Pearls and pebbles

Despite naive and misleading claims to the contrary, there is no Magic Formula to investing. A money machine, capable of detecting the precious signal amidst worthless noise at the push of a button is – and I think will remain – the pipe dream of the lazy.

Intelligent investing calls for dirty hands. It is like finding pearls among pebbles. The conceptual framework is a toolbox, but each investment needs be examined on its own merit.

My screens look for pearls in places where I think there is a higher chance of finding them: among companies with low valuation ratios and a history of high growth and strong profitability. Of course, there are many pearls elsewhere. But since pearls are difficult to find, it makes sense to search where they are probably more numerous.

The search must be based on the principle that missing a pearl thinking that it is a pebble is not as bad as picking a pebble thinking that it is a pearl. The first is a False Negative: a missed opportunity. The second is a False Positive: a bad investment.

Since there is a lot of junk among pebbles, and much of it looks mischievously like pearls, avoiding “value traps” is the most important tenet of intelligent investing. I am currently trying to decide if Meyer Burger is one of them.

What do I do with companies selected by my screens?

1)      First of all, I need to check if the numbers are correct. I use wonderful Factset, and they almost unfailingly are. However, looking at them in more detail, I may discover that appearance does not reflect reality. For example, recent earnings may have been abnormally high, or distorted; the value of assets and liabilities as stated on the balance sheet may need to be adjusted; high average profitability may be the result of a few isolated episodes. To find out, I look at the history of financial results. Factset has it all well displayed in several useful formats. But I also download the numbers in Excel to make my own calculations. Experience has made me familiar with financial reporting and the dynamic interplay of balance sheet, income and cash flow statements.

2)      I then look at the valuation history. Companies with a record of high growth and strong profitability are likely to have been valued in the past at higher multiples. A large valuation drop may be due to a temporary setback, but may also be a sign that the company has been undergoing major changes, which render past data a poor indicator of future prospects. If, on the other hand, past valuation levels are not very different from current ones, then perhaps growth and profitability may not have been as high as they appear.

3)      Often, in the course of the analysis, I discover that a stock is not as cheap as it looks. Therefore I stop and move on to other candidates. But if the stock is truly interesting the next step is to read the latest Annual Report, as well as subsequent releases of financial results. Reading statements is always the best way to learn about a company, its business and its management. I get Annual Reports through Factset, but they are also available on companies’ websites. I also ask Investor Relations to send me a hard copy through the post.

4)      Then I listen to or read the transcript of the latest webcast of financial results. This is usually accompanied by a slide presentation. Hearing management speak, listening to what they say and how they say it, and how they answer (or not answer) analysts’ questions is always informative. Meeting management directly, when possible, is a good thing, and sometimes it is essential. But it is not indispensable.

5)      Then I look at what brokerage analysts are saying. Factset provides a good summary of their estimates. Most analysts are smart, knowledgeable and conscientious professionals. It is always interesting and important to know what they think. However, their collective output is typically a far cry from their best effort (exactly the same is true for fund managers, I hasten to say).

Look at this figure:

The solid black line is Meyer Burger’s stock price. The quarterly bars give the percentage of analysts recommending the stock as a Buy (green), Hold (yellow) or Sell (red). The dashed line is the average Target Price. This is a stark illustration of the Prior Indifference Fallacy: rather than boldly anticipating future price movements, the Target Price meekly plods along the current price. The stock was a Buy at 30 for 53% of analysts in early 2011, with a Target Price of 40. As the price collapsed to 15 over the year, so did the Target Price, with the Buy percentage dwindling down to 14%. Analysts are subject to prior indifference: they take the current price as a given, focusing not on where it should be today, but on what will make it change tomorrow. Hence their Target Price is not an accurate price forecast, but a useful sentiment indicator. When a stock is cheap, having a majority of analysts on hold or negative, with a Target Price close to the current price, reinforces the investment case.

6)      Besides analysts, the press and other news flow are also an important source of information, as well as a useful gauge of market opinion. This is all well displayed in Factset, but also amply available on the web. Negative sentiment on a cheap stock is a sign of Overconfidence – an unwarranted belief in the correctness of the evidence at hand – and Confirmation Bias – neglect of evidence that runs contrary to the prevailing belief. Weighing negative sentiment is a tricky balancing act: seeing some of it is good, but when there is too much it is like catching a falling knife: Meyer Burger was below 8 last week – it is now approaching 6.

7)      Finally, I take a look at the company’s ownership. It is important to know if it is a public company or if it is controlled by one or few shareholders, and how large its free float is. It is also interesting to see who owns it. Finding some fellow value investors among the main shareholders is reassuring but, of course, should not be counted on as valid reason to invest. Aping what others are doing is a small-minded and ultimately deleterious investment strategy.

Looking for pearls – cheap stocks with an ample Margin of Safety and the prospect of a large appreciation – is a complex but, when done properly, most rewarding job.