The Genius Guide to Value Investing

My son sent me an interesting article from Royal Bank of Scotland where their analysts suggested selling off stocks because they expect a 20-21% correction.

As value vultures, we have to love stories like this, because enough of them cause the lemmings to become jittery, and lemmings “flight to quality” usually the “safety” of losing money in Treasury Bonds,  leaves dozens of the world’s best companies at amazing prices.

First, to the facts. There should be a 20-21% correction. The market has been far, far overheated the last few years, and is trading outside of the fundamentals of the world economy.

The last Great Recession was precipitated by not just far too much global greed in the housing market, but by other firms short-selling the market in companies which had stocked the housing system with junk, to blow it up for their own profit-taking.

It left numerous opportunities.  And, while some banks like Citibank never really recovered from their disaster, ladder-buying other “too big to fails” did end up becoming quite profitable.  We became debt holders of General Motors (GM), which made us equity holders of the new company, and saw one of the most profitable bond plays we’ve ever done.  Knowing which end of a distressed company to get into, their equity (shares) or debt (bonds), is really a matter of looking at their balance sheet and their ability to recover and deciding if you want to be there at all, or,  if you do, which end of the investments to participate in.   We bought Starbucks at $6.16 a share, and sold it at $16.85. We bought all kinds of companies whose dividends remained relatively secure, at base rates of 10-16%, and, even some that had their dividend slashed or dropped for a period of time reinstituted them when the storm clouds cleared, and we were rewarded with gains in both the stock and in the returns on the stock again. Meanwhile fully 3/4s of our stocks maintained their dividends, which we took in at double-digit rates and provided more cash flow to buy undervalued stocks.

Then the lemmings moved back into equities, out of treasuries. We made a lot of money selling to them.  The supply of quality value stocks really dried up, which is why you haven’t seen much in the way of articles at TheValueGenius.com because we haven’t had a ton to talk about.

As you know, if you follow my investment strategies over the years, I generally can find great reward in extremely large companies that have great cash flow, generally lower debt, and resources or infrastructures that cannot easily be replicated.  This is the modern equivalent of what Benjamin Graham dubbed “grimy companies.”  All of them hit hard times that are not of their making.  Some companies accumulate value that hasn’t been discovered by the analysts, or is discounted by people who don’t understand the business model, or who don’t have faith in it when the numbers suggest that they should.

So is the sky falling?  Not really.  The softening of China’s ability to produce is significant.  They were the fountainhead of cheap goods for decades, but the signs of the wheels coming off that cart have been happening for at least five years, as we’ve seen even the Chinese farm business into Vietnam and Cambodia in search of cheap labor, and develop connectivity into Africa as a future zone of cheap labor.

We should expect the correction shockwaves to continue, but we in the value world look at it like farmers in California see rain after their long draught.

There is no end of days in this modern economy. The world’s money is too interconnected. There are going to be cliff-worthy drops in some stocks that are overheated “air” that were purchased too high by amateur investors and their even more amateurish “experts” at the full and semi-service brokers schooled in grinding stocks like sausage.

Still, bottom line, you have to ask yourself:  Is McDonalds going out of business in a major correction? Is Starbucks?  Will a company that holds 30% of the world’s resources like aluminum or tin or copper really not have any value for a decade or more?  Oil will ultimately be phased out of the world’s energy supply as will coal, but will it happen overnight or over 10, 20, 30 or more years?

People panic because they make the mistake of thinking that the number on their brokerage statements when it’s up, sometimes way up is real.  Sell when you make a reasonable profit, lock it in, and that  is true. Otherwise, it’s just a notation, just as much as when it’s down 20-30%.

How you make money, as a value investor, is sticking to the fundamentals of the craft.

Find the stocks that are dinged or damaged by circumstances, but have the strength to weather the ups and downs of the market. Buy ones that pay a dividend that rewards your patient holding of them.  Sell when you can’t see any forward growth or them taking another turn downward after a period of great years, and then even buy them again if you find that opportunity to get them at a discount and another run of bright future lies ahead.

Other people’s fear is our fodder.

So what can we expect?

China’s economy will take a substantial hit.  It will not cripple the world economy. Beyond the initial panic of the cheap goods machine not producing at double digit rates, corporates from around the world will find opportunity in exploiting China’s woes because China’s oligarchs, as they always do, will tinker with their currency, economy, and market to get things on track again, which, in effect, will be something like a “sale” on their goods and services.

It’s a correction, and the DOW, which, by real value, really shouldn’t be much more than the mid 16,000s, will correct from the 17Ks where it’s been down to a more realistic level.

Meanwhile, several value stocks will get caught up as the lemmings freak and head for the exits, and those who are heavy into Exchange Traded Funds will see how they underperform in down market conditions enough to possibly think twice about holding them long-term. (We’re not  believers in this newest form of Emperor’s New Clothes market gambling.).

Some stocks to keep your eye on:

Amgen (AMGN), Proctor & Gamble (PG), and Koninklijke Philips NV (ADR) (PHG) – Thanks to Alex Ross for that last find, an excellent choice!  All are companies that are moving out of periods of doldrums into new phases of growth. At the right discount to fair market value, at least 17% under, they are attractive buys in a down market that can be held for years and perform well.  PG was THE flight to corporate safety during the bottom of the Great Recession, as it makes so many products that are a part of daily life that it really isn’t going anywhere, and people have no choice but to buy what they can with what they have, even when bankers are jumping out of windows.

Allegedly we’re still in a Bear market, which is only borne out by the large swath of stocks still crawling out from underneath the pummeling that they took in 2009.  Some companies, many of which we had already held positions in, rebounded handsomely. Some are slower to still make the grade.  Finding new opportunities under our strict value rules of higher capital, lower debt, high cash flow and a sustainable dividend yield at a 17% discount to value is, for the first time in decades, pretty impossible. There are no stocks that fully meet our criterion.

Reserving cash or short-term equivalents, your rain barrels to call upon and BUY when either a sector or the economy overall head south is prudent to a degree, but you have to put enough capital to work that the idle capital waiting for the bigger opportunities isn’t dragging down your growth.

To avoid shrinkage you have to beat the rate of inflation. To materially grow your money you have to beat it significantly.  This is what we in the value world do patiently, not chasing hot stocks or selling in the quarter of a second.

So where do we give in, when this racing, overheated market does not provide us with investments that meet all of our objectives?

You look for the best yield on overall income with the shortest (which may be years) window for sustained growth.  The trade off (a little) is in the price. You may have to go to a 12-15% discount window, which yields just a handful of stocks worthy of your long-term holding. Let’s talk about the first one of this week… EPB.

Pipelines are great. They’re run as master limited partnerships (MLPs) that trade like a stock and, from a tax standpoint act like a limited partnership. They have huge tax breaks and incentives put in by governments, state and federal, to build them. They also have incredibly high barriers to entry for competition as government greatly limits their construction and rights of way are not cheap.  Pipelines are a “grimy business,”  absolutely necessary, good times or bad, because oil and natural gas needed to heat homes and drive cars flow through them.  They are cash cows because they are the only game in town to move a lot of material over long distances at a pretty reasonable cost that trains and trucks can’t duplicate.

These MLPs often have good tax benefits because the K1s which they put out can pass through passive losses from the company back to the limited partners. We’ve made huge returns on Kinder Morgan (KMP) and (KMR), and often times the K1s offer some additional carryover “loss” that can be useful.

Pipelines are high cash flow and Mr. Kinder and his team have proven to be exceptional asset managers with vested stakes in the companies which they own and manage that are in line with those of the limited partner/shareholders.

You can’t touch KMP or KMR for the prices we’ve paid for them in the past. Those investments have doubled or tripled and put out huge returns, but there is a newer opportunity that we feel is a good buy in to the pipeline family.

We’ve always generally liked El Paso Pipeline (EPB) a LNG (Liquified Natural Gas) carrier. You might remember selling when we had a murky view about their forward outlook for the next year or three. We like it more now that Kinder Morgan took over management of the company in 2012.  EPB pays out a 7.33% dividend right now, and while we’d like to get it at $30.00, spending up to $34.10 is still in the comfort range of acceptable, particularly with that solid dividend yield.

The company lost a couple of regulatory fights which cost it some income, but that only slowed it to flat growth over the next 12-18 months. New projects coming on line will grow the bottom line and could increase the dividend in early 2016 and beyond that is already very respectable. Note that if you file a short or EZ tax return, this will increase slightly your accounting costs because the stock puts off a K1 limited partnership form which can only be filed with a full 1040. Your tax professional may charge a bit more to process it, but it’s amply worthwhile.

On the horizon: We look for bad news for large, stable companies. Intel (INTC) has had troubles in the news with its miscalculations of the processor market that have allowed ARM, which builds low-power brains for smartphones and tablets, to eat into their core businesses. Intel will do well in the growing cloud computing market, and is going after ARM. They also have space to do build-outs for other chip makers with equipment that isn’t possible to replace. If the price drifts down to the $17 range, buy it. Right now, sadly it is priced in the mid-twenties, at or above fair market value, which is not a good deal… yet, but we watch and wait to see. (WATCH)

Watch for changes in your stocks by reading the reports for warning signs.  We’re off about 12% in Cherokee (CHKE) and selling it off with that haircut, because we don’t like the company much now.

It was a bending of our rules regarding capitalization to take on such a small company that licenses clothing brands, but with a zero-debt balance sheet of a decade, solid brands being sold by the biggest retailers (Target, Kohls, etc.), great cash flow and very respectable profits, it warranted a small  investment, especially as they sell a lot of well-known value brands in budget-conscious stores that did profit from the down economy.

While profitability has been good, the bottom line has not been:  Cherokee has been buying new brands like Tony Hawk from Quicksilver and leveraging up its balance sheets to do it.  Debt has gone from zero to soar well past the company’s cash flow, reducing returns and indicating a very big change in the way that management is running the company.

Some of these purchases like the Tony Hawk deal are questionable, as it would seem that they might have overpaid for the label. It gets worse when the company starts violating its own operational tenets to chase after possible growth in already mature brands.   Last year seemed like an aberration. This year’s increase in debt seems like a trend which we’re not comfortable with.

The dividend borders around 3%. Growth prospects are not looking strong.  Some stocks we’ll ride with for years if we think that they can work through issues, mostly because we look towards management “walking the walk” of fiscal discipline and not chasing a quick buck. We are concerned that the mangement/debt issue will continue to escalate, which, in a zero-moat company that is very minimally capitalized, can cause the dividend that is marginal to evaporate, and further impact the price of the stock. SELL.

Banks are continuing to make the turn upward away from the disasters of 2009.  Bank of America (BAC) is moving into the land of the healthy and the profitable.  Lloyds (LYG) is further behind but getting much better.  Citigroup (C) is still a work in progress. All of these banks will, barring any other major calamities, be moving into good health. If you bought at the bottom, you are already doing fabulously well. Our bottom feeder buys are up 200-300%. Unfortunately we had some top buys too, so we’re averaging the high and low. BAC will have to hit about 19 before all of the stock hits profit territory, but it’s well on its way. Preferreds did well straight through. Wells Fargo Preferred Series J (WFC.J) has been particularly good.

More as we get through the research.

Great article at our sister publication, truth-2-Power.com: