A few months ago, I discussed my encounter with Warren Buffett, and promised that I would eventually analyze a stock using the value investing (VI) approach.
While I can`t say that I qualify as a hardcore value investor, there are many things about the VI approach that have influenced my thinking. For instance, I tend to stay away from very high PE stocks and momentum plays. While I take positions in firms with no earnings, they are generally relatively "unknown" or are past star stocks that investors have moved on from. I like the idea of investing in companies that have fallen below the radar, but that I believe have the potential to get back on it, either because they are fundamentally undervalued or because I believe they can execute on their business strategies and have a unique value proposition. However, I can't say that I have the discipline of a hardcore value investor, and will sometimes be swayed by a good story even though quantitative analysis dictates I perhaps shouldn't.
The value analysis I will conduct today is based on the methodology outlined in the book Value Investing: From Graham to Buffett and Beyond. If you are interested in finding out more about value investing, this is the perfect guide. It explains the philosophical approach to value investing, and provides enough information for you to build your own value analysis model in a spreadsheet. I will not go into a huge deal of methodological detail here, as this article is long enough as it is. I instead encourage you to buy the book (or any similar book) and read it.
Value Investing: The Three Sources Of Value
There are three key components to value to the VI approach: Net Asset Value (NAV), Earnings Power Value (EPV), and Growth.
Net Asset Value
NAV is the replacement value of the firm's assets minus its liabilities - this is therefore a balance sheet analysis. The way the value investor looks at the balance sheet and a firm's assets is in terms of what it would cost a competitor to come in and reproduce the firm's business. The firm is looked at as a going concern, and the balance sheet is therefore not a measure what one could fetch if they liquidated the assets, but rather the cost of matching the firm's position in a market. Certain adjustments must therefore be made to the balance sheet:
1) The gross value of capital assets (e.g. PP&E) is employed instead of their net value, and in certain cases such as land, those values are actually grossed up to reflect the fact that acquiring land today would be more expensive than at some time in the past. What assets are grossed up and by how much requires knowledge of the industry. For instance, machinery may be less expensive to acquire today for similar levels of economic output than it was 10 years ago because of technological improvements. In this case, the gross value would actually be brought down by an appropriate factor (eg. gross value x 0.8 or 0.7).
2) New assets are created for the product portfolio and customer relations. This is a way to account for the competitive edge represented by technological leadership and well-established relationships with key customers. The quick and dirty way to create those items is to take a realistic percentage of SG&A, and multiply it by the number of years it would take to reproduce the asset. For instance, assuming a company with a large market share spends half of its SG&A on sales and marketing, one could take 50% of SG&A and multiply that figure by 3, reflecting the fact that it would take about 3 years at this level of marketing and sales expenditure to match the level of customer loyalty.
3) Creating a liability for stock options outstanding in cases where this is material for companies
Now remember, this is just a rough guide to approaching replacement value analysis, and requires a good deal of judgment and knowledge. There are more things one could do, but those are the major items. Again, this approach comes from the book, and an analyst with plenty of experience in one industry could tinker more or differently.
Earnings Power Value
EPV essentially measures the cash generation potential of a firm's assets via an income statement analysis. Earnings are adjusted to come up with something akin to a free cash flow, which is then discounted and compared to the adjusted value of assets, or NAV.
In a situation of market equilibrium with ample competition, EPV should equal NAV for all market participants - the adjusted earnings of companies are just sufficient to replace assets, and revenue growth doesn't create any incremental value as the asset base grows by a proportional amount. In such a situation, the return on invested capital (ROIC) equals the weighted average cost of capital (WACC). I will expand on this later.
Just like for NAV, adjustments are made to the income statement. Changes are:
1) Take at a 5-year avg EBIT margin
2) Apply that margin to current year revenue to smooth out any unusual events
4) Take out taxes
5) There a couple more adjustments needed that are discussed in the Growth section below, but that I will leave out for now
You then take this number as a numerator and, using the firm's WACC, do a straight perpetuity assuming no growth. From the resulting figure you subtract debt and excess cash (i.e. greater than 1% of sales), and this gives you the firm's earnings power.
If this figure is equal to NAV, the cashflows from the firm`s assets after investors are paid at the rate they require are just sufficient to replace those assets, and no incremental value is created. If EPV is smaller than NAV, then managers are actually destroying value, and the asset base needs to shrink to meet EPV.
If EPV is greater then NAV, then the firm is able to replace its assets and create an additional return for investors over and above what is already captured in the discount rate - ROIC is greater than WACC and return on equity (ROE) is greater than the cost of equity. In end, equity holders are really the prime beneficiaries from this situation, as debt holders`returns are capped.
Value investors typically don't like to include growth assumptions in their models, because they believe that in most cases firms whose EPVs are larger than NAVs won`t be able to sustain that position because of competition, and therefore that the long-term equilibrium lays with EPV = NAV. Remember, in this case, ROIC = WACC, and sales growth does not create any incremental value as it just goes to pay for more assets.
The only time value investors actually compute growth is when a firm's EPV is greater than its NAV and they believe that the firm has a so-called moat, or a competitive advantage that can't be undone (think of Microsoft and its position in the operating systems market). Only in such a case would value investors actually pay for growth, and include it in their valuation (more on this later). Barring the existence of a moat, competitors will eventually notice the value creation potential of a given industry, will enter, and will force equilibrium through competition - all EPVs will equal NAVs.
In #5 above, the other two adjustments needed when computing EPV are to account for maintenance SG&A and maintenance capex. In other words, some of the SG&A expenditures and some of the capital expenditures are made to maintain and replace the existing assets, while some are made to grow sales. Since we are only interested in what it costs a going concern to maintain its existing asset base, we add back a percentage of depreciation and SG&A (between 25% and 50% - again, this is a matter of judgment and industry knowledge) to make up for the fact that some of this expenditure went to fund growth and shouldn't be accounted for.
Closing Remarks On The Value Approach
There are thus two main types of value plays (excluding growth, to be discussed later):
1) Asset-based --> If NAV/shr is larger than share price, is there a high probability that investors will eventually wake up to that fact and that the two will converge, creating a capital gain? If so, you have a value play on your hands and are paying for undervalued assets.
2) Earnings Power-based --> If EPV > NAV, does the company have the means to prevent competition from eating away at its margins – in other words, is there a moat around its market position? If so, is EPV/shr lower than share price? If you can answer yes to both questions, you also have a value play on your hands but you are paying for sustainable earnings power.
There are more adjustments to the financial statements and more nuances to those adjustments than I’ve presented here. However, in the interest of length, there is only so much I can get into. I just wanted to provide a high-level picture of how value investors approaches valuation and security analysis. As I mentioned earlier, I would strongly encourage those interested to read more about it on their own. In the end, what your VI valuation yields is a result of your particular assumptions, which by the way holds true for any type of valuation.
The Search Process
In theory, VI is a bottom-up approach, meaning that one typically starts the search for stocks by looking at fundamental ratios, and only worries about the industry and qualitative factors if the investment makes sense quantitatively. The two preferred ratios are the price-to-earnings (PE) ratio and the price-to-book-value-per-share (P/BVPS) ratio, and the preferred valuation levels are typically around 15x for PE and 1 to 1.3x for P/BVPS.
However, I’m not entirely sure how it is actually done in practice. For my part, I start at the industry level and then work my way down to valuation, and I don’t let a PE above 15x or a P/BVPS of over 1.3x discourage me from pushing on.
The company I chose to analyze for this article is Stella Jones (STLJF.PK or SJ.TO), which is a treated wood product manufacturer. The company’s main business segments are railway ties (35% of 2007 sales) and utility poles (48%). The remainder is made up of other treated wood products, but those are the two key segments. SJ thus has significant exposure to two sectors I believe are very well-positioned to benefit from the transition to a green economy: rail transport and the electricity grid.
Both the railway ties and the utility poles industries are fragmented in North America…or at least in the US. In Canada, SJ has been an aggressive buyer, consolidating the market. It now has a roughly 70% market share in both industries in Canada, and following a recent acquisition in the US now holds upwards of a 20% market share in railway ties, which places it second there in terms of market share. As you will see below, SJ has done a great job of integrating acquisitions so far, and is considered by analysts to be in a strong position to consolidate the US market, starting in the east and southeast. As can be noted from the share price performance over the past five years, this expansion hasn’t gone unnoticed, and this has been a great ride for shareholders who were there early.
The company currently trades in the FY2007 17x PE ($2.04/shr) and 3.4x P/BVPS ($10.35) ranges, so on the latter metric it certainly seems rich for a value investor. The reason why this company drew my attention is that the stock has seemingly halted a largely uninterrupted 4-year run over the past 12 months. The reason is simple: the company is based in Canada but has operations in the US, and it has been hit hard by a rapid increase in the value of the Canadian dollar. While SJ has some natural hedges in the form of facilities in the US, and uses derivatives to control its forex exposure, this hasn’t proven enough and SJ missed it targets in Q4 ’07.
Value Investors will typically like a stock whose underlying business is intact but in which, for one reason or another, the market has lost interest. This qualifies as one of those. Already liking the sector and the company’s positioning in it, the pullback in share price led me to want take my analysis further.
Despite completing five acquisitions in five years, SJ has managed to steadily improve margins as well as a key profitability ratios.
The capacity of Stella-Jones to acquire and successfully integrate businesses at this rate while continuing to improve returns for capital providers is a signal that the management team is likely very strong. While margins and other ratios will certainly not continue to improve at this rate indefinitely, SJ’s track record speaks volume as to its ability to be a successful consolidator in the US treated wood market.
Value Investing Valuation
Through my NAV adjustments, I ended up adding about $29 million in net assets, mostly as a result of adjustments to capital assets and the addition of a $15 million customer relations asset. As explained above, I took two years of 50% of 2007 SG&A (or full 2007 SG&A) as what it would cost a competitor in terms of marketing and sales expenditures to come and establish the market position SJ has achieved, especially in the Canadian market.
I did not push too much on this analysis because I knew that, at a non-adjusted BVPS of $10.35, no realistic adjustments would bring NAV anywhere close to the $35 figure the stock is trading at. Looking at the company’s margin and profitability ratio improvements over the past five years, I knew this was an earnings-power story and not an undervalued asset story.
My income statement analysis yielded more interesting results. Following the earnings adjustment approach above, I got an EPV of about $24 per share.
I discounted the company’s adjusted earnings at 11.15%, using a before-tax cost of debt of 8% and a cost of equity of 16%. The target capital structure for this firm likely lays at around 45% debt-to-total cap. About 60% of the stock is held by one shareholder, so I added a percentage point of liquidity premium to the 15% cost of equity I had originally come up with. The choice of a discount rate, however, varies widely from person to person, so this is by no means the only "right" discount rate.
Still, at $24/shr, we are still far from the ~$35 the stock is currently trading at, indicating that much of Stella Jones' potential is already priced in.
I believe Stella Jones has a moat, in the form of a high market share in Canada and the ability to consolidate at least a part of the US market on a back of a successful integration strategy to date. Moreover, my understanding is that wood is not about to be displaced as the primary material for railway ties and utility poles, because the cost of alternatives is plain too high.
As you can see if you compare SJ's profitability ratios to the cost of capital I came up with, the company is creating additional value for its stockholders, and there is a good bit of room to absorb any error on my part in computing that cost of capital. It would therefore seem reasonable to want to price in some growth, as discussed above.
In order to value growth, value investors (at least the ones who wrote the book :) use a matrix called the Growth Value Multiplier matrix. The GVM matrix outputs a number by which EPV is multiplied to get the value of growth for the firm.
The two axes on the matrix are the expected long-term sustainable growth rate over the cost of capital (g/K), and the ROIC over your cost of capital (ROIC/K). How does this all make sense? Believe me, the algebra works, and if you are familiar with the Gordon Growth Model the vertical axis should make sense. I'm not going to lay out the algebra here however, both because that would take too long and because this isn't my model, and I doubt the authors would be happy with me giving away too much.
So how does one use this matrix? First, a reasonable long-term growth rate must be determined, which can't be too much greater than the economy as a whole given that the underlying algebra assumes a perpetuity formula. In this case, I picked 4%, which places SJ between 0.25 and 0.5 on the vertical axis. I used a 16% ROIC as the long-term figure to reflect further marginal improvements on 2007 but not much more, which divided by the WACC at 11.17% lends SJ on 1.43, close enough to 1.5. Given the position on both axes, it would be reasonable to assume a multiplier of 1.2.
Multiplying the EPV/shr by 1.2 yields an intrinsic value of about $28.60/shr, still short of $35. And I haven't even worked in a margin of safety, which is a way to hedge risk in case the valuation is off or if one misses a major qualitative factor. Typically, the intrinsic value arrived at is multiplied by something like 66%, and if the share price is still below the resulting figure, it's a buy. Needless to say, we're not even close here.
Where Do We Go From Here
Any way you slice it using the VI approach, SJ's past achievements and future potential are fully priced in...and then some. The story remains pretty attractive, and although I didn't delve too much into the qualitative side, it's hard not to see a gem of a company here. The sell-side analyst notes I read on SJ are all positive with 12-month targets implying pretty respectable returns, all based on forward multiples (I didn't see a DCF, and I suspect it's partly because with reasonable assumptions you couldn't justify very elevated share price levels).
For the time being, however, I'm going to be disciplined and hold off on this one. SJ has essentially flat-lined over the past year, and it could be that some of the hype is gone - as I pointed out earlier, it wouldn't be realistic to assume a doubling of margins every five years in perpetuity.
Value Investing as a philosophy provides a good way of thinking about a business and its potential. However, I'm told by practitioners that you sometimes have to sit on the sidelines for long periods of time in hot markets, as you just can't find securities that meet the stringent value criteria. For my part, as stated initially, I can't claim to have the discipline of a true value investor, and maybe I'll end up owning SJ sooner than I think...
DISCLOSURE: The author does not a position in any of stocks discussed in this article
DISCLAIMER: I am not a registered investment advisor. The information and trades that I provide here are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.