Six steps to value… A share selection strategy for fantastic compound returns

Gareth Stokes, FAnews Online Editor

If you hanker after market-beating stock market performance one of your options is to follow the example set by the world’s greatest investors. On the international stage the likes of Warren Buffett and Franklin Templeton have outperformed their equity be

You have to put things in perspective to appreciate Biccard’s achievement. Over the same period investors in the US S&P Index or UK FTSE 100 Index would have broken even in rand terms, while R100 000 invested in the JSE All Share would have only (sic) grown to R350 000. How do you go about selecting “value” shares and emulating this performance? Biccard spelled out the six general principles of value investing at an Investec media presentation held in Johannesburg recently. The risk of not investing for value is great – he said – quoting Muhlenkamp: “In stocks, if you don’t have an idea of what the company is worth [value], and all you know is price, you tend to chase the price.”

Six simple rules for a value investor

Rule 1: Never buy a stock on a price-to-earnings (PE) ratio over 25 times. The PE is one of the fundamental “value” assessments used by fund managers. You can calculate a company’s PE by simply dividing its share price (in cents) by its latest full-year earnings (also in cents). Let’s say ABC Incorporated is trading at 500c, with earnings of 25c/share in the 2010 financial year. The PE of this company would be 20 times. Another way to look at PE is to ask how many years (at current earnings) it would take for your investment in ABC Inc to repay itself... If you pocketed all the earnings – this doesn’t happen in real life – it would take 20 years.

Plenty has been written about using PE as a measure of value. The PE mentioned above is also referred to as the historic PE, because it looks at prior year earnings. But analysts also consider the forward PE based on forecasts for company earnings one, two and even three years ahead. If you expect ABC Inc to earn 30c a share in 2011 then its forward PE is a more reasonable 16.67 times. Analysts say the JSE All Share is expensive at its current PE of 17.5 times, way above the 13 times average. Analysts expect locally listed firms to report stronger earnings for FY2010/11, which should bring the forward PE into a more reasonable range.

Rule 2: Dividends really count! Stock markets came about as a way for companies to raise funds for expensive ventures and capital expansion. Investors bought shares in these companies, using the market to facilitate the transaction, in the hope of sharing in the spoils. These spoils are known as dividends, and you’d do well to consider the dividend histories and forecasts before investing in a particular company. Over time these dividends make up a very significant portion of total investment return.

Rule 3: Beware fashionable shares and sectors. You should follow this advice to avoid value decimation. By the time a share or sector is fashionable every rand and cent of “hot” money has already flowed to it. Managers with years of experience are quick to caution against “following the herd” – getting into the market just because everyone else is doing it. Imagine, for example, you’d ploughed headlong into the resource sector between March and June 2008. At the time everything was about commodities… And local investors chased the JSE All Share index to record highs despite serious warning signs from the developed world. Six months later these fashionable investments had halved in value (or worse). Had these investor paused to consider the true “value” of their investments they could have avoided the loss.

Rule 4: Macro economic forecasting is a dangerous game. Biccard warns against the top down investment strategy so many fund managers adopt. “The odds against a fund manager getting the macroeconomic calls right are very high indeed,” he says. It’s time to move away from the economist making a forecast – the strategist deciding broad investment strategies based on this view – and the analyst picking shares and sectors to fit both... He prefers the “bottom up” methodology – buy cheap shares provided there is a chance the macroeconomic factors will play out to the company’s advantage!

Rule 5: Real assets are better investments for minority shareholders than intellectual capital. Anyone who survived the Dotcom bust of the late 1990s will understand the fifth value investment principle. It simply asks whether you’d prefer buying a company with buildings, manufacturing plants, inventories, accounts receivable and cash – or one where intangibles such as goodwill and patents litter the balance sheet.

Rule 6: Don’t buy companies you don’t understand. The final rule is borrowed from value investment greats like Buffett and Benjamin Graham. And the argument is fairly simply. A value investor has to assess the worth of each nut and bolt of a business enterprise. That’s easy enough when the company you’re investigating manufactures and distributes sodas or razor blades; but difficult when it deals in information technology consulting, patents and other intellectual assets. Buffett made his money from companies like Gillette, Coca Cola and American Express. He steered clear of Microsoft and other tech stocks despite repeated opportunities to get involved.

Cheap cash makes for dear equities

As the presentation progressed Biccard warned us not to expect similar performance from value strategies over the short-term, meaning one to three years. He said the JSE was expensive right now… “Market’s peak when money is cheap – as we enter 2011 all assets are expensive because money is cheap,” he says.

Editor’s thoughts: Biccard has emulated many of his asset manager peers by loading up on offshore equities in the Investec Value Fund. At 31 January 2011 the fund was already invested 19% offshore – in value companies in the US, Japan, Euro-zone and Israel. Local equity holdings included Steinhoff (10.6% of fund), Gold Fields (10.6%) and Sasol (7.8%). Where would you put your money today – in local value shares – or in the value shares in the UK, US and Europe? Add your comment below, or send it to gareth@fanews.co.za