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My investing philosophy mostly centers around the Value discipline and GARP- Growth at a Reasonable Price. This blog includes commentary on market conditions as well as fundamental analysis of specific companies. Graduated from Rhodes College with a degree in Business with concentration in Finance & Marketing. Currently working on obtaining the CFA designation. Previously worked in Mortgage Trading for a major bank. Use MS Excel extensively for developing investment models, notably valuation models based on DCF methods.

Thursday, June 7, 2007

High P/B Multiples do not Preclude the Notion of "Value"

Low price/book ratios have always been a primary tool to the value investor. Ben Graham popularized the ratio with his version of “net-net” stocks which were companies trading for less than net liquid assets. In today’s markets, those particular opportunities rarely, if ever present themselves.

Buying low price/book stocks has research to support its effectiveness. Fama and French conducted a study which found stocks in the bottom deciles for price to book ratio, outperformed stocks in the top deciles, as well as the market in general. An opposing argument states the reason for outperformance was due to added risk that was inherent in stocks with such low price/book ratios.

The underlying rationale is that these stocks have an uncertain future, thus investors react by taking the stock price down (boosting P/B ratio) to a level that is commensurate with the higher level of risk. Investors hailing from the Value discipline, argue that there is less actual risk since lower stock prices provide higher margins of safety. Market prices are now closer to book values, which to some degree, represent a value achievable through liquidation, at minimum. Either way, all these arguments appear to contain some logic.

So, is investing in stocks with low price/book ratios superior? * Low absolute price/book ratios- most likely NO. * Low relative price/book ratios- most likely YES. So what are the implications to those two statements? High price/book ratios don’t automatically imply a stock is overvalued and vice-versa.

It is my belief that high price/book ratio stocks should not be eliminated from an investor’s universe of potential buy candidates in spite of a high P/B ratio alone. Actually, I believe that companies with high P/B ratios can be great investments.

In cases where a company is “asset light”, value can be created from core competencies that arise from intangible assets, rather than from hard assets that are recorded on the balance sheet. “Asset light” firms do not require large sums of capital to invest in physical assets such as property, plant, equipment, and large inventory stocks. Asset intense firms will have lower returns on capital because of the large capital base needed to generate those returns. Moreover, growth is less valuable to the investor since large infusions of capital will be needed to increase and support higher returns. Yet, companies that require little capital assets do not need large amounts of cash to operate and grow. Less cash needed equals higher free cash flow which ultimately means higher market value.

Since Asset light companies possess assets not recorded on the balance sheet they will sport higher P/B ratios. Intangibles such as distribution networks, brand equity, expert knowledge, and an efficient organizational structure/business model, are all assets not listed in the financials. Yet, all those aforementioned factors contribute to a firms competitive advantage and its sustainability. These intangibles, or “x-factors”, allow a business to earn large returns on a small capital base. Firm strategy and the competence of management largely determine the returns to invested capital, not the actual physical capital itself.

A prime example of an “asset light” firm is Dell. Its stock provided monumental returns to investors in last decade. Dell had little physical asset needs since it had no retail stores, outsourced most product manufacturing, and possessed the ability to keep low inventory levels. Dell benefited from “x-factors” such as its distribution network and direct business model. Through the efficient and pragmatic organization of physical assets, Dell could operate with a fraction of capital than what its competitors required due to inferior strategic operating models.

Apple is another example. Its firm knowledge and brand equity allow Apple to generate higher returns than its peers with the same level of physical assets. Therefore, it makes perfect sense that Apple should trade at a higher multiple to book value.

Firms that require little capital to generate returns are attractive. Firms that possess “x-factors” that boost returns are even more attractive. These firms will have lower recorded balance sheet asset values than industry or sector averages, thus (all else equal) absolute price/book ratios will be higher than average. Firms with low absolute price/book values imply that more capital is required to generate adequate returns for investors. Thus, fewer “x-factors” are involved.

My goal is to demonstrate that stocks with high absolute P/B ratios are not necessarily overvalued. Further, it is likely that those members are above average businesses. What is important is to discover what the appropriate P/B ratio should be, for all stocks. The best way to accomplish this is on a relative comparison basis. After research and analysis is complete, an investor can then decide if a stock with a very low absolute P/B multiple is overvalued or if a stock with a very high absolute P/B ratio is undervalued.


Bud Labitan said...

The secret is P/V ratio.

WEB wrote:
"Our advantage, is attitude: we learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values.

When you invest, focus on your circle of competence. Draw a circle around the businesses you understand and then eliminate those that fail to qualify on the basis of value, good management, and limited exposure to hard times. Focus is one thing that Coke, Gillette & GEICO have in common. And I love focused management. Read the old Coca-Cola annual reports. You won't get the idea that Roberto Goizueta was thinking about a whole lot of things other than Coca-Cola. I've seen that work time after time.
And when you lose that focus as did both Coke and Gillette, at one point 20-30 years ago, it shows.

Think for yourself. I read annual reports of the company I’m looking at and I read the annual reports of the competitors—that is the main source of the material. Never mind what the professors say about Efficient Market Theories. For me, it’s what’s available at the time. Charlie Munger and I are not interested in categories per se., we are interested in value."

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