Value Investing in a QE3 Economy

Since Ben Bernanke released his latest bond-buying program, also known as QE3, U.S. and European stock markets have tacked additional gains on to a summer rally built on anticipation of such a program. They weren't let down. Not yet, anyway.

As was the outcome of both prior rounds of easing, the overall market indices continued their ascent although each successive program has predictably shown a decreased positive impact on equity prices. With aggregate corporate earnings growth stemming primarily from cost-cutting, i.e. smaller workforces and declining spending, the effects of quantitative easing have primarily served to artificially inflate asset prices. Underlying demand for stocks, as demonstrated by market volume, has continued to decline.

Earnings growth, employment, and thus overall economic growth has been flat even amidst the purposeful devaluing of U.S. and Euro currencies. Now, proponents of Federal Reserve and European Central Bank stimulus programs will point to measured inflation (when food and gasoline are extracted from the rate) as justification a government can continually devalue its currency until economic growth returns. However, these proponents still can't point to any proven, concrete benefit that the first two rounds of programs have delivered. The only argument is "Imagine what it would be like if we hadn't done it."

Well, that's up for debate. And so far, aside from undue increases in gasoline and food prices (amidst declining world demand) the long-term effects are not yet known. However, we can deduce that easing programs have done nothing to spur organic economic growth; the kind of growth so important to an investor when making forward-thinking decisions.

So, as an investor in an environment where market prices are not primarily derived from supply and demand conditions, but from artificial demand provided by government bond purchases and thus a systematic debasing of the world's reserve currencies, how should my investment strategy encompass this new reality?

First, one must keep in mind that with each new round of quantitative easing, associated marginal returns have declined. So, simply buying an asset, whether a stock or commodity, and expecting a subsequent rise in price may have worked under the first program but is unlikely to continue to work as well. With this thought in mind, traditional asset pricing models, i.e. earnings growth rates, will continually become more relevant. As world economic growth rates slow, a prudent investor will only seek out undervalued assets; those with low P/E ratios relative to their peer groups and/or those with high yields. Many times, emerging markets can provide both growth and yield while remaining somewhat buffered from the volatility of the world's reserve economies.

Second, implement this value strategy with a long-term horizon, but reevaluate every six months. New opportunities, and risks, seem to arise much quicker in a volatile world economy than in traditional one. It is safe to say that as long as central banks continue to intervene in asset markets, the likelihood of a random precipitous decline or advance remains high. As a value investor, these events present valuable opportunities, and not being aware of one's positioning can quickly equate to missed opportunities or unnecessary losses.

Finally, put excess reserves and savings to work in a municipal bond fund to avoid taxes and grow your savings. It is more important than ever to have money on the sidelines, but as world currencies are debased, keeping up with inflation becomes more difficult, and thus parking reserves in U.S. dollars or Euros is eroding your returns. Savings accounts at local U.S. banks are yielding approximately 1/10th to 1/5th of one percent. This is costing you money, not just in missed returns, but in decreased spending power. There are many states if in which you reside and purchase your state's local and/or state bonds, returns are exempt from local, state, and federal taxes. Take advantage of it.

I base my time horizons on six month periods, and continually reevaluate my holdings while planning for the next six months. Many times, I hold my investments for much longer than six months, and many times for a shorter period. In this economic climate, blindly buying and holding leads to "the lost decade" or what many have dubbed the first decade of the 21st century. Returns on investment only become lost when we don't adapt to continually changing economic realities. Everyone who is still sitting back on their heels waiting for "a return to normal" will still be waiting in another ten years. This is the new normal.

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A Beginners Guide: Value Investing

One of the greatest investors of all time, Warren Buffett, has proven that value investing can work: his value strategy took the stock of Berkshire Hathaway from $12 a share in 1967 to an astonishing $70,900 in 2002. Although Mr. Buffett does not hold himself only to value investing, most of his investments were made on the basis of value investing principles.

A value investor looks for stocks with strong fundamentals or strong earnings, dividends, growth, and cash flow. The basic principal of value investors is that you should first find out what the true price of a share of stock is and then determine if it is undervalued. After you have determined its stock price is below what it should be you would then buy and hold it until it gets back in equilibrium. There are several ways to find out exactly how much a certain stock is worth. The most basic way to do this is determining the company's book value. Book value is calculated by subtracting total liabilities from total assets. If a company has a history that you can go back and check to see what it's average market value to book value ratio this method would prove to be a key factor in your valuation. We can't stop with just book value though we must dive deeper.

The next major indicator I would look at is price to earnings ratio. The P/E ratio determines how the market feels relative to the earnings that the company is making. You would want to look at the stocks historical P/E ratio and determine where their current P/E ratio relative to historical. If it is below the historical average, we could say that the stock is undervalued.

A lot of the time when I'm picking a stock with this method I will also look at the major stock holders and try to determine if any hedge funds or other big institutions have picked up this stock recently. If they have then I will just move on to another stock because it has already been discovered.

Here is a breakdown of some of the numbers value investors use as rough guides for picking stocks. Keep in mind that these are guidelines, not hard-and-fast rules:

• Share price should be no more than two-thirds of intrinsic worth.

• Look at companies with P/E ratios at the lowest 10% of all equity securities.

• PEG should be less than one.

• Stock price should be no more than tangible book value.

• There should be no more debt than equity (i.e. D/E ratio < 1).

• Current assets should be two times current liabilities.

• Earnings growth should be at least 7% per year compounded over the last 10 years.

Remember these are rough guides. You can always try out some new stuff and see how it works for you. Value investing may not seem as sexy as some other styles of trading or investing but it relies on a strict screening process that helps you get to know the company you are buying in order to make the best decision.

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Value Investing the Warren Buffett Way

There are almost as many definitions for the term, "Value Investing," as there are people using it. No wonder it can be confusing. However the quintessential definition belongs to the way Warren Buffett does it.

After all, he's made over $50 Billion doing it his way. So if you're going down the Value Investing road, you may as well follow the man who is most successful.

Now most people think that Value Investing is simply buying cheap stocks. Unfortunately there are some serious downsides to simply finding cheap stocks, even fundamentally solid ones, and buying them.

First, the market could take a very long time to realize these stocks are undervalued. At the end of the day, it doesn't matter whether you own excellent value if nobody is willing to pay you for that value. This is called the realization-of-value-problem and is a very real concern, for anyone who invests money in the stock market, because the longer it takes the market to realize the true value of a company, the lower the compounded annual returns will be.

To see why, let's look at an example where a stock that has an intrinsic value of $10 a share is selling at a discounted $5 per share. If the market realizes the stock's true value in a year, the annualized return will be 100%. If it takes two years, the return will be 41.42%. Three years? 25.99%. Five years will return 14.87% and ten years will give a 7.18% return.

As you can see, the differences in annualized returns are significant, and we really don't know when the market will fully value the shares.

Another problem is that a company might look attractive at a particular point in time, but a host of intangibles, such as management integrity or government regulation, that weren't reflected in the numbers could cause an excellent business to decline in the future.

To guard against this occurrence, Benjamin Graham, Warren Buffett's mentor, would widely diversify, sometimes holding hundreds of stocks in his portfolio. He expected some would not perform well, but believed that the ones that did perform would more than offset the ones that didn't. And he was usually right, as his results often showed.

However Buffett soon tired of this way of thinking and started searching for a more efficient way to invest. He famously said that, "wide diversification is only required when investors do not understand what they are doing." This was not a slight at his mentor Graham, who would have agreed with Buffett, because Graham himself had to admit that he did not understand all of the companies he held. There were just too many of them.

Buffett eventually found what he was looking for in the works of John Maynard Keynes, Lawrence Bloomberg and Philip Fisher. When he combined their philosophies with Graham's, he arrived at an investment strategy that has served him well over the past five decades.

Buffett used Keynes' concept of the concentrated portfolio to focus his investment analysis on areas that he knew very well, and no others. During the Internet technology boom of the late 90s, Buffett refused to participate and was ridiculed by many for missing out on huge profits. However Buffett had the last laugh when the crash inevitably came. To this day Buffett does not invest in technology firms because he says that he doesn't understand their business models.

Bloomberg contributed the idea of the consumer monopoly (or economic moat). This is a business that has an extraordinarily high barrier to entry. It could be because of lucrative patents (think pharmaceutical companies), brand (for example, Coke) or a real monopoly (such as Microsoft Windows).

Bloomberg determined that such companies should be able to grow their earnings faster, which would lead to higher returns on equity and, eventually, higher share prices. By filtering on this criterion, Buffett was able to eliminate a large number of companies that had higher risks of failing. This one idea allowed Buffett to remove the need to diversify as widely as Graham had because he was relatively certain that the companies he chose had a far greater chance of success.

Coupled with Keynes' notion of intimately understanding a company's business model, Buffett was at last able to do away with Graham's need to diversify over hundreds of stocks.

Fisher's contribution was the idea of investing only in top-notch businesses and never selling them. This contrasted starkly with Graham's strategy of buying undervalued businesses and then selling them when they reached fair value.

Putting it all together, Buffett now had the seed of his investing strategy. Look for fundamentally solid stocks that represent good value with a built-in margin of safety, invest only in top companies that have a high barrier to entry, only invest in what you know, concentrate your holdings and hold your investments for a very long time.

If you'd like to outperform the stock market, then you can do very well following Buffett's method. He's already proved it works, so why not put it to work for you?

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Mark's best-selling software package is the acclaimed Value Stock Selector. It was designed for investors of all levels to help them find undervalued stocks sporting exceptional fundamentals with just a few mouse clicks.

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Equity Research for Value Investing

Despite many of the negatives that we hear about DCF-based stock valuation these days, it is still a mainstream method for stock valuation as part of fundamental equity research. In his 1992 Berkshire Hathaway (BRK.A) annual report concerning the DCF stock valuation method, Warren Buffett stated "In the Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset." Many of the popular stock market report bands equity analysis resources that retail value-investors rely on utilize this stock valuation method. This article will examine the strengths and weaknesses of DCF-based intrinsic value calculations and why it is importing for value investing.

Let's review the main weaknesses of DCF-based stock valuation.

The first is that it requires us to predict cash flows or earnings long into the future. Data shows that most equity analysts cannot predict next-year's earnings accurately. On a macroeconomic level, the "experts" have a terrible track record in predicting jobless claims, the year-end S&P, or GDP. This is no different when it comes to projecting the future cash flow of a business when picking stocks. We have to admit to ourselves that we have tremendous limitations in the ability to forecast future cash flows based on past results and recognize that a small error in the forecast can result in a large difference in the stock valuation.

The second challenge is determining the appropriate discount rate. What is the discount rate? Should we dust off our college or graduate school notebook and look at the CAPM, which calculates the discount rate as the risk-free rate plus the risk premium?

Well, since this I learned this formula from the same guy (by business school finance professor) that convinced me as a 22-year old, wet-behind the ears student that markets are efficient, I am skeptical. The most famous value investor Warren Buffett's public comments about the issue have evolved as he has stated that he uses the long term US treasury rate since he tries "to deal with things about which we are quite certain but reminded us in 1994 that "In a world of 7% long-term bond rates, we'd certainly want to think we were discounting the after-tax stream of cash at a rate of at least 10%. But that will depend on the certainty that we feel about the business. The more certain we feel about the business, the closer we're willing to play." I'm inclined to take these seemingly contradictory guidelines from Buffett and from there derive a reasonable estimate of the discount rate as part of my stock research. With the September 1, 2011 30-Yr treasury yield at 3.51%, we must think that our discount rate for large cap stocks is closer to 10% than to the risk-free rate.

Finally, the problem with determining a feasible growth rate is that a DCF will simulate the growth rate to be eternal, and we know that no business can sustain an above-average growth rate in perpetuity.

Let's now move to the strengths of a DCF model as a stock valuation tool.

George Edward Pelham Box, a Professor of Statistics at the University of Wisconsin, and a pioneer in the areas of quality control and experimental models of Bayesian inference famously remarked:

All models are wrong, some are useful.

I would argue that the DCF model can provide a useful stock valuation estimate as part of fundamental stock research if the user follows the following principles:

1. Invest in companies that have a sustainable competitive advantage. Stock investing should be though of as ownership interests in these companies.

2. As Buffett alluded to in his 1994 letter, certainty in the business is essential. I therefore look at different measures of stability in revenues, earnings, book value, and free cash flow as part of my equity research.

3. Your stock research should include through due diligence in analyzing companies financials (income statement, balance sheet, cash flow statement, efficiency ratios, and profitability ratios over at least a 10-year period of time.

4. Before using a DCF stock valuation model or a PE and EPS estimation method for valuation, kick the tires by using a valuation model that requires no assumption of future growth. Jae Jun at http://www.oldschoolvalue.com has some very nice articles and examples on this topic (reverse DCF and EPV). I like to use the Earning's Power Value (EPV) model (described below).

5. Look at simple relative valuation metrics such as P/E, EV/EBITA, PEPG, P/B etc.

6. Employ conservative assumptions of growth and a discount rate between 8-13%.

7. A healthy dose of intellectual honesty is needed so as not to modify the key growth and discount rate assumptions to arrive at a pre-conceived intrinsic value.

8. Always use a Margin of Safety!

As mentioned, I am a big fan of Professor Bruce Greenwald's Earnings Power Value calculation. Earnings Power Value (EPV) is an estimate ofstock valuation that puts a value of a company from its current operations using normalized earnings. This methodology assumes no future growth and that existing earnings are sustainable. Unlike discounted cash flow models, EPV eliminates the need to predict future growth rates and therefore allows for more confidence in the output. It is a valuable tool as part of thorough equity research.

The formula: EPV= Normalized Earning's x 1/WACC.

There are several steps required to calculate EPV:

1. Normalization of earnings is required to eliminate the effects on profitability of valuing the firm at different points in the business cycle. This means that we consider average EBIT margins over the past 10, 5, or 3- years and apply it to current year sales. This yields a normalized EBIT.

2. Subtract the average non-recurring charges over the past 10 years to the normalized EBIT.

3. Add back 25% of SG&A expenses to, as a certain percentage of SG&A contributes to current earnings power. We use a default add back of 25%. This assumes that the company can maintain current earning's with 75% (1-input) of SG&A. The input range can be 15-25% depending on the industry. Where applicable, repeat for research and development expenses.

4. Add back depreciation for the current year. We use a default add back of 25%. This assumes that the company can maintain current earning's with 75% (1-input) of capital expenditures. The input range can be 15-25% depending on the CapEx requirements of the industry.

5. Subtract the net debt and 1% of revenues from normalized earnings (this is an estimate of cash required to operate the business)

6. Assign a discount rate (or calculate WACC if you wish).

7. Earnings Power of Operations = Earnings of the firm * 1/cost of capital

8. Divide the EV of the firm by the number of shares, to get Price per share.

The DCF stock valuation model.

In this 3-stage DCF model, free cash flow growth rates for years 1-5, 6-10, 11-15, and the terminal rate, are estimated. The sum of the free cash flow is then discounted to the present value.

The formula for a DFC model is as follows:

PV = CF1 / (1+k) + CF2 / (1+k)2 +... [TCF / (k - g)] / (1+k)n-1

Where:

• PV = present value

• CF1 = cash flow in year I (normalized by linear regression or 10, 5, 3-yr average of FCF)

• k = discount rate

• TCF = the terminal year cash flow

• g = growth rate assumption in perpetuity beyond terminal year

• n = the number of periods in the valuation model including the terminal year

Again, we must recognize that intrinsic value that is produced by our model is only as good as the numbers put into the model. If as part of our stock research we assume unrealistic growth rates (or terminal value), or discount rates, you will get an unrealistic intrinsic value result. No stock valuation model is going to magically provide the completely accurate intrinsic value but, if you are conservative and intellectually honest, and dealing with a company with solid underlying economics in addition to a long track record, you can find this method useful in identifying stocks that are priced below their intrinsic value. Buffett seemed to do OK for himself using this methodology so, if you follow the above principles, you can too.

Author says that, the article is briefly explaining the points like stock valuation, equity research and stock research for value investing and to generate a proper stock market report. You can also visit [http://www.marginofsafetyportfolio.com] for further details about all these.

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Value Investing - Magic Formula Investing Proven to Beat the Market

In his book, The Little Book That Beats the Market, Joel Greenblatt explains how investors may outperform market averages by following his "Magic Formula" - simple process of investing in good companies (ones which return high returns on capital) at bargain prices (priced to give high earnings yield).

When tested against Standard & Poors Compustat "Point in Time" database on a portfolio of approx. 30 stocks, Greenblatt's formula actually beats the S&P 500 in 96 % of all cases, achieving an average annual return of 30.8 % over the last 17 years, turning $11,000 into over $1,000,000 over 17 years. Pretty impressive!

Greenblatt's "magic formula" is a purely quantitative, long-term stock investing strategy that works particularly well for small cap stocks (<1 billion) but also works for large-cap stocks (> 1 billion). Essentially, no matter what stocks we invest in, we want a strategy that ensures we can earn much more than we could get from purchasing say a "risk-free" 10 year U.S. government bond generating approx. 6%. Greenblatt's "magic formula" method of stock investing is one strategy that achieves this.

Value Investing

The central premise in Greenblatts's stock investing strategy is that of 'value investing'. Fundamentally, value investing involves buying stocks that are undervalued, fallen out-of -favor in the Market due to investor irrationality. Greenblatt's formula for value investing you could say is an updated version of Benjamin Graham's 'value investing' approach.

Graham is author of the classic bestseller The Intelligent Investor and widely acclaimed to be the father of value investing. Value investing follows the principles of determining the intrinsic value of a company and buying shares of a company at a large discount to their true value allowing a margin of safety to ride out the ups and downs of the share price over the short term but safeguard consistent profitable returns over the long-term. The hallmark of Graham's value investing approach is not so much profit maximization but loss minimization. Any value-investing strategy is very important for investors, as it can provide substantial profits in the long-haul, once the market inevitably re-evaluates the stock and raises its price for a stock to fair value.

Share Prices & Wild Mood Swings

Greenblatt's "Magic Formula" investing is designed to #1. beat the market and #2. withstand any short-term peaks and troughs in share price. Benjamin Graham, described investing in stocks as like being a partner in the ownership of a business with a crazy guy called Mr. Market subject to wild mood swings.

Why do share prices move around so much when it seems clear that the value of the underlying businesses do not! Well, here's how Greenblatt explains it: Who knows and who cares!! All you got to know is that they do. This doesn't mean that the values of the underlying companies have changed. And that's what Greenblatt's "magic formula" takes advantage of once you stick with over the medium-to-long haul.

Screening Stocks: How to Beat the Market

Greenblatt's "Magic Formula" uses two simple criteria to screen stocks for investing.

1. Earnings Yield

First, stocks are screened by Earnings Yield i.e. how cheap they are relative to their earnings. The standard definition of Earnings Yield is Earnings/Price i.e. Earnings Per Share. Greenblatt has a slightly different definition of Earnings Yield and calculates it as follows:

Earnings Yield = EBIT/Enterprise Value EBIT (Earnings before Interest and Taxes)

is used in the formula rather than Earnings as companies operate with different levels of debt and differing tax rates. And Enterprise Value (Market Cap plus Debt, Minority Interest and Preferred Shares - Total Cash and Cash Equivalents) is used in the calculation rather than the more commonly used P/E ratio. This is because Enterprise Value takes into account not only the price paid for an equity stake but also any debt financing used by the company to generate earnings.

2. Return on Capital

Next, Greenblatt's "magic formula" screens companies based upon the quality of their underlying business as measured by how much profit they are making from their invested capital. Return on Capital is defined as: Return On Capital = EBIT/(Net Working Capital + Net Fixed Assets)

Net Working Capital is simply capital (cash) required for operating the business and Fixed Assets are buildings etc. Greenblatt's "Magic Formula" simply looks for the companies that have the best combination of these two factors and voila....more or less. I think it could be worthwhile to look under the bonnet of any companies that satisfy these 2 criteria.

For instance, you might want to consider how sustainable is the company's competitive advantage i.e. how long can a company sustain its superior Return on Capital invested. Also, when applying earnings yield, make sure you are using normalized earnings (rather than overstated or super-normal earnings)? So now that you understand the 2 basic criteria by which Greenblatts "Magic Formula" screens stocks, how do you go about actually doing this for yourself?

How to Pick "Magic Formula" Stocks

The following is a step-by-step breakdown of how to pick "magic formula" stocks.

1. Screen for stocks with a minimum market capitalization (usually greater than $100 million)
2. Exclude any utility and financial stocks. This is because of the difference in their business model and how they make money and the oddities of their financial statements
3. Exclude foreign, non US companies (American Depositary Receipts)
4. Determine the company's Earnings Yield = EBIT / Enterprise Value.
5. Determine the company's Return on Capital = EBIT / (Net Working Capital & Net Fixed Assets)
6. Rank all companies above the chosen market capitalization by highest Earnings Yield and highest Return on Capital
7. Invest in 20-30 of the highest ranked companies, by acquiring 5 to 7 stocks every 2-3 months over a 12-month period i.e. dollar-cost-averaging.
8. Re-balance portfolio once per year. For tax purposes, sell losers one week before the year-end and winners one week after the year-end.
9. Repeat.

This is quite a tedious and time-consuming exercise to undertake by yourself.

"Magic?" Or Discipline?

When it comes down to it, Greenblatt's "magic formula" is relatively simple to understand compared to some of the other convoluted qualitative stock-picking methods out there. So, the toughest part about using the Magic Formula isn't the specifics of the two variables; but actually having discipline and the mental toughness to stick with the strategy, even during bad periods i.e. periods of low-returns.

Greenblatt explains that his strategy will work even after everyone knows about it. Why? Most investors and money managers seek short-term results. Their investment time horizon is short; hence they typically bail after a one or two year period of performing worse than the market average. Remember, this is a long-term strategy. On average, in 5 months out of each year the magic formula performs worse than the overall market. But over a period of 17 years it was shown to generate an average annual return of 30.8%

If the formula worked all the time, everyone would use it, which would eventually cause the stocks it picks to become overpriced and the formula would fail as there would be no bargains to be had. But because the strategy fails over short periods of time, many investors bail, allowing those who stick with it to get the good stocks at bargain prices. In essence, the strategy works because it doesn't always work - a notion that is true for any good investment strategy. So, in summary, if you're looking to build wealth and become rich and are not a hurry to do so than this "magic formula" stock market investing strategy just might be a really good starting point for you.

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What Is the Difference Between Growth Investors and Value Investors?

In stock investing, there are different terms that are often used to explain various investment concepts. For those of you who are planning to venture into the stock market or are already in this business, you must have heard of a growth stock and value stock. These are common terms used in investing but what exactly do they mean?

It is difficult to come up with a clear and set definition of growth and value stocks. However, there are some criteria that are used to define these stocks. It's important to mention that growth and value are not only methods of investing but also act as a guide for investors to narrow down their options and know what to invest in. For those who understand the stock market well, you will agree that there are times when growth stocks perform very well and others when value stocks excel. It is a wise investment practice to have stocks in a diversified portfolio in order to cut down on your risks.

Growth investors are those who focus on growth investing that revolves around a stock that has exhibited a potential to grow. On the other hand, value investing focuses on under priced stocks but still have enough room to increase. Growth stocks are usually associated with strong growth capabilities. Here, investors are keen on having a stronger return on equity. If you are interested in growth investing, you need to take into account both the pre-tax earnings and the earnings per share. Once this has been done, it is wise to project the future stock price in order to have a good idea of how much you are likely to earn.

As a growth investor, you need to be wise and use your judgment and common sense to make wise decisions. It is possible that the stock might currently not meet all the criteria but still has a chance to qualify as a solid growth stock.

Some people think value stocks are cheap stocks which is not the case. However, there are some instances where value stocks are listed alongside the lists of firms that have hit a 52-week low. For investors, value stocks are used as the bargain for investing. The ultimate aim of value investing is to select stocks that are under priced and wait for the prices to attain their ideal market rates.

How do you identify value stocks? A good way to choose a value stock is to find stocks with a price to earnings growth ratio of less than 1. The price earnings ratio should rank at the bottom 10% of all firms. A good value stock is one whose share price is a tangible value.

There are investors who prefer to focus on one type of stock and ignore the other. This is not a good strategy because diversification of portfolio of both value and growth stocks is the best and guaranteed ticket of obtaining good returns. If you are a beginner, investing in both stocks is a good starting point.

Ronald Hudkins has written articles, regulations, supplements, eBooks, Paperback and eReader books in both fiction and nonfiction publications across multiple genres. He has audio format books, provides various training courses and book reading lists in marketing, investments and health. To find out more about this author and his multiple publications and tasks visit his author platform at http://www.RonaldHudkins.com

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