New Era Value Investing: a Disciplined Approach to Buying
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NEW ERA VALUE INVESTING RELATIVE VALUE DISCIPLINE This book describes an innovative investment strategy called “Relative Value Discipline,” which provides a framework for in- vesting in traditional dividend-paying value stocks, as well as undervalued growth stocks. The graphic below illustrates how the stock selection process works step by step to winnow a thousand large cap stocks down to a focused portfolio of twenty to thirty holdings. Investment Universe • Large cap U.S. stocks • Approximately 1,000 companies • Market cap over $3 billion Divdend-Paying Stocks Low-Yielding Stocks in Traditional Value Sectors in Growth-Oriented Sectors Screened using: Screened using: Relative Dividend Yield Relative Price-to-Sales Ratio (RDY) valuation model (RPSR) valuation model Focus List • Approximately 100 companies • Low price versus historical company average Twelve Fundamental Factor Analysis Qualitative Factors/Quantitative Factors • Buggy Whip (product obsolescence) • Positive Free Cash Flow • Niche Value (market leadership) • Dividend Coverage and Growth • Top Management • Asset Turnover • Sales/Revenue Growth • Investment in Business/ROIC • Operating Margins • Equity Leverage • Relative P/E • Financial Risk Portfolio Construction • Rank each Focus List security based on both qualitative and quantitative analysis • Focused portfolio (usually between twenty and thirty holdings) • Highest confidence picks • Calculated sector bets versus S&P 500 NEW ERA VALUE INVESTING A Disciplined Approach to Buying Value and Growth Stocks NANCY TENGLER John Wiley & Sons, Inc. Copyright © 2003 by Fremont Investment Advisors, Inc. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photo- copying, recording, scanning, or otherwise, except as permitted under Sec- tion 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through pay- ment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-750- 4470, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wi- ley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201-748-6011, fax 201- 748-6008, e-mail: [email protected]. 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Library of Congress Cataloging-in-Publication Data: ISBN 0-471-26608-6 Printed in the United States of America 10 9 8 7 6 5 4 3 2 1 CONTENTS PREFACE ix ACKNOWLEDGMENTS xv CHAPTER 1 Is It Really “Different” This Time? 1 CHAPTER 2 A Short History of Fundamental Analysis and the Dividend 13 CHAPTER 3 The Development of Relative Dividend Yield 21 CHAPTER 4 The Challenges of the 1990s 33 An Historical View of U.S. Productivity 37 CHAPTER 5 The Twelve Fundamental Factors of RDY and RPSR Research 51 Qualitative Appraisal 53 Quantitative Appraisal 61 CHAPTER 6 RDY Case Studies 85 Oil Stocks 86 Pharmaceutical Stocks 88 Classic Fallen-Angel Growth Stocks 90 Consumer Stocks 93 Bank Stocks/Financials 97 RDY Failures—Terminally Cheap Stocks 100 v vi CONTENTS CHAPTER 7 RPSR Case Studies 105 RPSR and the Technology Bubble 106 The Intersection of RDY and RPSR 120 CHAPTER 8 Constructing a Value-Driven Portfolio 129 Merged Companies Combining High-Growth and Slow-Growth Components 141 New Companies with Too Short a History 142 CHAPTER 9 What Is Value Investing Today? 145 CHAPTER 10 Seven Critical Lessons We Have Learned as Disciplined Investment Managers 153 1. Wall Street Tends to Take Current Trends and Extrapolate Them Out to Infinity. 154 2. It Is Rarely “Different This Time.” 154 3. Market Workouts Are Often Great Investment Opportunities. 156 4. At Turning Points, Go with Your Discipline— Not Wall Street. 157 5. Investment Managers Need to Challenge Their Beliefs Every Day. 161 6. Use the Availability of Data and the Always-On Financial Media to Your Advantage. 162 7. It’s All Relative. 162 APPENDIX A New Era Value Composite 165 Disclosure 165 APPENDIX B Estee Lauder—Twelve Fundamental Factors: Estee Lauder Companies, Inc. Valuation Factors 169 Qualitative Appraisal 170 Quantitative Appraisal 173 CONTENTS vii APPENDIX C EMC—Twelve Fundamental Factors: EMC Valuation Factors 181 Qualitative Appraisal 182 Quantitative Appraisal 189 APPENDIX D Walt Disney—Twelve Fundamental Factors: The Walt Disney Company Valuation Factors 197 Qualitative Appraisal 198 Quantitative Appraisal 208 INDEX 215 PREFACE Most books on equities investing are written during the ad- vanced stages of bull markets when the public’s interest in the subject is peaking. This book was written almost two and a half years into a wrenching bear market by a portfolio manager whose investment performance has not been particularly good in this exceptionally challenging market environment. This begs two questions: Why now? Why me? The answer to the first query is easy. As a died-in-the-wool value investor, I believe in buying cheap and selling dear. Rela- tively few stocks are truly cheap during the latter stages of a bull market, whereas there are plenty of great fundamental bargains toward the end of a bear market. Bear markets are a perfect time for investors to pick off great companies at low valuations. What better time to introduce a value-driven in- vestment discipline to investors? The answer to the second query is a little trickier. I’ve spent my entire seventeen-year career as a value manager for large compa- nies, municipalities, mutual funds, and individual investors. My quest for value has resulted in a focus on discipline both from a val- uation and fundamental research standpoint. The Relative Price- to-Sales Ratio (RPSR) strategy detailed in this book has not been especially effective over the last eighteen months. Is this a cause for concern? We think not. The most important thing when em- ploying a discipline is consistent implementation. RPSR has identified cheap high-quality companies, and the market will eventually follow. The discipline works because the market cy- cles; if investors remain constant it will come back our way. Rel- ative Dividend Yield (RDY), our original valuation discipline, has ix x PREFACE produced results over the long term but has struggled during pe- riods when growth investing ruled. But, by their very long-term nature, both strategies will identify stocks that will not outper- form each and every year. However, they will outperform over the long term, which should be the time horizon of most in- vestors. The disciplines this book will discuss have produced ex- cellent long-term track records, which I believe will help readers target the stocks that will produce the most generous returns in the years ahead. There has been a long-running debate on whether growth- at-a-reasonable-price methodologies such as mine qualify as value investing. This debate has intensified over the last year, as traditional value portfolios have outperformed and value- oriented growth stock investing has underperformed. Indeed, “absolute value” investors, with low price/earnings ratio port- folios concentrated in the most defensive market sectors, have had considerably more success than anyone else as the stock market has plummeted over the last few years, which is how it should be. I believe in traditional value stocks and hold some in my portfolios, but with the flexibility of the discipline this book will be introducing to you, I am able to identify stocks that trade at value-investor valuations, with growth-investor earnings potential. Coming out of a bear market, this is where investors want to be. Over the long term, I believe buying in- dustry “Cadillacs” when the dealer (the market) is offering big incentives is a better definition of value than buying more cheaply priced, but much slower and poorer quality “Yugos.” Put another way, “cheap” is not a synonym for “good value.” Warren Buffett, the most famous value investor of our time, is what I would call a growth-at-a-reasonable-price investor. Mr. Buffett has earned his well-deserved reputation as a con- noisseur of value by buying high-quality growth companies when they are experiencing temporary difficulties or, for what- ever reason, have lost favor in the market. Although over the short term, Mr. Buffett’s portfolio of “fallen angel” growth stocks has periodically underperformed, over the long term PREFACE xi they have made Berkshire Hathaway (Buffett’s holding com- pany) shareholders an enormous amount of money. As I write (October, 2002), the Dow Jones Industrials and S&P 500 are at four-year lows and the NASDAQ Composite is off almost 77 percent from its March 2000 peak.