Update on my portfolio selected using Graham’s techniques

On 5 December 2008, I selected a portfolio of 11 stocks using techniques detailed by Benjamin Graham in his book The Intelligent Investor (see the original post here).

The initial portfolio value was $1 million with approximately $90,909 invested in 11 companies as follows:

Company	Buy Price	No. of shares	5-Dec-08 Value	2-Jan-09 Value
Caltex	$6.18	14,710	$90,908	$106,206
Harvey Norman	$2.35	38,685	$90,910	$102,515
Soul Pattinson	$8.33	10,913	$90,905	$100,400
Sims Metal	$11.74	7,744	$90,915	$137,611
Flight Centre	$8.30	10,953	$90,910	$95,072
Hills Industries	$2.90	31,348	$90,909	$95,925
Beach Petroleum	$0.75	122,026	$91,520	$114,094
ASX	$31.60	2,877	$90,913	$95,027
Austereo	$1.11	82,271	$91,321	$102,016
WA Newspapers	$4.70	19,342	$90,907	$104,253
Milton Corporation	$14.02	6,484	$90,906	$93,953
Total			$1,001,024	$1,147,072

As can be seen above, as at 2 January 2009 this portfolio had appreciated by 14.6% to $1,147,072. The All Ordinaries Index had appreciated by 6.7% over the same period. So I’m well ahead of the index (for the time being anyway!).

I noted in my original post that ASX, Austereo, WA Newspapers and Milton Corporation were not selected using Graham’s methods – most of those companies are much more to Warren Buffett’s tastes than Benjamin Graham’s. However, I do have confidence in those companies at the prices that were paid above.

It’s pleasing to see a fairly even contribution by most of the companies. The return was not achieved by one company increasing very significantly in value. Sims Metal (up 51.4%) and Beach Petroleum (up 24.7%) were the stand outs but very good contributions were also made by Caltex, Harvey Norman, Soul Pattinson, WA Newspapers and Austereo. In fact, every company had a market value of more than the purchase price.

But let’s not get carried away, this is only one month’s performance and while it is exceptionally good, it doesn’t mean very much. I will keep holding this portfolio and see how it goes. I’m a longer term investor and am happy to ride the ups and downs as long as I have confidence in the underlying values.

Note: None of the above constitutes financial advice. You need to do your own research and consult appropriately qualified people for advice (where necessary).

BHP Billiton – Is it time to buy?

There are at least half a dozen broking firms that I’m aware of that are currently recommending that their clients buy BHP Billiton. None of these brokers can mention BHP without also mentioning the word “China” in the same sentence.

Firstly let’s note this: The revenue that BHP derives from Europe, North America and Japan is (in aggregate) far greater than what it derives from China. Secondly, the UK, Germany, the United States and Japan are all in recession. Thirdly, a significant proportion of Chinese exports end up in countries that are currently in recession.

I’m convinced that what most research amounts to is looking at what the share price of companies like BHP were at their peak and looking at what the price is now and saying “it must now be cheap”. Throw is some vague notion about demand from China and some promotion by brokers and suddenly BHP is “cheap”.

But BHP is a company that is actually extremely difficult to properly value. What do you really need to know to accurately value BHP?

You need to know what the prices of the following commodities are going to be over 2009 and beyond: Oil, LNG, copper, silver, zinc, lead, gold, coal, iron ore, manganese, chrome, aluminium, titanium, nickel and diamonds. Do you know of anyone who could accurately forecast the prices of those commodities?

When the price of a barrel of oil can fluctuate between $US147 and $US32 in the space of six months you can begin to see just how difficult it is to make forecasts for commodity prices.

There have also been truly enormous fluctuations in the prices of other commodities such as copper, lead, zinc and nickel. However, oil is the only commodity that most people take notice of because they use it on a daily basis.

What is the fair price for a barrel of oil? Do you know? How about the price for a tonne of zinc – any ideas? [If you want to have some fun, ask your broker what the primary uses of zinc, nickel and titanium are and see what they say – I’ll bet you they won’t know.]

To understand what caused BHP’s share price to reach $50 you have to understand what was actually happening in the global economy, and it’s as much about the United States as it is about China.

During the boom years (up to 2007) Americans were consuming far more than their maintainable incomes would have allowed (Americans were not alone in this; other developed countries had similar consumption levels). Additional consumption was being financed by borrowing against the appreciating value of assets (primarily the home or the investment property).

China was supplying much of the consumed goods and running large trade surpluses with the United States (and other countries). Logically, the prices of raw materials used to provide these goods increased because of this demand.

For commodity producers this was fantastic, they were able to make very large (abnormal) profits during this period. This in turn sent the share prices of companies like BHP and Rio Tinto to levels that could not have been imagined even 2-3 years earlier.

As you all know, the game of borrowing against the appreciating value of assets has come to an abrupt and very painful end. Globally, banks have significantly tightened lending criteria and house prices in many developed countries have collapsed.

Consumption will now be curtailed – there is no alternative. For BHP, this impacts not only on their customers in countries that are actually in recession, but also on China’s exports to those countries.

It should also be noted that China’s growth rate dropping 2-3% is no different to a country that was growing at 2% per annum dropping to 0% or -1%. For commodity producers exporting to China, this is a recessionary like environment in comparison to what they had previously experienced.

In my opinion the profits generated by the likes of BHP, Rio and others during the commodity boom were abnormal profits and it would be dangerous to base any valuations of these companies on the assumption that they will return to those levels of profitability any time soon.

The profits were abnormal because they were based on a demand for goods predicated on the availability of easy credit which in turn was predicated on rising asset prices. This allowed many consumers to temporarily live beyond their means. This cycle is now well and truly over and it’s not going to recur again any time soon.

I cannot forecast the prices of all of those commodities that I mentioned above. However, the very fact that this forecasting is extremely difficult to do (if not impossible) means that anyone who is purchasing shares in BHP or other mining companies is speculating that the price of commodities will return to levels something like that seen during 2007. That’s a gamble that I’m not personally prepared to take, especially when most of the largest economies in the world are in recession.

Now you may have a very different opinion to me.

The Art of Stock Valuation

When you purchase shares in a company, how do you know that the price you are paying is a good price? When you sell, how do you know if the sales price is a good price?

To answer these questions you have to be able to estimate intrinsic value. Intrinsic value is the underlying real value of a share in a company. It doesn’t necessarily equate to the current stock price, although the current stock price is frequently (but not always) close to the intrinsic value.

The most widespread method used to determine intrinsic value is the discounted cash flow (DCF) method as put forth by John Burr Williams in the 1930s in his book, The Theory of Investment Value. Williams defined intrinsic value as follows:

“The value of any stock, bond or business today is determined by the cash inflows and outflows discounted at an appropriate interest rate that can be expected to occur during the remaining life of the asset.”

A bond can be valued with precision using the above method because most bonds are contractually required to pay a certain percentage of the face value of the bond each year for a specified period of years.

Seth Klarman (a highly successful investor who founded the Boston based Baupost Group) states in his book, Margin of Safety:

“Stocks, for example, have no maturity date or price. Moreover, while the value of a stock is ultimately tied to the performance of the underlying business, the potential profit from owning a stock is much more ambiguous. Specifically, the owner of a stock does not receive the cash flows from a business; he or she profits from appreciation in the share price, presumably as the market incorporates fundamental business developments into that price.

Although some businesses are more stable than others and therefore more predictable, estimating future cash flow for a business is usually a guessing game.

The financial markets are far too complex to be incorporated into a formula. Moreover, if any successful investment formula could be devised, it would be exploited by those who possessed it until competition eliminated the excess profits. The quest for a formula that worked would then begin anew.”

And that in a nutshell is the problem with the DCF method: It requires the forecasting of cash flows for years into the future and this simply cannot be done with a high level of accuracy. Because of this, most DCF valuations are very limited in their usefulness.

Another funds manager, David Dreman, has shown that forecasting by analysts is generally poor and certainly not precise enough to use in a DCF model. In his book, Contrarian Investment Strategies: The Next Generation, Dreman states:

“Most current security analysis requires a precision in analysts’ estimates that is impossible to provide. Avoid methods that demand this level of accuracy.

There are no highly predictable industries in which you can count on analysts’ forecasts. Relying on these estimates will lead to trouble.

Many pros believe that their own analysis is different. They themselves will hit the mark time and again with pinpoint accuracy. If they happen to miss, why it was a simple slip, or else the company misled them. More thorough research would have prevented the error. Next time it won’t happen.”

What most of the “pros” actually do is make a naïve extrapolation of recent earnings into the distant future (usually 10 years) and come up with a share value. It should be noted that even relatively small differences in the forecast results can result in significant differences in the valuation that is arrived at.

In my opinion, rather than messing around with highly imprecise DCF models, you would be much better off taking the advice of billionaire Kerr Neilson:

“When all the numbers and discernable facts point to a company being abnormally cheap using 20 to 30 year relationships of price to book, enterprise value to sales and understanding of the company’s inherent cash generating capacity, the shares have a high probability of making you a handsome return.”

I’ll give you two real life example of Kerr Neilson’s above advice.

During the period 2005-2007, Caltex traded at average prices of around twice book value. Looking at Caltex’s historical price to book value would have informed any potential investor that Caltex was very much over-priced at around twice book value. History showed that a fair price was approximately book value (or may be slightly more).

Analysts and brokers attempting to value Caltex using the DCF model were quite prepared to pay twice book value because they had incorrectly forecast the cash flows and therefore their models justified prices of $20 per share or more.

Caltex was included in The Stock Scribe portfolio at $6.18 because:

1. That price represents a very significant discount to its book value;

2. The company has low debt levels in relation to its tangible equity;

3. It pays an attractive fully franked dividend;

4. It produces a product which is absolutely vital to all of us;

5. It’s a large company with a long history (having listed on the ASX in 1980).

The second example is the banks. During 2006 to early 2008, the big four banks were all trading at material premiums to their long-term price to book values. Any potential investor who studied this one statistic would have known that the prices that these banks sold for during this period were too high.

As a shareholder in a few banks, I was happy to sell at the then prevailing prices (my best sale was NAB at $41.98). Analysts using DCF models and naïve extrapolations of the very recent past found justification for paying $50 or more for CBA or $40 or more for NAB, but I couldn’t.

Selecting stocks based on historically low price-earnings ratios, price to book values, high dividend yields, low debt etc, does not mean that you are going to automatically make a fortune.

Once you have selected stocks using these sorts of screens, it then requires very good judgement as to whether you make an investment or not - and that is where many investors will fall down. The screening process is relatively straight forward, but the next decision (to buy or hold off) is much harder and there is simply no substitute for experience and plain good judgement.