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The search for true value

Aug 14 2019 11:13
Simon Brown

Simon Brown, founder and director of JustOneLap.com.

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Back in March, I wrote about Barloworld* in one of my ‘House View’ columns. I picked this stock because it is the only local stock that meets the classic value investing definition.

Value investing is a phrase thrown around with abandon in the investment world, but in truth we have very few true value investment managers. Even Warren Buffett, who studied under the father of value investing, Benjamin Graham, is no longer a value investor in the classic sense.

There is also an argument that value no longer has a place in investing, but I disagree with that. But at the same time, finding true value stocks, especially on the relatively small JSE, is often difficult.

The original concept of value investing is Benjamin Graham’s book, The Intelligent Investor. First published in 1949, it remains the default guide for value investing.

In the book Graham details the criteria a stock must meet in order for it to be considered a defensive value investment (he also deals with enterprise stocks, but for the purpose of this article, I am focusing on the defensive side). 

The first rule is that the company should have a market cap of R10bn (as at the time of my search). So, immediately, it knocks out the majority of JSE-listed stocks, but it does leave a decent enough sample. 

The second rule deals with balance sheets and states that current assets (remember current means those that can be cashed in within a year) must be twice that of current liabilities (short-term debt), while long-term debt (more than a year to maturity) must not exceed net current assets (current assets less current debt). In other words, the company is in a position where it can liquidate the current assets and pay off the debt.

The stock must also have made a profit for at least the last ten years and must have paid a dividend every year for the last 20 years. Again, these time metrics immediately disqualify the majority of JSE-listed stocks. However, they do give us a short list of stocks that have long-term profitability and dividend payments. This tells us a lot about the quality of the stock and is therefore important.

The current price-to-earnings ratio (P/E) must not be above 15 times, while price-to-net asset value (NAV) must not exceed 1.5 times. These are fairly standard valuation ideas to select ‘cheaper’ stocks.

Then we get to the ‘Graham number’ or equation. This is how it works: One takes headline earnings per share (HEPS) and multiplies it by the tangible net asset value (TNAV). Then multiply that number by 22.5. (Graham uses 22.5 as the preferred P/E of 15 times, multiplied by the preferred 1.5 times price-to-book.) Finally: Find the square root of this equation. 

That answer is what Graham considers the fair value. One then wants to buy at a discount to that value. 

Lastly, Graham suggested a portfolio of ten defensive stocks using the above methodology. This means an exposure of no more than 10% in each stock at inception. Thus, JSE investors hit a wall because my recent search yielded only Barloworld rather than a list of ten.

For those wanting to really dig deep and hunt for what Graham called the ‘enterprising stocks’, the rules are even tighter in certain regards. But it does provide a little more scope in other criteria. Through my search, I indeed managed to find a few smaller stocks that meet the criteria. But they’re not as attractive as the Barloworld discount – according to Graham’s equation, the fair value for Barloworld is R200.

There is another (easier) approach, and that would be to just buy the Absa value exchange-traded fund (NFVAL). But they’re using their own idea of value rather than the classic Graham theory. 

But for a slice of a portfolio, they are focusing on issues such as low debt and whether stocks trade at, or below, NAV. Both are attractive valuation theories and worth a space in a diverse portfolio. 

*The writer owns shares in Barloworld.

This article originally appeared in the 15 August edition of finweek. Buy and download the magazine here or subscribe to our newsletter here. 

investment  |  portfolio  |  stock exchanges
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