MISC INVESTMENT INFORMATION PART 1 - SUNDAY 10/18/98
How important to buy at the bottom?
The bear has taken down a lot of good stocks. But before you snap them up, look at the effect price and timing have on projected returns for Dell, Johnson & Johnson and Exxon
By Jim Jubak - Microsoft Investor
Dell Computer (DELL) sure looks appetizing. At $52.50 a share, the stock's price on Oct. 13, Dell was down about 30% from its high of $69 a share on Sept. 28.
But wait a minute. I can think of plenty of stocks that looked cheap when they were down 30% a few weeks ago -- and that look even cheaper today. Merrill Lynch (MER), for example, looked like a screaming buy when it was at $75 a share, down from $109. Remember? But the stock just kept on falling. Right now it trades at about $48 a share, almost 60% below its high. And that's after a rally off its low of $35.75.
Buying on the dip used to be easy. You plunked down your money the day after a 500-point drop in the Dow Industrials and a week later you were in the black.
But this time it's different. Investors who have snapped up stocks on a dip have seen shares dip even lower. The market hasn't bounced off a bottom -- it's not even clear that the market has made a bottom. Even after Thursday's rally, I'd argue we're still stuck in a trading range at the moment. There's enough bad news ahead that it could send the market down below recent lows. And we can't tell how far off the upturn is.
But even knowing all that, I still find myself tempted. Some stocks that I've wanted to own for the last two or three years suddenly look very affordable.
So instead of either making a trade I might regret or just fretting about passing up these prices, I decided to take a look at exactly how much it matters to catch the absolute bottom for a stock. Does overpaying by 10% or more doom me to mediocre returns forever? Does being anywhere from six months to a year early insure that I'll never match the returns on 30-year Treasury bonds?
And I got a bonus for my work. Not only did I discover the answers to these questions, I learned I wasn't even asking the most important question of all in this market.
Charting the different scenarios
My study was pretty simple. I picked three stocks: A fast-growing, volatile stock, Dell; a solid growth stock that is about as volatile as the market as a whole, Johnson & Johnson (JNJ); and a solid performer that is less volatile than the market as a whole, Exxon (XON).
(I used beta, a measure that compares a stock's volatility to that of the market as a whole, to pick. Dell has a beta of 1.6. That means it's about 60% more volatile than the market as a whole. Johnson & Johnson has a beta of 1. Exxon's beta is 0.7.
Then I built 24 different scenarios for each of the three stocks using Excel. I based my first set of 12 scenarios for each stock on its historical rate of appreciation during the last five years -- that's 69.47% annually for Dell, 23.08% annually for Johnson & Johnson, and 19.08% annually for Exxon.
In Scenario 1, I assumed that the stock would climb from the current price at the historical rate for the next five years. Needless to say, those base cases were all pretty rosy. An investment in Dell, for example, under these conditions would grow by a cumulative 1,298% over five years, from $52.50 a share to nearly $734 a share. Johnson & Johnson would appreciate 182%, to $219 a share from $77.50, and Exxon 139% to $175 a share from $73.
Then I built scenarios that got progressively nastier. First, I asked what would happen if, instead of hitting the bottom, the stock fell another 10%, 20% or 30% before starting to appreciate. Then I asked to see the results if you got the price right, but the stock stagnated for a year or two years. And then, worst of all, I combined a continued decline of 10% to 30% with stagnation for either one or two years.
Of course, all those scenarios assumed that the future would mirror the past, in that stock returns would continue to far outstrip the long-term historical returns from owning equities. So I next rebuilt all these 12 scenarios for each stock with a lower rate of appreciation. I assumed that prices in the overall market would appreciate at about 10.6% a year -- roughly the long-term rate of appreciation for large-company stocks since 1926, according to Ibbotson Associates. Then I used the betas for each stock to calculate a new rate of appreciation for my three sample stocks. That gave me 16.96% annually for Dell, 10.6% (the market rate) for Johnson & Johnson, and 7.42% for Exxon. (Please don't read these, or the historical numbers I used above, as predictions for specific stocks. I'm not making predictions here.) I plugged those lower rates of appreciation into each of my 12 scenarios.
Finally, I calculated a rough benchmark by assuming that I would be able to get 5% a year in interest and appreciation if I bought long-term Treasury bonds. That gave me a kind of minimal risk appreciation of 27.6% over five years to use as a comparison to my stock scenarios.
The results?
As you might have guessed, if a 69.47% growth rate continues to be the norm for Dell, it really doesn't matter how badly you misjudge the bottom. Buy Dell and have it fall another 30%, and the five-year appreciation sinks to a meager 678%.
Profiting from Dell is timing issue
Your profit in Dell is much more sensitive to time -- hitting the entry price right, but having the stock stagnate for two years before the historical appreciation kicks in drives the five-year gain down to 386.7%.
At worst, however, you simply can't do badly in Dell as long as this rate of appreciation holds up. If the stock falls another 30% from your purchase price and doesn't move up for two years, you'd still more than triple your money over five years.
For Johnson & Johnson, the stock in the middle, price and timing work out to be about equally important. Buy 30% too high or two years too early, and the five-year gains -- 79.2% and 86.5%, respectively -- are about the same. And again, as long as the historical rate of appreciation holds up, you simply can't lose with Johnson & Johnson. Even buying 30% too high and two years too early still produces a gain of 30.5%, better than the 27.6% from bonds.
Exxon, the stock with the lowest rate of appreciation historically, is the mirror image of Dell. The investor who overpays for Exxon suffers more than does the investor who is too early. Returns in the two cases are 54.2% and 68.9% respectively. And you can actually do worse in Exxon than in the benchmark bond scenario. If you buy 30% too high and two years too early, the five-year gain is just 18.2%.
From this half of my study, I've reached a couple of conclusions. First, stock selection is more important than calling the bottom in price or time. These scenarios do so well because I picked stocks with solid or superlative rates of appreciation. If you get the stock right, timing and price matter relatively little. And second, timing and price matter less for higher-growth stocks. You could have bought at the worst possible time and you still would have made a lot of money over the last five years.
Bull markets that produce gains about twice the historical average are mighty forgiving of mistakes in when you buy.
When the market is less forgiving
It's a very different story if you assume that rates of appreciation are going to be closer to the historical mean for the next five years. (Please note that I'm still talking about very solid positive returns.) The market is clearly far less forgiving of mistakes when prices are advancing more modestly.
For example, at this rate of appreciation, if you buy Dell at the current price and it tumbles another 30% before recovering, the gain over five years dips to just 42%. If you over pay by 30% and the stock stagnates for a year, the five-year gain is just 31%. If you buy 30% too high and the stock stagnates for two years, the five-year gain is just 12% -- way below my Treasury benchmark.
Johnson & Johnson dips below the Treasury benchmark even if you make a much smaller mistake. Overpay by 20% and see the stock only sluggishly recover for the first year, and your five-year gain falls to 26.1%. In the worst-case scenario -- pay 30% too much and see no appreciation for the first two years -- and you actually wind up with a 5.3% loss over the five years.
And Exxon, as you'd expect, dips into negative territory much more quickly. Pay 30% too much and see no growth for a year and you're already looking at a five-year loss of 6.8%, for example.
Don't leap to the conclusion that this makes Dell the superior investment, however. Some of the worst scenarios for low-beta Exxon, for example, are extremely unlikely -- a stock that's less volatile than the market as a whole isn't likely to fall 30% from its current price.
Will the future resemble the past?
To compare these outcomes, I think you have to discard the extremely unlikely scenarios for each stock and concentrate on the possible worst-case scenarios. For example, I can see a 30% fall from current prices for Dell and a one-year period of stagnation in price if the PC market continues to show anemic growth. So for Dell, a realistic worst case to worry about would be a five-year gain of 31%. For Exxon, I could see a further 10% decline from the current price and a two-year stagnation if oil demand stays depressed. That gives me a realistic worst-case five-year gain of 11.6%.
But the most important conclusion I've drawn from all these case studies is that purchase price and timing aren't the most important things to worry about. The real question is: To what degree will the future resemble the past?
If we're looking at a resumption of the gains of the last five years after this economic mess has worked itself out, then timing and pricing aren't terribly important. But if you think that the world economy will grow more slowly even after the current crisis passes, and that the amazing returns on capital of the last five years will come back to earth, you need to buy carefully. That's only when you see evidence that a stock has formed a price bottom and that sales are headed back up.
Frankly, I think the latter outlook is more likely. So be careful out there.
Interviews
These stocks are down, but not out.
While others see gloom, contrarian value investor Elaine Hahn is happily pursuing discounted stocks like Union Pacific and Jacobs Engineering
By Eneida Guzman
Benjamin Graham and David Dodd, the legendary value investors, left Wall Street an investment legacy that may be perfect for the current market environment. Contrarian value investing -- buying solid but unloved businesses that are trading at marked-down prices -- is giving its disciples an opportunity not seen since the early '90s.
Elaine Hahn, founder and president of San Francisco-based Hahn Capital Management, is one practitioner. She uses the $65 million her firm manages for high net-worth investors (minimum account balance: $500,000) to buy out-of-favor companies that have improving fundamentals and catalysts in place that can move stock prices higher. Her favorite indicator is pretax cash flow -- the amount of money a company takes to the bank. "A company's real value can be found above the bottom line, and pretax cash flow is the purest way of determining that," Hahn says.
Amidst a lot of gloom in the market, Investor found contrarian Hahn excited about the opportunities at hand.
Picking stocks in this market must be like trying to catch a falling knife. Tell us about your approach.
Our investment philosophy is driven by a value contrarian orientation. In other words, we like to look for companies that have depressed valuations relative to the market, to their peers and to the industry that they're in. But we're not just looking for cheap stocks. We're looking for stocks that have something intrinsic that reflects the future value of that company's assets. So what we try to do is look beyond fundamental earnings and identify the specific intrinsic value characteristics of the company. That might be assets on the balance sheet or it might even be the value that the company might represent to a buyer. Once we've found companies that meet our valuation criteria, we try to identify catalysts that we call "value creators," which are going to ultimately improve the depressed valuations as well as the investor psychology that may be keeping the stock at those low levels.
What's a 'Value Creator'?
What would be some of these 'value creators' that you're looking for?
They include things like the restructuring of a company, changes in the management team, industry consolidation, new legislation that might stimulate revenues -- that sort of thing. As contrarians, we tend to step in when we sense either that the consensus is misguided or that a sell-off is overdone. Stocks tend to move in groups, so you typically get kind of an extension of whatever the consensus is. Ultimately, what we're trying to figure out is whether or not a sell-off or depressed valuation is really justified given the fundamentals of the industry or the company.
The Dow has been off as much as about 1,900 points from its high this year. Is this sell-off exaggerated or justified?
It's justified in some areas and exaggerated in others. Realistically, at the peak of the market back in July, most stocks in most sectors were excessively valued relative to forward earnings and cash flows. That sort of excessive valuation needed to be addressed and corrected. At that point, the bull market was extended way beyond the historical valuations seen in 1987 and 1973. At the peak of the market on July 17, the S&P 500 index price/earnings multiple was about 30. S&P earnings in 1998 were projected to grow at 6% over 1997's earnings. So you had a 30 multiple vs. a 6% growth rate -- effectively five times what you should be paying for that growth. Never before in our market history has the P/E to growth rate been that high.
It seems ludicrous that you would expect investors to pay 500% more for a company's earnings than those earnings are really worth. So that said to us something here is way out of whack. There were sectors and industries that clearly were not particularly overvalued. That was certainly true in the small and mid-cap sector. Especially in mid-caps, we saw continuing solid earnings growth. We continue to see very sound fundamentals in the area, but the broad sell-off literally took the baby out with the bath water.
You believe that a company's real values are most often found above the bottom line in their pretax operating cash flow. What specifically are you looking for there?
Our definition of pretax cash flow is earnings before interest, taxes, depreciation and amortization, or EBITDA. I specifically look for the amount of money the companies are taking to the bank, and that's pretax operating cash flow as opposed to earnings per share or net income, which will often include charges and other non-cash accounting earnings. Another ratio that we use is return on capital investment. If you build a plant that's state-of-the-art, and it replaces an older plant, normally the new plant will generate a higher return on its investment than the one that it displaced. Here we're looking for constant, improving profitability of the assets which translate into growing cash flow -- cash flow being the net result of whatever is produced from those assets.
On track for profits
Ultimately, your goal is to find companies that are trading at a discount to their private market value. Given the market's dramatic sell-off over the past three months, are there some names that are getting your attention?
Yes, there are. In our entire universe of stocks, the favorite is Union Pacific (UNP). They are the largest railroad company in the country. Since acquiring Southern Pacific, they now have about 36,000 miles of track. The industry has gone through a lot of consolidation. The leading players have merged with each other over the years to take advantage of geographic synergies. The mergers were also designed to make the industry more efficient. That was the expectation.
The reality was that they underestimated the complexity of combining large rail systems. That was Union Pacific's mistake, as well. Somewhere in midsummer, the Surface Transportation Board, a division of the Department of Transportation, stepped in and required the company to give up some of its business to other carriers in order to get the traffic moving again. That set the stage for Union Pacific to recognize that it needed to go through a restructuring of its own. They've recently gone through decentralization where they have created three regions with three separate operating systems and three separate teams of managers to basically work within their region to improve operations and serve customer needs.
Union Pacific's stock has suffered some disappointing setbacks this year. Is there light at the end of the tunnel?
We think the company is well on its way to getting back on track. No pun intended. They've added 282 new locomotives; they've added another 4,500 workers because they were enormously understaffed. We've spent a lot of time talking with the management of the company. Rather than rely on Wall Street research, that's one way we try to get our arms around a company.
What is management saying?
Traffic levels are up and car loadings are rising. And although the company is not expected to end the year with positive earnings, they are poised to earn $2.35 a share in 1999. The company has an enterprise value of $75 a share. And a few analysts have recently raised their rating on the stock to "buy" from "hold."
Any other picks with solid 'value creators' in place?
We also like Jacobs Engineering (JEC). It's a small engineering and construction firm. They specialize in constructing on a cost-plus basis as opposed to a fixed-cost basis, meaning that they're able to keep their costs as low as possible; and if those costs go up, they pass them through to their customers. They primarily build manufacturing facilities for pharmaceutical, biotechnology and environmental remediation customers. The key here is the particular niche that they have, working on a continuing basis with existing customers and keeping a fairly well-defined business strategy that focuses on the U.S. market. They've been able to limit their exposure in the foreign area, unlike some of the other, bigger players such as Fluor (FLR) and Foster Wheeler (FWC).
The company has historically grown at 13% a year and it trades at 13 times earnings. Where is the value?
In the past year the company's sales have increased at a 19% annualized rate. Earnings and return on equity have increased 16% and 15% respectively. Their fiscal year just ended Sept. 30, and we think earnings will come in at $2.08, and next year we expect them to hit $2.36. Another reason we're attracted to the stock is because it is under-followed. Few analysts track the company.
What's the catalyst that will get the stock to trade higher?
Jacobs is in an industry that will continue to consolidate over the next few years in order to achieve greater efficiency. We believe Jacobs will be an attractive acquisition candidate to a larger player because of its niche in specific markets and its efficient cost structure.
An energy sector fan
I hear you like the energy business these days -- the ultimate contrarian play. Why?
The prices of oil and gas have come down quite substantially over the last several months and we haven't yet seen a recovery from the lost business precipitated by a drop in crude and gas prices in the last few years. But as we look ahead over the next couple of years, we see a substantial contraction in supply and a resumption of the growth of demand worldwide as the Asian countries begin to pull out of their recessions. So the overall price of crude will begin to rise. It's likely that it has already bottomed out. Crude oil went to about $11 and it's now up to about $15.50. We see it getting to about $18.
Which stocks do you like in that sector?
The two stocks that we own in this sector are both oil service companies. The first is Weatherford International (WFT). The other is Halliburton (HAL). Both have recently merged with other companies in their business, so they clearly have value creators in place to help them achieve certain economies of scale by combining businesses in similar areas. Weatherford is trading at six times cash flow and nine times 1999 earnings estimates. That represents the lowest cash flow and P/E multiples for the company since 1992. Halliburton is also trading at historically low cash flow and P/E multiples. So they are both very compelling from a valuation standpoint and we continue to add to our positions in both stocks.
We'll take one more.
Another group that's sold off even though many of the sector's fundamentals are quite good is the real estate investment trust group. One of the companies we think is really outstanding in this area is Chelsea GCA Realty (CCG). It is the largest developer of upscale factory-outlet shopping malls in the country. They build these facilities in areas that get a lot of tourist traffic. The company is now paying a dividend yield from cash flow of 8.2% and, is also growing earnings by about 12% annually. So if you were to assume that you'd get somewhere in the range of a 10% to 15% price appreciation and you added in that 8.2% of dividends, you'd have a 20% total return, with very stable earnings growth. A stock like this is interesting to people who want more stability and dividend income in their portfolio.
In anticipation of a global recession, you focused on domesticating your portfolio this year. Has that helped your performance?
In the beginning of the year, as we began to see foreign markets -- and the emerging markets in particular -- deteriorate, we began to look at our portfolio and figure out if we could increase the domestic orientation. That in and of itself has contributed enormously to the stability and consistency of our returns for the past three quarters, and we think that has been a good strategy to employ as the market continued to worry about foreign sales, particularly with respect to the multinationals. So if you look at the companies we've given you as names, the common denominator is that their businesses are almost entirely domestic. We think that's one of the reasons why the profitability of these companies will hold up going forward.
Opportunity for value investors
As a contrarian value investor, your outlook is quite hopeful for the overall market at this point. But consensus views are proving you wrong so far.
I think that we are now seeing some of the best opportunities as value investors that we have seen, probably, in the last two to three years. Even though we expect that profits will continue to be under pressure, when we are looking for real intrinsic value we try to look at other variables that tell us if a company is undervalued. A telling sign about valuations in the market today is the fact that so many companies have been sold with little regard to their underlying intrinsic values. As we look at the companies' operating cash flows, we can often determine if the market is pricing those cash flows on a multiple basis correctly.
How do you determine that?
One way is by looking at historical multiples of cash flow for the industry as a whole and for the company. It's much better to look at the company's profitability today relative to its profitability in prior periods of prosperity than it is to look at the company's prosperity relative to the market as a whole. If we see substantial difference between the current price and the ratios that we are looking at comparatively and historically, we can often identify great investment opportunities. And that's what we're finding today.
One company that we like as it relates to historical cash flow and comparative multiples is the timber company Rayonier (RYN). It's only trading at 6.1 times cash flow, which is 60% of the industry average. And the company's EBITDA margin is now 23% compared with its historical average of 19%. That is a significant improvement. For investors who are discouraged and unsettled by the degree to which stock prices have dropped, it's helpful to know, or at least interesting to know, that this kind of environment presents them with an opportunity to find hidden treasures in the market. Only they have to do a little homework to look for them rather than listen to the market strategists tell you whether we're going up or down.
Are you saying that the market going forward will discount earnings momentum and reward stock pickers?
It's going to be a value investor's market, more so than a growth investor's market. Many companies today have seen a drop in their earnings per share but not a drop in their operating cash flows. Basically, that says that the fundamental businesses are in very good shape, and they're able to offset some of the decline in sales that they may be experiencing as a function of lower economic growth with changes in their operating expenses. So you have to get into the financial analysis of businesses in order to know whether or not a company is undervalued.
It seems you are not too concerned with the impact of the domestic political situation on our equity markets.
If you're talking about Clinton and the probability of an impeachment proceeding, I think that if it has any impact at all it will be a very temporary one, and again probably represent an opportunity to buy if the market were to sell off. I don't think that it has a structural impact on corporate profitability, and ultimately that's what you're buying. You're buying a piece of a business, not a piece of a political system.
Learn more about Elaine Hahn on the Hahn Capital Management Web site.
hahncap.com
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