Finding Under-Valued Stocks

Find under-valued stocks for high profits. Use the most hated stocks for the best investment returns.Jack Bogle gave us the index fund. Warren Buffett has said most people should put their money into index funds.

Personal finance bloggers—especially in the FIRE* community—spout “index fund” like it’s a nervous tick. And you might have noticed this blogger has the same nervous tick.

Some are worried about all this index fund investing. The concern is index funds will control so much of the market that it will lose its efficiency. I remember the same concerns in the 1990s, when I was a stock broker, about mutual funds in general, most of which were actively managed.

Index funds will not break the market any more than actively managed mutual funds did. For one, there will still be plenty of people investing in individual stocks. And the hedge fund guys will do their share providing liquidity.

Index funds are automatic investing. All mutual funds and ETFs for that matter. You drop in your money (dollar cost averaging is suggested) and let time perform its magic. The broader based the index fund, the better your chances of enjoying the stellar performance of the market averages.

But some people don’t like “average”. And even the most hardened index fund investor periodically finds a company she would like to own a piece of directly.

That is where we come in today.  Finding a gem that can add to your portfolio’s performance isn’t easy, but possible if you know where to dig. Many have made a career out of beating the market with thoughtful investments. 

Index funds should be the home for a good chunk of your money. However, you might have a mad money account or even a serious money account for investing in businesses you feel are under-priced while possessing future growth potential.

Investing in individual companies can be very rewarding, but carry significant risks. I’ve been fortunate in finding great businesses that have performed well over the decades. My individual stock investments have outperformed the market. I’ve also noticed I think differently about an investment than most. 

Today I will share why I buy what I buy, and more importantly, why I pass on so many opportunities that seem so obvious. 

 

Buy the Hated, Be Leary of the Loved

Most people buy the hot stock because everyone is doing it and the recent price action has been tilted steeply up. These are the loved stocks. In the early 1970s they were called the Nifty Fifty; we now call them FANG (Facebook, Apple, Netflix and Google, the parent company of Alphabet) today. 

Buying hot stocks is easy because everyone is doing it. That always causes me to pause. 

For disclosure, I own one share of Facebook and a modest amount of Apple. I never owned any Google stock, but had a brief fling with Netflix.

Most loved stocks are priced accordingly. While I do own some shares of FANG companies, they are not predominant in my portfolio. 

Let’s do a brief rundown of the list. Netflix is sporting a 134 price/earning (p/e) ratio as I write. While NFLX has a dominant market share and there are reasonable barriers to entry from competition, NFLX faces stiff competition from Apple and more importantly, Disney. NFLX doesn’t have to fail to drop significantly. If Disney captures even a small slice of NFLX’s business the stock is in trouble.

Google is also richly valued at over 40 times earnings. Facebook is a company I want to own, but management is concerning. FB has a dominant platform and not much in the way of competition. When FB dropped below 130 in December, the margin of safety was large enough for me to buy. But it was a modest investment. 

Apple is a story we’ll address shortly.

I’m not saying there is never value in popular businesses. What I am saying is they tend to be over-priced. Warren Buffet once said he preferred a great company at a good price than a good company at a great price. Think about that for a moment.

NFLX and GOOG are excellent businesses, but are difficult investments to make at the current price. You don’t buy a great company at any price! You want to buy great businesses at a good price (or better) with plenty of margin for safety. Things do go wrong, you know.

Another area I tend to avoid are the socially acceptable investments. Everybody wants to invest in green companies these days. As a result, all that extra money is pushing these investments to levels too rich for this accountant’s blood. There can be select quality investments in this area, but none of it is cheap.

Since investing is about making money and not some ethical or moral statement, I seek value where others tend to avoid. Think of the most hated stocks: oil, coal, tobacco, processed foods.

I don’t own Exxon-Mobile (XOM), but I did take a look-see. As longtime readers are well aware, I own a lot of Altria stock, one of the largest tobacco companies on the planet. This is a good place to start our research on what makes a business worth buying.

 

Anatomy of a Good Investment

I think it was Warren Buffett who said, “It costs a penny to make and it’s addictive. What’s not to like,” about Altria (MO). In my opinion, Buffett would own a large slice of MO if he didn’t have a reputation to uphold.

Peter Lynch, in his book Beating the Street, shared his wisdom with a set of principles. Peter Principle #14 said: If you like the store, chances are you’ll love the stock. While Lynch is a legend in the investing world with a whopping 29.2% average annual return (better than Warren Buffett’s) when he managed Fidelity’s Magellan Fund from 1977 to 1990, there are times his principles are not hard and fast.

Use the secrets of hedge fund managers to find hidden gems in the stock market. Buy before the stock moves higher.Take, for example, Amazon. AMZN is a great company with great management. I love the company and buy plenty of stuff from the platform. Unfortunately, the stock price is not so great. Buying even a great company with great management at nearly 100 times earning is a serious risk. AMZN is a great company, but probably not the best investment for me.

Which illustrates a point. I don’t smoke. Never smoked. But I do love MO as an investment. Their track record is unbelievable and they are doing it in a shrinking industry. 

Still, my purchases of MO slowed these past few years. The price was a bit high for the situation and the 30 years of a declining cigarette market was starting to look problematic. True, MO has the world’s leading cigarette brand in Marlboro and are one of the best managed companies publicly traded. Management loves rewarding shareholders which is also a good sign.

The declining market size didn’t concern me the most; competition did. Peter’s Principle #16 says: In business, competition is never as healthy as total domination. I agree. And MO was facing serious competition for the first time in decades from a new foe: Juul.

Vaping isn’t exactly the most loved industry either. However, vaping was taking market share from MO and it was starting to move the needle. MO made attempts with their Nu Mark product to no avail. Juul was taking over the vaping market the way MO took over the cigarette market. And the regulatory environment creates plenty of barrier to new entrants.

What turned me the most positive on MO in my life was the 35% purchase of Juul. And the best part is vaping costs less than a penny to make and is also addictive. (MO also invested in a Canadian marijuana company.)

My greatest excitement with Altria is the potential size of the vaping market. When you review the numbers it is not hard to see Juul could be a larger company than MO. And more profitable due to the lower taxes on vaping products. 

Excitement is not a good thing when investing! Boring is best because this is going to be a long slog. Patience is the most important quality when investing. I bought my first shares of the now Altria in the early 1980s. If you reinvested the dividends, MO was one of the best performing stocks of the last 30 years. And you enjoyed a couple of profitable spin-offs along the way. 

Here are the things I looked at when purchasing more MO in December and earlier this year:

Is there an existential threat? 

The massive investments MO made in late 2018 required review. The question has to be asked: If the government shut down Juul today would if put MO at risk of collapse? 

After researching the issues it became clear the answer was “No”. If Juul went out of business MO would lose their $12.8 billion investment. But(!), this would not be enough to cause a dividend cut. Dividends would climb slower, no doubt, but the enterprise would continue. Also, if Juul disappeared, the people using the vaping products would probably turn to cigarettes for their nicotine fix, which MO has a dominant share of the market.

What about debt?

All else equal, I prefer companies with less debt. MO certainly has debt. The debt they issued to buy Juul will increase interest expenses. MO management said cost-cutting would be enough to offset the entire additional interest expense. Very encouraging. 

An over-leveraged company should be avoided as the risks are too high. The balance sheet should provide all you need to determine the debt level the business has.

Everybody hates it!

MO’s stock took it on the chin as investors hated the Juul investment, at first. For a brief moment I was able to buy a great company in a hated industry that was hated by even its own investors. And there was nothing to warrant such a response. Yes, MO paid plenty for Juul. However, looking at Juul’s growth, the price will look like the steal of the century in less than a few years. So I backed up the truck. Now my dividends are even higher.

Financials?

You do not need to be an accountant or tax professional to read a public company’s financials. But you do have to read them. Let’s take a look at MO’s balance sheet.

 

 

The balance sheet is the most important financial to review. (The cash-flow statement is a close second.) Income statements can be cooked, if you will. The balance sheet tells me how solvent the firm is. It also tells me if a recent investment creates an existential threat. 

As you can see, MO has reasonable amount in cash and investments in other companies. If MO sold all investments in other companies they own for the price they paid they would have enough to retire all debt. MO investments in Juul and ABInBev are solid investments so they probably could sell these investment holdings at a profit. But we’ll discount some of these investments anyway to pad our safety margin.

When you review MO’s cash and investments against it’s debt and consider the shareholder’s equity, it is easy to see MO is not facing an existential threat due to their Juul investment.

One thing to note. The reason for the large negative number for Treasury Stock is due to share buybacks.  This is not unusual.

 

A Few More Investments

As I noted in the beginning, I have a large share of my liquid investments in index funds. My retirement funds are almost 100% index funds or cash. My non-qualified monies (money in non-retirement accounts) are partially in index funds; a large portion is also in individual stocks. Buying good companies and holding them for a long time by default will increase the percentage not in index funds.

Apple is one of my newer investments. I will not provide financials as I did for MO. You can see Apple’s financials at CNBC

I prefer buying when a company is on sale. December last year when the market was down ~20% had me buying heavily. APPL has been in my portfolio for years and I added to it. I never used their products so I didn’t know if I’d love them or not, but I am fully aware of the cult status Apple users feel about their Apple products.

APPL is a popular FANG stock so it might be something to avoid. Except, the stock price increase was accompanied by increasing earning, low debt, loads of cash and stellar management. Of all the FANG stocks, APPL has the best management team. 

If you take the cash and subtract all debt, APPL still has ~$35 per share in cash! This means the p/e ratio is lower than listed. In other words, the enterprise has a 13.74 p/e ratio on it as I write. This is more than a reasonable purchase price for a company in a class by itself and a cult-like following. Though, I would prefer it “more” on sale before buying more. 

 

Knowing When to Sell

Selling can be harder than buying. Even the world-renown Warren Buffett, who says his favorite investing horizon is forever, sells investments periodically.

Even your favorite accountant has sold a few shares of his beloved MO in the past.

Let’s take an example of why selling is different than buying. Buffett’s fourth largest holding is Coca-Cola (KO). He bought KO in the 1980s (if memory serves) and has held it since. The dividend is solid and growing. 

Learn the secrets of buying under-valued stocks before they are discovered. Buy your investments on sale for quick profits.If you looked at KO today (a hated stock because they sell sweet drinks bad for teeth and accused of causing obesity) you would probably take a pass. The company is awesome with an awesome product and solid management, however. KO is dominant in their industry. But where is the growth coming from?

KO has a lot in common with MO. People are drinking less fizzy soda water and the world population is no longer growing fast enough to power profits higher. Unlike MO, KO can’t raise prices as easily. 

That said, If I owned KO I might not sell it. (I owned KO from the mid-80s to the late 90s.) The financials don’t excite me enough to buy a piece of the company. However, selling doesn’t make sense either. Selling would cause a serious tax bill if you held the stock a long time. And dividends like that are hard to come by.

When I sell it tends to be early on. If my original premise starts to erode I sometimes exit the investment. I bought Tesla and eventually sold. Of course I look smart because the stock was straight up at that time. However, my investment was more along the lines of keeping an eye on the company rather than a new serious investment position. The issue: Tesla without Elon Musk is in big trouble and they might be in big trouble anyway. I consider that a management issue in a very competitive market getting more competitive by the day.

When Facebook did a Faceplant in December, I bought. After considerable thought I came to the same conclusion about management and sold. 

Like Buffett buying KO, I bought Aflac (AFL) in the B’C.’s (actually the early 1980s) and held it ever since. I haven’t bought more in longer than I can remember. The dividends are climbing and it has been a good investment with a very accomplished management team. I looked at AFL recently (for this article) to see if I should buy more. There are certainly reasons to buy, but not enough for me to add to my position.

Certain things will have me selling fast. Hints of accounting irregularities are usually a sign to exit. If new management is failing, I leave. (I owned GE once upon a time and sold all of it because I had no faith in new management after Jack Welch left.) 

 

Waiting List

Patience is key to winning at investing. You wait for the right deal, then buy and wait forever as the business value keeps climbing. The stock price and dividends soon follow.

Finding a list of “hated” companies is easy. I want big, dominant companies in my portfolio. This reduces the chance of catastrophic failure. A good example is Boeing (BA).

BA is one of two major aircraft manufacturers in the world. (There are some smaller firms, but BA and Airbus control most of the market.) Recent crashes of Boeing 737 Max planes put BA under pressure. I bought a share so all the news stories would populate my feed. The stock started climbing so I thought I might not get a chance to buy at a “good” price. It happens. Most “watch list” businesses never become a real investment. 

BA came down again, but not enough for me to buy. Personally, I like BA more than airlines. Buffett disagrees, but I’m okay with that. 

Another watch list stock is JNJ. I owned JNJ in the past and I forget why I sold. (It was a dumb idea.) The recent asbestos in baby power/talc court ruling drove the price down. A little. Not enough to buy.

I’m watching Microsoft (MSFT) also. They really found their mojo after years where management struggled. I think Satya Nadella is a good leader at MSFT.

 

Of course, I own other businesses not discussed here. The idea is to give you the mindset necessary to win at investing.

Here is my final note: There is no crime is holding cash! Sometimes I catch heck when people realize I’m holding cash instead of investing in index funds. I can handle it. When the market is up I buy less because good investments are harder to find. When the market declines, like it did late last year, some businesses get discounted more heavily than others. Usually I find reasons to put my cash to work at those times. 

Now the market is near a new high again and new money is still looking for a home.

So I wait. Patiently. 

 

* FIRE: Financial Independence, Retire Early

 

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11 Comments

  1. Josh on April 14, 2019 at 7:52 pm

    I would love to see more of the FIRE practitioners embrace investing in businesses, as much as they do index funds or rental properties. For some reason, the index fund religion brushes away some important facts:

    Index funds are comprised of individual companies (the good and the bad), and therefore perhaps it is a good idea to locate the good (and the cheap), and avoid the bad (and the expensive). It is not EASY! Like most things good in life, it takes hard work.

    Buying a rental property requires hard work too! It is also very risky, as you are putting a substantial portion of your savings into a single investment (and leveraging it 5-to-1 usually). It is interesting that I often hear podcasts or read blogs about buying that first rental property, yet I rarely hear/read about buying that first great company (and a good price).

    So in my household we do have a portion of our savings in funds (index), but those were bought at cheaper valuations than now. They were also made prior to recent “tax cut stimulus” measures, which look to me to be a temporary bump in profits for the market. These profits are projected to drop next year and get back to a more rational growth level. This will affect valuations. Just look at entire sectors for crazy valuations: consumer staples, utilities, net lease reits, Software-as-a-service technology, etc. These make up substantial portions of the SP500 pie (along with FANG+microsoft).

    I have the ETF “VTI” included in my current valuation spreadsheet, and I think we are looking at something like this: (1.9% dividend) / (2% average dividend yield) – 100 = 5% overpriced to the historic average yield. Growth rate going forward 6.5% if using the median historical rate. So this equation looks like 1.9% + 6.5% – 1% = 7.4% annual 5-year returns if reverting to normal yield. If inflation achieves the Fed’s 2% target, we are looking at 5.4% annual returns. Not terrible, but not great either.

    Wouldn’t it be better to get closer to 3.5-5% yields with a growth rate of the same 6.5%? We look no further than taking your big MO and adding a dash of ENB, Simon Property Group, Home Depot, JP Morgan, and General Dynamics? Talk about some hated industries with great management, high returns on equity, and achievable growth rates.

    I’m way more interested investing in this bunch (and a few more unmentioned), than I am an index fund today, and maybe regardless of the market’s valuation. I don’t like to throw money at something for the “efficiency” of it. I want to know the particulars and be able to back up the what with the why. Why should I invest in this business? The index fund is too general for me to get fully behind in any meaningful way with our savings here.

    One more thing I would point out (and maybe this would be a good blog topic), is that investing in REIT’s is under-appreciated in this world as well. If we would consider buying one or two investment properties, why not invest in a REIT which will do all of that work for you? I cannot understand why folks are scared to invest in a company like Federal Realty Trust, but are perfectly comfortable buying a duplex in an “up and coming” part of town.

  2. Mohammed on April 14, 2019 at 11:04 pm

    Good post.

    I also love index funds and ETF’s and do not believe ownership is mutually exclusive to actively buying individual stocks.

    Great minds think a like.

  3. Katie Camel on April 15, 2019 at 3:43 pm

    Thanks for the visual on the balance sheet! I always find them so intimidating and will have to review your example when I have more time, so that I can become stronger at analyzing stocks – it’s something I’ve wanted to learn more about. I’ve purchased individual stocks in the past and still hold several. Overall, they have served me quite well and I have no problem with them. I’m sure I’ll purchase more in the future. Previously, I watched what people were buying en masse and purchased stocks accordingly — AAPL is one example. But this isn’t the method I want to continue using, since I’d prefer being a more informed investor, so thanks for breaking down your thought process! I agree that the lesser knowns are likely the more desirable stocks as well.

  4. ClayRogers on April 15, 2019 at 7:09 pm

    Great article! I think it would be great if you did a series on this going into more detail.

    To start with, what information do you pay attention to that provides you with the companies that you decide to dig a little deeper and analyze the financials as you did with MO in your article?

    One problem I find I have is that I read an article on a certain company or stock, and the case is made in pretty convincing fashion as to why the stock is a buy. I will admit to buying several stocks based on these articles. I have done OK with those stocks. But, a lot of stocks have gone up in the past couple years. I know this is not a solid investing strategy though.

    So, I would love to hear how you find out about what stocks and companies that you want to do your due diligence on.

    Regarding the Microsoft stock. How much farther would it need to go down for you to decide to buy? What platform do you use for trading? Does that platform send you alerts if a stock drops to a price you are willing to buy at?

    Thanks as always for all you do! Keep up the great work!!

    • Keith Taxguy on April 15, 2019 at 8:01 pm

      Clay, you have a lot to unravel in your comment. At some point I may produce a course along with articles taking a detailed look at how I find potential investments and what triggers the exodus from my wallet to ownership of a faction of a publicly traded business.

      As for MSFT. I sold some 75 strike puts last December expiring in a few days. I get to keep all the premium, but have no ownership of MFST. In hindsight I should have picked up at least a token amount of MFST when it was below 100 for a brief time. Instead I sold options which gave me an immediate gain, but no long-term growth from ownership. In my opinion, anything under 100 is a buy for MFST and 75 would be a screaming buy. That may never happen unless the market has another fear-fit. I’ll wait patiently. Also keep in mind the value of MFST climbs as they grow their businesses. Same goes for MO. Anything under 60 (for MO) is an easy buy for me. Still like up to 65 and would cautiously buy up to 70. Then again, if MO starts growing faster and Juul turns out to be what I think it is I would be willing to up my buying price. (For the record, I made another small buy of MO today.)

      As for platform; I use E*Trade. I buy 1 share (or 10 or so) as a way of keeping an eye on a company. Every time I open the account I see news on all the companies I own. I also use CNBC a lot when researching and just for a casual review of the market. Specifically, I’m looking for companies punished for some misdeed or mishap more than they should have been. Example: If BA has another round of fear, driving the share price close to 300 I will probably be the proud owner of a fractional share of BA. I’ll also probably die holding those shares, living off dividends if the need ever arises.

      • ClayRogers on April 20, 2019 at 6:19 am

        Keith, thank you for the reply. How do you determine what price is acceptable in your mind to pay? Take MSFT for example again. How do you determine that under 100 is a buy for MSFT in your opinion?

        I like MSFT long term so this is one of the stocks I have purchased a small amount of outside my normal index funds. I plan on holding for years though so my thought process was that I think it will go up from where it is now, so might as well buy in now. I am also continuing to buy small amounts as I have funds available. Kind of using DCA to buy in to the stock.

        I think I need to revisit my thought process if I am going to buy individual stocks though. I was thinking of it like I do my index funds where I just slowly invest more and more but in individual stocks instead of the index. I would just pick a number of stocks that I like long term and just invest more and more in them each month. It seems like the strategy would be more so to set more and more cash aside to have available to deploy when there is a stock that goes on sale.

        Thanks for all you do and taking the time to reply!

    • Josh on April 15, 2019 at 8:32 pm

      ClayRogers,

      I can answer from my perspective, but would also like to hear Keith’s.

      I get investment ideas from Seeking Alpha, the WSJ, news in general, and daily life observations. I have analyzed a lot of businesses at this point, and so that accumulated knowledge also creates some adjacent ideas.

      I will say that I don’t pursue every company that seems interesting or attractive. I tend to continue adding to what I already own when those prices are reasonable. My core holdings each make up about 3-7% of my overall portfolio, and so I am a proponent of concentration (not diversification). Use your index funds for diversification insurance. Avoid sprinkling your cash around in too many disparate businesses, and instead find a few that you are very comfortable investing in (that are priced well).

      I like to gather company financial data and create spreadsheets that organize this data. Then I keep them updated, and use the sort features to narrow down my choices when I have cash. So I may add companies to my spreadsheets and/or lists, but may not make any moves for months (maybe years). I look at investing as a bunch of opportunity costs. I may like this or that company, but if there are more attractive options in stocks I already own or elsewhere I will continue buying them instead.

      Microsoft is way way ahead of its ski’s as to the price. It is a really great business with a close to perfect A credit rating. It mints money, has plenty of cash, and pays a dividend to reward patient shareholders (not speculators on the price). Management has greatly improved. The price! My god the price of this beast. By every measure, MSFT should produce exactly 0% returns over the next 5 years, as all their earnings growth and discounted cash is already in the stock (and then some). Yet, perhaps it was simply way way undervalued for many years (it was). So how do we square this circle?

      Microsoft today trades with an “earnings yield” (earnings divided by price), of 3.6%. That means essentially that you are accepting a 3.6% shareholder return on today’s earnings. These earnings will rise in the future, but the stock price will HAVE TO rise much slower than earnings in order for this return to be more in the range that investors require (something more like 7-9% earnings yields). If you can buy MSFT today and earn 3.6%, perhaps you can find a stock with an A credit rating that promises a better return? You can buy Apple today for an earnings yield of 5.7%, and their financial position is similar.

      It’s all about trade-offs. This or that?

      My favorite ways to look at a business’ valuation is to look at:
      – earnings yields (this is the implied return on current earnings today)
      – historic p/e vs today’s p/e
      – compare to the broad market earnings yield and p/e (use the website mltpl.com for this information)
      – historic dividend yield vs current yield (yields tend to revert to the mean just like earnings and stock prices)

      I only look at these metrics once I have identified a great business that I can wrap my head around and be comfortable buying. I use these metrics to put everything into a spreadsheet so that I can sort the sheet to compare them against one another. Since the entire market is a giant weighing machine, you can use this to weigh your odds and safety margin. Find stocks that are trading well below your required return rate, below historical average dividend yield and earnings yield, etc. Buy those companies above the rest.

      • Josh on April 15, 2019 at 8:42 pm

        I should also recommend the Folio investing platform. You pay a once a year fee of $290 or so, and get essentially unlimited fractional share trades. I use this to make about 10-15 purchases per month, which in my schwab or vanguard accounts would cost me $50-$100 per month in commissions! That price also covers any tax loss harvesting you do when selling some here and there. They have a very robust tax-planning tool called the “tax football,” which allows you to arrange it so that you maximize losses, gains, etc when you sell or buy. You can make a bunch of portfolios and buy them as a whole according to your weightings. You can rebalance easily. It’s a lot of functionality that you would not get at really any other broker online. I have been also looking at m1 finance as a potential home for my roth ira account. They have a similar window-purchase fractional share system, and charge exactly $0 to use it. They lack the tax planning tools and diy platform of folio though, so I am on the fence.

      • ClayRogers on April 20, 2019 at 7:10 am

        Josh – Thank you for the time you took in posting that info. I have read it a couple times and still don’t fully understand it all. I would love to follow along with your thought process as well as you analyzed some of the stocks you mentioned. I really like Seeking Alpha so far as well!

        In your example of MSFT vs Apple. How do you factor in things like future growth? Say for example you think MSFT is going to continue to grow at a constant pace because of their move to the cloud business and SAAS model. But, are less sure of where Apple’s continued growth is going to come from in the future. How would you weigh that in to your strategy?

        As I said in my response to Keith’s post, I think I need to re-think my strategy if I am going to invest in individual stocks. My thought was to find companies I like long term and continue to invest in them each month. It seems like I need to more so build cash to keep on hand to deploy when the stocks I like are at a price I like vs just paying whatever the price for them is when I am ready to buy that month.

        I am actually using M1finance right now. Just their free version though. It fit well with what my strategy was which was to buy small amounts of stock each month. My plan was to treat it like dollar cost averaging into a index fund though. I picked stocks I liked and was going to just continue to invest in them each week. I will have to look at Folio. Although, at this point it is more so my knowledge that needs an upgrade, not the tool I am using. For the small amounts I currently have allocated to individual stock investing, free is probably a better match vs $290/yr.

        I think I did pick way too many stocks though to be in my M1 portfolio. I thought that would be a good way to diversify but I may need to revisit that as well. Part of my thought there was wanting to pick several companies I liked that were in different sectors.

        Would you be willing to share your spreadsheet? That might help me understand some of the analysis that you are describing. Although, I would probably need some commentary along with it to help me get your thought process as to what those numbers led you to buy and when.

        What stocks do you lock that you find are fair priced right now? With the stock market so high, it seems like so many stocks are at, or close to their historical highs.

        Thanks again for all the time you took to right your post!

        • Josh on April 20, 2019 at 7:22 pm

          I would say that generally you should stick to your own stock selection, and only use things like Seeking Alpha to learn how others think about investing (and the way they evaluate their picks).

          Use company annual reports to determine the status of their balance sheet, and to see how profitably they are deploying equity capital (the cash flow statement). Once you can wrap your head around these numbers for a business you like, then and only then can you determine a good price.

          Since future earnings until the end of time are what a stock price is based on, you need to make many guesses along the way. Since this is the case, I recommend only buying when you have a big discount to what you think is “fair value.” This compensates for life and its vagaries.

          Some approaches that I recommend, that have sound reasoning and records of success:

          1 – Use the inverse of the P/E ratio: Divide the earnings by the price, and you will get what is called the “earnings yield.” Since this is based on the trailing 12-month earnings as reported, it does not rely on future growth projections (re: guesses). To make this even more robust, I suggest deciphering the 5-year average “normalized” earnings and base it on that. This will iron out any recent anomalies from tax reform or asset sales. If you see an outlier year where earnings swing wildly in one direction or another, then remove it from your calculation.

          Let’s look at Altria Group (MO). If I take the average of diluted eps for each of the last 5 years, I get $4.70/share. That includes a $7.28 print from 2016 tax reform (accounting windfall but not actual cash flow). So if I look at the other 4 years instead, they show a more typical 8-9% growth rate. MO’s average in this case is $3.15/share eps averaged over 4 of the last 5 years.

          So to find the trailing 5-year average earnings yield, we divide $3.15 by today’s price of $54.37, and get 5.8% e/p. That implies that if we see growth that only keeps up with inflation, we will get close to 5.8% real returns by buying MO today. Since the dividend yield is 5.9%, we can probably safely assume this return is almost certain.

          Altria group has historically grown at 8% a year. If we add this earnings growth, we can imply that much of this will pad the earnings yield. To determine how much growth rate to add to the earnings yield, you’ll need to look at the cash flow statement and determine the company’s historic returns on equity capital. Divide “net income” for last year, by “shareholders equity.” In this case net income for 2018 is $6,963, and shareholder’s equity is $14,787 (values in millions). This gives us 47% return on equity. That is very high. The SP 500 average ROE for the same period was just above 15%. The consumer staples sector was around 25% roe. This shows us that we can feel confident in MO’s ability to reinvest our capital at high rates of return. We can therefore look at that 8% growth rate and see that to maintain that growth, the company only needs about $0.53 of capital to earn a dollar. That is one efficient business. Most businesses are lucky to spend $0.85 to earn a dollar.

          Ok now that all of that work is done, we have something like a 5.8% earnings yield, and 8% growth that we are highly confident in. Add those two together and we get 13.8% shareholder returns implied per year. That is a very attractive return.

          We can do the above for all of our favorite great businesses and then compare the implied returns of each. Simply buy a basket of the highest and sleep well at night.

          2 – Another valuation method that I like, and that is more of a rule of thumb that you can do prior to the earnings yield calculations, is something called “Dividend Yield Theory.” This is best used for mature businesses that offer consistent growth and pay a growing dividend over many years. It can also be used for higher growing businesses, but they must have at least 5 years of dividend growth (and be profitable!). Microsoft has 16 years of dividend growth, and Altria has 50 (factoring in the spin-offs).

          So here is how you do it. Find the current forward dividend yield (take the most recent quarterly payout or recently announced increase). In this case MSFT is 1.5% and MO is 5.9%.

          Find the 5-year average growth rate of the dividend. MSFT is 13.1%. MO is 9.7%.

          Find the 5-year average yield. MSFT is 2.4%. MO is 4.1%.

          Taking those three numbers, we can see how much the companies can pay us in cash to be their shareholders. This typically predicts the direction of the stock price and yield over time. When taken together, dividend plus growth will be our return.

          Current yield + 5-year average growth rate +/- mean reversion. I like to look at 10-year mean reversion as these things can take time.

          For MSFT we see 1.5% + 13.1% – 4.6% = 10% annualized growth over 10 years.
          For MO we see 5.9% + 8% + 3.8% = 17.68% annualized growth over 10 years.

          To get the mean reversion number, you need to divide the current yield by the historic yield and subtract 1.

          MO: (0.059/0.04) – 1 = .475 or 47.5%. This is the price growth that must occur in order for the yield to get back to the 5-year average.
          MSFT: (0.015/0.024) – 1 = -0.375 or -37.5%. This shows that Microsoft will need to drop in price by 37.5% in order to get back to the 5-year average.

          I show these two here and you can see that MO looks like it has a large margin of safety (47.5% under-valued). A lot can go wrong and you will still turn out fine here. If they never revert to their average yield, you can still book a 5.9% dividend and 8% growth, or 14% returns. You get the bonus 3.8% if things go well. This is like driving over a 10,000 lbs bridge with a 5300 lbs truck; there is plenty of safety.

          Microsoft on the other hand, may have to stagnate in price while continuing its growth. If everything goes perfectly, you may see 10% a year, which is quite nice (I’d take that!). The numbers here show us though, that if growth were to slow we would have to adjust our expectations. We may be driving over that 10,000 lbs bridge with a 9800 lbs truck. We could be driving a 13,000 lbs truck in the worst case. The past two years show dividend growth has slowed to 8%, and steadily did so each year. We should then expect maybe an 8% growth rate going forward instead. If we use 8% growth, we will be lucky to get 5% per year.

          These are a few methods I use to compare businesses against one another.

          PS, if we look at the S&P 500 index, we see the following:
          Earnings yield = 4.6% (median historical is 6.8%)
          CAPE ratio = 30 (median historical is 15.7
          Dividend yield = 1.9% (median historical is 4.28%)

          Under these numbers, we should think that things may go awry, yet the dividend yield has been around 2% since 2000, and the CAPE is based on old earnings data that change all the time. The earnings yield may be a better assumption.

  5. Triple Fi Guy on April 16, 2019 at 1:41 pm

    It appears we all missed out on America’s top performing stock this century at a gain of over 60,000%!

    https://www.marketwatch.com/amp/story/guid/C499A68E-6058-11E9-95B5-94067A85380F

    Anybody have any ownership of MNST?

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