Global Value Investing

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A multifaceted approach to value investing with stock valuation based on intrinsic value estimated from cash returns, appraised value of assets, and other facets of value.

 

 

Invest

 

Four-Step Investment   |   Stocks and Bonds   |   Other Securities   |   Hedging


Investing is a life-long activity focused on creating a better future. A sound disciplined investment plan can help you reach your goals -- for retirement, family, or business. In the following sections, a stylized approach to investing is outlined, and the different investment opportunities among marketable securities are discussed. Special emphasis is placed on the appropriateness of these for individual investors.

Four-Step Investment

The Four-Step Common Stock Investment Program serves as a point of departure for investing in common stocks. Following these steps is like waltzing your way to wealth. There are no easy roads to riches, but there are many roads to ruin on Wall Street. And there is no one correct path for all investors. The four-step program reflects the philosophy of intrinsic value investing and provides the framework for the Four-Step Common Stock Selection Process (see select).

Four-Step Common Stock Investment Program

 

say 'No' to the folly of...

and instead choose...

Step 1

market timing

fundamental analysis

Step 2

growth for the sake of growth

intrinsic value

Step 3

accounting value

economic value

Step 4

pricing models

valuation models

Delimiting the investment process into steps and choices is somewhat arbitrary. The first two steps can help the investor overcome fear and greed and escape from the wilderness. The third and fourth steps are required to overcome ignorance and cross the desert to reach the promised land. At the final step, we identify the most appropriate valuation model to estimate the absolute investment value of a company and its common stock. The choice of models is critical because some models have self-contradictory premises. Global Value Investing addresses these four crucial choices.

The raison d'Ítre of investing based on intrinsic economic value is the a priori premise of non-identity, i.e., value is not the same as price. In a valuation model, a valuation anomaly if the mean estimate of intrinsic economic value equals the current market price which occurrence would be transient and coincidental. In contrast, the raison d'Ítre of investing based on pricing is the a priori premise of identity, i.e., value is the same as price. In a pricing model, a pricing anomaly occurs if the risk-adjusted price includes a risk factor with a statistically significant risk premium (or what amounts to the same thing, the risk premium is statistically significantly different from zero, usually at the 5% probability level in statistical hypothesis testing). Thus, the asset pricing artifacts of volatility, beta and portfolio measures do not belong in valuation models because this combines diametrically opposite premises.

All monetary expenditures can be analyzed in terms of risks, costs, and returns. In addition, all investments can be characterized in terms of safety, income, and liquidity. On the basis of risk and return, a useful distinction can be made between five activities of an individual involving her or his money, to wit: consumption, saving, gambling, speculating, and investing. Other than consumption, each of these activities involves a degree of speculation because the future cannot be accurately and consistently predicted.

John Burr Williams (1938:552-553) writes: "As [the company's stock price] rose, many conservative investors were tempted to sell [the shares they had received as a special dividend in the form of stock in the spun-off company], and would have done so if they only could have been sure that it was really too high. Too high to them meant so high that permanent investment was no longer justified, because future dividends could not give a fair return on the then attained price. The investment policies of these conservative investors forbade them to speculate on the ups and downs of ordinary bull and bear markets, but required them to consider the long-run merits of their holdings; and to sell if the price got too high as judged by that standard."

The philosophy of intrinsic value investing is an example of the application of the theory of positive nonintervention at the individual level. While doing nothing is easy, positive nonintervention in the form of "buy and hold" is continuous hard work to resist the temptation to do something merely for the sake of activity. For investment managers and brokers, it further means resisting the pressure by peers and incentive compensation schemes to trade, sometimes in conflict with stated policies and without the knowledge or permission of the investor.

The intrinsic value of an investment asset can be estimated according to agreed upon principles using a sound methodology. One such application is the
DCF Valuator investment models, a suite of free online award-winning interactive models to estimate intrinsic value, goal implied value, range of value using Monte Carlo simulation scenarios, and rate of return on investment. Using these online models, you can value any stock in any currency any time any place.


Stocks and Bonds

The focus here is on investing primarily in common stocks and secondarily in bonds. A useful distinction also can be made between stock screening and stock valuation. Stock screening, based on one or more simple ratios such as the Price-to-Earnings ratio or P/E, is designed to eliminate stocks that are not even close to providing a sufficient margin of safety. Screens eliminate passion, but they also eliminate judgment. The screens are not a substitute for valuation, but rather serve to quickly reduce the universe of common stocks to a short list for more-intensive, time-consuming, in-depth investigation. No matter what screening criteria are used, the resulting list of relatively underpriced stocks will include stocks that deserve to have low prices. The important question is whether these apparently underpriced stocks are really absolutely underpriced, and this is what value analysis is designed to answer.

To determine whether a seemingly underpriced stock is truly underpriced for no reasonable cause, an exhaustive knowledgeable study of the company and its competitors is required. The relevant data are not generated by the market and do not change significantly during a month. Therefore, a monthly screening will suffice. This can be done by purposefully searching through Standard & Poor’s Stock Guide and Standard & Poor’s Earnings Guide. The short list of companies not screened out can be further researched in Moody’s Manuals, mostly in the Industrials Manual. From there, the surviving companies can be studied further by reviewing the documents they have filed with the U.S. Securities and Exchange Commission, including Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Annual Proxy Statement, any special proxy statements, and other filed documents.

There are on-line sources of data for global depositary receipts (GDRs) and American depositary receipts (ADRs) for investors interested in non-US domiciled companies. The ADRs come as either non-sponsored or one of three levels of sponsored. One receipt may represent more than one share of common stock, especially if its price is relatively low. In most cases, the U.S.-listed stocks offer better liquidity and lower commissions, as well as greater visibility and accounting that meets U.S.standards. If the goal is to diversify out of the US economy, then this can be accomplished by investing in US-based multi-national companies that have significant proportions of their sales revenues that are not US-dollar-denominated. Two additional factors must be considered in the valuation of such stocks: one is the risk of political instability in the other country and the impact on its economy; the other is the rate of exchange between the foreign currency and the US dollar.

Once a genuinely absolutely underpriced company has been identified with an adequate margin of safety, then an order can be placed on-line using competitively-priced electronic transaction services. Most trades made by an individual small investor can be executed and documented for less than $15.00 per transaction, and these transaction fees are decreasing.


Other Securities

In addition to common stocks and bonds contracts, there are other securities and financial instruments that are bought and sold in the capital markets. Some market activities may appear to be investing or trading, but on closer inspection are more akin to noise-trading or gambling when and to the extent they are not part of bona fide business-related hedging, risk management, portfolio management, arbitrage, or other investment operation.

The major types of noise-trading activities include commodities and derivatives both of which trade in contracts. Commodities include physical and financial products. A derivative is a security whose value depends on the value of one or more separate underlying securities. Derivatives include future contracts as opposed to cash contracts on commodities as well as option contracts and indexes. Options include puts, calls, and combinations of these two forms. Warrants are long-term options. Rights offerings are in effect negative dividends or assessments that require the investor to contribute capital to the company issuing the rights.

Not all derivatives involve get-rich-quick schemes with undisclosed risks and costs. The most popular form of derivative is the investment company, both mutual funds or open-ended and the less common closed-ended. A mutual fund is merely a portfolio of cash and securities and its value is derived from the value of the portfolio holdings. Stock funds and bond funds might be useful for an investor with limited time, human capital, or financial capital.

In particular, index funds might be useful "parking places" for cash when an investor wants to be fully invested in equities and has not yet found a common stock with the requisite margin of safety. The best known index for common stock funds is the S&P 500 Stock Price Index. The largest such fund for any particular index can provide the lowest annual expense ratios for investing in that index.

Another exception is writing covered call options. This is at best a performance enhancement technique to increase total portfolio returns from say, 20 percent per annum to 21 percent per annum, as an example of the order of magnitude involved. Like all option contracts, there are conditions, limitations, risks and costs. One condition is there must be sufficient market demand for the stock option as indicated by stock trading volume, stock price level, and stock price volatility. Another condition is you can "write" or sell a covered call option only if you already own or control the underlying stock. Thus the number of contracts you can write is limited to the number of shares of stock you own.


Hedging

In the course of pursing an investment strategy, an investor may purchase and sell exchange-listed and over-the-counter options on securities, equity and fixed-income indices and other financial instruments, purchase and sell financial futures contracts and options thereon, and enter into various currency transactions such as currency forward contracts, currency future contracts, currency swaps or options on currencies or currency futures. Collectively, all of the above can be referred to as hedging transactions.

Hedging transactions, whether entered into as a hedge or for gain, have risks associated with them including possible default by the other party to the transaction, illiquidity and, to the extent the investor's view as to particular market movements is incorrect, the risk that the use of such hedging transactions could result in losses greater than if they had not been used.

The use of put and call options may result in losses to the investor, force the sale or purchase of portfolio securities at inopportune times or for prices higher than (in the case of put options) or lower than (in the case of call options) current market prices, limit the amount of appreciation the investor can realize on his investments, increase the cost of holding a security and reduce the returns on securities or cause an investor to hold a security he might otherwise sell. For example, an investor's common stock may be called away before expiration of the covered call option he wrote on it, thereby triggering a taxable event with associated capital gain taxes and trading commissions.

The use of currency or foreign exchange transactions can result in an investor incurring losses as a result of a number of factors including the imposition of exchange controls, suspension of settlements, or the inability to deliver or receive a specified currency.

The use of options and futures transactions entails certain other risks. In particular, the variable degree of correlation between price movements of futures contracts and price movements in the related portfolio position of the investor creates the possibility that losses on the hedging instrument may be greater than gains in the value of the investor's position. In addition, futures and options markets may not be liquid in all circumstances and certain over-the-counter options may have no markets. As a result, in certain markets, an investor might not be able to close out a transaction without incurring substantial losses, if it is able to close out a transaction at all. Although the use of futures and options transactions for hedging should tend to minimize the risk of loss due to a decline in the value of the hedged position, at the same time they tend to limit any potential gain which might result from an increase in value of such position. Finally, the daily variation margin requirements for futures contracts would create a greater ongoing potential financial risk than would purchases of options, where the exposure is limited to the cost of the initial premium.

Losses resulting from the use of hedging transactions would reduce net asset value, and possibly income, and such losses can be greater than if the hedging transactions had not been utilized. The cost of entering into hedging transactions may also reduce the investor's total return. An investor can improve his performance by using options pricing models based on application of the theory behind the capital asset pricing model as in the Black-Scholes option pricing model. Derivative pricing models range considerably in mathematical complexity and sophistication. There is a Pareto effect in the use of these financial engineering techniques, i.e., a commercially available package that costs 20 percent as much as the most expensive package available might cover the core 80 percent of the models of factors that influence the prices of derivatives (see FinancialCAD in the Selected Links).

Hedging transactions are most appropriate for investment managers, institutional investors, and high-net-worth individual investors. The prospectus from which I freely adapted this section was provided by an investment company that has a value-driven strategy and the right to use margin and hedging transactions. In its Annual Report dated 31 December 1996, shows total net assets over $6.5 billion, no use of margin, one open option contract constituting 0.47% of total net assets, and three securities sold short for purposes of protecting long positions in the same securities constituting 0.40% of total net assets. In addition, it had 425 open written option contracts valued at about $150,000, about $1.1 billion open sales of foreign currency exchange contracts, and about $55 million open purchases of foreign currency exchange contracts. About 82% of the total investment in securities is located in the United States and 12% in twelve other countries including Western Europe and Japan. Transactions in options written during the year were as follows: Options outstanding at 31 December 1995 = 110 with premiums of about $15,000, Options written = 141,850, Options expired = (138, 770), Options terminated in closing transactions = (1,190), Options exercised = (1,575), and Options outstanding at 31 December 1996 = 425 with premiums of about $180,000.


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