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The Measured Approach to Value

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Tevye the milkman.

He’s not the first person who comes to mind for the average value investor, but according to value guru Vitaliy Katsenelson, we can learn a lot from Tevye, the iconic farmer and defender of tradition from the musical Fiddler on the Roof.

In Katsenelson’s telling, Tevye needs to buy a cow, so he goes to auction to buy the best one available at the lowest price. First, Tevye needs to know how much the cow is worth: how much milk will it produce over the next five years and how many calves might it birth? Once Tevye has calculated the cash flow for this mythical cow, he can determine the value. For instance, it would be silly to buy a cow for $10,000 that will only produce $7,000 in revenue (including her value at termination), so Tevye, a shrewd buyer of cattle, will look to establish a margin of safety by buying the cow at a discount to its actual price. Once he’s factored in inflation, opportunity cost and the cow’s relative value, Tevye can make an informed and prudent purchase.

That, in a nutshell, is what value investing is all about, according to Katsenelson, chief investment officer at Denver-based Investment Management Associates and author of two books, including The Little Book of Sideways Markets, a guide for investing in our topsy-turvy economy.

“You basically look for companies that you can understand, you figure out how much they’re worth, figure out the discount to the fair value, and that gives you a buy price,” Katsenelson said. “When the companies get to the buy price, you buy them. Otherwise, you just wait.”

Value investing. It’s a topic that brings to mind apple pie, baseball and Warren Buffett. It also can be about as exciting an investing strategy as watching paint dry. For value investors, high-flying IPOs, overvalued tech companies or the hot stock of the moment don’t hold interest. Careful research, due diligence, patience and integrity, on the other hand, do.

The question is, in our present-day “sideways” market, where the peaks of 2007 and the valleys of 2008 were followed by the false expectations of 2010, is value investing the right approach? That is, with price-to-earnings ratios falling on the one hand and corporate America ringing every cent of profit out of their leaner companies on the other, are there still quality companies with great growth prospects at a decent price still to be found?

Yes and no. While  Katsenelson and others argue that a value approach is always the best way to value the purchase of stocks, the data show that value investors have taken a beating recently.

According to data provided by Frank Voisin, a value investor whose blog is titled Frankly Speaking, hedge funds taking a fundamental value approach were down 23.6% in 2011, the worst performer of 14 hedge fund categories.

However, over the last decade value stocks have performed better than the wider market. Data supplied by Russell Croft, co-manager of the Croft-Leominster Value Fund (CLVFX), show that Russell Value 1000 stocks returned 3.37% from 2000 through 2011 while the S&P 500 returned just 0.55%. Looking at larger stocks, data from San Francisco-area Equius Partners show that large value stocks as an asset class outperformed large market stocks both in the United States and internationally.

Keeping Steady

David Merkel, a value investor who has come to some renown through his Internet commentary at the Aleph Blog, believes that a value investing approach is always optimal, no matter the market conditions. That said, Merkel carefully reevaluates his portfolio three to four times per year and turns over the majority of his stocks every three years.

For Merkel, value investing is fundamentally about not losing money. The Maryland-based investment professional says that over 20 years as a value investor and approximately 300 stock purchases, he has made money 75% of the time. He doesn’t make a pot of gold, but says he has outperformed market averages. “I focus on companies that have reasonable prospects and not a lot of debt,” Merkel explains. “If you take on stocks that have a lot of risk, yes, you could gain a lot — or you could lose a lot.”

To evaluate which stocks to buy, Merkel says he first focuses on a margin of safety by searching for undervalued assets. He seeks companies with low debt that are capable of operating for three years without borrowing or selling equity. Like other value investors, he also looks for low price-to-earnings ratios and decent growth prospects. “Surprises will always come, but with value investing, positive surprises tend to drive things up considerably and negative surprises tend to drive things down not all that much.”

Though Warren Buffett has made much of his fortune investing in railroads, insurance companies and banks, Merkel says there is no longer any typical value investing sector. “If someone had said to me 10 years ago that 15% of my portfolio [would consist of] technology stocks, I would have said you are nuts.” But today, Merkel owns Intel (INTC), Hewlett-Packard (HPQ) and Oracle (ORCL) and even bought his first biotech stock, Amgen (AMGN) last year.

Merkel, who manages a little over $4.3 million for individuals and institutions, says that patience, education and risk aversion are a value investor’s best friends. It also helps not to create great expectations. “I try to be a singles hitter,” Merkel says, using a baseball analogy. “I like to come up to the plate and get a hit. I don’t try to hit a home run.”

Being Contrary

Along with his brother Kent and his father Gordon, Russell Croft runs Croft-Leominster, a Baltimore-based investment advisory that manages over $1 billion in separately managed portfolios and two no-load mutual funds, CLVFX and the Croft-Leominster Income Fund (CLINX). Kent says the firm is all value investing all the time, regardless of market conditions.

Kent says the company’s managers have three criteria when choosing stocks. First, they take a contrarian approach. When everyone is selling, they are buying. “We’re prepared to buy and lose to money to watch things unfold,” Kent explains. Second, they want growth at a discounted price, which translates into buying stocks when they are trading at 50 or 60 cents on the dollar. Third, they look for opportunities that are “catalyst driven,” in other words, companies with good tangible assets that are, for instance, going through a buyout or restructuring.

In 2012, the Crofts see a U.S. market where price-to-earnings ratios are favorable, dividends are increasing, interest rates are low and balance sheets at U.S. corporations are in good shape. “That’s a good time to be investing in equities,” Kent says. The Crofts like auto parts manufacturer Dana (DAN), which recently hired a new CEO, and they also favor blue-chip Johnson and Johnson (JNJ), which offers a dividend yield of 3.5%.

Assessing Honestly

Investor Frank Voisin takes a more cautious view on market prospects in 2012. He’s wary that this year will be a repeat of 2011, when early positive economic news provided false hope for a full-throttled recovery. “For value investors today, the best advice I would give would be to not assume we’ll see a recovery in the near term and continue to be vigilant in demanding a sizable margin of safety,” says Voisin, who currently lives in Hong Kong. “Investors need to get comfortable sitting on cash for extended periods of time, even as the markets might soar in the short run.”

Voisin, who holds law and business degrees and is a chartered financial analyst, advises investors to be logical and intellectually honest when appraising stock purchases. As he says, “the easiest person to fool is yourself.”

“You have to be comfortable identifying what elements of your [investing] thesis you are assuming and what elements you know as fact,” Voisin suggests, “and then work diligently to test your assumptions. In the best cases, you find a company that is cheap even when using the worst-case scenarios you can realistically conceive of. But most companies don’t fit this scenario and, especially as the market rises, there is a lot of grey area where the company may only be cheap in some scenarios. This is where intellectual honesty becomes extremely important.”

Caveats aside, Voisin believes that traditional electronics retailers are “historically cheap” at the moment. He’s bullish on Best Buy (BBY), RadioShack (RSH) and GameStop (GME). As with any good value picks, Voisin says these companies have extremely strong balance sheets and are priced at a discount to their intrinsic values, especially given their historically strong returns.


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