Low P/E

Thank You David Dreman. His books were the first that led me to become a value investor and I actually followed his strategy that he lays out in the book for a while. I started having problems when I bought cyclicals and value traps. Apparently, no one told me at the time that low P/E’s  in cyclicals were a bad thing.

DCF

I first learned about discounted cash flows from the Fool.com. I thought they were the holy grail of investing and especially for any value investors. Plugin some numbers, change the discount rate, and WHALA!!  I soon found myself doing the same thing as Warren Buffett. While I found nothing wrong with discounted cash flows, I always had it in the back in my mind that a change in growth rate or discount rate could change the values produced and thus, I have avoided DCF for the most part.

Magic Formula Investing

At last, a simple strategy that is endorsed by well known value investors. Only problem, no rankings and some clunkers along the way. I actually know someone doing a magic formula portfolio that is fully automated and he is outperforming the market.

Magic Formula Investing +1

My current and most successful “strategy”. I screen stocks on the magic formula list, and buy when they are trading at a discount. I do not rely on future earnings,only present cash flow. While not 100% crash proof, my results have been great and it fits my style. I do not worry what a stock is going to do, how the economy is going to look in the next X months/years, etc…

Finally, being a value investor is fun and rewarding. Is it for everyone? I don’t think so. I personally do not look at my portfolio throughout the week. I do my stock research on the weekends (usually Sunday), enter my orders , if any, Monday morning. Some people have t be looking at their portfolios throughout the day. How do I avoid my portfolio? Most of it has to do with my mind being conditioned that the magic formula works, but more importantly why it works.  As this crisis continues to unfold, I was convinced I was going to go crazy trying to decide which stocks to buy. Surprisingly, I haven’t been that active. And if you notice, Warren Buffett hasn’t been that active on te stock sides. His bets are mainly on the debt side of things.

Definition of shorting according to Investopedia.com

The selling of a security that the seller does not own, or any sale that is completed by the delivery of a security borrowed by the seller. Short sellers assume that they will be able to buy the stock at a lower amount than the price at which they sold short.

Yes, some individuals are successful

Bill Ackman comes to mind as a successful short. Im pretty sure there are other individuals who have successfully shorted stocks for a living and will continue to do so.

Logic

I might not be the smartest men alive, but logic is the main reason I avoid shorting. Here it goes:

If I short a stock, my biggest gain will be 100%  and my biggest loss could be limitless (assuming I do not get a margin call). On the other hand, if I buy a stock, my gain could be infinity, while my downside is limited to losing my intial investment or 100%. Now that’s what I call controlling my risk/reward.

An example:

On January 2007, David Dreman wrote an article for Forbes properly titled “Short The Exchanges“, in which David Dreman considered the stock exchanges (CME,ICE,NYX). At the time of writing, Chicago Mercantile Exchange Holdings (CME) traded at $530. The stock continued its unprecedented run up to $714. The stock is well off its highs, but an individual would have had to stomach a 35% increase in CME’s stock price.

Without a doubt Warren Buffett and Charlie Munger have provided some of the most memorable quotes in the investing arena. Not too far behind the dynamic duo are the late John Templeton and the contrarian maestro himself David Dreman. Below are four memorable quotes David Dreman has enlightened the world with.

1. “Psychology is probably the most important factor in the market – and one that is least understood.”
2. “I paraphrase Lord Rothschild: ‘The time to buy is when there’s blood on the streets.’”
3. “One of the big problems with growth investing is that we can’t estimate earnings very well. I really want to buy growth at value prices. I always look at trailing earnings when I judge stocks.”
4. “If you have good stocks and you really know them, you’ll make money if you’re patient over three years or more.”

It’s pretty hard to argue with any of the above quotes. All four quotes are only part of the solution in outperforming the market. Number four in particular is something most investors (including myself) lack, patience.  In a world where everything moves at a fast pace, its tough waiting for value stocks to rebound. Ultimately, its the patient investor who is able to wait out the storm who benefits the most when contrarian stocks rebound.

A particular Warren Buffett quote reminds me that doing nothing is good:

“”I call investing the greatest business in the world because you never have to swing. You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! and nobody calls a strike on you. There’s no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it.”-Warren Buffett

With 14% cash on hand, its tempting to get into some positions. Especially Microsoft which has been climbing the magic formula list this past week as it hits new lows. I continue to tell everyone I know that the magic formula has to be among the most undervalued books/sites/investing system around. Where else can I find a screen that looks for great businesses at a discount. Its only a matter of being patient and sticking with the system. For many years studies have proven that low P/E’s outperform the market, but investors/speculators continue to invest in companies that are trading at sometimes catastrophic P/E’s. Companies with high P/E’s are usually dangerous in this type of market as analysts expect companies to deliver outstanding numbers. What happens next? The company delivers great numbers (usually double digit growth ) but the stock gets pummeled (i.e. AAPL, GOOG,MSFT). How do low P/E’s fare during earnings season? Good. David Dreman highlights this in the book. Expectations for these companies are so low, no matter what kind of numbers the company reports, chances are a) a positive earnings surprise will make the stock soar (WFC)  or b) the news has been priced in already.

1. Avoid the market while it is open.

As mentioned in my article The Secret To Value Investing, avoiding the market while it is open will rid of any temptation one might get while watching CNBC.

2. Read, Read,and Read More

Warren Buffett is a perfect example of a reading machine. According to CNBC.com, while on the way to China, Becky Quick was amazed by how much Warren Buffett reads and how quick he reads. Warren Buffett usually reads six newspapers a day.

• The Wall Street Journal
• USA Today
• The Financial Times
• The New York Times
• Omaha-World Herald
• American Banker

3. Employ a low P/E approach to stock selection and avoid potential bankruptcies and “hot” stocks.

I am a big believer in applying a low P/E strategy. Every study that I have read has showed a low P/E portfolio will outperform the market indexes in the long run. According to Dreman.com, the website for Dreman Value Managemtn,LLC, their investing philosophy is based on a low P/E approach, short term market overreactions, and having a disciplined and consistent investing style. Their contrarian philosophy is summarized below:

Low P/E approach – we look for stocks where the price to earnings ratio is low and the company exhibits strong fundamentals, as well as a history of earnings growth that we through extensive research, believe will persist into the future.

Market overreactions – Years of proprietary research in behavioral finance help us distinguish between short term changes in the market and long term trends. We are able to take advantage of short term swings in order to buy fundamentally strong stocks at bargain prices.

Discipline and consistency in style – we have applied our investment strategy without wavering since inception and have avoided getting caught up in the rush of market.

Each item on the list can and should be expanded. The internet is changing the world’s information landscape. One is able to access millions of news sources ranging from personal blogs to community driven stock market news (i.e. valueinvestingnews.com). In addition, individuals can now join forums that pertain to a certain hobby. I am active in a value investing forum that is full of high quality posts by real value investors.

Be fearful when others are greedy and be greedy when others are fearful-Warren Buffett

It is easy to understand but few will follow through once crisis hits such as the current credit crunch. In his classic book Contrarian Investment Strategies: The Next Generation, David Dreman devotes a whole chapter on how to profit when blood hits the street.

Know Your Enemy

All throughout the book, David Dreman introduces the reader investment rules to follow and this chapter was no exemption as chapter 12 included 3 rules starting with number 29.

Rule 29: Political and Financial Crisis lead investors to sell stocks. This is precisely the wrong reaction. Buy during a panic, don’t sell.

If one can somehow shutoff the noise on Wall Street, you have the oppurturnity to make make major gains. According to David Dreman, holding stocks for two years after a crisis resulted in spectacular returns (263).

Symptoms of A Crisis

How does one know when a crisis has arrived?

The symptoms of a crisis are anything but hard to find, and usually are downright unavoidable
-p.264

If your CNBC, you check how the DOW is doing every 10 seconds. I have found that people who could not tell the difference between a stock and a stick become interested in the market. Also, the list of stocks hitting 52 week lows tend to get longer. In addition, the magic formula screen will churn out the full results. When the market kept making new highs (remember that?), very few stocks appeared using the magic formula stock screens. Also, check out industry returns for a certain period. For examaple, looking at this chart, one could see the home construction and mortgage finance indexes are down greater than 50% from one year ago.

Rule 30

In a crisis, carefully analyze the reasons put forward to support lower stock prices-more often than not they will disintegrate under scrutiny.

Essentials for Crisis Investing

Contrarian Investment Strategies: The Next Generation, was published in 1998, less than a decade removed from the Savings and Loans crisis of 1990. At the height of the crisis most banks were trading at 50% off their market values a couple of months earlier. Also, most banks were priced at discounts to their book value. David Dreman used different criteria to increase his odds of his holdings not going under.

Buy Financially Sound Banks

In today’s market, this would equate to one avoiding the likes of E-Trade Financial, Countrywide Financial and American Home Mortgage to name a few.

Buy Banks With Adequate Capital

In his book Beating The Street, Peter Lynch used Equity-to- Assets Ratio to insure a bank had enough capital to survive the same S&L crisis. For example, US Bancorp (USB) currently has an equity-to-assets ratio of 9.08%. Most banks have an average equity-to assets ratio of 8% but anything over 6% will do.

Pay Attention To Financial Ratios

Most banks will trade well below book value during a crisis. Doing some security analysis will help determine whether book value reflects real value. The higher quality banks like Wells Fargo and US Bank will trade at or below historical low levels. I have found banks with high ROE have better staying power.

Hedging Your Bets

Crisis brings enormous opportunity, but there is always the fear something will go wrong
-page 268

Although banks can currently look undervalued, it is no guarantee your bets are safe. For example, many investors flocked to Delta Financial Corp. (DFC) figuring if Mohnish Pabrai bought at X, it is a steal at $3. Those investors were greatly disappointed as Delta Financial Corp. filed for bankruptcy. The best way to guard against negative surprises is to spread ones bets (diversify). The Garcia Value Fund currently holds 8 financials. Worst case scenario, Vineyard National Bancorp goes bankrupt. Best case scenario, all financial holdings rebound nicely.

Value Lifelines In A Crisis

According to David Dreman, the common denominator in all crisis is a sharp drop in prices caused by serious investor overreaction. With this comes a shrinking of financial ratios. For example, in 2004 Well Fargo Corp (WFC) finished the year with a P/E of 14. Currently, Wells Fargo has a P/E of 10 with a forward P/E of 9.

Rule 31

(A) Diversify Extensively. No matter how cheap a group of stocks looks, you never know for sure that you aren’t getting a clunker.

(B) Use the value lifelines as explained. In a crisis, these criteria get dramatically better as prices plummet, markedly improving your chances of a big score.

Disclaimer: I own US Bancorp (USB)

After acquiring Marmon Holdings, Buffett acquired a re-insurer from AIG financial and started his own bond insuring business. Apparently, the bond insurer will start doing business in New York and expand throughout the country.

On the other hand, David Dreman’s new article came out earlier in the week. Being a contrarian, he gave out a list of financials that should perform well in the coming years. Also, he does mention that the “worst might have been over.” Below is the list of banks being recommended. All have adequate size and attractive dividend yields.

• Bank of America (BAC)
• Wachovia (WB)
• Citigroup (C)
• KeyCorp (KEY)
• JP Morgan (JPM)

Along with the above names, David Dreman gave another list in which the banks are more volatile but might provide better returns.

• Washington Mutual (WM)
• Freddie and Fannie (FRE) & (FNM)

Being a student of Dreman, its satisfying knowing he is looking in the same location as I am. Although,I do have different picks than the above list, its great knowing we are fishing in the same lake. Currently, financials represent the majority of the Garcia Value Fund with 31% invested in the financial sector. My financials include American Express (AXP), US Bancorp (USB) , Wells Fargo (WFC), American Insurance Group (AIG),E-Trade Financial (ETFC), Moody’s Corp (MCO) and Capital One Financial (COF).

American Express has been beaten down for subprime fears and fears that consumer spending is slowing. I found this interesting as American Express has a great business clientele and little if any exposure to subprime. It currently trades at about 13 times forward earning which is amazing considering the moat the company has. Patient investors buying in the low 50’s will be rewarded 3-5 years from now.

US Bancorp (USB) and Wells Fargo (WFC) are both conservative banks with great management and great histories. Both banks have little sub prime exposure but for some reason are beaten down. Both banks also trade at lower valuations than their historical averages and post consistent ROE around 20%, which is above the industry average of 15%.

American Insurance Group (AIG) is another business trading at a discount. The big insurer stated its subprime exposure is manageable and re-affirmed the company’s growth of 10-12% for the next 5 years. Yet, the stock is trading below $60 with forward P/E of 8! Analyst have AIG earning $6.20/share this year. Assuming management is able to maintain a conservative growth rate of 8% for the next 5 years we can do a quick back of the envelope valuation using simple math.

• 2008 : $6.70 EPS
• 2009 : $7.23
• 2010 : $7.81
• 2011 : $8.44
• 2012 : $9.10

using a P/E of 10 on 2012 earnings we arrive at a $91 stock. Demanding my standard 34% margin of safety, the stock is a buy below $60. The stock currently trades at about $58.
I also have Moody’s (MCO) and Capital One Financial (COF) on my financials list. Both businesses follow the same idea that in 3 years these businesses will be more valuable than what the street is valuing them today.
Now time to comment on E-trade Financial (ETFC)*sigh*. The worst performer in the Garcia Value Fund and also the riskiest stock in the portfolio. The main thesis behind E-Trade is that the company will get rid of its subprime mess and stick to its retail operations. So far so good. The company is trying to make progress by launching a customer “win back” campaign. The street is valuing the whole business at roughly $1.6 billion . I think the business is worth more. Obviously, this is going to be a wild ride as management turns things around but hopefully being patient will result in a great investment as it has been a drag on the Garcia Value Fund.
In an earlier post, I mentioned I was going to read Ben Graham’s The Intelligent Investor. Well, change of heart. I read it twice in 07′ and decided it would be more interesting reading something else. So I decided of digging into my David Dreman collection. Which book will I re-read ? Undecided.
Finally, I would like to wish everyone a happy and safe New Year. 2007 has been an incredible year for me as I met a personal goal. 2008 will be better. God bless.

-Alex Garcia

Disclaimer: I own shares of US Bancorp (USB)