Bulkowski’s Book Reviews

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The Little Book of Value Investing, by Christopher H. Browne

The Little Book That Beats the Market, by Joel Greenblatt

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."

The Little Book That Beats the Market, by Joel Greenblatt

The Little Book That Beats the Market, by Joel Greenblatt

For six months now, I have been wondering how to achieve the kinds of returns I made 20 years ago. This book might have the answer. The hardback explores one facet of value investing, what the author calls the magic formula. If you buy a portfolio of 20-30 stocks based on a high earnings yield and a high return of capital, hold them for a year and reshuffle, you will beat the market over time with less risk.

When I first started reading the book, I rolled my eyes at the simplicity of the presentation, but did not find myself yawning. His words were engaging and lively while intentionally presenting the information in an easy-to-understand manner. Knowing that the author has "9 years of teaching at an Ivy League business school" and is the founder and managing partner of Gotham Capital certainly helped. In other words, he intentionally wrote the book so that "even my kids could understand." He succeeded.

Greenblatt focuses on the magic formula, that of ranking companies by their earnings yield and by return on capital. By ranking a company on each factor separately, summing the results, and then buying the stock of companies that rank near the top of the list, you can beat the market while lowering risk.

On page 56 he compares the results of approximately 30 of the highest-ranked stocks selected using the magic formula with the S&P 500. The magic set returned 30.8% from 1988 to 2004 while the S&P 500 averaged 12.4%. The S&P beat the magic formula only in 1995, 1996, and 1998, and the magic group were profitable in all years except one (2002 when they lost 4% compared to a loss of 22% for the S&P). In other words, the stocks did well in both bull and bear markets.

Greenblatt admits that small cap companies do better than the large caps so he provides additional tests to show that large caps also outperform the general market using the magic formula (page 61: 22.9% return for the magic group compared to 12.4% for the S&P 500). In this case, though, the S&P beats the magic group 5 years out of the 17 studied and the magic group has two losing years, 1990 (down 6%) and 2002 (down 25.3%).

The Magic Formula

Greenblatt spells out the details of the magic formula beginning on page 138, but the concept of the formula is simple. Select companies with the highest earnings yield and highest return on capital. How high is high, and what does he mean by earnings yield and return on capital? Before I define them, he says you can go to his website and get the results of his magic formula: magicformulainvesting.com. You select the minimum market cap for a company (he used 50 million in the study) and then you have to register to get the results. I stopped right there because I do not want to be added to someone’s %^@* spam list. You might feel otherwise.

He also says that you can find similar information, either for free or not, by using the screening packages at businessweek.com, aaii.com, moneycentral.msn.com, powerinvestor.com, and smartmoney.com. I did not check these sites.

Earnings Yield

Early in the book (page 40), Greenblatt defines earnings yield as the annual earnings per share divided by the share price. Near the end of the book (page 141), he refines it as EBIT/Enterprise value. That’s pre-tax operating earnings (EBIT: earnings before interest expense and taxes) divided by the market value of equity (number of shares outstanding times share price) including preferred stock plus net interest-bearing debt. He discusses reasons why earnings per share and share price are inferior to the more complicated formula.

Return on Capital

This is a measure of how well a company does when it invests its own money. From page 101 he says, "For return on capital, the formula looks for companies that earn a lot compared to how much the company has to pay to buy the assets that created those earnings." He uses trailing (last year’s) earnings.

In the appendix, he gets more specific and says that return on capital is EBIT/(Net working capital plus net fixed assets). EBIT is pre-tax operating earnings compared to tangible capital employed. He says that "This ratio was used rather than the more commonly used ratios of return on equity (ROE, earnings/equity) or return on assets (ROA, earnings/assets) for several reasons," which he lists and I won’t go into. You’ll just have to read the book for additional details.

Active Value Investing: Making Money in Range-Bound Markets, by Vitaliy N. Katsenelson

Active Value Investing: Making Money in Range-Bound Markets, by Vitaliy N. Katsenelson

Katsenelson defines what he means by range-bound markets: "Range-bound markets are the bear markets of price-earnings (P/E) ratios (they decline), whereas bear markets are the bear markets of P/Es and earnings (they both decline)." That is a complicated way of saying that a range-bound market sees lower prices, but a bear market has price dropping faster than earnings.

He shows a chart from 1900 to 2006 and extends the test range back to 1802 and finds only one bear market: the October 1929 to July 1932 drop. He concludes that the 2000 to 2002 drop is part of a range-bound market and not a bear market. There is nothing wrong with this conclusion; it is just a different way of looking at the data.

Katsenelson touches upon foreign securities and other asset classes. About gold, he writes, "Despite its unique properties, gold has not been a good investment. Over the past 100 and 200 years its returns have barely kept up with inflation." Amen to that. A chart shows that the total return from $100 placed in stocks, bonds, gold, and T-bills from 1925 to 2006 shows stocks in first place (valued at $328,450), followed by treasury bonds ($7,169), gold ($3,078), T-bills ($1,929) and the consumer price index (inflation, $1,141). I was toying with diversifying into bonds...forget that idea!

He then discusses the duration of range-bound markets. "The higher the valuations of stocks are at the beginning of the range-bound market, the more likely that the range-bound market will last longer." According to his calculation, the current range bound market began in 2000 and will last to about 2020. Ouch! "Negative emotions that accumulate in the market since the prior bull market are apt to drive stock prices far below their intrinsic value, as has occurred every time in the past century."

He demonstrates the results with a few tables of information from the 1900 to 2005 period using the S&P 500 stocks and concludes, "Lower P/Es lead to higher returns, and higher P/Es lead to lower returns. ...If stocks are bought when the P/E is below average (less than 12), P/E is the investors’s best friend... However, if stocks are purchased when the P/E is above average (greater than 16), the P/E turns into a foe, as its compression diminishes returns." In short, growth stocks don’t grow as fast as value plays. I still find that surprising, but it is a lesson that other value books discuss.

On page 58, he makes an interesting statement: "Exhibit 3.16...shows that dividends contributed the bulk of the returns to previous range-bound markets. In fact, of the 5.9 percent average total return investors received in the range-bound markets of the twentieth century, 5.3 percent came from dividends; dividends contributed more than 90 percent of total return!" No wonder I’ve liked electric utility stocks for years now. Last year (2007), the Dow utility average (16.6% rise) was the best performing among the Dow (industrials: 6.4%, transports: 0.2%), Nasdaq (9.8%), and S&P (3.5%).

Quality

In part 2 of the book, he discusses his framework for active value investing: Quality, Valuation and Growth (QVG). He devotes a chapter to each. Characteristics of a quality company include strong brands (recognizable names that cost more than other brands), high barriers to entry, regulated monopolies, patents, and a strong management team (one with integrity -- willing to admit mistakes and is honest -- and focus on creation of long-term shareholder value, often as a sacrifice to short-term value). Those characteristics give the company a competitive advantage. "A company that is earning above-average returns on capital (the best kind) will attract new competition," but a history of high return on capital is a sign that a company can maintain that high return.

The competitive advantage will help the quality company prevail whereas those companies with a weak competitive advantage will drop product prices, sacrifice volume, or invest in ways to differentiate from the competition in order to stay competitive.

He then discusses the balance sheet and writes, "To gauge a company’s true indebtedness and the risk that comes with it, you should utilize debt and interest coverage ratios in relation to net income; earnings before interest, taxes, depreciation, and amortization (EBITDA); operating cash flows; and/or free cash flows. These ratios tell a more accurate story about the balance sheet (debt) risk and are not distorted by share buybacks. Here are some examples of these ratios: debt/EBITDA; debt/operating cash flows; EBITDA/interest expense; operating cash flows/interest expense."

Pension plans and leases are off-balance sheet bombs waiting to explode. A company that assumes a high rate of return on its plan assets may mean the company uses aggressive accounting. Companies with stellar balance sheets are takeover bait.

Growth

Growth is composed of two parts: earnings and dividends. Revenue growth drives earnings. If revenue is rising faster than costs, net margin will expand and net income growth will exceed revenue growth. Revenue growth can come from selling more products both domestically and internationally, raising prices, or lowering prices that creates higher demand and lowers costs.

As part of the revenue discussion, he says that stock buybacks are great ways for a company to boost shareholder value providing it is done at a cheap price. Using debt to finance a stock buyback is less attractive than using free cash flow to pay for it.

Companies that pay a large dividend tend to have stocks that drop less. When the price drops, the dividend rate increases, attracting more shareholders looking for income. That buying demand supports the stock. Katsenelson writes that "A study conducted by Cliff Asness and Robert Arnott called ’Surprise! Higher Dividends = Higher Earnings Growth, ’ published in the Financial Analysts Journal, showed that companies that had a higher dividend payout actually grew earnings faster." They showed that when the company retained earnings instead of paying them out, they had a tendency to invest poorly by buying other companies at prices too high or that were not a good fit to begin with. "Cash that has not been paid out is often squandered by management," he writes.

Valuation

Ratios such as price to earnings, price to cash flow, price to sales, price to dividends, and price to book are good ways to screen for stocks, according to Katsenelson. One of the startling statements in the book is that the PEG ratio is flawed because it "assumes a linear relationship between P/E and earnings growth. ...Higher growth of earnings usually comes at higher risk; thus the relationship between P/E and a company’s growth rate is far from being linear, and the PEG ratio doesn’t address this issue. In addition, the traditional PEG ratio is focused solely on earnings and ignores dividends. On top of all that, it assumes that a company that is not growing earnings is worthless (P/E divided by 0 percent growth = 0 value)."

The author examined the range-bound market from 1966 to 1982 and found:

• "The high-valuation stocks performed worst in terms of change of the P/E from the market’s P/E contraction.
• Lowest-P/E stocks consistently outperformed highest-P/E stocks, in many cases by a margin of 2:1.
• Lower-valuation stocks consistently dominated higher-valuation stocks, producing much better returns than their higher-valuation comrades. They suffered lower P/E decline at the time of P/E compression. They also achieved higher P/E expansion at the time of P/E expansion."

Concerning the three QVG elements, he assessed whether or not you can use one or two of the elements instead of all three. In the chapter’s conclusion he says that "As a general rule, you should not compromise on more than one Quality, Valuation, or Growth dimension, as it introduces too much risk and/or subpar returns (to say the least) into the mix. Each of the Quality, Valuation, and Growth dimensions is an important source of value creation." In other words, if you can’t find a good quality company with good growth at a low price, then keep looking.

Active Value Investing

Katsenelson discusses active trading using the value approach. He says, "Anybody who invests in stocks should expect to commit capital for five years or longer." That is not the same as holding a stock for five years, but it emphasizes the long-term approach needed. He explains what he means by active value investing when he writes, "In the range-bound market you should employ an active buy- and-sell strategy: buying stocks when they are undervalued and selling them when they are about to be fully valued (as opposed to waiting until they become overvalued)."

He further explains the method: "For every company you find worthy of owning (high quality and growth marks), set the optimal price or valuation levels at which it transforms into a good stock. First, determine the fair value of the company using the combination of relative-and absolute-valuation tools discussed in the Valuation chapter. Then, settle on the required margin of safety (the discount to the fair value) that will lead to the buy P/E. And finally (the hardest part), sit and patiently wait for the stock to come down to the predetermined target valuation level and/or price.

When deciding when to sell, he offers an invaluable tip in the form of a question: "If a new person were to manage [your] portfolio, what would he/she do?"