[ Valuation Methods: Price-to-Cash Flow and Contrarian Investing ]
Is there a single, best valuation method out there? Does the winner go to the low price/earnings ratio group? Or as James O'Shaughnessy advocates in his recent book, What Works on Wall Street, the low price/sales ratio?
But how about walking away from the beaten path and looking at the valuation methods the famed Warren Buffett uses? After all, his success is so well documented ( according to Buffett: The Making of an American Capitalist, his investment returns from 1970 to 1995 had a compound annual gain of 29.5%) and untouchable that the so-called "Efficient Market" theoreticians have written him off and labeled Buffett as a "five-sigma event," a statistical phenomena so rare that it practically never occurs.
Warren Buffett likes to look at something he calls "owner earnings," which is equivalent to what accountants call free cash flow. This is different from just standard cash flow, which is calculated by adding to a company's net income the depreciation and amortization charges. Free cash flow takes the extra step of subtracting from this number the additional capital expenditures necessary for the continuation of a business. Simply stated, free cash flow is what you have remaining after you are done buying all your equipment from the money you have from your earnings. The more free cash you have lying around, the better. It can be used for all sorts of purposes: providing a dividend, buying back shares, etc.
Since there aren't too many sources I know of that calculate free cash flow on an automated business, I have decided to use as a proxy the plain-vanilla cash flow figures found in various investment services like Baseline to help screen for stocks using this valuation method. Using the cash flow valuation method has been proven to have some promising results:
A study done by David Dreman (I believe he's a fund manager) looked at the 750 largest public companies from 1963 to 1985, and ranked their stocks based on cash flow to market price (price/cash flow), and measured their subsequent returns. The stocks with the lowest price/cash flow ratios generated a 20.1% total annual return, versus 10.7% for companies with the highest price/cash flow ratios.
It appears that with numbers like this, Warren Buffett was on the right track, only he extended his search to companies with pricing power. He evolved from a pure value investor (buy a basket of beaten issues, as was taught by his mentor Benjamin Graham), to a value investor who appreciated the fundamental health and strength of a business (some value investors just buy based on valuation--that's like buying purely of FA without any consideration for TA--a no-no on this thread, at least).
How about if we do the same, but with a simplified twist: in the search for Contrarian Value Plays, let's take not only the fundamental aspects of a pick, but the TA aspects into consideration as well, with the most important TA factor being that the stock is not in a downtrend. In particular, in following some of the guidelines presented in Contrarian Investing: Buy and Sell When Others Won't and Make Money Doing It, when searching for a Contrarian Value Play, let's keep the search limited to stocks with the following characteristics:
1. Price/Earnings of less than 12
2. Price/Book ratio of less than 1.0 (that's tough--the business might really be suffering if you find ones with such valuations in this market environment--maybe we could stretch it to less than 1.5 times book value)
3. Price/Cash Flow of less than 10 (actually, the book uses Price/Free Cash Flow, a different (and superior, IMO) figure, as described above)
4. Price/Sales ratio of less than 1.0
5. Non-declining TA characteristics(i.e. broken out of downtrend)
Ideally, we want something with all five characteristics, and is heading up out of a major base. I would be very interested in seeing some candidates out there. If there is anyone who could provide a screen for the first four characteristics, it would be of tremendous help to have the results posted on the thread for all to see. Afterwards, it will be simple to eliminate by eye the issues that are technically unattractive.
Please let me know if anyone has a candidate or can help in this search.
Regards,
Rainier |
