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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

Buffet: Bond Investor in the Equity Market

Warren Buffet’s strategy, in its simplest form, is buying stocks with equal or less risk than treasury bonds. He bought financial instruments with the amount of risk as bonds, the amount of return achievable with equities, and at prices that over-compensate the actual risk entailed by delivering greater returns.

In Essence, Buffet is a bond investor who does his shopping in the equity market. Sometimes Mr. Market gets confused and sells “equity-bonds” at a discount to Treasuries, because he feels the risk outweighs the potential return. Buffet knows that in the long-run there are select stocks that actually provide much greater returns than bonds with less risk.

How is it possible that a stock could be less risky than bonds? Especially given that the market has always valued equities with a risk premium over bonds? Well, if one finds stocks with a solid historical record of always paying a steady dividend, and increasing payouts with earnings growth, then those stocks can be considered “bond like.” Buffet’s prefers to look at stocks as “equity-bonds.” His goal is to find firms with solid economic moats so that dividend payouts are never a risk of decreasing, much similar to coupon payments Treasuries provide.

In this aspect, a stock is very much the same as a bond. Second, Buffet searches for those companies that can increase their dividend at a rate at least equal to inflation + GDP, but ideally, those firms that can grow at even higher pace. This growth ability of dividends provides the equity characteristics of “equity-bonds.” In summary, Buffet likes to find stocks that are no different than bonds in regard to safe, predictable cash flows, yet the equity or “ownership” component allows the investor to share in firms’ success as shareholder payouts increase.

Bonds have fixed cash flow payments. Whether a firm is an average or top performer makes little difference to bondholders. Since the upside potential is limited for bondholders, the amount of risk of their investment is lower due to “first in line” claims on assets over equity holders.

But, if one buys a solid enough business where the possibility of default is so infinitesimal, does it really matter who is at the head of the line ? in a situation that will never occur? If the cash flows are not at risk to neither debt nor equity holders then there should be no need for an equity risk premium. Additionally,bondholders actually face more risk over the long-term than equity holders.

First is inflation risk.
Since interest payments on debt are fixed, higher future inflation eats up bond returns. Yet, for stockholders, companies can increase their dividends to keep pace with inflation. Since inflation stems from companies charging higher prices, then sales and income will be higher resulting in higher dividend payments.

Second is re-investment risk.
If interest rates fall resulting in robust economic growth, bond payments are re-invested at lower current interest rates, whereas public firms can re-invest the dividends internally to capitalize on the favorable growth environment. In sum, debt holders face re-investing at lower return opportunities contrary to equity holders.

Third is interest rate risk inherent in bonds.
This risk increases with maturity. If the economy is robust and interest rates rise due to demand for capital and loanable funds, previously issued bonds lose value. If a bondholder has been receiving a 6% semi-annual coupon and rates move to 8%, then the investor loses out on higher coupon payments currently available in the market since the interest payment is fixed.

Additionally, if the bond is sold before maturity then it would be sold at a discount to face value, hence a loss. On the other hand, robust economic activity benefits firms as revenues and profits grow. This allows the stockholders to participate in economic windfalls by increased dividends.

Over a long time horizon, It is evident that stocks have much less risk than in a comparison of bonds and stocks over a short time horizon. It is also fathomable that a few, select stocks may be less risky than bonds over the long-run. In essence, there should then be a negative equity risk premium since bonds carry more risk relative to Buffet’s “equity-bonds” and additionally provide larger returns.
So what does all this mean? When the market applies risk premiums greater than the actual inherent risk, those stocks are undervalued. The market makes risk adjustments to stocks by taking down the stock price, thus lowering price-earnings multiples to increase required return. When investors perceive lower risk they bid up prices and multiples resulting in lower required rates of return.

Buffet dislikes bull markets. Rising stock prices make him anxious. Buffet only cares about the price paid- NOT the current market price due to his intention of holding the shares forever. He seeks to buy stocks that are solid enough he would never sell thus making current market prices of holdings irrelevant.

Since he only cares about the price he pays, upward markets mean Buffet has to pay more for an “equity-bond” resulting in lower future returns. Falling markets allow Buffet to buy attractive investments at a lower prices which, in itself, adds to the attractiveness. Stock prices fall to increase required returns resulting from higher risk premiums being priced-in by the market. If the long-term risks remain unchanged, then investors are getting higher returns without the additional risk. This is how Buffet views investing.

Warren Buffet was able to capitalize on the mispricing of risk in the market. Especially the price of risk viewed from a long-term vantage point. He bought stocks that traded at multiples much too low for the risks involved and the firm’s future growth prospects. Additionally, the market as a whole traded at a 5% - 6% premium to Treasuries when Buffet started BRK. That premium has fallen to the 3% range today, and will probably fall even further.

Buffet understood that there are stocks that are less risky than bonds when viewed from the long-run approach. He saw much of the time markets assigned too large of risk premiums creating investment opportunities.

Today, it is much more difficult. The market applies higher multiples to stocks that have “equity-bond” characteristics resulting in lower returns. Buffet has demonstrated to the investor class that superior returns can be earned of the long-run with minimal risk. Having become apparent, most Buffet type stocks command a premium making it tougher to attain outsized “Buffet-like” returns.

Many investors have adopted Buffet’s philosophy in hopes of achieving his high returns, eliminating much of the opportunities underpinning the advantages of the Buffet philosophy. Even Buffet himself admitted it has become harder for him to invest with as much “Buffet Savvy”

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.

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