Whitman Finding Bargains through Graham & Dodd, with a Twist

The Financial Post of Canada takes an interesting look today at the Benjamin-Graham-esque approach that longtime market-beater Marty Whitman uses to pick value stocks.

According to The Post’s Levi Folk, Whitman’s strategy is based on the “net-net” approach that Graham and David Dodd laid out in their 1934 classic Security Analysis. (Net-nets are firms whose liquidation values are significantly greater than their market capitalizations, after all liabilities are factored in.) Whitman — who “is finding bigger discounts in the market than at any time in his 50-plus year career”, according to Folk — makes four alterations to the net-net method.

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Gross: Investing “Revolution” Is On

In his April market commentary on PIMCO’s web site, bond guru Bill Gross says that we’ve entered a new world of economics and investing, one in which “there should be no doubt that the bull markets as we’ve known them are over and that the revolution is on. Investing is no longer child’s play.”

Gross says that the future of investing will depend on the future of the global economy, and the future global economy “will likely be dominated by delevering, deglobalization, and reregulating. … We do not envision a mean reversion, cyclically oriented future, but instead a new world where players assume different roles, and models relying on bell-shaped/thin-tailed outcomes based on historical data are less relevant. Historical models look backward while modern-day finance is being fast forwarded and reconstituted almost as we speak.”

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Stocks for The Long Run — Riskier than Stocks for The Short Run?

In his latest column for The New York Times, Mark Hulbert highlights an interesting new study that examines the concept of long-term risk in the stock market.

The study, performed by University of Chicago Booth School of Business Professor Lubos Pastor and Wharton School Professor Robert F. Stambaugh, questions whether the concept of mean reversion really indicates that stocks are less risky over the long run, a theory that has been espoused by many investors and academics, most notably Jeremy Siegel. Siegel’s research has shown that stock returns have shown a remarkable tendency to revert to about 7 percent per year, after inflation, over the past two-plus centuries.

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Tilson Turns Bullish on a Few Financials

Whitney Tilson, whose calls about the housing bust, financial crisis, and huge government bailout have proved prescient over the past year, tells CNBC that after making a bundle shorting financial stocks he’s now finding some good long opportunities in the sector.

“Valuations have compressed so much we actually flipped around and went long some financials such as American Express and Wells Fargo,” says Tilson, who runs T2 Partners and is also a Kiplinger’s columnist. “I think there’s a 70% chance Wells Fargo makes it without any kind of catastrophic outcome in which case it’s a $40-$60 stock. And at current levels [about $15] that’s a pretty attractive risk/reward.”

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Top Timing Newsletter Turning Bullish

The Cabot Market Letter — one of the top-performing newsletters of the past decade — is moving back into stocks, seeing the odds as “increasingly good” that the market has bottomed.

“We’ve had the snapback; we’ve had the rally,” Michael Cintolo, the newsletter’s editor, wrote yesterday. “And while a technical correction is quite possible from here, the odds are increasingly good that the ultimate low of the bear market has passed, and that buying select leading stocks now will pay off in the weeks and months ahead.”

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Get into “The Glitch” — 10 Top Scoring Price-to-Sales Stocks

The Price-to-Sales ratio (PSR) is a measure used by many of the Guru Strategies I run on Validea.com as a way to find undervalued stocks. The ratio, which is simply the market capitalization of the firm divided by the company’s sales, has become more popular over the years as investors look for additional ways to uncover value among publicly traded stocks.

The individual who popularized the PSR is Ken Fisher. Fisher, a longtime Forbes magazine columnist, is one of the most widely recognized names in the money management business. His firm, Fisher Investments, manages tens of billions of dollars. In his 1984 book Super Stocks, Fisher outlined an investment approach using the PSR – this is the approach I utilize in the computerized Price/Sales Investor strategy on Validea.com.

In the spirit of the PSR and Fisher, I thought it would be worth taking a look at why this variable can be useful in finding stocks with value. The following is excerpted from my new book, The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies, while the stocks in the table are current holdings in the Validea.com P/S Investor portfolio.

- Excerpted from The Guru Investor -

If you’re going to understand why Fisher believed so strongly in using the PSR to identify undervalued stocks, you need to understand what he called “the glitch.” Like some of the other gurus we’ve looked at, Fisher is a student of investor psychology, and one thing he believed investors did was raise expectations to unrealistic levels for companies that have periods of strong early growth. When these darlings of Wall Street have a setback—maybe their earnings drop, or maybe they continue to grow but simply don’t keep pace with investors’ lofty expectations—their stocks can then plummet as investors overreact and sell, thinking they’ve been led astray.

But while investors overreact, Fisher believed that these “glitches” are often simply a part of a firm’s maturation. Good companies with good management identify the problems, solve them, and move forward. As they do, the firms’ earnings and stock prices begin to rise again. If you can buy a stock when it hits a glitch and its earnings and price are down, you can make a bundle by sticking with it until it rights the ship and other investors jump back on board.

The trick is thus trying to evaluate a company during those periods when Wall Street is down on it because its earnings are in flux, or even negative, so that you can find good candidates for a rebound (remember, you can’t use a P/E ratio to evaluate a company that is losing money, because it has no earnings). The answer, Fisher said, was to look at sales, and the PSR.

“Why should one consider price-sales ratios at all?” Fisher asked in Super Stocks. “Because they measure popularity relative to business size. Price/Sales Ratios are of value because the sales portion of the relationship is inherently more stable than most other variables in the corporate world.”

His point is this: Earnings can be highly volatile, including the earnings of good companies, while sales rarely decline for top-flight businesses. They may be flat, but they generally tend to be less volatile than earnings. Earnings, however, can be moved quickly and dramatically by a wide variety of variables that do not necessarily portend how the company will perform, such as changes in accounting procedures or in the amount of research and development the company engages in. Wall Street focuses on earnings and abandons companies with earnings troubles, which is why Fisher liked to look at sales. A company with troubled earnings but strong sales is a company Fisher may well have wanted to own in his Super Stocks days.

Part of Fisher’s thinking was that, if a company has a low PSR, even a slight improvement in its profit margins can produce a big gain in earnings, which will then drive the stock’s price up since most investors react to earnings. Companies with high PSRs don’t have this leverage.

Another part of Fisher’s thinking was that investors should focus on causes, not results, when it came to evaluating a firm’s prospects. “What is the bottom line?” he wrote. “To buy stocks successfully, you need to price them based on causes, not results. The causes are business conditions—products with a cost structure allowing for sales. The results flow from there—profits, profit margins, and finally earnings per share.”

One more general note on Fisher’s take on PSRs: He doesn’t like looking at per-share numbers because he thinks it is important to focus on the overall business, including its size.

In terms of specifics, Fisher listed three rules regarding PSRs in Super Stocks:

Rule 1. Avoid stocks with PSRs greater than 1.5, and never buy those with a PSR in excess of 3. In this case, you are paying $3 for every $1 of sales. He admits stocks with such high PSRs can increase in price but only based on hype, not anything of substance.
Rule 2. Aggressively look for stocks with PSRs of 0.75 or less. Such a PSR means you are paying 75 cents or less for every $1 of sales. These are the stocks you want, and you should hold onto them for a long time, he says.
Rule 3. Once you’ve bought a stock with a desirable PSR (0.75 or less), sell it when the PSR reaches 3.00 (if you don’t want to take much risk) or hold it even longer, to 6.00 or higher, if you are really a risk taker.

-End of excerpt-

The 10 stocks in the table below are taken directly from Validea’s P/S Investor portfolio. As you will see, five stocks were added on the portfolio’s last rebalancing (March 20). Each of these holdings meets the PSR tests developed by Fisher and also a host of other important investment criteria.

Crisis Predictors Offer Advice

Three of the financial minds who warned of the current credit crisis — Banc of America Securities-Merrill Lynch’s Richard Bernstein, PIMCO’s Paul McCulley, and author and former Wall Streeter Richard Bookstaber — offered their views on the current economy and what investors should do in this market on WealthTrack with Consuelo Mack recently. (Click on the WealthTrack Video on Demand image to watch the video.)

Bernstein said it is difficult to form a consistent investment strategy when the system is not following a typical risk/reward pattern. He says his firm has tried to form well diversified portfolios — something that has become harder to do as more assets seem to move in synch, and swing for singles instead of home runs. Some assets that still offer diversification: Treasuries, high quality munis, and gold (though gold is losing some of its diversifying benefit as its price rises higher).

Bernstein says he thinks the U.S. is better off than many other countries dealing with similar crises, and says investors should turn their focus to the U.S. and developed countries rather than emerging markets, as they had done for several years prior to the crisis. But he also says he wouldn’t rush out to buy stocks, and a big reason involves earnings.

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What to Expect from Here

How quickly will stocks rebound when the current bear market ends (if it hasn’t already done so)? The New York Times’ Paul Lim offers some interesting data on that subject in his most recent column.

Citing data from James B. Stack, editor of the InvesTech Market Analyst newsletter, Lim says that after the nasty bear markets that followed the peak of 2000 and the peak of 1973, stocks took more than seven years to climb back to their previous highs, and after the crash of 1929, it took more than 25 years to do so.

Based on the average recoveries of the past, Lim says the Dow Jones Industrial Average might not make it back to previous highs until 2014 — “and some market observers say it could take significantly longer.”

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Don’t Be a Bottom-Hunter

The big question in the market these days seems to be, “Have we hit a bottom?” After enduring a bear market that has lasted nearly 18 months and cut the value of the S&P 500 in half, it’s certainly a reasonable question. But in the latest issue of my Validea Hot List newsletter, I explain that now is no time to be sitting on the sidelines trying to wait for a clear, precise bottom.

In reality, any bottom-call is just an educated guess — and, given the depth of this crisis, the unprecedented government actions made in response to it, and the sheer panic gripping many investors, trying to figure out whether we’ve actually hit bottom yet is something of an exercise in futility. You could analyze the heck out of every indicator you can get your hands on, and in the end you might not be much better off than if you’d just flipped a coin to decide whether we’ve bottomed or not.

For long-term investors — those with horizons of three, five, ten years (which, in my opinion, should be the only type of investor dealing in stocks) — now is a time to step back and consider the bigger picture, and not get caught up in overanalyzing where the bottom is. The bottom line is that stocks, by just about every valuation measure, are undervalued. Yes, valuations fooled most investors a year or two ago, when massive leverage had propped up earnings, making P/E ratios and other metrics artificially low. But now, we’ve been in a recessionary climate for more than 15 months, credit is moving at a snail’s pace, and the most conservative valuation measures are saying stocks are cheap.

Among those valuation metrics are the 10-year (Shiller) price/earnings ratio, which is now around 12, significantly below the 16.4 historical average. Another example is Tobin’s Q Ratio, which divideds the total market value of stocks by their total asset value (or replacement cost). John Mihaljevic of The Manual of Ideas blog wrote recently that the market’s Q Ratio was at 0.43 in mid-March, below its historical average of 0.76. (At the end of 2007, stocks were above that level, at 0.89, indicating they were overvalued.)

Another reason to be bullish, I believe, involves the effects the Federal Reserve’s actions could have on the economy. While the huge increase in the Fed’s balance sheet may well be necessary to pull the economy out of this mess, it’s looking more and more like we will be in store for some serious inflation once the economy gets back on its feet. And history has shown that fixed-income investment vehicles like bonds, T-Bills, gold, and money market accounts can have their nominal gains wiped out by inflation — even during times of only average inflation. But because of their ability to produce increasing earnings streams, stocks have been able to post solid real, after-inflation long-term returns throughout history. Some top investment minds — like those at bond giant PIMCO — are saying inflation could start to really kick in as soon as 2010.

Of course, inflation could take longer to materialize, and stocks could still go lower from here. Both the 10-year P/E and Tobin’s Q have been lower during other economic crises. But the problem is that if stocks retreat to even lower valuations from here, it will be because of either fear, or some new, yet-unknown fundamental event or events. So, the bottom line is this: If you think you can predict investors’ emotional states, or how an unprecedented economic crisis will play out, then go ahead and wait for the bottom. I suffer no such delusions, however. Rather than playing the risky game of bottom-calling — which more often than not leads to investors missing the big initial push of a new bull run — I’ll continue to put money into undervalued stocks. And, just as it has tended to do throughout more than two centuries of stock market history, I expect such a practice to yield strong returns over the long haul, regardless of what happens today, tomorrow, or next week.

Fisher: Fears are Greater, but Risk is Lower

In his latest Forbes column, Kenneth Fisher offers advice for those who feel like the stock market is too risky a proposition right now.

“This is not an irrational fear; stocks that are off 50% from their highs (and a lot are, at this point) can keep falling,” Fisher writes. “But you can temper your fear by realizing that low prices make stocks less risky, not more risky. Unless there has been a corresponding collapse in its business, a company whose $60 shares are now at $30 is less risky for the investor.”

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