Today I review the investment classic authored by Christopher Browne, ‘The Little Book of Value Investing’. Browne was a partner at Tweedy, Browne Company – the oldest value investing house on Wall Street. Again, I recommend reading the book in its entirety. However, here are my favourite chapters.
Buying Earnings on the Cheap
Browne emphasises the “tried-and-true” method of successful investing, acquiring companies at low multiples of their earnings. The lower the multiple, the cheaper the company. The simplest valuation measure to apply is the price to earnings multiple or p/e multiple. The p/e multiple is calculated by dividing the stock price by its Earnings Per Share.
Earnings per share (EPS) = Net Profit After Tax divided by the Number of shares on issue. E.g. $10m NPAT divided by 10 million shares outstanding = $1 EPS.
If a stock price is $10 and its earnings per share is $1, the p/e ratio is 10x. If you take the inverse of this ratio, you arrive at an earnings yield of 10% (i.e. $1/$10 = 10%). This assumes that all the earnings are paid out to investors each year. In practice, a portion of the earnings will be used to pay dividends and to re-invest in the company. Despite this, the earnings yield is useful and can be compared to any publicly traded company.
The market tends to favour the multiple approach over the earnings yield. However, Browne likes to compare the earnings yield to the applicable 10-year government bond rate. The 10-year Government Bond Rate is also known as the Risk Free Rate. This is the return to which all investments should be compared. Currently, the 10-year Australian government bond rate is 2.876%.
This basic metric provides a lens through which every publicly traded company can be evaluated. At the time of writing, there are 2,279 companies listed on the Australian Stock Exchange. Interestingly, only 28% of these companies delivered a positive Net Operating Profit After Tax (NoPAT) in 2017 (Bloomberg estimate). Accordingly, limiting your investment universe to profitable companies reduces the number to 630!
Seek and Ye Shall Find
Identifying cheap companies can take considerable time. Fortunately, there are several freely available websites, such as Yahoo Finance, which allow investors an opportunity to identify companies based on certain criteria. You may like to consider the following metrics to help create a focus list.
- Revenue growth;
- Return on equity;
- Debt to equity ratio; and
- P/E ratio.
Sifting Out the Fools’ Gold
Browne examines the results of buying stocks on low p/e multiples versus high p/e multiples. Remember the lower the multiple the cheaper the stock! The studies are conclusive, low p/e stocks deliver far greater returns over time than high p/e stocks.
How does one separate the ‘genuinely cheap’ stocks from the ‘cheap for a reason’ stocks? Browne identifies the key traps for investors. The list includes too much debt, product obsolescence, shifts in the competitive environment, disruption or structural change, and accounting fraud. This is by no means an exhaustive list.
Little or No Debt
Debt can be particularly damaging, and Browne devotes considerable attention to this subject. Unfortunately, the future is unpredictable, and companies borrowing too much have less chance of surviving an economic downturn. Therefore, it makes sense to focus on companies carrying low levels of debt. This ensures that they can weather any storm and emerge stronger than their more leveraged peers.
Companies Not Meeting Consensus Expectations
Browne recommends investors sift through companies failing to live up to analyst expectations, known as ‘consensus estimates’. Analysts tend to be focused on the short term, so missing consensus estimates often provide good opportunities for the long-term investor. Missing earnings estimates is not always a harbinger of doom. It can often be as minor as a contract moving into the next quarter. Nothing to lose too much sleep over!
It’s a Marathon, Not a Sprint
Browne reminds us that investing is a marathon and not a sprint. It’s time in the market, not market timing, that counts. Browne notes that despite many studies, countless mathematical equations, and investment rules, no-one has successfully been able to time markets over the long term. Predicting short term market movements is a mugs game.
Browne cites a study by Sanford Bernstein & Company demonstrating from 1926 to 1993, the returns in the best 60 months, or 7% of the time, averaged 11%. The other months, 93% of the time, returned 1/100th of a percent. As a long-term investor, the biggest risk is being out of the market for a strong month, where you may miss an 11% monthly return. Market timers like to think they can predict the movements, they can’t!
There is Value in Friendly Countries
Browne discusses a tendency known as ‘home bias’. This is a feature of most markets around the world, however, it is particularly prevalent in Australia. Home bias is the tendency for investors to allocate money to domestic equities only.
Despite the significant benefits of adding international shares to a portfolio, investors often stay with names they know and understand. However, Browne highlights that global investing should not unsettle people. In fact, a large body of research has proven that adding global shares to a domestic portfolio can increase return whilst decreasing risk.
I will leave the final word to Christopher Browne;
“Value investing requires more effort than brains, and a lot of patience. It is more grunt work than rocket science. But over time, investors should continue to be rewarded for buying stocks on the cheap”.
I hope you enjoyed this review. I look forward to bringing you book review number 5 tomorrow.
Book Number 7 – The Great Crash 1929 by John K. Galbraith.
Book Number 8 – Common Stocks & Uncommon Profits by Philip A. Fisher.
Book Number 9 – The Art of Short Selling by Kathryn Staley.
Book Number 10 – You Can Be a Stock Market Genius by Joel Greenblatt of Gotham Capital.
Lachlan is the founder and CIO of Swell Asset Management, a boutique investment manager specialising in global equities.