Value Investing w/ High Quality?

"Value lies in the eyes of the beholder," is a tremendous insight toward further understanding what it means to be a value investor. Often times, I've seen it associated with deeply depressed or "recovery" investment themes, or the famous "cigar butts", which all basically derive their profitable outcome from the avoidance of further deterioration - simply turning the corner, and getting back to break-even. Pardon me for saying so, but that sounds awfully challenging and places such a large emphasis on some type of catalyst taking effect, which is further complicated by the fact that the uncertainty associated with this is extremely high, and one's dependence on coming up with a fair value estimate is as accurate as my jump shot - I don't play basketball. In my previous post, I discussed how value investing (successfully) comes down to a quality estimate of fair value and the discipline and patience to hit your mark when the appropriate margin of safety is in place. If I don't have a good sense of what the investment/company is worth paying for, how could I be any good at finding and profiting from my investment decision, except for good old fashioned luck? I'll give you one exception, which is that there are analysts out there kicking the tires of these companies and traveling to meet with company managers, suppliers, clients, and trying to fit all the pieces of this massive puzzle in place, who might ultimately obtain some kind of informational advantage to which they can lessen the uncertainty of these deep value opportunities, but things change, faster than one can imagine, and the consistency in getting it "right" often times could be attributed to luck - a broken clock is right twice a day.

Enter value investing with a high quality bent. If you've ever heard of Donald and Stephen Yacktman, these guys are basically the poster child of the approach - in my opinion. Nonetheless, I've gained my own personal affinity toward the approach out of my own common sense, and realization that I know what I don't know and what I'm capable and tolerant of doing. So, what is "high quality"? Answer probably depends on who you're asking (as always) but my definition could basically boil down to a few (not exhaustive) of the following: consistency in operational performance - operating margins, return on assets and return on invested capital, generation of free cash flow, payment of dividends and a clear history of increasing them, low business risk/financial leverage, and an economic moat or some kind of competitive advantage. Why does consistency matter? It lessens the amount of uncertainty associated with the company and therefore increases my level of confidence in determining the intrinsic value of the company. Amazingly, these are all things that I can look for with the help of a decent stock screener, and I know that high quality management can be assessed in two ways: qualitatively and quantitatively, so I choose to let the numbers speak for themselves. Keep in mind that I'm not looking at price/multiple ratios, or trying to predict the next couple years of earnings. I'm trying to find the best business first and then I'll go through the process of determining a fair value. Obviously, investing can't be this easy, and things can always change, but here comes the margin of safety to protect me. I'm counting on this discount to cover me from all the unpredictability associated with the company and its future. The greater the uncertainty, the more I'll require, but I'm typically looking for 30%. So what kind of companies am I presently finding today? Here's a short list of some companies that I either own or plan to own (at the right price):

Pepsi, Unilever, Johnson & Johnson, Novartis, Medtronic, Becton Dickinson, Exxon Mobil, Chevron, 3M, Emerson Electric, Graco, Microsoft, and Analog Devices.

Good luck in 2012!,

Dave DeVita, CFA, CFP

Current Stock Screener via Morningstar

Cash / Total Assets % >= 5
Current Assets ($ mil) - Latest Quarter > Noncurrent Assets ($ mil) - Latest Quarter
Current Ratio - Latest Quarter >= 1.25
Financial Leverage - Latest Quarter <= 3
Cash Return % >= 5
Market Capitalization (mil $) >= 100 & Market Capitalization (mil $) <= 2000
Return on Assets % - Trailing 12 Months, Year 1, Year 2, Year 3 >= 6
Operating Margin % - Year 1, Year 2, Year 3 >= 8
Dividend Yield % > 1
% Below 5-Year High >= 20

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In an effort to always question my thinking and try different approaches to the stock idea generation process, or in this case, enhance/change my stock screener, I think I've found six really solid small cap companies. But it's never enough to just find a great company, because you also have to be able to purchase it at a great price, so the follow up valuation work is just as important.

Hawkins (HWKN): manufactures, blends, and distributes bulk and specialty chemicals in the United States. It operates through two segments, Industrial and Water Treatment.
Est. Intrinsic Value: $34 - Fairly Valued

Cal-Maine Foods (CALM): engages in the production, grading, packaging, marketing, and distribution of shell eggs primarily in the southeastern, southwestern, mid-western, and mid-Atlantic regions of the United States.
Est. Intrinsic Value: $33 - Fairly Valued

American Science & Engineering (ASEI): together with its subsidiary AS&E Global, Inc., engages in the development, manufacture, marketing, and sale of X-ray inspection systems for detection and security screening solutions in the United States and internationally.
Est. Intrinsic Value: $71 - Fairly Valued

Micrel (MCRL): designs, develops, manufactures, and markets high-performance analog power, mixed-signal, and digital integrated circuits (ICs) primarily in North America, Europe, and Asia.
Est. Intrinsic Value: $13 - Undervalued

PetMed Express (PETS): markets non-prescription and prescription pet medications; and other health products for dogs, cats, and horses.
Est. Intrinsic Value: $15 - Undervalued

National Presto Industries (NPK): engages in the production and sale of housewares/small appliances, defense products, and absorbent products in North America. The company operates in three segments: Housewares/Small Appliance, Defense Products, and Absorbent Products.
Est. Intrinsic Value: $115 - Undervalued

These are the moments worth waiting for

Value investing can ultimately boil down to two key elements; one quantitative and the other qualitative (behavioral). Firstly, it is extremely important to have a solid understanding of security valuation. In my honest opinion, two methods come to mind that offer the most protection from relying too heavily upon long-term terminal values and/or projections into the distant future that are by no means anything a clear-minded and rational investor can anchor on. The residual income method and a blended measure of reproduction book value, normalized earnings power, and should a franchise exist, a present value of growth, but done very conservatively so as to not overpay for this more uncertain factor. Obviously it is very difficult to ascertain an exact intrinsic value, one most recognize that he/she cannot possibly know everything, so it becomes crucially important to require a margin of safety onto this best estimate of intrinsic value. Granted, you can adjust for the perceived riskiness in the security through the use of a required return (discount rate), which I typically use in a range of 10-12%, while also demanding a purchase price range of low .70s/fair value (or lower, of course).

Secondly, and equally as important, one needs to maintain discipline and patience. Discipline in the sense of not compromising any of the valuation steps discussed beforehand, for it becomes certainly tempting to cave in and buy the company as everything is going up and everyone is making money and patience because Mr. Market is a very temperamental person who suffers from unpredictable and aggressive mood swings, which means that the market price of a company can move very aggressively (up and down) around its intrinsic value. You should most certainly have an opportunity to obtain outstanding companies at discount prices as long as you can maintain a long-term perspective in mind; a few months is hardly a long-time to wait for the opportunity to own a company with compounding value capability.

Finally, as it relates to building a portfolio of these outstanding bargains of solid businesses, value investing, by its nature, will only give you a couple chances to act. It's exactly what Warren Buffett was getting at when he said you can stand up at the plate and watch as many pitches go by as you like until you know for sure that this is the right pitch to swing at.... and swing hard. As the CFA textbook would have it, the information ratio (IR), an indication of skill for an active manager, is approximately equal to the information coefficient (IC), an indication of how much work you've done researching each company and coming up with the valuation, times(x) the SQRT(Breadth), or the number of companies you conduct research upon. Now, I'm not going to even begin to plug in various numbers, but instead, illustrate both sides using common sense. Would you rather, 1) limit the number of companies to research down to a narrowly defined list of candidates that exhibit certain positive characteristics and are engaged in businesses that you would want to own and can understand, or 2) invest in a very large number of companies without any deep understanding of what they're worth or why they would be worth owning? I hope you get the point.



P.S. There are only two sources of money to which you can act when the time is right. Cash or current holdings. If the reason you're able to buy new or existing companies is because market prices now provide you with an appropriate margin of safety, it also probably suggests that your current holdings are also down in value, which certainly hurts when you're looking to raise cash. Therefore, maintaining the discipline of reducing/selling holdings as they've reached points of offering limited/no margin of safety is extremely important in order to replenish your cash (along with being a prudent saver) so you can take advantage of these points in time.



Best of luck!