Undervalued Weekly
The Undervalued Reports Company’s weekly newsletter
Towson, MD
January 31, 2003
http://www.dynamicinvestors.net
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Another week, and there’s more snow and bad weather in the northeast. It’s beginning to become like a bad habit around here, shoveling snow and clearing ice. Alas, the thought of Spring just around the corner is barely enough to keep me motivated.
This has been a busy week here at the Undervalued Reports Company main office. We got some new office furniture this week, and the process of switching everything from the old desks to the new has been quite time consuming. I managed to publish two more articles on The Motley Fool, which you can find here.
There’s also a survey for UW readers that should be posted by the time you read this. Please take a moment to fill out the questions on the survey. I put a lot of time and effort into this newsletter, and I want to make sure it’s what you want to read.
One last item of housekeeping before we delve into this week’s news (of which there’s plenty). I’m changing the publication schedule for the Undervalued Weekly from Saturday morning to Sunday morning. I’d like to see how that works out, as I know Saturday is a popular day for newsletters to publish, and I’d hate for you to be overwhelmed. There will also be some changes to the website coming soon.
Again, in case you’ve lost your password to the Dynamic Investors Member Area, here it is:
Username: member
Password: only
Market Update
It was a pretty tough week across the board, with stocks, bonds, and metals all dropping. The Dow dropped 80.22 points (0.8%) to close at 10,488.07. The S&P 500 was down 10.42 (0.9%) to 1,131.13. And my friends at the Nasdaq took a nose dive of 57.72 points (2.7%), ending the week at 2,066.15. Less than stellar economic news was the catalyst for this week’s downward move. With three down days this week (four for the Nasdaq), I’m thinking the correction has started. Of course, I don’t know much, but if I was a betting man I’d put all my money on the downside. With P/E multiples in the twenties on blue chips, and over 50 on many tech stocks, I just can’t see the market going much higher.
Bonds lost ground this week, as traders sold off after the Federal Reserve changed the wording in their monthly statement. The two year Treasury yield (which moves opposite the price) rose 15 basis points, while the ten year was up six basis points. Yields are still ridiculously low, offering no safety for investors.
The dollar rallied this week on the Fed news. The greenback finished the week at the $1.2481 mark against the Euro, up from last week’s $1.2710. That’s a nice 1.8% move. Yet the dollar’s less than a penny better than where it finished last year against the Euro.
Gold fell $5.60 per ounce, and silver was down $0.10 on the week. Gold dipped below the $400 mark on Thursday, before rebounding to close the week at $402. Gold stocks got hammered, with the XAU down 2.3% and the HUI down 3.4%. Gold is climbing the “wall of worry” that all true bull markets have to overcome. Is it a good buying opportunity? Maybe. I think the metals could correct further in the short-term, but I expect much higher prices by the end of the year.
Rates were left unchanged after the FOMC meeting, but a slight change in the Fed’s outlook statement spooked the markets. Their pledge to keep rates low “for a considerable period” of time changed this month to a belief that they can “be patient” about raising interest rates. The herd mentality kicked in, with almost unanimous agreement that the Fed’s going to raise rates sooner than expected.
But maybe there’s another way to look at the Fed’s pronouncement. I’m going to quote Strategic Investment’s Dan Denning, who offers a different view on the new wording:
“Nothing has really changed. The Fed sees no inflation in consumer prices. The labor market is a joke. Home sales were down 5% in December. New mortgage applications dropped over 5% last week as rates crept up. Taken altogether, there's no macro case for raising rates any time soon. In fact, the only good explanation for the change in phrases is that the Fed wants to support the dollar in words without actually changing its policy at all."
Who really knows? I don’t, but I find this explanation more palatable than the idea that rates are going up anytime soon. It’s an election year, and the Fed’s not going to do anything to rock the boat.
Lot’s of economic news this week. As noted before, new home sales dropped 5% in December, and inventories are at a 15 year high, representing a little over 4 months supply. Existing home sales jumped in December, rising 6.9% as prices increased 7.5%. The price increase is the largest gain since 1980.
GDP growth came in at 4% for the fourth quarter, lower than the expected 4.8%, and less than half the third quarter’s 8.2% increase. It’s still greater than the average 3% growth economists look for, but the slower-than-expected pace could mean the economic stimulus is running out sooner than expected. For the year, GDP growth was 3.1%, up from 2.2% from 2002.
The University of Michigan consumer confidence index was revised to a final 103.8 reading for January, while the Conference Board’s confidence index was revised to 96.8 from 91.3. Whether this translates into even higher consumer spending is something we’ll have to wait and see.
US exports rose 19.1% in the fourth quarter, thanks to the falling dollar. This is one positive aspect of the dollar’s decline, although it certainly doesn’t make the Asian exporters happy.
Orders for durable goods were flat in December, after falling 2.3% in November. Analysts had expected 2% growth, and needless to say there was some disappointment in these numbers. The expectation has been that businesses will pick up the spending burden this year, as consumers reach their limits. If business spending doesn’t improve, it will remain on the consumer’s shoulders to continue carrying the economy. With debt levels at historically high levels, is there any more capacity for consumers to keep buying?
And on a final note, I got a kick out of this story. You can’t write irony this good.
Please take some time to fill out the readers survey. It’s important to me, and will hopefully make a better newsletter for you.
One last item. If you know anyone who’s interested in writing articles on financial analysis or personal finance, I’m looking for contributors. Tell them to contact me via chrismallon@dynamicinvestors.net.
Until next time, best wishes. And help support the Undervalued Weekly by visiting some of our sponsors.
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Book Recommendation
Risk…
It’s everywhere; part of everything we do. We evaluate risk with every investing decision we make. It’s the most important factor we look at when we determine an appropriate price for an investment.
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Balance Sheet Analysis
Now that we’re familiar with the Balance Sheet structure, it’s time to roll up our sleeves and figure out what the numbers are telling us. The corporate balance sheet is like a snapshot of a company's financial condition at a specific point in time. Analyzing the balance sheet is the best way to gauge a company’s long-term health. Consider the analysis like a physical for the company, where you're the doctor checking for anything out of the ordinary. And just as changes in your physical body might tell a doctor that something's wrong, changes in the balance sheet can offer investors signs that a company's health is failing.
You should always compare the balance sheet from year to year, preferably going back at least five years. Five years of data is available through the following sites, simply by putting in the stock ticker symbol and looking for “Financials”.
Dynamic Investors
Yahoo! Finance
The Motley Fool
http://quote.fool.com/Index.aspx
MSN Money
http://moneycentral.msn.com/home.asp
Almost all companies are now required to post financial reports on their websites, so if you want the raw data direct from the SEC filing, you can try the company site. SEC filings are also available at www.edgar.com, but you have to sign up and you pay for printable versions. The company sites usually have printable versions for free, so try them first
The first order of business when evaluating the balance sheet is to set up a year-to-year comparison and a common size balance sheet. A common size balance sheet converts all the balance sheet items to a percentage of total assets, and it’s a fantastic tool. It allows you, at a glance, to see the change in balance sheet composition over the years.
For an example of year-to-year and common size statements, click here. I’ve put an example on the website, using data from Anheuser-Busch’s 2002 annual report. Notice how some items have changed over the years. For example, not how plant and equipment have declined relative to total assets, while other assets and investments in affiliated companies have increased. Your job as an analyst is to find out why.
The following ratios and calculations are essential for balance sheet analysis. I encourage you to print this article, and keep it handy. And if you haven’t already, start keeping spreadsheets on all your investments. At a minimum, you should have a workbook for each company you own, with tabs for the Balance Sheet, Income Statement, and Cash Flow Statement. At least annually, but preferably every quarter, update these spreadsheets with numbers from the company financial reports. Then create a common size statement and year-to-year statement, similar to the example. This is a quick way to force yourself to review your companies’ financials and keep historical data for future analysis.
Now, let’s look at some analysis tools. I'm focusing on balance sheet only ratios, and I'll get into analysis involving multiple statements, like debt coverage ratios, when we look at the other statements.
Current Assets / Current Liabilities
The current ratio measures a company’s cash plus assets expected to be turned into cash within a year relative to its short-term obligations. A higher ratio generally indicates better liquidity and a safer company. It’s useful to compare the company’s ratio to competitors and to industry averages.
(Current Assets – Inventories) / Current Liabilities
A company with a large amount of current assets tied up in inventory could have a high current ratio, but depending on how quickly inventories can be turned into cash, could still have low liquidity. The quick ratio gets around this concern by removing inventories from the equation, focusing only on assets that can quickly be turned into cash. This is useful mostly for companies with long product cycles and large inventory balances. The quick ratio and the current ratio are highly correlated, so if they are showing different trends, either in direction or magnitude, you should look at possible inventory issues.
Cash and Equivalents / Current Liabilities
This is the most conservative estimate of liquidity, comparing only the amount of cash on-hand to the current liabilities. It determines what percentage of short-term obligations could be paid immediately.
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Current Assets – Current Liabilities
Net working capital is the amount of liquid assets netted against short-term obligations, and measures the company's ability to fund operations without taking on additional financing. You'll notice that net working capital and the current ratio are the same measurement, only from different perspectives.
Market Capitalization / Shareholder’s Equity
Market capitalization is calculated by multiplying the stock price by number of shares outstanding. The market to book ratio measures what investors are willing to pay for the amount of equity in the business. A ratio less than one means the company is trading for less than the equity value of the business, and could indicate an undervalued company. On the other hand, it could also indicate a company whose assets aren't worth the balance sheet value, and therefore will reduce book value when written off. Studies have shown, however, that a low market-to-book ratio is a good indicator of an undervalued stock.
Total Liabilities / Equity
or
(Short Term Debt + Long-Term Debt + Other Interest Bearing Liabilities) / Equity
This is a measure of the company’s leverage, and a ratio greater than one indicates a company that’s borrowed more than investors have put in. Companies with higher debt tend to have more volatile earnings, as interest expense is fixed regardless of sales changes. Some people use only interest-bearing liabilities in this calculation, considering other liabilities as “free” capital. I prefer to look at both methods.
Total Liabilities / Assets
or
(Short Term Debt + Long-Term Debt + Other Interest Bearing Liabilities)
The debt / assets ratio measures leverage, same as the debt / equity ratio. It measures the percentage of assets that are financed by debt, and a ratio greater than 50% could indicate an over-leveraged company. I like this measure better than debt-to-equity, and it's calculated right on the common size balance sheet.
Current Assets – Total Liabilities
One of Benjamin Graham’s 10 value stock criteria is a stock price less than 2/3 of the net current asset value. The NCAV measures the amount of liquid assets an investor would be left with if the company paid all its obligations. Graham believed, and I see no reason disbelieve, that buying a company for less than NCAV is like paying 67 cents for dollar bills.
Market Capitalization + Total Debt - Cash
Enterprise value can be considered the "takeover value", or what someone trying to acquire the company would really be paying. If you've ever heard a takeover priced described as some price plus the assumption of some dollars of debt, you know what Enterprise Value is. When a company is acquired, the purchaser pays the stock price, but also takes on the company’s debt which, since it has to be paid eventually, we assume the buyer is laying out cash for as well. We subtract cash because it’s assumed that cash can be used to immediately pay the debt off, therefore reducing the net debt.
For a good description of Enterprise Value, check out this Motley Fool article.
Here’s an article I wrote putting Enterprise Value into action.
Another of Ben Graham’s criteria requires the company’s stock price be less than tangible book value, which measures the amount of physical assets investors can lay claim to. The tangible book value is a conservative estimate shareholder equity that assumes intangible assets are worthless and actually reduce the investor’s value in the company. If you pay less than tangible book value for a company, the odds of getting your money back in the event of liquidation is fairly high.
Again, I encourage you to print this article, or at least take notes on these calculations. Start keeping a notebook or file with analysis tools that you find useful, and keep it near your annual and quarterly reports. You’ll begin to find that analyzing financial statements is as simple as pulling out your notebook, which I call the Analyst’s Toolbox, and running through the calculations.
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Quotes of the Week
"The truth is, there’s no better time to be happy than right now. . . . Your life will always be filled with challenges."
-Richard Carlson
“Money never starts an idea; it’s the idea that starts the money.”
-Mark Victor Hansen
Until next week my friends, happy investing. Don’t forget to forward this newsletter to a friend.
Sincerely,
Christopher M. Mallon
Have you checked out the Dynamic Investors Marketplace?
How about the Required Reading?
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Attention advertisers!
If you’d like to advertise in the Undervalued Weekly, please send e-mail to chrismallon@dynamicinvestors.net. My rates are reasonable, and I’m willing to work deals for ad swaps and joint ventures.
Attention authors!
The Undervalued Weekly is always looking for quality original content. If you’d like to write an article for publication in the Undervalued Weekly, send a copy of your article to undervalued@dynamicinvestors.net. Include a one-paragraph abstract of your article, and a working e-mail address. I will contact you if your article is approved. I reserve the right to correct any grammatical mistakes.
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