, all club members share the knowledge of their own respective pool with other club members and this diversifies the portfolio for all members. When an opportunity arises, all members are alerted and the club is rewarded as all members benefit from participation.
This lesson explains the benefits of using pools of similar potential investments as a value investor. Pools reduce risk exposure due to the comprehensive understanding of the key performance indicators and industry standards learned from research work and review of multiple similar reports. Secondly, with this knowledge, value investors can create highly accurate intrinsic and market price models to set the buy/sell points for investment with each member of the pool. Another advantage pools of investments create is the ability to efficiently utilize time to update the models. This in turn, allows the investor to focus on properly carrying out the systematic buying and selling of stock to generate excellent returns. The following three sections cover these three benefits of pooling of similar investments.
Pools Reduce Risk With Value Investing
Comprehensive understanding of an industry is one of the top three tools with managing risk as explained in Lesson 6. The other two include purchasing only high quality, top 2000 companies and purchasing stock of companies with deep financial pockets to withstand economic recessions and if needed, depressions.
Comprehensive understanding of an industry begins with understanding how each industry has its own set of revenue streams and corresponding performance standards for that class of income. In-depth knowledge of the production metric reinforces financial outcomes. During interim financial reporting cycles, many value investors delve into the production reports to ascertain actual performance as the financial results will follow performance.
The key to risk reduction is using highly restrictive attributes of the respective members. This is essential with comparing performance among the respective members of the pool. When starting out in the creation of a pool, select an industry with as many participants as possible. For example, suppose you decide to create a pool whereby the members must be in the utilities business. Utilities are interesting because it is an economic sector and not an industry. Utilities include:
- Electricity
- Water
- Sewage
- Power (oil, coal, natural gas & propane)
- Debris and Waste Removal
- Heat (oil, coal, natural gas & propane)
Notice the wide diversification within the utilities sector. The performance standards of the electrical energy segment is quite different than those addressing waste removal. The respective areas of this sector are actually industry level groups. But even within that group, there are different revenue streams and it is important for the value investor to have a pool of investments as similar as possible. For example, within the electricity industry, there are 100’s of producers. Many are owned by municipalities or authorities. In all, there are about 168 investor owned (publicly traded) electric utility companies. Of these, approximately ten exceed $5 Billion in market capitalization value. They are listed below:
Sourced from Statistica.com; thank you.
It would initially appear that all ten utility companies could be included in a pool of similar investments. The reality is quite different. Each potential member of this electric utility pool must have similar attributes in order to effectively reduce risk. The problem is that none of the ten are purely electrical generators of power.
The top three are vastly different. Here are their respective summary write-ups:
NextEra Energy – NextEra owns Florida Power and Light (FPL) the largest electric energy company in the United States. Altogether, NextEra has three revenue streams, the first is FPL; the second is NextEra Energy Resources, a clean energy generating resource company that operates solar, wind and nuclear facilities; the third is Gulf Power, a traditional electric power company located in the panhandle of Florida.
Dominion Energy – Dominion Energy has two revenue streams from two different utility sources. Its primary source of revenue is the traditional electric power generation. The second source is natural gas storage along with a pipeline system to move the gas. Take note, it doesn’t actually extract natural gas, it primarily transports natural gas. To complicate this a tad more, Dominion’s electrical arm also incrementally has revenues from its electrical transmission lines. In effect, it charges other utilities to use its transmission lines. Thus, Dominion is not a pure electrical generator and seller to residential users. Their revenue sources are complex increasing the difficulty of comparing to other electric utility generators.
Duke Energy – Duke Energy is also a conglomerate in the utility sector. Duke has two distinct revenue streams. One involves traditional electric utility generation, distribution and sale to consumers; the other is gas utility and infrastructure. Although somewhat similar to Dominion, their respective ratio mix is dissimilar.
The primary key to a successful pool is find similar companies in the same industry with similar attributes. Similarities in descending order include:
- Market Capitalization Above a Preset Minimum;
- Comparable Business Models via Revenue Streams;
- More Than 90% of Revenue Must Be North American Based;
- Key Performance Indicators Are Similar;
- Indistinguishable Balance Sheet Relationships.
When the respective potential investments in the pool are so similar that the companies are almost identical, it makes it easier to calculate intrinsic value and perform analytics to set the respective buy/sell points for each company within the pool. The following subsections clarify each of the primary attributes required for a pool of similar investments.
Minimum Market Capitalization
Market capitalization is defined as the market value of the company. It is merely the number of shares outstanding at the current market price. Thus, for Consolidated Edison, it has 342.115 Million shares outstanding. The current market price (01/19/2021) is $69.50. Therefore, market capitalization equals $23.77 Billion. Remember, this market capitalization value fluctuates daily.
In general, the minimum market capitalization for any member of any pool within the potential investment portfolio is $200 Million. This mimics the lower 20 percentile bracket of the Russell 2000 and is slightly less than the lower 10% of the S&P Composite 1500. Any lower market capitalization and the risk factor associated with the going concern principle comes into play with value investing models. Better value investors are able to create a pool of similar investments with market capitalizations that exceed $1 Billion for each member of the pool. The stronger the market capitalization for the pool, the less risk associated with not only the going concern issue but also the ability of the respective member to withstand difficult market recessions/depressions with share price. The idea is to have a potential investment that can weather market turmoil or a corporate level embarrassment.
A good example of this is PG&E from the list above. Back in 2105 and 2018, the Butte and Camp Fires respectfully in California caused extensive damage and PG&E took responsibility. In total, PG&E agreed to pay out $25.5 Billion to settle claims from the two fires. The company completed its Chapter 11 bankruptcy filing back in the summer of 2020. Currently, the stock is trading at or around $12.00 per share. It has 530 Million shares outstanding. Thus, the total market capitalization for PG&E equals $6.36 Billion. It currently has about $85 Billion in assets on its balance sheet. The book value per share is around $9.50. At the end of 2017, the company had $19.2 Billion in shareholder’s equity with a book value of $37.33 per share. On December 31, 2017, the company’s share price was $42.43 with 515 Million shares outstanding for a total market capitalization of $22 Billion.
Thus, the company was able to endure the high cost associated with the two large fires caused by faulty equipment. To pay the settlement, the company used its strong shareholder equity position and net earnings from three of its fiscal years. It will take several years more for PG&E to fully recover and begin the process of regaining its former market capitalization position.
This minimum market capitalization footing ties directly to the first principle of value investing – risk reduction. To augment this risk aversion attribute, another attribute is required, comparable business models.
Comparable Business Models
The second most important attribute of the potential investment pool of similar companies is that they all have comparable business models. It is often assumed that a member of a particular industry solely performs that respective service or sells that industry’s product. This is more often not the case than normal. Compare the respective revenue streams for six of the above electrical power companies. The information is sourced from their respective 2019 annual reports.
Name of Company Electrical Power Natural Gas Sales Gas Distribution Other Total
Dominion Power $10,202 Million $2,413 Million $2,475 Million $1,482 Million $16,572 Million
Duke Energy $22,615 Million $1,759 Million $705 Million $25,079 Million
Southern Company $16,872 Million $3,792 Million $755 Million $21,419 Million
American Electric $9,246 Million $4,319 Million $1,997 Million $15,561 Million
Exelon $30,315 Million $3,636 Million $487 Million $34,438 Million
Xcel Energy $9,575 Million $1,868 Million $86 Million $11,529 Million
It is difficult to determine the respective relationships between the various revenue streams for each company. Their respective ratios of electric power to natural gas is significantly different. With Dominion, approximately 30% of its revenue is tied to natural gas. Whereas Exelon, natural gas is less than 11% of its revenue stream. How do you compare companies with such differences? In order to reduce risk, the respective members must be comparable with their business models. This allows the value investor to better evaluate intrinsic value and opportunities. Furthermore, comparable business models ease financial analysis making it incredibly easy to determine market recovery prices for the sell point in the buy/sell model.
Don’t misunderstand, you can utilize the above six companies in a similar pool; it just makes the work of analysis extremely difficult. The research work is more intense and often, one has to make some inferences in order to solve equations. The more comparable the respective business models within the pool, the easier it is to assess the respective buy and sell points for the respective members of the pool.
North American Based Operation
Every publicly traded company operates under a charter and a set of regulations promulgated by their respective government. All North American operations must comply with not only their respective highest tier government regulation but also with the U.S. Code and its corresponding regulations. The current US-Mexico-Canada trade agreement and the former NAFTA trade agreement created a set of regulations that all three countries agreed was in the best interest of all parties. Thus, any North American based operation generally complies with U.S. law. Furthermore, compliance documentation requirements and access to that information reduces risk for all investors.
If a company is outside of North American compliance requirements, it requires a lot more research and understanding of foreign regulations in order to determine financial results. This is simply too extreme for a traditional investment portfolio. Thus, in order to minimize time investment and create uniformity, only consider North American based operations when selecting potential investments for your pool.
Similar Key Performance Indicators
Lesson 11 goes into more detail about key performance indicators. To effectively reduce risk and improve outcomes for intrinsic and market recovery values, the key performance indicators must be similar among the potential investments in the pool. Key performance indicators are customarily industry production standards which assist the value investor with identifying similar companies to include in the pool of investments.
When the key performance indicators are similar, it is easier to gather the data, compile the information and then present the outcomes in an organized format. This allows for easy comparisons within the group of companies.
For example, with the electrical companies above, a key performance indicator would be the cost per kilowatt of energy produced. Another indicator could be mix of energy production, i.e. an energy matrix. How much is produced by the lower cost methods against the more expensive fossil fuel driven production plants. Other performance indicators include number of employees against revenue generated or maybe the ratio of the cost to revenue per stream against the revenue mix. As explained in Lesson 11, often the key performance indicators are identified in the annual reports as there are often a lot of information or write-up about the respective performance standard (typically found in the ‘Notes’ section of the financial statement).
Indistinguishable Balance Sheet Relationships
A fifth attribute that helps to reduce overall risk with the pool of similar investments is ensuring that all the members of the pool have indistinguishable balance sheet relationships.
Balance sheet relationships refers to the respective ratio relationships of:
- Current/Fixed/Other Assets Percentages to Total Assets
- Assets to Total Liabilities
- Debt to Equity Ratio
- Fixed Assets/Debt Ratio
- Common Shareholder’s Equity Percentage
It is important that these relationships are indistinguishable among the respective members. Any differential greater than 20% of the average presents either an advantageous or detrimental position for that company over the other members of the pool. The easiest method to compile the information is to create a table of comparatives. With some industries, the analyst will have to modify the respective relationship ratios to match that industry’s typical balance sheet model. For example, insurance companies often have strong investment portfolios as a function of current assets or other assets. These investment portfolios act as the reserve for claims tied to catastrophic events. Thus, the ratio relationship should be similar among all members of an insurance pool. If not, this can impact other income results or require deeper available lines of credit to meet sudden claim demands.
Other industries may have an inclination towards the fixed assets to long-term debt ratio. The longer lived asset driven industries such as REIT’s, airlines, railways, shipping, and entertainment finance these respective assets with long-term debt. If the ratios do not mirror each other, e.g. one is leveraged significantly more than others it can moderately to greatly impact critical line items on other financial statements. Think of increased interest payments for debt in excess of average. Or, just as importantly, the impact of principal payments for cash flows in the future.
Thus, it is important that the member’s balance sheets are similar with relationship ratios. Extreme deviations from the average or normal will distort results with other financial statements causing the reader to misunderstand the outcomes or miscalculate the respective buy/sell points for that company.
The primary purpose of a pool of similar investments from the same industry is significant risk reduction. Having similar companies with market capitalization, business models, key performance indicators and indistinguishable balance sheet relationships all based in North America allows the value investor to create comparable models that distinctly improve analytical results. With this information, value investors can then accurately determine intrinsic value and the associated market recovery values.
Pools Increase Accuracy for Both Intrinsic and Market Recovery Values
There are two financial points required for value investing. The first is the buy point or what is customarily referred to as the intrinsic value measurement. This particular financial value is a reasonable dollar value for the stock. In effect, it is the dollar amount that reflects what the right to ownership of the stock is truly worth. There are multiple tools to measure this value; and each industry uses different methods or combination of measurement tools to determine intrinsic value. The goal is to determine the buy point for the value investor.
The second financial point is the market price. The idea here is that the market often drives the price up due to multiple reasons. Everything from economic wide enthusiasm to company specific results. In many cases, the market price is pushed higher because the industry is viewed favorably; the economy is strong and the company reports good earnings at the end of quarter. Suddenly, this triple effect pushes the price of the stock past its prior high. Value investors use several financial measurement tools supported by historical information and documented with business ratios to determine this market price. With this information, a market recovery value is determined and now it is just a matter of maintaining patience to deliver good results.
Pools allow the value investor to determine the industry element of the respective formulas when setting both intrinsic and market recovery price points. In Lesson 3, it was explained that industry wide issues have the second greatest effect on stock prices for industry members. By having a pool of multiple similar potential investments, calculating the respective buy and sell points for the members of this pool is efficient. More importantly, industry wide standards and application of key performance indicators for the respective companies assist with effectively determining the buy and sell points for each company. Pools increase accuracy with setting the buy/sell triggers for each company within that pool.
Pools Assist With Managing the Investment Portfolio
One of the advantages of having pools of similar investments is the improved manageability of an investment fund. By restricting the investment fund to a set few pools, the portfolio manager only needs to review industry wide issues and standards to stay abreast of interpreting key performance indicators and corresponding financial results from the respective members in that pool.
Instead of a vast array of potential investments and lots of spreadsheets, an investment portfolio of a few pools can be easily managed and updated on a regular basis. For most pools, updating performance indicators and standards is an annual step. Reviewing financial results is a quarterly update to a comparative spreadsheet for that pool.
The next lesson explains how the investment fund works and why developing pools enhances overall returns for a portfolio. Act on Knowledge.
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Quality means doing it right when no one is looking. Henry Ford
Have you ever wondered how the measurement of length called a ‘meter’ came to be? It is simply the distance light travels in a given time period. The key isn’t the actual definition; it is whom dictates this time period of travel. Some authority states that this is the definition of a meter (also written as ‘metre’). It is currently the International Committee for Weights and Measures based out of France. It is an 18 person task group promoting uniformity with units of measurement. This committee is the authority.
This same principle of authority exists in business. Every industry has their own authority or set of principles promulgated by an agreed upon group of individuals or a leader within that group. For value investors, understanding the authority for the respective industries is essential to measuring success for each member company within the pool of potential investments. Once a value investor recognizes what is the standard of production or performance, it becomes easy to compare their respective investments and then equate this into financial value. There is a hierarchy of authority for all industries. In almost all cases, the number one authority is a governmental institution or law. Other levels of authority at the next level include academia, associations, journals, books, white papers and committees. The third level of authority include experts and company level affiliations. The final level of authority is the leader in the respective industry.
Each of the following sections explore these different levels of authority. In each section, there is an introduction to the various resources the value investor may wish to use when investigating their respective industry. The key to this lesson is to understand that higher levels of authority are the standard setters. Value investing is about having facts to support a buy/sell position with each member of the pool of investments. The stronger the authoritative position of the standard setter, the more accurate the buy/sell trigger points can be calculated.
Industry Standards – Government Authority
The government gets its authority from the citizens it represents. There is a high level of trust between the citizens and the government to properly create law, regulations and monitoring systems to enforce the laws and regulations. In turn, the government creates a hierarchy of authority within its bureaucracy. Since every industry traded on the market participates in interstate commerce, the federal government is the authority to turn to for standards related to the respective industry.
At the federal level, the Federal Code is the law as passed by Congress. The Federal Code is divided into 54 titles. In turn, each title is supported by a set of regulations, the actual law passed by Congress. To augment regulations, each agency of the government creates rules and these are published in the Federal Register and posted to the agency’s website. If regulations or rules are challenged, court rulings (case law) and opinions act as the next level of authority.
In addition, these rules, rulings, and opinions are further supported by agency interpretations, determination letters and examples.
With respect to standards, each agency creates standards and guidance for corporations and individuals to follow. In many cases, committees are created as a public/private affiliation to provide guidance, opinions and suggestions to agency management in order to advise Congress when creating law.
It is within this organizational structure that value investors will find the highest level of authority related to industry standards. The most common section of the U.S. Code used by value investors is Title 15 – Commerce and Trade. However, some industries are governed and monitored by other titles of the Code. For example, banking and finance is controlled under Title 12 – Banks and Banking. In some cases, there may be more than one section of the Code that governs an industry. For example, railways are governed by several Titles:
- Title 15 -Commerce and Trade
- Title 45 – Railroads
- Title 49 – Transportation
For those readers interested in the U.S. Code breakout, go here: https://www.law.cornell.edu/uscode/text.
Each agency will have a subagency or department specifically dedicated to the particular industry that is the pool of potential investments value investors create. For example, within the Department of Transportation, there is a a department that governs railways. It is the Federal Railroad Administration. It is here that a value investor will find guidance and standards as it relates to railroads. Within the research and development section, an investor can find all sorts of library information including research papers, technical reports, and results.
One of the benefits the government provides are audits of certain industries and their members. Some industries are highly regulated to the point where the government frequently audits their financial performance. For example, banks are highly regulated. Under the Federal Deposit Insurance Corporation’s Law, Regulations and Related Acts, Section 5000 for Policies and Procedures:
“In accordance with Section 36 of the Federal Deposit Insurance Act, as implemented by 12 CFR Part 363, each insured depository institution with $500 million or more in total assets at the beginning of its fiscal year is required to file with the FDIC and the appropriate federal banking agency, an annual report, including its financial statements which have been audited by an independent public accountant, and a management report and independent public accountant’s attestation concerning both the effectiveness of the institution’s internal controls for financial reporting and its compliance with designated safety and soundness laws. In addition, each such institution is required to have an audit committee consisting entirely of outside directors who are independent of management. For state nonmember banks subject to Section 36 and Part 363, these audit and audit committee requirements take precedence over the provisions of this Statement of Policy.”
This information is publicly available. In addition, the data is compiled for a peer group average. This average is tiered for banks of certain sizes in terms of assets. Thus, an average standard is generated in these reports for comparative purposes. This data is compiled by the Federal Financial Institutions Examination Council and is retrievable from that agency’s website.
This further substantiates why it is so much better to only consider high quality top 2000 companies for investment purposes. In most cases, strict governmental regulation is required for these companies. This further reduces their respective risk of default which in turn improves the safety margin of investment. Therefore, when a value investor discovers an investment opportunity, the associated risk is reduced significantly as there is more public information available to protect the investor. Remember, the first of the four principles of value investment is risk reduction. The government information also augments the calculation tied to intrinsic value, the second principle of value investing.
A good perfunctory requirement of value investing is to research the respective governmental authority related to the industry you select for your pool of investments. The five existing pools of investments on this website have their resources page included in that pool’s directory. There are many supplementary articles written for certain governmental standards with each pool. You must be a member of this site’s Value Investment Club to access this information.
The next level of authority customarily comes from the industry’s associations, consortiums, and academia.
Industry Standards – Academia, Journals, Associations and Industry Boards
In the prior section, the government was cited as the absolute best authority tied to standards for industry. The government gets its authority from the public. The public is willing to spend the necessary resources to research and compile information allowing Congress to formulate law, regulations and agency rules to best serve the public. The next level of authority gets its backing from historical knowledge and industry data compiled from years of activity. The industry creates associations and authority boards to assist in better understanding the industry. All these sources provide needed research and guidance to their members.
Within the industry you select, do your research to find supporting authorities from this second level of dominion.
One of the pools of investments used by this site’s Value Investment Fund is Real Estate Investment Trusts. The resources page within this pool’s information base covers several second level authorities.
- The National Association of Real Estate Investment Trusts (NAREIT) – “Nareit® is the worldwide representative voice for REITs and publicly traded real estate companies with an interest in U.S. real estate and capital markets. Nareit’s members are REITs and other businesses throughout the world that own, operate, and finance income-producing real estate, as well as those firms and individuals who advise, study, and service those businesses. National Association of Real Estate Investment Trusts® and Nareit® are registered trademarks of the National Association of Real Estate Investment Trusts (Nareit).”
- New York School of Professional Studies – NYU SPS Schack Institute of Real Estate REIT Center is a forum for the study of real estate investment trusts.
- Wharton School of Business, University of Pennsylvania has a program “Assessing Commercial Real Estate Investments …” whereby the current market issues are raised and the forces that impact real estate investments are explained.
- REIT Magazine as written and printed by NAREIT.
- Journal of Real Estate Research
- Global Real Estate Standards Board (GRESB) assesses and benchmarks data about real estate investment trusts to the capital markets.
The key here is that a few hours of research online will provide the necessary resources for your respective pool of investments. You will have to dig into each site’s source data in order to determine what is applicable to your particular pool. The overall end result is a greater understanding of your industry and confidence related to your buy/sell decision model.
There are other authorities before utilizing the standards from the standard bearer within your pool of investments.
Industry Standards – Experts and Company Level Affiliations
With each industry, there are experts; individuals that have written extensively about the respective industry. In effect, they have been exposed to all the impact factors and variables associated with the respective industry. Many have committed their lives to the subject matter and often teach advanced courses about the respective subject. These experts are excellent sources of information especially for someone learning about a particular industry.
As an example, with Real Estate Investment Trusts, Su Han Chan is considered an authority on the subject matter. She has written extensively about the subject matter and is a professor at John Hopkins University. There are many others, but it is best to use someone with credentials to back up their respective position as an authority on the subject.
Other sources include company level affiliations. These can be associations, data centers, conference presentations, and private collection centers. For example with the railways industry, here is a list of company level affiliations used for that respective pool of investments:
- Association of American Railroads
- Railinc.
- International Union of Railways
- American Public Transportation Association
- Surface Transportation Board
- Progressive Railroading (publication)
- The Railway Educational Bureau
All of these lower level authoritative sources assist value investors with answers to peculiar and uncommon questions. Often, their knowledge supplements provide additional confidence with the decision model constructed for the respective industry you select.
In some cases, the lowest level of authority is often the best. As stated multiple times throughout this series of lessons, finding a standard bearer within your pool of potential investments is an excellent standard to use.
Industry Standards – Industry Leader
Within each industry there is a leader. Just as in sports, medicine, politics etc. there is always someone or some organization that stands out among the crowd. In business, leadership is a result of a long history of profitability, outstanding performance, good management, and strong ethics. Leaders follow the rules, not just the law and regulations, but the core business principles that exist within that industry. Your job as a value investor is to discover that leader within that group.
Often, it is easy to find the leader; in general, they are the most profitable and have a long history of good profits. Other indicators include superior valuation ratios, positive news about the company, extensive annual and quarterly reports, and well designed informative website. A simple comparison table of different metrics will reveal the leader within the industry.
Once known, a value investor gets well versed with this company’s activities, performance and goals. Learn why they are the leader, what makes them superior to the other members of the pool in this industry.
Once the industry leader is selected, learn how they are viewed from the other authorities in the hierarchy above. Do the others consider this company the leader in that industry? If indeed the company is the leader, then their performance standards are the ones to use when evaluating other members of the pool. Gauge whether the other members are improving towards that standard or having troubles achieving the respective metrics. Those that are improving will have faster improving price recovery periods whereas those having difficulties will take longer to recover to a good market price. This has a significant bearing on overall return for the respective investment. Remember, the longer it takes to achieve price recovery, the lower the overall return on the investment.
Summary – Industry Standards
Each industry is different with the performance and financial metrics. The key is to understand how the particular industry makes money and turns a profit. Find the top three performance indicators and focus in on those three. The standard bearer will provide the answer. Furthermore, the various levels of authority will assist with disclosing and/or reaffirming the top performance metrics for the industry. Use the various authorities to aid you with finding and getting answers to what makes this industry tick. Once there, each member within your pool should have a table of these metrics and indicate whether their trend line is improving or having issues. This assists the investor with setting the buy/sell points for the respective investment.
During Phase Two of this program, developing these three top performance indicators and evaluating them are explained in detail along with several examples and illustrations to help the value investor perform thorough research for their model. In addition, during Phase Two, spreadsheets, formulas and simple decision models are provided to assist the investor with their goal. Act on Knowledge.
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Without the ability to compare potential investments, how does an investor know what is good and what is not so good when reviewing financial information? There must be some tool or set of tools to compare similar companies?
There is. Business ratios are used to compare similar companies within the same industry. RULE #1: DO NOT USE BUSINESS RATIOS TO COMPARE COMPANIES AGAINST EACH OTHER IF THEY ARE IN DIFFERENT INDUSTRIES.
Business ratios are not perfect, they have their respective flaws and it is important for value investors to understand the algorithms used with business ratios. It is also important to note that business ratios can be easily manipulated and result in misleading outcomes. More importantly, business ratios only reflect current information and not long-term trends. Think of business ratios as comparable to a doctor acquiring your vitals upon your medical visit. The vitals only reflect the ‘then and now’ status of your medical condition. They do not reflect your lifetime nor trending condition.
In effect, business ratios have a purpose, albeit limited. They are the best tools to compare similar companies within the same industry and typically the same market capitalization tier. Thus, a second rule to use with rule number one above; RULE #2: USE BUSINESS RATIOS TO COMPARE SIMILAR MARKET CAPITALIZATION COMPANIES WITHIN THE SAME INDUSTRY.
Because business ratios can be easily manipulated, it is important that users of business ratios have a full understanding of their respective formulas. RULE #3: BUSINESS RATIOS ARE NOT AN ABSOLUTE RESULT. They are merely indicators and that is all they are good for when interpreting their results.
Even with the above limitations, business ratios are beneficial to investors as they are the best method of comparing existing or potential investments. Their results are not perfect, but they can indeed provide adequate confidence when making pertinent decisions about a companies current financial status.
As illustrated in the prior lesson, it is a good idea to set the standard first. Again, the standards to use will come from the best company within your pool of similar investments. With a known value for each business ratio used, the investor can then evaluate the other members of that pool of investments.
This lesson introduces business ratios by explaining that there are five basic groups of ratios. Each group has a purpose and it is important to acknowledge what that purpose is and how to interpret the results. For those of you that are members of this site’s Investment Club, your initial e-mail came with an e-book ‘Value Investing with Business Ratios‘. Please refer to the e-book for each ratio’s formulas, nuances, illustrations and drawbacks. This lesson will not go into that level of detail.
The five groups of commonly used business ratios are:
The following sections introduce each group of ratios and goes into some common ratios used and their proper application.
Valuation Ratios
Of all the business ratios, this group is not an internally pure business ratio. All the ratios within this group derive their results as a function of the market price per share at a single moment in time. In effect, every single ratio in this group fluctuates every single moment the stock market is open. The outcome can swing wildly in a single day. HOWEVER, this group of ratios is the most commonly cited ratios when discussing shares. There are four commonly used ratios in this group. The first two exist on every broker’s dashboard for every stock.
- Price to Earnings (P/E)
- Price to Book
- Price to Operating Cash Flow or Price to Free Cash Flow
- Price to Sales
The last one in this group is rarely used because it is an outdated ratio and was more commonly used pre-1930’s. Since then, it has lost favor with investors due to its easy manipulation and of course its irrelevancy towards profit. This ratio is more appropriate for small business valuations, especially those in the service industry.
Since price is dictated by the market, valuation ratios are considered an externally driven ratio and therefore, they are used as a quick tool to compare the investment against other similar industry stocks. Many less sophisticated investors will use the ratio to compare dissimilar industry investments because they perceive the ratio as a barometer of a return on investment. For example, an investor will purchase an investment with a 12:1 P/E ratio over a 25:1 P/E ratio as the return on the investment initially appears superior.
Value investors are not fooled by the casual use of these ratios. They are only indicators of the market’s perceived value at this moment in time and are often distorted by psychological intemperance. Smart and sophisticated investors use average values from historical results to derive value. The key to wealth accumulation is to know the value of a stock whether tied to earnings, book or cash based on average results against the current market’s interpretation of value. If there is a distinct discrepancy (> 9%), an opportunity to buy or sell may exist warranting action by a value investor.
As stated multiple times in these lessons, value investors think long-term; the market is short-term driven as conveyed by valuation ratios.
To truly understand a company, value investors turn towards internally driven ratios. The best group of internally driven ratios are performance ratios.
Performance Ratios
Performance ratios are oriented toward profitability, i.e. the various profit points along the income statement’s organizational presentation. In addition, it takes the net profit and compares this net profit as function of assets and shareholder’s equity. Think of it as ‘return on investment’ indicator.
In general, a business has three goals. The primary goal is to earn a profit. The other two address long-term security for the company.
Performance ratios measure the ability of the company to achieve the primary goal of earning a profit. Performance ratios consist of:
The first three measure the income statement relationships for the three basic sections. If you look at a basic income statement (profit and loss), you will find the layout as follows:
Revenue (Sales) $ZZ,ZZZ,ZZZ
Cost of Sales ZZ,ZZZ,ZZZ
Gross Profit Z,ZZZ,ZZZ
G&A Z,ZZZ,ZZZ
Operational Profit Z,ZZZ,ZZZ
Deprec./Amort. & Taxes Z,ZZZ,ZZZ
Net Profit $Z,ZZZ,ZZZ
All three profit points reflect the first three performance ratios. The ratios are a percentage of revenue. Gross profit should have a higher percentage than operational and operational is customarily higher than the net profit margin. These relationships tell the investor how well the company is performing financially related to actual operations. At anytime, if the profit point in the report is negative, it is a sign to the reader to investigate further to determine the contributing factors. But the traditional outcome is always a stepping down of percentages, whereby the bottom line is a positive percentage of revenue. Of course, the greater the net profit percentage the greater the performance of the company.
The last two performance ratios tell the investor how well the company is doing utilizing the existing equity and total assets. The ratio formulas are the net profit earned during the period divided by the respective average balance of either equity or total assets (more conservative investors use the beginning balances). Since equity is a function of total assets less total liabilities, its ratio outcome will always be greater than the return on assets result.
In the overall ratio hierarchy, performance ratios carry greater weight than the other ratio groups. Why? Well, performance ratios measure what the company actually does, not how the market perceives the company (valuation ratios). The other ratio groups measure the relationships between the income statement and the balance sheet. Performance ratios focus on what the company does as a business. As an investor, you want to know the value of how well the company performs financially selling its product and/or services.
In Lesson 8 of this series, there are five identified essential financial points of information every investor must know about a company. Two of those points are tied directly to performance ratios. The most important one is gross profit as a percentage of sales. This is referred to as gross profit margin stated as a percentage of sales. The higher this percentage, the more efficient corporate operations. Each industry will have its own average gross profit margin.
As a sidebar, some industries refer to the reverse of gross profit margin and disclose their gross profit margin by disclosing the cost of sales as a function of sales using the term ‘operating ratio’. Operating ratio is the cost of sales in percentage format.
Performance ratios are given the greatest weighted value when using business ratios to evaluate a company’s overall value. Performance ratios reflect the power of earnings for a company. Not only do value investors want to understand financial performance, they want to know if the management team is a good steward of the assets of the company. Activity ratios address management’s ability to maximize value with existing assets.
Activity Ratios
Activity ratios are easy to spot because they always relate a balance sheet group of accounts against either its average balance or against sales. In addition, activity ratios use the word ‘turnover’ in their title. There are six common activity ratios. Five of them are the different groups or accounts with the assets half of the balance sheet.
Recall, assets are the upper half or one side of the balance sheet. It’s formatted as follows:
ASSETS (in thousands of $)
Current Assets
. Cash $ZZZ,ZZZ
. Inventory ZZ,ZZZ
. Prepaids Z,ZZZ
Sub-Total Current Assets $ZZZ,ZZZ
Fixed Assets Z,ZZZ,ZZZ
Other Assets ZZ,ZZZ
TOTAL ASSETS $Z,ZZZ,ZZZ
The five ratios are used to compare the asset’s ending balance against its average balance or sales. The five are:
- Inventory Turnover Rate
- Receivables Turnover Rate
- Working Capital Turnover
- Fixed Assets Turnover Rate
- Total Assets Turnover Rate
The sixth activity ratio mimics the receivables turnover rate by evaluating accounts payable in the liabilities section of the balance sheet – Accounts Payable Turnover Rate.
The key to proper application of activity ratios is understanding what type of asset is most utilized by the respective company. Greater credence is given to the inventory turnover rate for retail based operations. Those entities involved in production of inventory (manufacturing & mining), emphasis shifts towards fixed assets turnover rate. For those organizations where inventory and equipment combined are essential to success, the total assets turnover rate is given more weight value. Service based companies have greater reliance on receivables turnover rate.
When working with high quality top 2,000 companies, only the fixed assets and total assets turnover rates gained prominence in the decision model. The other turnover rates tend towards lesser value as they become standardized perfunctory values from year to year with little deviation.
Of the six activity ratios, four are production based and two are performance tools. Production activity ratios are 1) Inventory Turnover Rate, 2) Working Capital Turnover, 3) Fixed Assets Turnover Rate and 4) Total Assets Turnover Rate. The Accounts Receivable and Payable Turnover Rates are used to evaluate the quality of the customer base and the ability of operations to timely pay the bills.
Notice how activity ratios are oriented towards the upper half of the balance sheet. The next group of ratios are similar, but they are designed to evaluate the bottom half of the balance sheet.
Leverage Ratios
Leverage refers to the ability to lift a heavier load using a fulcrum, a lever and a second lighter weight. The common image is a board on a triangular pivot point with a heavy weight (M1) on one end and a lighter weight (M2) on the other. As the lever shifts towards the lighter load it starts to lift the heavier weight.
In effect, as the distance ‘b’ gets longer, it becomes easier to lift M1.
This principle works with finances too. How so?
Well, in finance, leverage is the use of borrowed funds (M2) to increase the profits (M1) of the company. Simply put, the money is borrowed to purchase assets and then these assets are sold or utilized to generate profit. The core accepted principle is that the cost of the borrowed funds is less than the profits generated before the interest is paid. An example is appropriate here.
Airlines use leverage to increase their profits. They identify that there is indeed a consistent demand for additional flights to and from a particular destination. After some analysis, the airline determines that the revenue less the marginal costs of operating a plane will exceed the interest cost to buy that plane. Thus, sales less operating costs (including depreciation for the plane) will exceed the cost of interest on the debt to buy that plane. The result is additional profit to the bottom line. The airline is using financial leverage (borrowing money) to increase net profits.
Leverage ratios evaluate proper financing of a company especially those companies that are dominated by fixed assets on their balance sheets.
There are three commonly used leverage ratios.
Debt Ratio
The debt ratio is a simple comparison of total debt to total assets. It is common for certain industries to have higher debt than other industries. For example, a real estate investment trust will carry debt of more than 70% of total assets. This makes sense, real estate is a long term investment, bonds are issued to buy the apartment complexes or commercial locations. Rents cover operating costs and the remaining amounts pay interest and debt service for the real estate.
Interest Coverage Ratio
Interest is customarily paid from the earnings of the company, referred to as operational income. The interest coverage ratio evaluates the ability of the company to make its interest payments on its debt.
There is no universal interest coverage ratio that is acceptable. This is because each industry has its own set of dynamics. The more elastic the industry, the higher the ratio necessary to protect against economic volatility. As an example, retail industries require very high interest coverage ratios to reduce risk exposure related to consumer confidence. Walmart’s interest coverage ratio is:
EBITDA (2018 Fiscal Year Ending 01/31/18) = $30,966 Million = 14.22:1
Net Interest Paid $2,178 Million
Whereas inelastic industries can have significantly lower ratios. A perfect example is real estate (relatively inelastic). It is customary to have high debt ratios thus interest payments are greater than other industries. Also, inelastic industries tend to have lower operational profits as a percentage of sales. Thus the EBITDA is lower per dollar of revenue and so when the numerator decreases, and the denominator increases, you end up with a significantly lower ratio than retail.
Simon Property Group is the 2nd largest market capitalization REIT in the world. It owns malls and premium outlet centers. Its earnings before interest, depreciation, amortization and income taxes (REIT’s are technically income tax free under the Internal Revenue Code) in 2018 was $5,009,464,000; its interest expense was $1,282,454,000. Simon Property’s interest coverage ratio was 3.91:1. As an interesting side note, Simon Property Group’s debt ratio is 87%!
Notice the vast difference between a retail entity and a real estate company. This is a perfect example of why business ratios are not universal across all industries. As a user of ratios, be respectful of the industry standards and not some universally assumed norm.
Debt to Equity
Debt to equity ratio measures how much shareholders have in the game against debt holders. The lower the ratio, the more favorable for debt holders. A high number like 4:1 means that shareholders have only posted 20% of the risk that the company will go out of business. Debt holders frown on risk even though they are legally preferred for payment in bankruptcy. Typically, good companies have less than a 2:1 debt to equity ratio. This means that it is uncommon for debt to exceed 67% of the total assets value of the company. Debt is relatively protected at that level. However, this common value is adjusted for more fixed asset intensive operations such as REITs, utilities and raw resource extractors (oil, mining, natural gas). It is also common to have high debt to equity ratios for lending institutions.
Liquidity Ratios
The last group of ratios measures the ability of a company to meets its short-term obligations. With large-cap and DOW companies, these ratios are not emphasized due to the volume of sales and ability to access cash from their lines of credit. In effect, liquidity ratios are given little weight in decision models. However, it is still important to know them and understand their formulas. It is often here that value investors discover safety with their investment.
Liquidity refers to the ability to turn current assets into cash. In effect, at the large-cap and DOW level, all current assets are similar to cash as all of the current assets will soon become cash (typically in less than 60 days). Thus, when looking at the assets section of the balance sheet, a strong current assets position as a percentage of the entire assets position provides greater assurance of the company’s ability to continue operations for an extended period of time. The stronger the cash position, the less riskier the respective investment. There have been recorded instances whereby the cash position alone was more than total debt and the remaining balance exceeded the market capitalization position of the shares of stock. This means the price in the market for the stock is less than leftover cash! This is a value investor’s dream come true. If you had enough money, you would buy every share, shut down the company and take the left over cash and make your profit.
There are four liquidity ratios:
Most value investors use a variance of the operating cash ratio to evaluate a company’s ability to pay all its commitments throughout the year. This is explained in more detail in Phase Two of this program. Liquidity ratios should not have a lot of weight with a business decision model.
Business Ratios – Summary
When using business ratios to evaluate a business remember the three rules:
RULE #1: DO NOT USE BUSINESS RATIOS TO COMPARE COMPANIES AGAINST EACH OTHER IF THEY ARE IN DIFFERENT INDUSTRIES.
RULE #2: USE BUSINESS RATIOS TO COMPARE SIMILAR MARKET CAPITALIZATION COMPANIES WITHIN THE SAME INDUSTRY.
RULE #3: BUSINESS RATIOS ARE NOT AN ABSOLUTE RESULT.
The author also wants to emphasize the importance of not relying on one or two business ratios when making buy or sell selections. It is best to use at least a dozen business ratios to assist in ranking companies, not for the buy/sell decision itself. Ranking of potential investments is one step in creating a good buy/sell model. Sophisticated investors think holistically when buying and selling stock. It is about buying low with the least risk possible and selling at or near the market’s price tolerance for the stock. Act on Knowledge.
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“If it cannot be measured, it cannot be managed.” Peter Drucker
All of us use indicators everyday to help us manage our lives. These indicators assist us with making good decisions. This same concept exists with stock investments. There are several different indicators related to stock. Most of them are financial in nature and often summed up via business ratios. However, many of the top companies provide additional indicators. One of these additional groups of indicators are ‘key performance’ markers. In effect, they are production based bits of information that assist value investors in developing and validating a good buy/sell model for that particular company.
Performance indicators are different for each industry. For the value investor, understanding the respective industry along with their systems, processes and critical points are essential when evaluating the current stock price along with market reactions. It is important for the value investor to understand not only the quantitative results of performance, but the standard of performance to measure the actual outcome against. In most cases, performance indicators exist with sales, production, and marketing/advertising. The key to success is to incorporate all these different data points and create an impact factor upon the company’s stock price.
The first section below explains how each industry is different and the thought process value investors must use to assess the respective members of that pool of investments. It is best to identify the top three key performance indicators and their respective impact on the overall financial performance of the company. Once you understand the industry’s respective critical points, value investors can then develop the standard of performance. Often the standard of performance is provided by the company in its annual report. There are other resources for each industry, one of the best resources is the Department of Commerce for U.S. based operations. With a standard to work with, quantitative results can then be compared against this standard and often a trend line is necessary to grasp whether the respective company is doing well or having problems. The third section below breaks down key performance indicators into the respective major areas of the financial statements. By understanding the overall industry and the respective lower level indicators a value investor can easily assess corporate performance. Finally, it is important to tie it altogether and determine a simple ‘Yes’ or ‘No’ to a company’s overall performance. By understanding these key performance indicators, how to obtain the information and interpret the results, a value investor can have greater confidence in their buy/sell model.
Industry Level Key Performance Indicators
There are three economic wide indicators commonly followed by all investors – gross domestic product, the inflation rate and unemployment rate. These indicators give a sense of the overall picture. The same concept exists at the industry level. The only difference is that at this level, the indicators are strictly industry related and have some connection to the economic wide indicators but mostly, industry level indicators merely paint a picture of that industry only.
Be careful when reviewing industry level indicators; less sophisticated users of data believe that sector level indicators are indicative of the respective industry within that sector. This is not the case. The economy is divided into approximately eight sectors:
- Financial
- Utilities
- Manufacturing
- Wholesale Trade
- Retail
- Transportation
- Information
- Other
Each sector has their respective sets of industries. For example, transportation is divided out into:
- Air
- Ocean Going
- Railroads
- Trucking
- Private
- Seaports
- Terminals
- Express
- Logistics (Fleet Management/Warehousing/Handling)
The point is that a value investor can’t really compare the performance standards of one industry against another. They use different models and there are certain business principles more equitable to some over others. As an example, economy of scale is more critical to ocean going shipping than to express shipping. Express shipping is keyed to delivery times, ocean going is about volume at the least cost per unit of measurement. Thus, it is important for value investors to ask themselves pertinent questions about each industry. Always be thinking – ‘What makes this industry go?’. For example, with the railroad industry (one of the Pools of companies the Value Investment Fund uses with the membership club), the key performance indicator is revenue ton miles. What is the cost per revenue ton mile to ship the goods? How many revenue tons were shipped during the respective financial period? How much is charged on average per revenue ton?
In some industries, what makes them go may be market share (restaurant chains, pharmacies, and equipment rental) or occupancy rates (think hotels, resorts, and REITs).
The best sources of industry related performance standards are found with the federal government websites; especially with highly regulated industries such as banking, utilities and pharmaceuticals. During Phase Two of this program, there are a couple of lessons that illustrate this very process of research related to the development of a pool of similar investments.
Key Performance Indicators – Setting the Standard for Value Investing
Once a value investor identifies the top three industry performance standards, the value investor must then set the standard. In effect, the value investor must find the best company within that pool of similar companies. How do you find this standard? The most likely outcome will be from the leader of that industry.
Every industry has a leader, a company that dominates over others. Typically, they are easy to spot; in some industries there are possibly two and they compete with each other. To figure out the leader, simply create a table tied to two valuation ratios. Valuation ratios are how the market perceives the respective company.
The two valuation ratios to review are price to book value and price to earnings. In general, the price to book ratio is a longer term valuation ratio (it is a balance sheet based ratio) whereas the price to earnings (income statement driven ratio) is merely a reflection of value tied to the most current year of earnings. To illustrate, the following is an example of a table tied to the Investment Fund’s Railways Pool. The market price is as of today, 12/23/2020.
Name Book Value 12 Months Trailing Earnings Market Price Price to Book Price to Earnings
Union Pacific $25.41 $7.85 $202 7.9 25.7
Canadian Pacific 43.95 12.54 341 7.75 27.2
Kansas City Southern 47.35 6.04 203 4.3 33.6
Canadian National 27.19 3.56 110 4.0 30.9
CSX 16.64 3.60 90 5.4 25.0
Norfolk Southern 58.82 7.76 232 3.94 29.9
Historically, Union Pacific has been the benchmark company to use. There are several reasons, 1) it has the longest history of existence; 2) the company is the largest railway with market capitalization of $137 Billion almost twice the value of the closest market capitalization for a railroad; 3) the company has weathered many economic recessions and still generated profit during those recessions. Look at its price to book; only Canadian Pacific comes close, the others are significantly less. Canadian Pacific has shown continuous improvement over the last few years.
As stated above, the price to book is a longer view valuation ratio whereas the price to earnings reflects the trailing twelve months. Thus, the price to book ratio is given the greatest weight when determining the standard of performance to use in buy/sell models. It is the author’s opinion at this point to continue to use Union Pacific, but the author believes Canadian Pacific will overtake Union Pacific within a few years due to multiple reasons. This information is discussed in more detail in the member’s section of this website within the Railways’ Pool of investments.
If there is some anxiety with future earnings, the price to earnings will reflect this perceived depression with earnings. Currently, all the railroads are financially performing less than their historical earnings due to the reduced revenues tied directly to COVID. What is truly fascinating is that their respective market prices are at or near all time highs even with reduced revenues. As an example, Norfolk Southern’s revenue for the first nine months of 2020 is $1.4 Billion less than 2019 yet its stock price is trading well above its peak pre-COVID price. How can this be true? It’s simple, the above six companies are all Class I railways and all of them have demonstrated highly stable historical earnings, the number one factor that impacts market pricing.
Without a doubt, Union Pacific continues to lead this industry; Canadian Pacific is catching up and they may well take over in a few years. But for now, Union Pacific is the standard against which all other rail lines are compared.
Thus, the next step is to identify the top three performance standards with which to measure success. How does one identify the key performance indicators within the respective industry. The answer is simple: read that company’s annual financial report to identify what management identifies as critical performance metrics. Another alternative is to go to the company’s website and click on the investors tab and look at their performance metrics’ results.
On page 31 of Union Pacific’s SEC filing for 2019, management does indeed identify the key performance indicators for their company. Here is a copy of that section of their report to investors:
In Union Pacific’s case, two of their top three clearly show negative performance in comparison to the prior year of 2018. More importantly, the number three KPI doesn’t really have anything to do with earning revenue, it is really more of a cost control tool. In effect, Union Pacific hauled a lot less in 2019 than in 2018 significantly impacting sales.
If you were to read the other five company reports, you will also see how they too focus on revenue ton-miles, train speed and dwell time. Take note of the last line of data.
If you have been reading the lessons in successive order, you should have already gathered that one of the key financial performance indicators is the operating ratio. This is the cost per dollar of sales. In this case, Union Pacific’s cost per dollar of revenue decreased 2.1 points (3.3%). It is directly tied to gross profit margin and is explained in detail as one of the top five key financial points every value investor must know for all their stock selections; see Lessons 8 and 10.
For those of you interested in railways as an investment pool, this site’s Value Investment Club utilizes this pool of information in its fund groups. To access the details, you must be a member of this site’s Value Investment Club.
Now with the key performance indicators set, the next section explains how to quantify information and tie it to financial results.
Quantification of Key Performance Metrics
Quantifying information is merely a three step process. First, gather the data; next, compile the data; and finally, organize the information in a coherent presentation format. Most folks will utilize spreadsheets to compile and organize the data. The actual source information is found at the respective company’s website. Once the spreadsheet is built, it is a simple step to update it once a quarter or annually depending on the nature of the respective data metric.
For those of you that are currently not members of the Investment Club, the club’s pools of investments have their own respective spreadsheets that are updated by the facilitator and information is disseminated to member’s on a regular basis to reinforce or modify the respective buy/sell models for each company. During Phase Two of the program, members are taught via several different lessons how to build their own spreadsheets for their particular pool of investments. The respective spreadsheets are turned into the club for review by the facilitator and members; questions and concerns are raised to the spreadsheet’s author in order to confirm its validity. With each successive update, the spreadsheet’s results are included in that Pool’s database for access by other members.
For the purpose of this lesson, the author will continue by illustrating how revenue ton miles are evaluated in the railway industry. Again, the key is to find the standard and use that to compare against the other investments of the respective pool.
Since the standard bearer is Union Pacific, the first step is to pull the volume of revenue ton miles per quarter. The goal is to understand the impact of revenue ton miles on sales.
The orange highlights the tonnage moved during each quarter. Naturally, revenue correlates directly to revenue tons moved. Thus, at the end of the third quarter 2020, Union Pacific moved 97 Billion tons and earned $4.8 Billion.
For the fourth quarter of 2020, through December 26; total revenue tons moved equals 99.7 Billion tons with one week to go. Thus, it appears that Union Pacific’s revenue for the 4th quarter 2020 will exceed $5 Billion. If you were to graph this to this chart, the trajectory is continuing upward. Thus, once the financials are reported in mid February, odds are that the stock price will not decrease in value; it is expected that the fourth quarter financial results will be good.
The interesting aspect of this is that each Monday, Union Pacific reports its performance results, i.e. the revenue tons moved, carloads and travel velocity on its website. Institutional investors are keyed into this and monitor this data as it is released. Thus, Union’s stock price should show some improvement*, at worse, stagnant changes in value. But, it is unlikely the price will drop dramatically.
*As of this writing, at 4 PM, Union’s stock price improved $2.25 per share; this is a 1.1% improvement. This validates that company level performance has some immediate impact on the price, but unless there is some form of an extraordinary event, it is unlikely the share price will deviate dramatically (< or > 5%) from its current market price.
This same concept is applied against the other members of the respective investment pool value investors use to buy and sell stock with a particular industry. The key is to track the trend line over an extended period of time. If there are no significant changes in the interim period, then it is highly unlikely that the stock price will experience a price reduction due to industry and company level performance. In effect, all members of the pool of investments should display similar results with their operations. Slight deviations are acceptable, but significant (> 3%) change in any direction calls for review and monitoring of that stock’s respective market price as there will be some impact on the market price. Remember, economic wide issues have the greatest impact on stock price, review Lesson 3 about market fluctuations. This means that any significant change of more than 3% at the industry or company level will indeed affect the stock price for the respective company or industry.
Furthermore, this tracking is done for all of the top three key performance indicators for each pool. In most cases, these three performance indicators are reported quarterly. It just so happens the railways industry reports their respective information weekly. This is due to the volume of rail cars moved and the technology used to compile data.
Key Performance Metrics Conversion to Financial Results
Converting performance metrics is similar to how small business owners review their production and the anticipated impact on the financial results. The key is to increase sales and reduce direct costs of sales creating greater profit margins. At the upper end of corporate operations, it is exactly the same. Key performance indicators should tie to sales and cost of sales reduction creating better gross profit margins and ultimately absolute dollars to the bottom line.
With the railways industry, tonnage moved equates to sales as illustrated above. The other performance metric used that is tied to sales are the number of carloads moved during the interim periods. As for cost of sales, the Railways Pool utilizes two important performance metrics.
Think of the two key costs to move tonnage. The first is fuel consumption and the corresponding cost per gallon for diesel. The second big cost is labor.
The key metrics that directly connect to these two cost elements are a function of efficient operations of the rail cars. Thus, freight car velocity (how far a car travels per day) and train velocity (how fast the train travels per hour) are a reflection of the both fuel costs and labor costs. The further a freight car travels each day, the more efficient the labor costs to move tonnage. Train speed affects fuel consumption, but typically the cost per gallon is beyond the control of the company.
Just as with the tracking of revenue ton miles above, both freight car velocity and train speed are tracked and compared against overall costs of operation for the respective members of the Railways Pool. Any significant deviation from expected results will impact the market price per share. In the long run, this also impacts the buy/sell model as minor adjustments are necessary to the company’s buy/sell model in order to achieve maximum return on an investment.
One of the drawbacks to the above is of course the reporting periods of both bits of information. With the railways industry, the key performance indicators are in the form of non-dollar amounts reported weekly. Financial results are reported quarterly. Thus, it is difficult to have a pure correlation between the two values. Therefore, value investors have to monitor other sources in addition to what is reported by each company. For example, with railways, a value investor may also monitor the cost of fuel and if there is a sudden increase, the associated costs will be reflected in the quarterly financial results when they are reported at the end of the current period. Fortunately, railways, as with all large transportation industries, assess a fuel surcharge to offset sudden fuel price surges. This doesn’t take away from the importance to monitor fuel prices as supplementary information.
Key Performance Indicators – Corporate Performance
The end goal of monitoring key performance indicators is to validate ongoing performance of the company’s operations. This validation process prevents ‘surprises’ and boosts confidence with the buy/sell model developed. For many value investors, it takes about 10 to 20 minutes per week depending on the number of pools of investments the respective investor utilizes. For most investors, it is a function of the quarterly updates when the respective companies report their financial and performance results via the SEC 10-Q report.
The end goal of monitoring performance is to determine if the buy/sell model requires any update. It is a simple ‘Yes’ or ‘No’ decision. When creating a trend line of data, it is best to look at as much history as possible, the author suggests no less than five years; preferably the trend line should be greater than seven years. Analytical standards place more emphasis on recent results in comparison against historical outcomes. Value investors take a more conservative approach and use the average of the trend line to determine the ‘Yes’ or ‘No’ model update. The reasoning is simple, short-term results or near-term expectations should have little bearing on overall historical performance and the corresponding buy and sell triggers for a particular stock. Just because the recent performance is either elevated or depressed doesn’t indicate an ongoing trend. Recent performance may have been hampered or enhanced due to environmental or unusual conditions. Basing one’s decision on the most recent results is speculative and not a sound investment concept. Using the overall average is superior as it eliminates speculation. Act on Knowledge.
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Accounting is the language of business. Warren Buffett
Each year, every publicly traded company is required to report their financial status. Many go beyond simple financial statements and prepare an annual report covering all the relevant issues affecting the company. The high quality corporations present a fully comprehensive document that covers the prior year activity, including impact factors and why there is a difference between what was expected and the end result. In addition, these companies prepare forecasts of production, sales and any pending changes with systems and production processes. Most importantly, they include key performance data that allows shareholders to have a deep understanding of the economic variables that affect financial results.
But the primary purpose of the annual report is the financial information presented. This is where the average non accountant degreed investor has trouble. Many are not confident about interpreting and understanding financial statements. Don’t let this lack of knowledge prevent you from pursuing value investing. Understanding financial information isn’t as difficult as one may believe or have been told. In Phase Two of this program, there is a lot more information and exposure to the different ways of interpreting financial results.
To understand financial information, first the member must understand their general purpose and how they are prepared. The first section of this lesson introduces financial statements and their two primary purposes. In addition, pertinent issues are introduced that a company must endure to finally present a well prepared set of reports. Next, each of the five major types of financial statements are introduced. Most companies present a core set of five that include a 1) balance sheet, 2) income statement, 3) statement of retained earnings, 4) cash flows statement and 5) a set of notes to clarify the four statements. Some go further and present industry and highly customized financial reports. These are covered in Phase Two of this program along with the Pool’s information center that members have access to on this website. Finally, this lesson covers the importance of a few key bits of information and how these critical financial values impact the respective buy/sell models value investors develop.
Many stock market investors are not familiar with financial reports; they rely on accountants to provide the results in laymen’s terms in order to make decisions. This program is designed to build the confidence of non-accountant types to not only understand financial reports but to appreciate and ultimately, eagerly await their arrival each quarter. Again, Phase Two of this program goes in-depth about financial statements and how to interpret the information.
The first step with all of this is to be introduced to financial statements and why they exist.
Introduction and Purpose of Financial Statements
Simply stated, accounting is the recording of economic activity. It is done after the fact of the transaction. The entire profession is driven about proper organization of information. This includes terminology, definition and of course legal compliance. The profession uses a set of rules called Generally Accepted Accounting Principles (GAAP) along with a hierarchy of authority to support and promulgate these rules. As an aside, many non accountant types do not realize that the recording of data is an in-house process. Furthermore, this in-house team organizes the data and reports the results in the form of financial statements. An outside team, typically CPA’s from an accounting firm, validate the information by performing an audit of the financial information.
An audit means that they tested the data for accuracy and proper organization. In effect, the CPA’s verify that the company followed the rules. If the company followed the rules, the firm issues a letter that is customarily a component of the cover letter to the section for the financial statements in the annual report. When the report is issued, it typically states that either the information is ‘FAIRLY’ presented or they qualify their opinion. If the firm qualifies their opinion, they will state why it is qualified. The most common reason for qualifying the reports is that the company departed from GAAP in some material way.
Almost every single large-cap and DOW company issue ‘FAIRLY’ stated reports and will not depart from the rules of how data is recorded and reported. If they did, the company would see a sell-off of their stock. Remember what this is about, if you want to play in the big leagues, you must follow the rules. This is another reason why value investing only uses high quality large corporations for their stock selections. The other tiers have higher risks because many of them have trouble following the rules.
Thus, the primary purpose of financial statements is to answer the question: ‘Did the company follow the rules?’.
Whenever you look at the annual financial statements of any company, your first step is to read the Independent Auditor’s Report. Did the company follow the rules? If not, don’t invest in that company!
For clarification purposes, quarterly reports, i.e. the first three quarters of each fiscal year are called interim reports. Interim reports are rarely audited. In most cases, these reports have not been looked at by an out-sourced accounting firm for compliance.
If the statements are ‘fairly’ presented, then this means the information is organized properly and as such, this means the information is reliable.
A second purpose of financial reports is that the financial information must be disseminated in a timely manner. The accounting profession has two tenets. The first is referred to as accuracy. Did the company properly record the economic activity, i.e. did they class the information according to the rules and for proper amounts. Secondly, did the company do this in a timely manner.
It does no good, to get financial information in a tardy fashion. Shareholders and those interested in buying into a company are eager to get information; so is the Securities and Exchange Commission. The SEC actually has time compliance requirements for publicly traded companies. In general, companies have 40 days to report quarterly information and 60 days for annual information. Since most companies have fiscal years that end on the same day as the calendar year, most companies must report to the Securities and Exchange Commission by March 1st of the following year. This means there is a real push in each company to get the information out on time. Delays are symbolic of troubles. Top notch companies always report on time.
Core Financial Statements
There are five core financial statements. These are common among all publicly traded entities. Each statement has a primary purpose and provides a lot of information. It is important for the reader to recognize that at this level of corporate sophistication, these statements are presented in a summary format. Additional detail can be found in the auxiliary segments of the annual report. In addition, there are often supplemental financial statements breaking out a few of the more important financial components. The following subsections identify each report, their primary purpose and provide an example. In addition, each subsection below will highlight the one area every investor should look at first with each statement.
Balance Sheet
The balance sheet is really a two sided document. On one side (commonly presented as the upper half of the report) are assets. Assets are everything the company owns from cash to legal rights. This ownership costs the company money and the values presented reflect the ownership costs in dollars. Naturally, cash is self explanatory. It costs a dollar to own a dollar.
The other side, typically the bottom half of the report, reflects liquidation position if the company were to stop doing business at the moment the statement was dated. Most bottom halves of balance sheets reflect liabilities, outside creditors with superior rights to the assets, if the company were to cease operations. In addition, the bottom half states the equity position of the company; the estimated amount shareholders would receive if the company were to cease operations and liquidate.
It is important to understand that the balance sheet’s primary purpose is to provide a statement of financial position at the end of the respective quarter or year. It is a lifetime to date report. As a company earns money, it accumulates these earnings in the ‘RETAINED EARNINGS’ account which is a sub-account of equity. To illustrate, look at this simple balance sheet for Coca-Cola:
Notice two highlighted values. The first item is total assets of Coca-Cola. They have $86 Billion of assets. The second highlighted value reflects the estimated value all owners of the company including shareholders would receive if Coca-Cola were to cease operations and liquidate on that day.
Basically, $21 Billion of the $86 Billion in assets is owned by these shareholders and non-controlling interests (explained in Phase Three of this program).
Take notice of the title and the date near the top. The values throughout reflect the lifetime cumulative balances in the respective accounts through the date of this report. Go down into the ‘The Coca-Cola Company Shareholder’s Equity’ section and find the line ‘Reinvested Earnings’. This dollar value reflects all earnings over the last 100 years (Coke went public back in 1919) less dividend payments made over the 100 year period. It is the net amount the company retained for other purposes. You can see that the bulk of it is used to buy back stock (Treasury Stock) and cover other types of losses over the lifetime of Coca-Cola.
Basically, Coca-Cola returns its earnings to its shareholders by either paying dividends or buying back stock from shareholders. Remember, Coca-Cola is a DOW company and is considered one of the most successful companies in the world. Because it is a dividend driven company, most buyers of Coca-Cola purchase the stock to hold it in a portfolio of dividend based investments. Value investors only use dividend driven companies as standards in their pools of investments. Every now and then, the stock price may take a sudden deep price discount and value investors will snatch up these types of companies; but this unusual and unexpected.
For the purpose of this lesson, the key is that whenever you look at a balance sheet, your very first step is to identify the ratio of equity to total assets. The higher the ratio, the more protected the shareholders are with their position in the company. In this case, the equity position is 24.4%. High quality investments typically have more than 20% equity to assets position. Here are just a few current equity to asset ratios for popular companies:
Disney – 41%
Apple – 20%
Microsoft – 39%
Bank of America – 11%
For the member, the key is that the higher the ratio, the more protected you are as an investor. Ideal positions are over 50%, but these types of investments are hard to find at good prices with publicly traded companies.
As for the balance sheet, it has two halves, the upper reflects assets, the lower a combination of liabilities and equity – amounts owed to third parties and the value for shareholders. Within the equity section sits a single account which reflects the lifetime earnings to date net of dividends paid called retained earnings. Retained earnings are a function of net income.
Income Statement
The income statement reflects amounts earned within a period of time. It is the most popular of all the financial statements. This doesn’t mean it is the most important, it is popular because this is where owners discover if the company is making money – ‘Profit’. Notice a key difference between a balance sheet and an income statement. The balance sheet reflects a lifetime to date status of the monies earned, a snapshot at a moment in time. The income statement is an incremental portion of the retained earnings. Go back to Coca-Cola’s balance sheet above. Lifetime earnings net of dividends paid out equals $66 Billion. Look at Coke’s income statement for 2019:
In Lesson 8, five key financial points were identified, three of them are tied to this financial statement. The first identifies revenues. Notice the variances among the three years? Secondly, and reiterated several times in that lesson is the importance of the gross profit margin. Look at Coke’s gross profit margin for 2019. It is an unheard of 60% ($22.6 Billion divided by $37.3 Billion in sales). But it makes some sense, their products are not much more than water and syrup mixed together, bottled and distributed to consumers.
The third important financial data point is of course the one that almost everyone likes to celebrate and that’s net profit. It is highlighted in orange here. Coke earns $9 Billion off of $37.3 Billion in sales, net of all expenses, net of income taxes. This is an incredible 24% bottom line net profit. This is one of the reasons why Coca-Cola’s stock price is so high in comparison to its book value. Every year, Coke does well. Look at 2018 and 2017. Immediately, several of you are saying to yourself, well, 2017 isn’t that impressive. Look again. Look at how they paid almost three times their normal amount in income taxes. Why? Because Congress passed the tax act of 2017 allowing major corporations like Coke to recapture historically deferred income and pay taxes now at a lower rate. Almost every major corporation took advantage of this reduced tax rate and paid taxes on deferred and overseas profits during 2017.
As a side note, look at the expense line called ‘Selling, general and administrative expenses’. This line reflects mostly the marketing campaigns Coke utilizes to sell their products. When you see their commercial at half-time during the Super Bowl, that cost is included in that line right there.
Back to net income, the $9 Billion in profit earned has dividends paid out to the shareholders. In 2019, Coca-Cola paid out $6.8 Billion in dividends to shareholders. This means the difference, $2.1 Billion is accumulated in the ‘Reinvested earnings’ account on the balance sheet. Thus, of the $66 Billion of reinvested earnings, $2.1 Billion of that is from 2019’s profits.
There are two important lessons here with income statements. First, it identifies the net profit of the company during a short period of time in the life of the company. The periods are either during a quarter of a year, or for the entire year. Secondly, the income statement customary puts forth three of the five critical financial data points explained in Lesson 8. It just so happens that Coke also reports the fourth important data point of earnings per share in their income statement. Thus, during 2019, Coca-Cola reports that the company earned $2.09 per share. There are 4.3 Billion shares in the market.
To have a more detailed understanding of how the earnings were allocated, a third financial statement is prepared – Statement of Retained Earnings.
Retained Earnings
Retained earnings is a corporation financial statement term reflecting the net balance of all earnings during the corporation’s life. It reflects the net amount after paying out dividends and other preferred positions in the equity section of the balance sheet. The equity section of a balance sheet is divided out into three major groups. The first group are preferred positions of ownership, often referred to as ‘Preferred Stock’. These are owners with a superior position for earnings but gave up the right to vote for control purposes to gain this preferred position in receiving earnings. The second group are the actual shareholders, the owners that have the right to earnings and have the right to vote their shares when appointing board members. The third group are called ‘Minority Interests’. These are often small positions held in subsidiary corporations. In most cases, they are individuals or a management team that is a part of a joint venture or some partnership with the subsidiary company. These minority interests only have the right to vote their position with the subsidiary company. The mother corporation owns the majority stock position of the subsidiary and in general controls the subsidiary. However, these lesser shareholders still have a right to their share of their company’s respective earnings which is included in the overall corporation’s ‘Comprehensive Income’.
This exists with Coca-Cola. Coca-Cola has multiple subsidiaries in many different countries throughout the world. In the U.S., Coke has partnerships with many distributors and packaging companies (the actual bottlers of the product). In addition, Coke has purchased multiple brands of products. For example, they own Minute Maid and this company has its own distribution deals, plants and rights to transport product. Thus, when you look at Coke’s income statement, remember that comprehensive income includes all these other subsidiary companies.
To ensure that readers of financial statements are not mislead about the net profit, a statement is issued explaining how this net profit is allocated to the respective ownership groups in the organization. Here is Coca-Cola’s retained earnings statement, they call it the Consolidated Statement of Shareholder’s Equity. They are effectively explaining the equity section of the balance sheet in more detail.
Look at how this broken out. The report is actually divided into two sections reflecting two groups of ownership. Coke does not have a set of ‘Preferred Shareholders’ and as such, only has two groups. The first section is for the primary owners, the shareholders.
Look at the title of this section – Equity Attributable to Shareholders of The Coca-Cola Company. It starts out by identifying the number of common stock shares. Recall from various business lessons in your life that common stock has three traditional values comprising its total value. First is the legal value for corporate organization, it is simply called common stock. Next are the original amounts paid to the company in excess of par value (the legal value) and Coke calls this ‘Capital Surplus’. Now for the third financial value of the stock, the lifetime earnings value. Here, the company starts out with a beginning balance of $63 Billion and has to adjust this value due to some accounting changes – legal requirements. Thus, they add a half a billion dollars to the total. Then, comes the net profit from the income statement. From this net profit is deducted the dividends paid during the year. Remember on the income statement, Coke earned $2.09 per share. Look at the per share dividend payments for 2019. Coke paid out $1.60 of the $2.09 earned per share. Coke is one of the more dividend friendly stocks in the market because they do pay out more than 70% of their net profits year after year. Most companies do not pay out more than 50% of their net profits.
The two highlighted values reflect the discussion points from the income statement section above. Net profits and the amounts paid out in dividends contributed $2.1 Billion towards the cumulative lifetime to date balance of reinvested earnings of $66 Billion.
The report continues by breaking out comprehensive income issues, treasury stock values and then finally the total amount attributable to the shareholders of Coke. These are the owners that have a right to vote their stock for management purposes.
The second section are the dollar values associated with minority interests. Take note that although their position is only $2 Billion of the combined $21 Billion of equity (review the balance sheet above), it is significant enough that it must be reported separately with this financial report so that voting owners (traditional shareholders) can determine proper allocation of the entire equity of the company.
In Phase Two of this program, this particular report is explained in more detail and several illustrations demonstrate how to interpret the information as it relates to value investments. For the purpose of this lesson, it is introduced to the reader that the most important data point is cumulative lifetime earnings and how the current period of activity contributed to this lifetime value. This also makes the connection between the income statement and the balance sheet.
These first three statements tie together how the company performed and where it stands financially. But, another report is required to explain how the cash position of the company changed during the year. Look again at the retained earnings above. The net increase of $2.1 Billion is impressive. Novice business investors would jump to the conclusion that the difference must be in the form of additional cash in the bank account. This is not the case. Investors want to know, how was this $2.1 Billion used if all of it didn’t end up in the bank account. The cash flows statement explains how this difference is actually used.
Cash Flows Statement
This one particular financial statement is more misunderstood than any other report. For those not trained, it can be very confusing. This lesson introduces this particular statement and how to properly interpret the information in an overall viewpoint. But before it is introduced, let’s first recap Coca-Cola’s financial information as presented thus far in this lesson.
From above, Coke generated a profit of $8.9 Billion. With these earnings, it has certain obligations. First, Coke must pay any legal obligations such as debt instruments including principal on debt no differently than a small business must make its monthly payments for its mortgage or transportation notes. Every note payment has two components, interest and principal. Interest is a deduction on the income statement. Principal payments merely reduce the obligation on the balance sheet. Go to the balance sheet under the liabilities section and notice that Coke has long-term debt of $27.5 Billion. During 2020, a small percentage of this $27.5 Billion is due back to the lender in the form of principal along with the interest payable.
Secondly, Coke wants to pay its shareholders their reward for risk. As illustrated above with the consolidated equity statement, Coke paid $6.8 Billion in dividends.
A third use of these proceeds are to expand the company. Just like any other well run organization, Coke does not want to loose its position with non-alcoholic beverages worldwide. Therefore, it needs some capital to reinvest in potential new products or expand operations in other countries and so forth. This is commonly referred to as investing to not only maintain a company’s economic position, but to expand it as well.
Finally, profits are used to reduce other debts such as current liabilities or even buy back some of the common stock in order to buttress the market value of existing stock.
Whatever is the difference is the effect on the cash account. Realize, it is possible to spend more than one earns in a given period and this reduces the cash in the bank.
Now let’s look at what happened with Coca-Cola for 2019.
Every cash flow statement has four distinct sections.
The first section is located at the bottom of the report, the author has no idea why the accounting profession advocates placing the first section down at the bottom.
Anyway, it basically reflects the change in the overall cash position of the company during the fiscal period of the report. In this case, Coca-Cola started out the year with $9.3 Billion in its bank accounts. It ends the year with $6.7 Billion in its bank accounts; thus, it spent $2.6 Billion of its cash plus the net profit it earn (almost $9 Billion).
Where did all this money go?
It gets worse. Go to the very upper section entitled ‘Operating Activities’. Notice that the very first line reflects the net income of the company earned. This is always the starting point for every cash flows statement.
For those of you not aware, the net profit includes accrual adjustments which are often non-cash in nature. For example, the largest adjustment is always depreciation. Coca-Cola takes a depreciation/amortization expense in 2019 equal to $1.4 Billion. There are some other lesser value adjustments listed there, but for most companies, the biggest non-cash adjustment is depreciation. Depreciation was deducted in the income statement; therefore, for cash purposes, it is added back.
The net effect is that the cash income produced from regular operations equals $10.5 Billion.
Thus, what this really means is that the company spent this $10.5 Billion along with an additional $2.6 of cash from its bank accounts; therefore, in the aggregate it spent $13.1 Billion during 2019. How on earth can a company spend $13.1 Billion. Let’s find out.
From above, it is stated that the first requirement of a company is to pay its legal obligations, i.e. its long-term debt principal as agreed in the various loan documents. This is reported in the third section of the report call ‘Financing Activities’. The very first line it states ‘Issuances of debt’; these are the amounts borrowed. Notice it is a positive number which means, cash came into the company. The second line is the one we are looking for. Payment of debt was $24.9 Billion. This means Coke paid out $1.9 Billion more than it borrowed from creditors.
Go down a little further, do you see the big payment for dividends? It matches the amount as reported in the consolidated equity report. In effect, Coca-Cola pays down its debt $1.9 Billion and pays out to owners another $6.8 Billion. Altogether with the other minor amounts, Coca-Cola paid $9 Billion to address financing issues. There is one other minor adjustment which reflects $72 Million for the effect related to currency rate changes. Notice this is a negative value. This leaves $4.0 Billion for the third purpose of earnings: expanding the scope of operations to maintain economic or improve the company’s overall economic position.
In accounting, we call this ‘Investing Activities’. This is the second section of the report. It identifies where Coca-Cola spent some of its money to expand its economic position. The main line item is acquisitions of businesses for $5.5 Billion. This is Coke going out and buying up distributors and purchasing certain rights for certain products. In 2019, Coca-Cola paid $4.9 Billion for a company called Costa. Costa is a coffee company with retail outlets in 30 different countries. Coca-Cola decided to expand into the hot beverage side of the non-alcohol based beverage business. This makes sense, it wants to compete with Starbucks and the other big coffee retail operations. This is the reason Coke spent some of its cash. Altogether, Coke spent $4 Billion on investing including $4.9 for Costa and another $2.1 Billion for production facilities. It cashed out some of its existing investments in order to assist with the purchase of these new assets.
To help you comprehend this a little more, go back up to the balance sheet. Look at how Goodwill increased from $14.1 Billion to $16.8 Billion in one year. This goodwill increase is a reflection of the amounts paid in excess of book value for Costa.
Now let’s put this altogether in a little summary report:
*All values are in Billions of Dollars
Net Profit $8.9
Non-Cash Adjustments from Operations Section 1.6
Cash Position Increase Due to Operations $10.5 (ties to Operational Cash Flow)
Cash to Expand The Company’s Economic Clout (4.0) (ties to Investing Cash Flow)
Cash Used to Pay Down Liabilities (2.1)
Dividends Paid (6.9)
Change in Overall Cash Position ($2.5)
Currency Exchange Adjustments (.1)
Overall Cash Position Decrease ($2.6)
Again, the top three driving forces of money being spent are 1) dividends paid, 2) the purchase of Costa, and 3) paying down debt.
One last note, remember from Lesson 8 that there are five key financial data points. The last of the five addresses cash from operations earned per share. This is simply:
Operational Cash Flow = $10.471 Billion = $2.45 per share
Number of Shares Outstanding 4.28 Billion Shares
As stated in Lesson 8, cash earnings from operations per share should always exceed net earnings per share. From above, net earnings per share were $2.09. Thus, Coca-Cola does indeed generate more cash per share than it earns and this is tied to the additional non-cash depreciation deduction getting added back to net profit.
During Phase Two of this program, the value investor member is provided multiple lessons with how to read the cash flows statement in a more comprehensive manner and tie the information to the balance sheet. In addition, in Phase Three of this program, the value investor is trained about cash flows statements for the respective pools of investments. Remember, each industry is different. Some industries keep their cash flows statement simpler than Coke’s; others can be quite convoluted and it takes some additional understanding to interpret this information.
But most importantly, the changes that do occur with the four above statements are explained in detail in the report of financial statements called ‘Notes’.
Notes
The devil is in the details. The notes to financial statements offer deep insight into the respective reports and certain key information. Typical larger corporations often have more than 50 pages of notes and key supplemental schedules. With Coca-Cola’s annual report as delivered to the SEC, there are 23 notes covering 65 pages.
Most of the notes cover standard required pieces of information such as:
A) A summary of significant accounting policies is presented. This is especially important with really large conglomerates like Coca-Cola. The accounting function has a bearing on how financial information is presented and any changes can influence how an investor values the organization.
B) How long-term debt is allocated and accounted for over time including any pertinent parts of the respective bonds & notes.
C) Several notes address the company’s pension plan. Often pensions are a source of hidden liabilities as accounting for them is constantly changing in order to better identify these hidden liabilities.
D) Foreign investment is covered which helps to identify risks for value investors. A good example is an investment with China; given the contentious diplomatic relationship between the two economic powerhouses in the world, it is critical to limit exposure to China.
Notes are pretty easy to read and understand. They really clarify the financial information reported. Here is just one page of the four pages dealing with Note 2: Acquisitions. The area highlighted in yellow is about Costa.
If you read it carefully it provides two interesting tidbits of financial information. The first is on line 4 about mid-way. It says that $2.5 Billion of the $4.9 Billion was allocated to goodwill. Remember, up in the balance sheet, goodwill’s balance at the end of 2018 was $14.1 Billion and at the end of 2019, it increase to $16.8 Billion. This $2.7 Billion increase is mostly attributable to the purchase of Costa.
Just prior to that part, it says that $2.4 Billion of the $4.9 Billion is allocated to trademarks. Just as with goodwill, the balance sheet states that the trademark balance on 12/31/18 equaled $6.7 Billion and on 12/31/19 it increased to $9.3 Billion. This change is $2.6 Billion driven by the $2.4 Billion allocated to Costa.
If you were an investor with a hold position on this particular stock, e.g. you purchased it at a good price and are strictly interested in the high dividend payout; acquisition of a United Kingdom company in the hot beverage industry would be something you would want more information about. How is Coca-Cola going to develop this, especially in the United States. What are the forecasted earnings and sales?
As a value investor, your concern may be more in-line with risk exposure. Could this investment cause a sudden market price dip with the stock price?
Notes add a lot of value with interpreting the respective lines of information on the first four reports. Furthermore, notes fill in the blanks for certain parts of each report. If a note is written for a particular item, it is identified with a numerical code on the respective report and that code ties to the particular note in the Notes section of the annual report.
Altogether, Coca-Cola’s annual report to the SEC is 214 pages long. It is filled with supplementary schedules, comments from the management team, write-ups about the respective operations and how the company makes its money. With value investors, this information is read once a year when the new report comes out just to ensure that the company didn’t make significant changes that would impact the buy/sell decision model developed for that respective company.
Coca-Cola is not currently an investment potential in any of the Investment Fund’s pools. There is no non-alcoholic beverage pool of companies. For those of you just learning about value investing, value investors use pools of similar companies in a single industry. Value investors may have upwards of five pools with about 30 to 40 different potential stock investments.
Pertinent Bits of Information – What Value Investors Want to Know
Other than the five important financial data points, what else would a value investor want to know and how is it found in the annual report.
The key is the respective industry where the company belongs. Each industry is different. Always think holistically first. What exactly does this industry do to make money.
For example, one of the pools the Value Investment Fund currently uses is the banking industry. Banks basically want a volume of customers to deposit money into their bank and in turn the bank lends this money out to third parties. The bank earns interest and pays out a little bit of interest for the use of that money. They also borrow money from other parties to lend out. A common fear among banks is that when they lend money out, the borrower will be unable to pay it back. Thus, how much is set aside to cover potential loan losses? Another important piece of information would be the spread differential between interest receipts and interest paid to deposit accounts at the bank. This spread is the net money earned to cover all the expenses of the organization. Are there other sources of earnings, where does this come from?
The annual financial reports of banks clarify this and answer these pertinent questions. Again, each industry is different and therefore, what is important to understand changes with each industry. Thus, there is no universal question that will encompass all industries. Value investors acknowledge this when they create their pools of potential investments. They create a key set of questions to ask that pertains to all potential investments in that pool. The answers are compared and it becomes easy to recognize the better operations in that pool. It is these companies that value investors desire and often slightly modify the buy/sell model in order to take advantage of that company’s better overall financial status and risk position.
This entire concept is covered in more detail in Phase Two of the program and already exists for the current three pools of investments advocated by the Value Investment Fund. In order to access any information related to the three existing pools, the reader must be a member of the club. Act On Knowledge.
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The most difficult principle to adhere to with value investing is patience. There is a mindset that when you have a high level of confidence with your decision model, you are eager to see it come to fruition. The trouble with this is that others in the market don’t see it the same way as value investors. There are so many different investing programs, thoughts about buying and selling and pure greed. All of this combined creates volatility in the stock markets. Reasonable volatility, found with large-cap and DOW stocks is what value investors seek. Volatility with mid and small-cap stocks shifts the mindset from value investing to active trading in order to earn good returns. Market fluctuations are necessary in order to create the opportunities to realize gains. The other investing systems, programs and greed cause fluctuations along the spectrum of tiered markets. As the spectrum tends towards the lower end of the tiers, volatility increases. The upper tier, the value investing zone of large-cap and DOW stocks does experience fluctuations but nowhere near the volatility of the other zones.
Value investors must be patient to allow these competing forces to sometimes align with each other to either depress or magnify the entire market, an industry or a particular company. When the market causes a certain stock to depress to the value investor’s preset buy price, an opportunity exists and the value investor snags up a good deal. If irrational exuberance kicks in, opportunities to sell are presented and gains are earned. In the interim, value investors must simply wait.
There are so many similes to many life experiences, they all can’t be listed here. One good example is that patience in the stock market is like hunting from a deer stand. You know the prize will show itself at some point. Years of experience and lessons learned reinforce your basic instinct to be patient. It is the same for value investing. Good risk management, intrinsic value buying and financial analysis is rewarded when exercising self-restraint.
This lesson isn’t about emphasizing patience, it is about understanding how patience actually creates financial wealth in the market. Unlike day trading which is not much more than gambling, value investing is about earning good returns on one’s investment. The decision models built will never create instantaneous wealth, they are simply designed to take advantage of a good portion of the market price extremes that stocks experience. The first part of this lesson introduces the reader to certain terms used with cycles. It explores cycles with two areas of nature, sound and ocean waves. The next part of this lesson explains how the market as a whole experiences ups and downs just like wave patterns. These cycles, just like sound and ocean waves have a reasonable correlation to predictability. The next section takes this cycling effect into the industry level of the market. What is commonly called the ‘Pool’ of investments with value investing. This cycling of value continues into the respective investments. These first four sections introduce the overall concept of cycling with stock prices.
With the concept of cycling, this lesson then introduces how a value investor captures maximum return on an investment by smartly setting the respective buy and sell points. There are some drawbacks to this concept, if the cycle is extended, the overall return on the investment decreases. This is covered in the fifth section below. What is really important to remember is that even though there may be an extended cycle period, it doesn’t mean the value investor lost money; it just simply means the overall return on the investment fund will be less than anticipated. Thus, in some years, your fund may experience only 10% to 15% overall growth whereas in some other years, it may experience 40 to 45% growth. The key is the long-term approach to value investing. What accumulates wealth is patience, a lifetime of patience.
Value Investing – Cycle Patterns
Wave patterns are common in both audio and ocean surface movement. A standard visual of an audio wave looks like this:
This is one full cycle. The ‘X’ axis (horizontal direction) represents time and the ‘Y’ axis (vertical direction) represents volume. In business, this same image exists with the respective different markets, not as pure, often rigid and with more changes as it progresses forward in time. The key here is that the ‘X’ axis still denotes time, the ‘Y’ axis denotes intensity. The intensity is a numeric value with a baseline of zero worth.
With ocean wave science, it is somewhat similar. Look at this ocean wave depiction explaining terminology.
Notice here, that there are about 3.5 cycles.
Yes, many of you are wondering, ‘What does this have to do with value investing?’
The stock market also experiences ups and downs, just like these wave patterns. Thus, there is some terminology used with market cycles that somewhat mimics the terminology used with ocean wave patterns. Let’s compare:
Wavelength – with ocean terminology, it represents the time period for a full cycle, i.e. a complete top to top of a wave or a full trough to trough cycle. It is denoted in terms of time. With market cycles, it is also denoted in time. Unlike ocean waves which can be as short as a few seconds, market cycles range from a few weeks (high frequency) to years (extended frequency). In economics, it is often in years to complete a full economic cycle. The most commonly accepted economic cycle is about 11 to 14 years. This means, that the economy will go through a growth period, a leveling off or slow growth, then a sudden recession (in extreme cases it is referred to as a depression) and the cycle starts all over again. Typically, the recessions are very short in duration, about one to two years.
Amplitude – when a wave peaks in height, it is compared against the still-water line (think of a calm lake) to determine its strength. The higher the amplitude, the more powerful the wave is. In business, it is similar. Here, the peak point is often referred to as the market high. With the DOW Jones Industrial Average, those involved in the brokering business talk about achieving new highs, like breaking 38,000 points.
Crest – unlike amplitude, a crest can exist at various levels. The same exists with market terminology. Here, the term peak price or most recent high represents crest.
Wave Height – with an ocean wave, the wave height depicts the maximum change in a single wave. With stock market indices, it represents the volatility of the respective market during that time period. If there is a sudden drop then a peak in price, it is referred to a volatile. Whereas a slow downward and then upward shift over an extended period of time (several months) is considered reasonable or normal.
Still Water Line – with oceans, the still water line is considered stagnant, never changing (technically it is rising due to ice melt, but for the purpose of this lesson, it stays unchanged). In the respective different indices, there is no still water line. There is an imaginary line of value that has been ever increasing since the indices were developed. This long-term increasing value line represents the impact of the entire expanding economy on the respective index group. Thus, there is one slight difference between the ocean wave cycle concept and standard market cycles. When the imaginary value line is tending up faster than historical normal, it is referred to as a ‘Bull’ market. If this line is decreasing, no matter its angle, it is called a ‘Bear’ market.
With the terminology explained, the next section will explain and illustrate market cycles. Pay close attention to frequency (time periods) and amplitudes (peak points).
Value Investing – Market Cycles and Patterns
Value investors are limited to three common indices representing a portion or the entire top 2,000 publicly traded companies. Other indices are either too broad in scope or highly defined to a particular economic sector. The three top indices value investors use are 1) DOW Jones Industrial Average, 2) S&P 500 and 3) S&P Composite 1500.
This is a snapshot of 40 years of the S&P 500.
Notice the upward trend overall. Secondly, within this 40 year period, there are hundreds of full cycles. Some may have occurred within a single day, others within weeks. During this time period, there are cycles within larger cycles that they themselves are within even longer cycles. The point here is that the so-called ‘Still Water Line’ is continuously rising. This is an important characteristic with value investing. Value investors know that this line will continue upward over the next 40 years. IT HAS TOO in order for the economy to expand. It is possible for it to reduce its trajectory by a lower incline and that is OK too. What happens economy wide affects all investors. The goal of value investors is to simply outperform others over a long and extended period of time.
Now, lets look at a more narrow window of time and discover the cycles that exist. Here is the same S&P 500 over the last five years.
Notice that over the last five years, the S&P 500 has many different cycles, some are frequent and others are more extended.
Do you notice the peaks? Remember with ocean waves, they are referred to as crests. Can you detect the wavelengths? If not, it is OK, the next exhibit will clear this up for you.
The one point of this exhibit is that if you look at the early 2020 time frame, notice that there is a cycle within a cycle. If we were to close in on this, we would find even cycles within cycles down to a few minutes. The point is that cycles can exist within other cycles. Overall though, compare this to the concept of wavelengths. During some time periods, the cycles are reasonable, not volatile; while with other time periods, there can be significant volatility. Look at the chart around the 4th quarter of 2018. Notice the significant drop in the index and then the recovery during the first half of 2019. This is important to understand. In general, the market index recovers. Let’s narrow this down to what appears to be a relatively calm period of time whereby the ‘Still Water Line’ just simply improves. Let’s look at the time period of 2017. Are there cycles within this period of time? Let’s see if you can detect the wavelengths in this next exhibit.
You can now begin to detect shorter cycles and cycles within cycles. Take a close look at the two month period of March to May. Notice at the beginning of March that the S&P is nearly 2,400. Around the first week of May, it is again nearly 2,400. During this 9 week period, there are multiple cycles with some internal peaks and troughs (low points).
Walk through this logically. There are 500 different stocks compounded together causing this aggregated index value to increase or decrease during this time period. Assume that two or three of them are related to the 18 to 30 you target in your respective pools of investment. This would mean that those stocks presented opportunities to buy and then when they recovered a few weeks later, they are sold.
This is what value investing is all about. It is obvious highs and lows are going to occur. Value investors recognize this and the goal is to take advantage of these cycles.
Now don’t think that this is easy. You still have to do your work to identify good buy and sell points. The point of this exercise is to illustrate to you that economy wide, there is going to be cycles. These cycles benefit value investors because they have the greatest influence on stock market price changes for stocks. The main point of emphasis is that as a whole, the economy is continually expanding and as such, this change works to value investor’s benefit. Even if the economy contracted, it is still beneficial to the value investor because gains will not be as strong but will be superior to other investment models. Value investors are interested in the economic wide change over shorter periods of time; not extended periods of time.
Take note, the above illustrates the S&P 500. Are there indices for particular industries? Can these indices help value investors with their pools of investment. Do cycles exist within these industry wide indices?
Value Investing – Industry Level Cycles
There are indices at the industry level. This is important for value investors as having an industry index that corresponds to a pool of similar investments aids the value investor with making better buy/sell models for that particular pool. Here is an example of the banking index:
Take note, the industry as a whole has been performing poorly over the last three years. But still, within this time period, there are multiple cycles. There is a different approach value investors exercise with ‘Bear’ market based industries and this is covered in Phase Three of this program.
This next exhibit is the same index, but reflects the past three months as of 12/10/2020:
Take a look at the two points between the yellow markers. This is a 6% change in this index during this one week period. Notice that within one additional week, the index recovers? Assume one of your pools is a banking pool. The fact sheet on this index indicates there are 88 financial institutions monitored. The top 10 make up 20% of the aggregated results.
Suppose Comerica Inc. is in your pool of banking investments. Your preset buys/sells are 6% decreases and a 97% recovery; thus a 3% spread. Take a look at Comerica’s stock price change during this same time period.
On November 24, 2020, Comerica peaks at $54.59. On November 27, 2020, the price dropped to $51.31 (Red Marker) which is a 6% decrease from a peak point which is a trigger to buy the stock. Remember, these triggers are preset based on your intrinsic and financial analysis for each potential investment within your Banking Pool.
Your sell point is 97% of a prior peak point, which is $52.95 (Blue Marker).
During this eight day holding period, the stock price did continue downward, but recall that the financial analysis conducted along with the intrinsic value calculation assured you that a price depression rarely exceeds 12% and therefore the risk of a sustained depressed price was negligible. Your model also assures you that the recovery is often quick and thus, patience will reward the investor. In this case, the value investor earns $1.64 on a $51.31 investment. The absolute return was 3.19%. Many of you reading this will say, “Well, that is not impressive”. Actually, it is very impressive. Extrapolate this result out over a period of one year and the actual relative annual return is now a whopping 145%.
A few interesting connections to value investing’s principles and concept. First off, notice that it is possible to have much deeper discounts and make a much greater return on the investment. Suppose the discount was 8%, the buy price would have been $50.22 on 11/27/2020. The holding period is still eight days. However, the gain would have been $2.73 per share which is a 5.4% return or an unheard of 248% annual return. Another connection relates to greed. Value investors seek out ‘reasonable’ anticipated changes to make good returns on an investment. Every now and then, exceptional returns will occur, but these are driven by higher frequency periods (wavelength) than the idea of a deeper discount (trough) and higher peak (crest).
This takes us back to cycles. How often does Comerica have cycles that are 8% changes versus cycles with 6% changes? This is the frequency key that makes value investing so successful. The next section explores this very issue with company level cycles.
Value Investing – Company Level Cycles
Value investors look at cycles at the corporate level too. Here, there are two questions. First, how often are there significant peak to peak activities and secondly, what is a reasonable discount to peak change within these peak to peak cycles?
Sticking with Comerica. Here is Comerica’s stock price activity during the last six months (mid June to Mid December 2020):
With the existing Investment Fund’s Banking Pool (requires membership to access the data), Comerica’s buy/sell model dictates a 9% drop in market price from a prior peak to buy the stock. The sell point is 102% of prior peak. The above chart identifies four times during the last six months where there is a minimum 9% drop in the market price.
On 06/16/2020, denoted by the green line drawn vertically on the chart (ignore the volume indicators of green and red at the bottom of the chart), the price on that day peaked at $41.47. The 9% discount occurs on 06/24/2020 denoted by the end of the wide pink downward mark. On that day, the price at 9% discount is $37.74. It is at this moment that the value investor purchases this stock. Notice how the price continues to decline over the next few weeks and then begins to recover. There is another 9% decline from 08/11/2020 to 08/21/2020. HOWEVER, the investment fund did not buy at this point. Why?
The recovery point had not been met yet. Recovery is 102% of prior peak. Prior peak is $41.47, thus the sell point is $42.30 which occurs on 10/07/2020. The August 11th price is $42.15.
On 10/23/2020, a new peak is achieved (crest in ocean wave terminology). This resets the new buy price at 9% discount from the prior peak. On 10/28/20, the fund buys Comerica for $42.21 a share. This is denoted at the bottom of the pink downward line. On 11/09/2020, the stock is sold at $47.32 which is 102% of the prior peak. Now the whole process starts all over. A new peak occurs on 11/09/2020 and resets the entire schedule to a peak price of $53.93. On 11/12/2020, a 9% decrease exists from the prior peak and the fund buys at $49.08. It is now waiting to sell once the stock price hits $55.01 (102% of $53.93).
Thus, during the last six months, there were 2 full transactions and an existing buy for this stock in the pool. How well did the two transactions perform? Let’s do the math:
Transaction #1
Buy on 06/24/2020 $37.74
Sell on 10/07/2020 42.30
Gain per Share 4.56
Costs to Trade/Share (2.00)
Net Gain per Share $2.56
Investment Basis/Share $38.74 (Actual Cost Basis + $1.00 Transaction Fee/Share)
Absolute Return 6.6%
Holding Days 106 Days
Annualized Return 22.75%
Transaction #2
Buy on 10/28/2020 $42.21
Sell on 11/09/2020 47.32
Gain per Share 5.11
Costs to Trade/Share (2.00)
Net Gain per Share $3.11
Investment Basis/Share $43.21 (Actual Cost Basis + $1.00 Transaction Fee/Share)
Absolute Return 7.20%
Holding Days 13 Days
Annualized Return 272%
With the first transaction, the return was reasonable and the holding period was a little over three months. Whereas with the second transaction, the short holding period of only two weeks accelerates the annualized return. Go back to the ocean wave depiction; a higher frequency between cycles is a desired characteristic for stock investment. There is increased risk with higher frequency, thus it is important to ensure intrinsic value exists with the stock in order to ensure a good safety margin. With Comerica, the book value of the stock is in the low 50’s per share. Thus, higher frequency below book value is a desired attribute for quality investments.
During this sixth month period, Comerica Bank stock has earned a net $5.67 per share on an average investment basis of $40 per share or around 14.17% absolute return. This annualized average return is around 30%.
Now the question is: ‘Can we increase our return on the investment by either reducing the discount/sell points thus having greater frequency of activity or by extending the buy/sell criteria?’.
Value Investing – Frequency of Cycle’s Impact with Value Investing
Recall that with ocean wave terminology, wavelength refers to the time period between either peaks or troughs of a wave. With business, the typical wavelength or frequency changes all the time; but it still refers to a peak to peak review. With the Comerica Bank six month chart above; the first peak to peak with this depiction is about two months, mid June to mid August. However, based on the buy/sell parameters, the next peak actually has to crest at least 102% (the minimum recovery sell point) of the prior peak. This adjusted second peak turns out to be 10/07/2020, almost four months later. Thus, the first full transaction took 106 days.
Many inexperienced value investors often ask, what if we deepened the discount and raised the crest requirement thus acquiring a greater absolute return on the investment. Yes, the return on the investment will improve significantly, it mathematically has to based on the greater spread (amplitude) between the two points. The question is this: ‘Is this a superior method than more modest discounts and modest recovery points (crests)?’. Let’s find out.
Using the same initial peak date of 06/16/2020, let’s assume the discount is now 11% and not 9%. The first time there is an 11% discount from a prior peak occurs on June 26th when the price dips to $37.15. Now we are looking for a stronger recovery point and let’s use 103% of prior peak and not 102% as used above. Thus, 103% of the prior peak of $41.47 is $42.71 which happens on October 7, 2020. Here is the transaction’s earnings:
Transaction #A1
Buy on 06/26/2020 $36.91
Sell on 10/07/2020 42.71
Gain per Share 5.81
Costs to Trade/Share (2.00)
Net Gain per Share $3.81
Investment Basis/Share $37.91 (Actual Cost Basis + $1.00 Transaction Fee/Share)
Absolute Return 10.05%
Holding Days 104 Days
Annualized Return 35.27%
This is a huge improvement over Transaction #1; yet almost identical in every way except that the spread is an additional 3% in the aggregate. Furthermore, there are two less days of holding time and the margin of safety tied to intrinsic value is better; thus, less risk involved. Why didn’t the investment fund not pursue this as its buy/sell parameters?
To answer this, we must continue to look at the balance of the six month time period. The fund is now looking for the next 11% discount from a prior peak (crest). The next prior peak with a corresponding 11% discount has not occurred as of 12/11/2020. There have been several new crests along the way; but no discount large enough from that crest to meet the more aggressive parameters as set in the model.
What the model demonstrated in the prior section (9% discount/102% recovery) is that two full transactions and a current active hold means that more than likely that the investment will have three full transaction cycles in comparison to the more aggressive buy/sell set of parameters as illustrated with Transaction #A1. In the above section, the two full transactions have already generated $5.66 of realized gains. This more aggressive model has only realized $3.81 of realized gains.
The lesson here is simple, if the model dictates a more aggressive set of buy/sell parameters, the frequency of transaction activity is greatly diminished. The more aggressive model is definitely more lucrative per transaction and less riskier because the value investor purchases the stock for less than the modest model in the prior section. However, total aggregated income goes down! Yes, value investing is about buying low and selling high. However, if the buy/sell points are too strict (aggressive) the value investor may never have an opportunity to exercise this very risk reduced approach. Value investing really means to buy low and sell high under ‘REASONABLE‘ parameters, not highly restrictive.
In order to compensate for a highly restrictive model, you would have to have a much larger pool of investments, the author estimates more than 50 different stocks among 8 different pools, in order to accumulate similar aggregated dollars. This is covered in more detail with Phase Three during the sophistication part of this program. With this many stocks, value investing becomes a full-time job.
Given this, then why not be more liberal with the parameters and definitely take advantage of the multiple cycles with less amplitude (spread) of change between peaks. Let’s explore this.
Now, suppose that instead of a 9% discount, the parameters are more liberal and the value investor sets the buy point at 7% of prior peak and sells at 101% of prior peak. The results should be more activity during this same time period.
Same start date as before with a prior peak on 06/16/2020 of $41.47. The new buy price is $38.57. The recovery point is reset to $41.88. The buy date is June 24th and the sell date is August 11, 2020. Here are the transaction results:
Transaction #B1
Buy on 06/24/2020 $38.57
Sell on 08/11/2020 41.88
Gain per Share 3.31
Costs to Trade/Share (2.00)
Net Gain per Share $1.31
Investment Basis/Share $39.57 (Actual Cost Basis + $1.00 Transaction Fee/Share)
Absolute Return 3.31%
Holding Days 49 Days
Annualized Return 24.66%
Notice a couple of interesting conditional issues that drives the return on the investment. The realized amount is a mere $1.31 driven by the costs of activity; i.e. the value investor is paying two dollars to the broker for a $1.31 return. Secondly, the holding period is drastically reduced in comparison to the modest or more aggressive models. Also, the risk factor is higher because the basis with the buy is much higher than the modest model, by 83 cents a share. Remember from Lessons 7 and 2, risk aversion is essential with value investing.
However, with this more liberal model, there are now new opportunities. The next 7% discount from a peak occurs 08/02/2020 from the peak on 08/11/2020. On that day, the price peaked at $42.15 and on 08/11/2020 the 7% discount kicks in for a buy of $39.20. The 101% recovery point occurs on 10/07/2020. Here are this transaction’s results along with the next three full transactions:
Transaction #B2 Transaction #B3
Buy on 08/20/2020 $39.20 Buy on 10/27/2020 $43.14
Sell on 10/07/2020 42.57 Sell on 11/02/2020 46.85
Gain per Share 3.37 Gain per Share 3.71
Costs to Trade/Share (2.00) Costs to Trade/Share (2.00)
Net Gain per Share $1.37 Net Gain per Share 1.71
Investment Basis/Share $40.20 (Actual Cost Basis + $1.00 Transaction Fee/Share) Investment Basis $44.14
Absolute Return 3.41% Absolute Return 3.87%
Holding Days 48 Days Holding Days 6 Days
Annualized Return 25.91% Annualized Return 236%
Transaction #B4 Transaction #B5
Buy on 11/04/2020 $45.39 Buy on 11/11 /2020 $50.15
Sell on 11/09/2020 49.30 Sell on 11/24/2020 54.47
Gain per Share 3.91 Gain per Share 4.32
Costs to Trade/Share (2.00) Costs to Trade/Share (2.00)
Net Gain per Share $1.91 Net Gain per Share 2.32
Investment Basis/Share $46.39 (Actual Cost Basis + $1.00 Transaction Fee/Share) Investment Basis $51.15
Absolute Return 4.12% Absolute Return 4.54%
Holding Days 6 Days Holding Days 13 Days
Annualized Return 250.5% Annualized Return 127%
On 11/24/2020, the newest crest is $54.47 and on 11/30/2020, a 7% discount to prior peak happens and the fund buys at $50.66 and is holding as of today 12/11/2020. The recovery point is $55.01.
The above five full transactions earned realized gains of $8.62 over the same time period. This equates to an annualized return of approximately 39% based on an average investment basis of $45 per share.
It appears that this more liberal model is more lucrative to the value investor. The realized gains are $2.96 greater than the modest model and $4.81 over the more aggressive model. The key to this successful approach is the volatility of the stock. The more volatile the stock, the more liberal the discounts and recovery points may be. The problem is the risk factor involved. Notice that with this liberal approach of lower discounts and lower recovery points, the only reason it was successful was because on the same day, November 9th, 2020 the stock’s price recovered to the required $49.30 (See Transaction #B4) and continued until it closed at $53.93. In one single day, the stock’s market price improved $8.98 (20%). The very next day, the price started to drop ($1.20 in one day/2.3% down) and continued until on November 11th it hit the 7% discount and the fund bought at $50.15 (See Transaction #B5). Thus, in the course of 3 business days, this stock’s price had a full cycle of $11.30; more than 23% of its intrinsic value. This rare cycling effect added $2.32 to the overall results. For the reader’s understanding, on November 9th, the entire market exploded upon the news that Pfizer’s Phase 3 testing of Covid-19 vaccine was successful.
In effect, this frequency of activity is rarely observed with high quality stocks. To earn these types of returns assumes a very high frequency of discounts and recoveries and they simply do not happen with higher quality stocks. This type of volatility is more present with low-caps and penny stocks. It is one level up from day trading, commonly referred to as active trading. Also, look at the work involved in keeping up with entering buy/sell orders with the broker.
The modest approach is not only reliable, but is less riskier because the deeper discount price provides a better margin of safety and in addition, there are less dollars invested per share on average. Don’t kid yourself, the above liberal model was presented to illustrate a rare occurrence related to the crests and troughs of high quality stocks. It is only because of the one additional transaction that the return of this model outperformed the modest model. What if only three transactions occurred during this same time period? Total earnings would be similar to the modest model and yet the risk factor much greater as there is more invested with the liberal model.
Go back to Lesson 1, value investors are looking for reasonable outcomes; aggressively pursuing more dollars by applying liberal models increases risk and exposes the investment to much lower overall returns. Without volatility, an investor can not acquire the gains necessary to match a modest approach value investing advocates. High volatility is the enemy of value investing. To help you further understand this, look at this table.
Type of Trading Risk Factor Return Potential
Day Trading Highest Negative (During ‘Bear’ Markets, Day Traders Absorb Huge Losses)
Active Trading High Highest (Requires Volatile Stocks w/Good Information)
Buy/Hold Low Good (Assumes Investment was Bought Low w/Good Dividends)
Value Investing Low High (Requires Modest Models to Ensure Returns)
With value investing, the more aggressive the discounts and higher recovery points, the longer the hold required with the stock which in turns lowers the overall return on the investment; you still get good returns, just not high returns (> 20% year after year).
Value Investing – Patience is Key
In the opening paragraph of this lesson, it was stated that reasonable volatility, commonly found with large-cap and DOW stocks is tolerable and necessary in order to earn good returns on buy/sell decision models. As stock cycle frequency increases, chaos begins to creep into the picture of buying and selling stock. The concept of systematic buying and selling shifts from value investing towards active trading. This shift requires additional time commitment with much greater risk involved. Furthermore, finding highly volatile quality stocks is difficult because the two attributes are diametrically opposing. You can’t have quality with greater volatility.
Value investors build good buy and sell models for each respective potential investment within a pool of similar investments. With a few pools available, a value investor has adequate diversity to earn good returns. These buy/sell models utilize modest discount and recovery points to exercise the buy and sell transactions. It is here that faith in the model is practiced by engaging patience. Patience is the key to successful value investing. Act on Knowledge.
The post Value Investing – Principle #4: Patience (Lesson 9) first appeared on ValueInvestingNow.com.
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