Value Investing White Paper
Value Investor Orientation & Analyzing New Investment Alternatives
When evaluating potential investment opportunities, it is critical to filter noise, eliminate fluff and unclutter the mind in order to think rationally. Nerves of steel, you do not need. What is needed are a few basic tenets you can apply that then allow you to calm your nerves, make rational and profitable decisions and perhaps more importantly sleep well at night.
Value Investing Tenets
An oft-spoken core tenet of the value investor playbook is to go where others fear to tread. It takes courage to buy when there is “blood in the streets,” but the strategy of going against the grain and buying out-of-favor sectors can be quite profitable, if executed effectively. In hindsight, the Global Financial Crisis provided an excellent opportunity to acquire high-quality companies at heavily discounted prices. The investor anxiety caused by U.S. healthcare reform was effectively the same thing – i.e. it caused otherwise rational individuals to momentarily wander into the path of insanity, and thereby sell high-quality companies at fire-sale prices. For those investors aware of the follies of human nature, healthcare reform was effectively a great opportunity to profit.
Return On My Money
Most understand what a return on money is. However, a return on money does need some clarification.
How exactly do our clients make a return on the money they entrust to us? When examining the rate of return on stocks there are two basic components in assessing the overall rate of return of a stock: 1) whether a stock price increases compared to the price it was purchased at, and 2) the dividend yield a stock pays, if any. Dividends, which are generally paid from a company’s earnings, often comprise a notable percentage of a stock’s overall investment return. However, this article will concentrate on comparing the price of the stock to the earnings of the company, and how the ratio of the price (P) of the stock to company earnings (E) can influence a stock price. The price of the stock compared to the earnings of the company is referred to as the ‘price to earnings’ multiple, or ‘P/E’. The earnings per share of a company is derived from taking the company’s total profit after paying taxes and dividing that number by the number of shares it has issued.
Clearly, a higher stock price today than when it was originally purchased is what we strive for, but how we get to that point can take different routes. There are many reasons why a stock might increase in value. The price of a stock can go higher (or lower) in the absence of any underlying positive performance of the company. As an example, sometimes investors will pay more for a stock because low interest rates make it difficult to find anything else to invest in with a reasonable expectation of making a decent return. However, more likely the reason investors will pay more for a stock is that there is something going on within the company that makes the stock more attractive to investors based on some particular items of interest. A common item is the expectation of revenue growth and / or lower costs resulting in higher company earnings (profits). Higher earnings often result in the stock price going up. This is particularly the case if investors were not already expecting the company to have increased earnings by the time the earnings are announced. This is just to say that investors are willing to pay a higher stock price because they feel the company’s earnings will be increasing fast enough to justify paying more for the stock. So a higher P/E multiple is an important component of the share price valuation (i.e. when a stock is a good buy) and total investment return. Investors can still make money without a higher P/E multiple, but the upside needs to come from earnings growth alone. As an example, if I buy a stock for $40 that has $2.00 a share in earnings, I am paying a 20X P/E multiple for it. Should the earnings grow to $2.50 a share but the P/E multiple remain the same at 20X P/E, then I would have a $50 stock price. Both price (P) and earnings (E) increased by the same percentage, thus leaving the overall P/E multiple unchanged. This is a nice return that came entirely from earnings growth and nothing from a higher P/E multiple.
Typically, many industries, in the absence of rapid technological change, will over time have a stock price that sits within a ‘normal’ trading range of what investors will pay as a multiple of its earnings. We get interested when valuations for industries fall to the low end or below a ‘normal’ long-term range. Healthcare is highly valued right now, but this wasn’t the case several years ago.
How Investors Got it Wrong & U.S. Healthcare Reform
During the fourth quarter of 2009, across the healthcare sector valuations were depressed due to the specter of U.S.-led healthcare reform. We bought Bristol Myers Squibb (“BMY”) at a historically inexpensive P/E multiple of 12X. That is to say we paid a stock price that was 12 times higher than its earnings for one year. BMY now trades at a P/E of 33X. That’s what you call a P/E expansion. At a 12X multiple, investors felt that future earnings were never going to measure up to anything good, and at a 33X P/E investors feel highly confident good things will happen in the future. For a historical valuation perspective please see the charts below.
During the second quarter of 2010, Baxter International (“Baxter”) was purchased at a 10X forward earnings multiple and now trades at 15X. Covidien Ltd. (“Covidien) was bought during the third quarter of 2010 at a 10.5X P/E and now trades at over 23X since its acquisition by Medtronic Plc. We purchased more Pfizer Inc. (“Pfizer”) for our investors in the first quarter of 2011 when it was trading at 9X forward earnings, and it now trades at 14.5X forward earnings. Rounding out our healthcare picks was the purchase of Wright Medical Group Inc. (“Wright Medical”) in the fourth quarter of 2011. This was a turnaround situation where earnings metrics didn’t apply because prior executives mismanaged the company to the point where it had no earnings, but a new, highly respected CEO had just joined the firm. We bought the stock at $14.75 and doubled our money.
The above examples demonstrate that companies can be bought ‘on sale’ when there is an overriding investment concern that turns out to be faulty. It is also much easier for companies to show better-than-expected earnings growth when investors aren’t expecting much. In the above-mentioned instances, investors benefit from not only better-than-expected earnings growth but also from higher P/E multiples. Now, however, the recovery to a more normal valuation range for the health care sector has taken place, and then some. The great success we have had in buying healthcare stocks when they were out of favor is what value investors do. Similarly, when investors pile on and P/E multiples become significantly higher than historical valuations for a particular industry, we reduce our exposure to the area, which is what we have done with the sales of Wright Medical, Baxter and Covidien. I am pleased we had the opportunity to buy these stocks when we did, but finding value in healthcare now is considerably more difficult. We will be concentrating our research efforts on other parts of the market until value presents itself in this area again.
Political crises, regulatory reform (healthcare or otherwise) and or recessions are all typically associated with large stock market sell-offs. The good news is that otherwise rational investors will momentarily behave irrationally during these times, thereby providing opportunities to buy high-quality companies at heavily-discounted prices. Investors are therefore encouraged to not let a good crisis go to waste.