Undervalued Weekly
The Undervalued Reports Company’s weekly newsletter
Towson, MD
December 6, 2003
http://www.dynamicinvestors.net
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Winter has unofficially arrived here in the Northeast as we suffer through our first snow storm of the season. It’s not yet officially winter, and I could swear I just finished shoveling the rest of last year’s snow off my porch. At least it feels that way. I’m just such a huge fan of winter weather, with all the cold, and the snow, and the ice. I like winter about as much as I like a hangnail or the flu. Some people love the snow, and I hope they’re having a great time. Personally, I’ll take sunny and 80 degrees any day.
A little reminder: The Undervalued Weekly subscription promotion starts tomorrow, and there’s still time to get in on the action. I’m offering the chance to win a free book each week. If you’d like more information, click here.
We saw a lot of economic data this week, and plenty of action in the markets. The Dow Industrial Average was up 80.22 points (0.8%) to 9862.68. The S&P was up 3.3 points (0.3%) to 1061.50. And those crazy guys over at the Nasdaq were down this week, dropping 22.44 points (1.1%) to close at 1937.82. Gold had another good week, finishing at $406 per oz.
I was right when I said it was only a matter of time before gold broke $400 and stayed there. I just didn’t think it would happen the very next week. And it didn’t just break $400; it closed above $400 / oz. every day this week. It appears that while $400 was a resistance level up through last week, it’s now a floor.
Someone in the Bush administration must have heard me complaining about protectionism, because the President reversed himself on steel tariffs this week. Yielding to international law (ha!), the President dropped the tariffs and declared victory. In a statement, the President said,
“I took action to give the industry a chance to adjust to the surge in foreign imports and to give relief to the workers and communities that depend on steel for their jobs and livelihoods. These safeguard measure have now achieved their purpose, and as a result of changed economic circumstances it is time to lift them.”
If by relief, he means relieving people of their jobs, then he truly was successful. Despite the tariffs, U.S. production of steel was down 6.7% between October 2002 and October 2003, according to the American Iron and Steel Institute and the International Iron and Steel Institute. And it’s generally agreed that the tariffs caused more non-steel job losses than were saved in the steel industry. Hey, at least he tried, right?
How Treasury Secretary Snow keeps a straight face when defending the administration, I don’t know. In an interview Snow claimed that the President’s change in policy on steel tariffs “wasn’t really a change in policy. The tariffs worked. The industry is now in a much better position.” In a better position to do what, continue it’s descent into irrelevance?
I kid about this because it was obviously a political feel-good gesture, designed to get the steel industry’s vote come next year, and not something the administration was willing to fight for. The tariffs were set to expire in three years, or less than a year after the 2004 election. I’m glad that the president backed down though, because we could have been facing a very serious trade war, which is in no one’s interest. We’ve got serious structural problems in the United States that would be exacerbated, not fixed, by protectionism and trade wars.
The US unemployment rate dropped to 5.9% in November, the lowest level since March 2003. The number of non-farm jobs increased by 57,000 last month, less than the October increase of 137,000, and far less than the expected 150,000 job increase. The Institute for Supply Management (ISM) manufacturing index rose in November to 62.8, its highest point in twenty years. Yet, despite improved activity and a 2.2% increase in factory orders, the manufacturing sector shed 17,000 jobs in November. The drop in manufacturing jobs was offset by an increase in service sector employment.
Apparently, more output with fewer jobs is what people mean when they talk about productivity increases. US productivity rose at a 9.4% clip in the third quarter, the strongest showing since the second quarter of 1983. Though I suppose that’s little consolation for those who don’t have a job. I believe the improved conditions will lead to some job growth in manufacturing over the next year, but we need to face the facts: American workers are not competitive vis-à-vis Asian workers. Unless there is a serious drop in the US currency, we will remain uncompetitive for the foreseeable future.
Obviously, I’m not the only person who understands this. The US dollar hit new lows against the Euro this week, falling to 0.82 Euros. This values the Euro at $1.21, a penny higher than last week. Interest rates in the US are 1%, compared to euro zone rates at 2%, British rates at 3.75%, and Australian rates of 5% (which are expected to go higher). It’s no surprise that capital is leaving the US’ low interest rate environment to seek higher interest rates.
According to the Bank of New York, November saw a net $2.3 billion in cash from equities and fixed income leave the US. When a country runs a negative current account deficit, and has a net outflow of capital, there’s only one way to balance the Balance of Payments. The US has to sell some of its foreign currency reserves. When this happens, the foreign currencies are sold for dollars, and those dollars are brought back into circulation in the US. What happens when the supply of something increases? All other things remaining equal, its value falls. That, in a simplified sense, is the reason for a falling dollar.
Turning to the mutual fund scandal, more charges were filed this week. State and federal officials filed civil suits against Invesco Funds Group. Four of the company’s top executives are accused of allowing as many as 60 hedge funds and special investors to do market timing, which is a semi-legal practice that takes advantage of the inefficiency in pricing mutual funds. Mentioned in the filings was Canary Capital Partners, who settled allegations of illegal trading with New York Attorney General Elliot Spitzer’s office in September, and agreed to help in the mutual fund industry probe.
In an effort to stop late-trading by mutual fund investors, the SEC voted 5-0 to propose that mutual funds not be allowed to accept orders after 4:00 pm from broker-dealers, even if the order was placed with the broker before 4:00 pm. Right now, broker-dealers can submit orders for the pre-closing price after 4:00 pm if they ensure that the order was placed by the investor prior to the close. The SEC also voted to order funds to appoint Chief Compliance Officers who would work for the fund managers, but report to the fund boards.
Here’s a fun story. A federal judge this week awarded plaintiffs a victory in a law suit against CD manufacturers and music clubs for conspiring to set prices of CDs sold to club members. The total award was $143 million dollars. Each individual will get about $13.50 in vouchers for the music clubs, and free shipping on their order. In other news, the lawyers got $99 million of the settlement.
In a move that could become a catalyst for an industry shakedown, Wal-Mart said on Wednesday that it would stop accepting MasterCard debit-card transactions that require a signature. You know the ATM MasterCard that you got from your bank? Don’t expect to use it at Wal-Mart anymore. They will continue to accept regular credit card and pin-based transactions.
That’ll do it for this week. Enjoy your weekend, and don’t forget about the subscription promotion.
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Book Recommendation
Have you ever wondered how the US Dollar came to be the world’s reserve currency? Do you ever wonder why the US Dollar is no longer tied to any hard metal like gold or silver? Do you want to know the real story of the American money and banking system?
A History of Money and Banking in the United States: The Colonial Era to World War II takes you through the history of American money and banking as only Murray Rothbard could. He presents evidence that sound money and banking were the cornerstones of economic expansion in the 1800’s, and shows us how loose credit, paper money and inflation have caused social and economic decay.
Rothbard relates how the gold standard was attacked and eventually subverted by the biggest names in banking from the late 19th and early 20th centuries. But it’s more than just numbers and currency data. The story is told from a human perspective, detailing the intense personal rivalries, and the machinations of the elitist of the elite.
It’s a fascinating history that I couldn’t put down. You can get a copy of the book here…
A History of Money and Banking in the United States: The Colonial Era to World War II
For more must-have books, check out the Dynamic Investors Required Reading.
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Margin of Safety Part I
The concept of the margin of safety is the most important tool in the analyst’s toolbox. I like to define the margin of safety as the “just in case” factor. Just in case you make a mistake in your analysis, the margin of safety is there to protect you.
So what is the margin of safety, and why is it so important?
Benjamin Graham defines the margin of safety’s purpose to be “that of rendering unnecessary an accurate estimate of the future.”[i] Graham says that if you build enough margin of safety into your investment, you don’t have to be accurate in your prediction of the company’s future prospects. This may seem strange, considering the financial industry’s emphasis on earnings estimates, but that’s what makes it so important.
Let’s face it, how accurate can you really be when predicting the future? You certainly don’t have a crystal ball. (Or maybe you do; but then I suspect investing isn’t your first passion.) No one knows with even relative accuracy what future business conditions will be.
Yet analysts everywhere crunch numbers to arrive at quarterly per-share earnings estimates for thousands of companies. Based on the number of revisions made to these estimates, it’s apparent that even professionals can’t predict with any accuracy. The margin of safety can protect you from faulty estimates.
Graham’s definition above is fairly general, and could apply to any purchase, including stocks, bonds, even real estate. A more specific definition applicable to stocks might be:
The margin of safety is the difference between the conservatively estimated intrinsic value of a stock and the price for which it sells.
First, let’s define intrinsic value. Without going into the mechanics of it, intrinsic value is the analyst’s estimate of a stock’s “true” value. The purpose of fundamental analysis is to arrive at that intrinsic value estimate using all the tools available, such as past earnings or cash flow data, balance sheet ratios, and future estimates. Just be sure the intrinsic value is conservatively estimated.
The poorest investor is one who buys without a margin of safety. He buys companies based on analysts’ expectations hoping the company will outperform. Maybe he’s heard of the company on CNBC or noticed that analysts rate the stock a Strong Buy. Maybe his day-trading cousin offered him a hot stock tip that he needed to act on NOW!
Selecting investments that way guarantees you will underperform the market. These types of stocks are usually trading at or above a conservatively estimated intrinsic value, leaving no room for error.
As we saw in the late 1990’s, the biggest investment losses come from buying mediocre businesses during good business conditions. The late 90’s was a period of exceptional economic growth that coincided with a stock market bubble. These conditions allowed some very bad companies to sell stock for very high prices. Of course I’m talking about the dot-com and internet stocks. Many of these companies had negative intrinsic value, yet they sold in the market for billions. There was never a margin of safety in these stocks.
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A margin of safety tilts the odds in your favor. When the margin of safety is sufficient, it will increase the probability of earning a good profit, while reducing your potential downside risk. By focusing on the margin of safety, you eliminate emotional decisions. It also helps you weather adverse business and economic conditions, and protect you from a decline in a company’s earning power.
Let’s look at an example. Suppose you have a company that during an overall market downturn has fallen from $18/share to $10/share. The company has trailing twelve months earnings of $1.50 per share. You analyze the company, and make a conservative assessment of the intrinsic value at $16 per share. The assessment assumes an average P/E of 10 based on an estimate of $1.60 for next year’s earnings. You buy the stock with a 37.5% margin of safety ($6 / $16).
Over the next year, the stock rebounds to $18/share. Now assume that your estimate of future growth was way off, and the company actually earns $1.30 next year. On top of that, the earnings multiple drops to 8. With these assumptions, the intrinsic value (and presumably the market value) drops to $10.40 per share. But, because you had a margin of safety built in by purchasing at $10/share, you’re still ahead.
Margin of safety flies in the face of the mantra, “higher risk = higher return”. The high risk / high return philosophy is one of the hallmarks of the Efficient Market Hypothesis and is preached as gospel by most professionals and business school educators. Investors who follow the concept of market efficiency have no use for the margin of safety, which leads me to believe they have no use for long-term profits either.
Markets are not efficient, regardless of studies that attempt to prove otherwise. If the market was efficient there’d be no opportunities to outperform said market. We know from history that it’s not only possible to beat the markets, but that some investors can do it consistently. Study these investors, and you’ll find margin of safety is at work in every decision they make.
Growth companies are normally marketed as the stocks to buy for big returns. On the surface, this makes sense because these companies show rapid sales and earnings growth, which drive stock prices. The problem with growth stocks is that they’re generally overpriced. Almost invariably, the market prices them based on aggressive estimates of future earnings, eliminating the margin of safety for the buyer.
As I’ve said before, there’s no harm in using future estimates to determine the intrinsic value of a company. In fact, I encourage you to develop and use estimates. But those estimates need to be conservative. Go back through a company’s financial results over a number of years to establish historical earning power, coverage ratios, balance sheet stability, etc. Then use the historical analysis, coupled with your knowledge of the company, to develop a conservative estimate of future growth.
There’s no reason that growth stocks shouldn’t be part of your portfolio. You just need to buy them at reasonable prices to ensure your margin of safety. However, when you find a growth stock that’s priced below conservatively estimated intrinsic value, it won’t be called a growth stock. It will be called a value stock. Value stocks, by definition trade with a margin of safety. That’s what makes them valuable.
Understand that just because a stock has fallen from a high price doesn’t make it a value stock, nor does it guarantee a margin of safety. When looking for value stocks, be careful not to pick companies that are bad businesses. There’s often a reason a stock is beaten down, and if it’s because the business is performing poorly, you should stay away from it. There’s no value in poor performance.
Next week, I’ll discuss how the margin of safety ties in with portfolio diversification, and explain some methods of valuing companies.
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Quotes of the Week
"When you're afraid, keep your mind on what you have to do. And if you have been thoroughly prepared, you will not be afraid."
-Dale Carnegie
"I am a great believer in luck. The harder I work the more of it I seem to have."
-Coleman Cox
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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