Valuation

• “Safety and value are qualities conferred not by the nature of an asset, but by the price at which it is acquired.” James Grant, Forbes October 28 2002
• “I believe in stocks for the long run - but only is purchased at the right price.” Bill Gross, Pimco's December 2008 Investment Outlook. That's Mr Gross' underling, not mine.
• “[I]n the long run, everything depends upon value: the price you pay when you get into the market” Bull! A history of the Boom by Maggie Mahar. Connolly Report front page, first line April 2004 along with a chart of the cost of dividends going back to 1986. Dividends were not cheap in 2004 at $30.80 per dollar. Dividends are half that price per dollar as I key this in March 2009
• Analysts exist to sell stories…remember that Thomas.
• “a high price can turn a investment issue [common stock] into a speculation” p. 438 Security Analysis by Graham and Dodd 4th edition, 1962.
• “The single factor that drives investor success is not picking winning firms, but rather the entry point at which the firms are purchase.” Sept'09 D.R. for J.S.

• “If our initial purchase price of a stock is at too high a p/e ratio, we will never earn the ROE of the company for our invested capital.” Dr. Peter Kirkham 52 Feb'09
• “You can destroy a lot of value by overpaying for for a security. It could be a great company but it may not necessarily be a good investment if your overpay for it at the outset.” Juliette John, lead manager, Bissett Dividend Income Fund, june 17 2009
• “stocks are probably still the best of all the poor alternatives in an era of inflation - at least they are if you buy in at appropriate prices” Warren Buffett, Fortune magazine 1977. Notice Mr Buffett's last few words. If you do not buy at appropriate prices, your future returns will be euchered.
• Stocks purchased with a p/e between 10 and 15 returned 10.3% subsequently. Stocks bought when the p/e was 20 or over returned 1.1% (Fortune, December 2009 page 38 - based on median data from 1926 to 1998 for S&P 500)

I will be adding more to this page. Valuation is a most important topic.

My primary indicator of value, since I began the Connolly Report close to twenty nine years ago, has been yield. Yield was the preferred valuation method* (dividend payments were actual cash) decades ago because earnings could be manipulated: hence the P/E ratio was unreliable. Today, though, earning are not manipulated, are they? Since April of 2003, I have also used Graham value. I'll do a page on Graham value soon. I compute cyclically adjusted (ten year trailing) P/E too (C.A.P.E.), of course and price to book, now and then. (As I write this in February 2009, bank stock book value ratios are not down (should we say 'yet' down ) to historic low price to book values (for instance, BMO's p/bv was .89 in 1984) * Peter L Bernstein, Financial Analysts Journal, March/April 2005:'Dividends and the Frozen Orange Juice Syndrome' This is a great six page paper which included this statement: “For a rational investor, investments that never yield cash are extremely risky.” Would you buy an apartment building in which the tenants did not pay rent or deposit money in a bank that did not pay interest? Is buying a stock which does not pay dividends, or gold, any different?

Part V of James Grant's last chapter in Mr. Market Miscalculates (MMM pages 381 - 389) discusses Graham's seven criteria for conservative stock selection. It's great and worth the $20 price of the book alone. The bonus, other terrific material in Grant's book on pages 266 (bonds), 76 (stocks vs. bonds), x, xv, 394, 95, 36 (risk), 412, 81, 386. Subscribers will get a book report inside this site. If you don't at least glance at these pages from Mr. Market Miscalculates (at an independent book store - I do not buy from Heather), I hope you end up with an expensive stock and a piddly return, or with a bond just as the current cycle ends (interest rates began to fall in 1981 - ask yourself if rates can go much lower).

• “Starting valuation is one of the most important factors in determining future returns.” Active Value Investing by Vitaliy Katsenelson - a good book about 'Making money in range bound markets'
• © Connolly Report - For your own non-comercial use only.
• “the return to investors over a given period depends upon tow things: the return made by the companies on their net worth and variations in the extent to which share prices are over- or undervalued” p84 Wall Street Revalued by Andrew Smithers. Hence, you can buy the stock of a good company, one with a high return on equity, say, but if you pay too high a price for the shares you cannot obtain the high return.

• “It's an investors low entry point that keeps on giving.” Grant, MMM p.394
• “Timing of entry is everything.” Dr. Peter Kirkham, Jan 9 09, #30 Part II

SNOWBALL 8.2% vs 12.9% Here's an example of what is meant by “timing of entry is everything”, as my neighbour Peter Kirkham says. We bought a batch of TransCanada in April of 1999 for $18.60 a share (a decade ago). In early 2000, TRP reduced its dividend. We bought 500 more TransCanada just after that dividend reduction (from $1.12 to .80) on March 17 2000 for $11.80. We still have all those shares. The yield now on our 1999 TRP is 8.2% (1.52/18.60) and the yield on our St Patrick's Day TRP is 12.9% (1.52 / 11.80). I write this in early February 2009 just as TransCanada has announced its 2009 dividend increase (from $1.44 a share to $1.52 a share). The market may be down, but our income is up. Some would say I could have (or should have) sold our TRP in 2007 before the market crashed in 2008. But if we sold, we would have lost our 12.2% yield. We kept our shares. Our yield is now just about 13% (In comparison, as I write this in the 2009 RRSP season, the first year yield on a TD stepped GIC is 2.25%. You decide if you want a guarantee of your money back and 2.25% or a 13% dividend yield from a fine company providing a needed service.) In a period of low interest rates, a 13% yield is 'right some' terrific. It beats the market…on yield alone, never mind counting the price of our shares, which after all the carnage in 2008, are still close to three times what we paid for the last batch in 2000. This is what dividend growth investing is all about. However, we had to wait ten years for dividend growth to work its magic. ARE YOU PATIENT? You need patience with this strategy. “As a result, he [Warren Buffett] tends not to sell, letting the snowball gather weight as it rolls downhill” (Economist October 18 2008 p.95 book review of The Snowball: Warren Buffett and the Business of Life by Alice Schroeder. Mr Buffet, in his 2009 Letter to Shareholders, put it something like this: hold through thick and thin, though we prefer thick and thicker.

There's no doubt, the market sank in 2008. But from what? Giddy heights. If you purchased your dividend growers some years ago, even with the crash, the current price will most likely still be nicely over your purchase price. There' no problem, as we know, that after a long, long, bull market (it began in 1981), prices sink well below the mean. That's where they are now…early 2009. You get higher future returns, if you buy at lower prices (8.2% vs 12.9%) as in this TRP example.

WHEN TO BUY - In the July 19 2008 issue of The Economist, I found this sentence in the obituary section on John Templeton: His iron principle of investing was “to buy when others are despondently selling and to sell when others are greedily buying”. Question: Are people despondently selling yet? As of February 3 2009, I do not think so. The point of “maximum pessimism” as Sir John called it, in my view, has not yet arrived. I remember quite clearly going to an RRSP presentation by Dominion Securities in February 1981…months before the great bull market started. There was no way people at that meeting were going to buy stocks even seven years after the 1974 crash.

• “'true' financial value is itself a suspect notion” Emanuel Derman, My Life as a Quant.
• from Buttonwood Blog May 8 2009 “In theory, the value of a stock is equal to the future cashflows received by investors, discounted at the appropriate rate. The curse of investing is we know neither what those cashflows will be, nor the right discount rate to use. But because we have data going back many decades, we do know what cashflows investors actually received from individual stocks. As to the discount rate, we can use either the return from the overall market or that return suitably adjusted for a stock's volatility (its beta).”

from Warren Buffett 2009 Letter to Shareholders

• “We like buying underpriced securities…”
• “Price is what you pay, value is what you get.”

Prefer Mr. Buffett's own words: not words about him.

• At the peak of the market in 1929, the p/e was 20. “By contrast, in 1949, at the beginning of this* bull market, stocks were priced at only 5.4 times earnings.” (the yield was 7.6%) from The Evaluation of Common Stocks by Arnold Bernhard, page 1. *This book ( a series of four lectures, actually) was written in 1959.
• FORWARD P/E: “nearly 80% of analysts choose the forward P/E as their preferred valuation method. The second most popular valuation technique is relative valuation.” Dukes et al (2006) Journal of Investing. James Montier in his Behavioural Investing text has a chart of this data. By using forward P/Es, realize, analysts lower the P/E and make the stock seem more value priced. Remember that analysts exist to sell stories. Sell the sizzle, they teach in marketing classes, not the steak. Beware of 'story' stocks.