Bulkowski's Book Review: The Little Book of Value Investing
The Little Book of Value Investing, by Christopher H. Browne
The Little Book of Value Investing,
by Christopher H. Browne, reviewed 3/6/2008 and written by Thomas N. Bulkowski. Copyright (c) 2008 by Thomas N. Bulkowski. All rights reserved.
This is the only book on value investing that I have read that covers or even mentions foreign markets. That may not be saying much because I don't read many financial books and even fewer ones on fundamentals. Browne says that the secret is not to try and mold a foreign country's accounting to our standards but to better understand their methods.
For example, he cites Lindt and Sprungli where he found that assets were being depreciated every 2.6 years, which was unusually short when compared to other candy companies like Nestle. He spends a page discussing the financial shenanigans he does to tweak the numbers, but found "an adjusted P/E ratio of 7.5, which was one of the lowest P/E ratios for a major consumer franchise in the world." He goes on to say that, "I found numerous accounting anomalies of this sort as I researched companies in Europe. Almost uniformly, the odd accounting practices resulted in a company reporting lower earnings and lower asset values than would be the case under U.S. accounting standards." Buying opportunities, in other words.
I am not recommending that you go out and buy foreign stocks on a fundamental basis, but the discussion does make his book unique.
He offers lots of tips, but you have to dig for them. The presentation would be much better if Browne used bullet items to identify important points or even included a summary at chapter end.
Here is some of what he considers important.
Avoid companies that have a lot of debt to net worth. This provides a margin of safety for when times get difficult.
Buy stocks selling at a low P/E (price to earnings) ratio when compared to other companies and market indices. When a company with a low P/E reports a bad quarter, the market tolerates it better than it does when a high P/E company stumbles.
Since earnings are affected by one-time charges, some analysts use cash flow instead. "Free cash flow is cash flow minus the capital expenditures that are needed to maintain the assets of the company," he writes. It is the amount of money you can withdraw from a company while still keeping it running.
EBITDA tells how much cash is available to reinvest in the business. If you were thinking of buying the company, this would be the cash available to service the debt added during a leveraged buyout.
Book value per share is net worth divided by the number shares outstanding. Look for companies selling below book value per share. He describes (pg 37) a study he did on book value using 7,000 companies from 1970 to 1981, with market caps of at least $1 million and no more than 140% of book value. Then he looked at performance over 6 months, 1, 2, and 3 year periods. "Buying the lowest grouping, stocks selling for less than 30% of book value, would have turned $1 million into more than $23 million over the time frame, compared to $1 million growing to just $2.6 million in the overall market."
Companies selling below the net cash balances make for good values but are rare.
Browne is also a fan of insider buying. Buy when they buy. "Stocks bought by insiders outperform the market by at least a two-to-one margin," he writes.
When a company buys its own stock (using cash on hand), it is a good sign, but be sure that an announced buyback actually takes place. Some companies will announce buybacks that never happen.
Current assets to current liabilities should be at least 2 to 1. This will vary from industry to industry, but it's a good benchmark to use. This helps avoid companies with liquidity problems (too much debt to survive), especially when compared to other companies in the same industry.
Remove from consideration any company with excessive pension liabilities or contentious labor unions. Car makers and airlines come to mind.
Liabilities growing faster than assets suggests the company needs to borrow more just to stay afloat.
A high debt-to-equity ratio means the company is financing operations and growth with debt. If the debt gets too high and conditions worsen, then look out.
A rising cost of goods sold as a percentage of revenues suggests that rising costs are not being passed on to the customer or that competition is growing.
A high or growing SGA (selling, general and administrative expense) suggests wages are too high or the company is not paying attention to overhead.
A rising number of shares outstanding suggests excessive stock option grants and a dilution of shareholder value.
A rising return on capital means the company is reinvesting profits well.
The author suggests looking at the trend of various fundamental data, like the current ratio (steadily declining may indicate liquidity problems), working capital (rising is good), inventory to sales (rising inventory means they can't sell what they make), rising revenue (good), growing net profit margins (good), and so on.
The final chapter of the book, called, "Don't Take My Word for It," reviews a number of studies by independent individuals on how well value investing works over time. They confirm that low P/Es, low price-to-book value for foreign companies, and insider buying are all helpful.
Finally, one study of "falling knives," those stocks that dropped at least 60% over the prior year, found that they were four times as likely to go bankrupt, but outperformed the market during the next 1, 2, and 3 years holding periods. "The larger the market capitalization of the company, the higher the outperformance and the less the chance of corporate failure."