This week we take a look at what value really means, and I offer a few thoughts on the recent employment numbers. They may not be what you think.
I am taking a little R&R this weekend, and have asked my friend Lynn Carpenter who is the editor of the Fleet Street Letter and The Optionist to give us her thoughts on value investing. It is a wise and witty essay, and I commend it to you.
But first, let me make some brief comments on the recent employment numbers. The market went crazy on Friday as the Bureau of Labor Statistics told us 308,000 new jobs were created, far beyond the expectations of even the most wild-eyed optimists. As an aside I should note the futures market went crazy about 90 minutes before the announcement of the official figures, as S&P futures were up big and fast before anyone supposedly saw the numbers. Now, the Fed, the White House and various relevant agencies saw the report the evening before, as well as the guys at the BLS. I am sure no traders got to see an early "hint." It must have been some optimistic traders starting a trend and then someone wondering what they knew and then some program trading kicking in, with the momentum guys all jumping on the bandwagon. These things can happen. It is just that they don't usually happen 90 minutes before a BLS announcement, many of which have been quite disappointing in recent months.
Even so, inquiring minds would like to see a print of the tape and know who was buying and why. If it was innocent, it was a gutsy call. But that doesn't tell us anything about the underlying employment numbers.
Employment Games and Other Silly Statistics
I remember seeing the BLS report headlines flash across my screen and thinking, "Finally, some good news. About time." Ever the optimist, I should have waited a few hours. Bill King sent this note out to his readers:
"We have never seen such a grossly misinterpreted Employment Report in our 30 years in this biz...
"...About release of the report, we immediately noticed some huge red flags. How could non-farm payrolls explode 308k when a) the unemployment rate increased to 5.7%; b) wage growth was less than expected at 0.1%; c) the "employed population ratio" actually FELL to 62.1% from 62.2%; d) the "employment participation rate" was unchanged at 65.9%; e) total employment was unchanged at 138.3m and most importantly f) the average workweek fell 0.1 to 33.7, which is near a 40-year low (33.5)!
"When dissecting the numbers we learned that NSA (non-seasonally adjusted) service job wages fell 8 cents and they accounted for 230k of the 308k job growth. Leisure & hospitality wages NSA fell 4 cents; and NSA avg hours worked fell 0.3. Something is obviously wrong. Healthcare contributed 36k jobs, leisure & hospitality 28k, retail 47k, government created 31k and the phantom jobs estimated to be created by small business was 153k! This is now known as the business birth/death rate. Apparently a large number of workers entered the workforce in order to force the unemployed rate higher, but still something seemed incredibly wrong."
Lacy Hunt of Van Hoisington Management tells us what the "wrongness" is (as did several others on Monday, after digging through the data over the weekend. Of the 308,000 jobs created, 296,000 are temporary or part-time jobs! "In March, the number of persons who worked part time for economic reasons increased to 4.7 million, about the same level as in January. These individuals indicated that they would like to work full time but were working part time because their hours had been cut back or because they were unable to find full-time jobs."
Wages and hours fell slightly, which is not consistent with out-sized job growth. Certain figures in the statistics just don't add up. Again from Bill King: "In the Employment report there is this illumination in Table A-7: 'NOTE: Detail shown in this table will not necessarily add to totals because of the independent seasonal adjustment of the various series. Beginning in January 2004, data reflect revised population controls used in the household survey.' So we checked to see why the caveat. 'More unemployed' increased 182k; but in the table, men age 20+ saw unemployment increase 182k. Women age 20+ had a 142k increase in unemployment. That totals 346k more unemployed by real math, but not BLS seasonally adjusted math. http://www.bls.gov/news.release/empsit.t07.htm
But on the bright side, the usually reliable TrimTab looks at the same figures and think BLS doesn't know how to add. Applying a year-over-year methodology, TrimTab says non-farm employment actually increased by 519,000 employees, representing an improvement of 211,000 jobs over BLS data.
The January and February employment numbers were also revised upwards by a total of nearly 90,000 jobs. The job gains came primarily in the construction sector, which added 71,000 jobs reflecting strong demand for new housing, and the retail service sectors. March marked the first month since August of 2000 that there were no job losses in the manufacturing sector.
So, who's right? The optimists or the pessimists? If you are looking for the monthly BLS survey to tell you, I think you are wasting your debating time. The numbers are estimated, based upon a "survey," seasonal adjustments and a host of guessing games. Again, these are estimates which will inevitably be adjusted as real numbers begin to show up a lot later. The staff at the BLS does yeoman work, and I believe they sincerely do their best, but latest month reports are subject to fluctuations due to assumptions. We all know the old line about what assumptions can do.
Remember, we are looking at very small percentages in estimating the employment rate and the number of jobs created. There are 147,000,000 some odd workers in the US. 308,000 jobs is 0.2% of total jobs. Lately, the normal move is less than 1/10 of 1%. Do you really think they are anywhere near that accurate on a most recent month basis?
The value of the report is to see the trends over longer periods of time. The trends are clearly getting better than last year. Should we get excited (or distraught) over any one month's report? Probably not. Leave that nonsense for the politicians.
But the trends also show job growth weakness as compared to previous recoveries. This recent report suggests a new trend may be starting, one which is consistent with the weakness in job growth. Remember when I wrote a month or so ago that there were large numbers coming to the end of their welfare checks starting in the first quarter? There was a significant increase in the number of people looking for work in this most recent report. Coincidence? I think not. Evidently they decided it was better to get part-time or temporary jobs than remain without any income. I personally know that lack of money can clarify your priorities. That may be the lesson to take from this report and one which bears watching, to see if there is a new trend being started here: part-time and temporary work on the rise. Such is not the stuff of legendary recoveries, nor contented voters.
Also, I suspect, but have no statistical proof (although reasonable anecdotal evidence exists), that many companies are hiring "temporary" workers because such workers do not come with health and other benefits, nor do they bring a rise in unemployment insurance if they leave.
The bond market went into full retreat on these numbers, thinking the Fed will soon be able to raise rates. This data does nothing to suggest the Fed is going to feel free to move any time soon. Indeed, I exchanged a few emails with Greg Weldon on that note, and he wrote back:
"THE source of strength ... Part-Time for Economic Reasons ... Up Huge, enough to suggest Full-Time jobs contracted, and a thought FULLY supported by the disinflationary Earnings and Aggregate Hours figures...Let alone the new HIGH in Number Wanting a Job ... and rise in Unemployed More than 27 Weeks ...AND ... DROP in Employment/Population Ratio. Hardly enough to 'budge' the Fed."
There are some monthly statistics from government sources that I think are reliable and meaningful. I would pay attention and adjust investment and trading strategies based upon them. But trading or investing based upon the most recent household employment survey? I leave that to those with more seasonally adjusted intuition. Or to those who get early hints.
Again, trends in the statistic can give us some clues, but monthly numbers are there to be gamed by the fast and nimble. If you are not in that crowd, I suggest you not play the game.
This is all the more reason to look to value as a reason to invest. Let's enjoy what Lynn Carpenter has to say.
The New Value Revolution... Same Old Misunderstandings
Five years ago, value investors were dinosaurs. Young men were hissing that Warren Buffett was all washed up. The score since then: Berkshire Hathaway up 30%, Nasdaq down 20%.
How things have changed. Now everyone who got caught in the bubble has taken up the value religion. But touring a mosque doesn't make you a Muslim. These days I hear more unadulterated claptrap in the name of value than there ever was silliness in the name of growth.
Value investing has roots that go back hundreds of years to when upper class families in England provided for their heirs with English gilts, high-quality bonds. The father of American value investing, Columbia professor and money manager, Benjamin Graham made a direct connection between bonds and value...
It's all about acquiring an asset that produces a stream of earnings at a fair price. The asset's proper value depends on future earnings it will garner. If you pay grandly today for meager capacity to make profits tomorrow, you are not a value investor. That's it. That's the nut, the essence, the very spirit of value investing in a paragraph.
Unfortunately, describing it is not doing it, and it's in the doing that things go agley. It's easy to figure out what a brand-new bond is worth. It pays a set dividend, so you know exactly how much money is coming in eventually. A hundred years ago, most investors bought stocks much the same way... the price was related to the dividend they'd get, but even better. Stocks don't expire. As long as the company was in business, it paid.
How Value Investing Paid the Piper, and the Painter, and the Librarian
All across America, but particularly along the East Coast cities, symphonies, libraries, art museums and schools were endowed with stocks of railroads, steel companies and other industrial giants in the 19th century. They benefactors expected the dividends to support their charities to infinity.
Then the world changed. Not only did American industry begin a downward path in the 20th century, stocks in general stopped paying high dividends, and investors began to look for other attributes, predominately growth.
In some cases, these fortunate 19th century institutions found themselves in dire trouble when the 20th century rolled around and their fortunes were tied to particular stocks. Dividends were barely enough to keep the electricity on. I recall reading a story several years back about a museum here in Baltimore that had to go to court to get permission to sell the B&O railroad stock in its endowment fund. The founder had decreed that the stock should never be sold, nor the principal touched. Alas, 100 and some years later, the stock no longer paid enough in dividends to support the institution. Worse, the company was headed into oblivion.
Now that's buy and hold!
But since John asked me to write about value in general, I'd like to slay a few leading myths today. First, the notion that value is boring.
There Is No Straightjacket on Value--Let It Grow
Chief among the odd notions that I hear about value investing is that it's radically different than growth investing. Staid. Limited to mature, slow-growth companies that pay dividends.
But if you would think back to that short description of value investing I gave you earlier, you will see that's obviously not right. It's completely illogical, in fact. If value investing is buying a stock at a reasonable price related to its stream of earnings, a company that is earning more and more money certainly ought to be a value candidate... if the price is right. In fact, Warren Buffett once said, "value and growth are joined at the hip."
A value investor can certainly be a growth investor. I am. In the past year, I recommended several growth stocks in Fleet Street Letter. Among them: Zimmer Holdings, which has gone up 74% in the last year, and Guitar Center, which has gone up 68%, and GTech Holdings which rose 108%.
So, if anybody has told you that value stocks are only maiden-aunt stocks that rise 10-15% a year at best, tell him to get a good book and learn something. In fact, I can recommend an excellent one to start with: How to Think Like Benjamin Graham and Invest Like Warren Buffett, by Lawrence A. Cunningham.
What all those nice double-digit winners I just mentioned (and many more) had in common was that their price was fair and their expectations were outstanding.
Which brings me to the second most common myth about value among the uninformed...
Cheap Is Cheap, Value's Something Else
Last week when I spoke to John on the phone, he mentioned that most people seem to think value stocks are ones that have fallen a lot, and now that they're cheaper they're values.
Well, Enron fell a lot. But it was no value.
Companies on the way to bankruptcy fall a lot. They're not values either.
Companies with earnings disappointments of a lingering nature and declining sales are usually cheap. They're not values.
In short, a 2002 Hyundai for $20,000 is not a value. A 2002 Mercedes S-600 would be a steal. Value means value, not cheap. A stock may have risen 100% in the last year and still be a value.
In fact, I can give you an example of this. In 2000, I added Centex to the Fleet Street portfolio. Since then, it has gone up 308%... and it is still a value stock. It is still-even with doubts about interest rates and overbuilding-priced at a discount to its earnings expectations.
How can I tell? I use several metrics, including price to sales, price to cash flow, price to EPS growth, price to book value (plus earnings and sales growth outlooks and many other criteria). But the one I haven't mentioned yet is the value metric most people associate with finding a "cheap" value stock-the price to earnings ratio, or P/E.
A Simple Measure for Simple-Minded Folks
I always look at P/E ratios. That, after all, is the embodiment of the value idea... a good price relative to its earnings. Or it should be.
In truth, it doesn't work out so purely.
But let me step sideways here and ask you another question. Would you be willing to marry a tall, blue-eyed blonde?
OK, the honey of your dreams just popped into your head. But would you really accept bad breath, a scary uncle in the Mafia, a mother-in-law who's going to move in with you, a screechy voice, a terrible temper, no sense of humor and acne? That's probably not the dream you had in mind.
So it is with low P/E ratios. They are the tall, blue-eyed blondes. But they may have dire faults nonetheless. Anyone who only looks at the current P/E ratio and doesn't compare it to the industry norm or the company's own outlook or check the quality of the earnings reported in the first place is taking a dangerous shortcut. You might as well mail order a bride.
Many low P/E stocks are not values, they are traps.
The big problem is the quality of the E. There are a thousand ways a company can generate misleading, poor-quality or doubtful earnings, and that's not even counting fraud. If a company delays paying some big bills or speeds up its depreciation schedule, it can show more earnings than it would otherwise. If it sells off a division for mega-millions, those dollars add to the bottom line and swell the earnings.
But you can only sell something once. And advancing a collection or delaying a cost, is only borrows from one year to prettify the results of another.
A P/E ratio is a good guide, but only as a rough-cut tool. You have to be awfully careful to be sure that E is trustworthy. Can the company duplicate those earnings, or better yet, increase them? Are they real earnings from operations, or did it merely float a secondary offering and sell a bushel of stock. If that's the case, not only will those earnings not repeat, you'll have to share the pie with thousands more people at the end of the next year.
Most advisors will tell you something along the lines of "a stock with a P/E below 18 is a value stock," or 15, or 20, or 12. It varies from person to person. Those who put the limit at 12 or 15 are likely to be the ultra-cheap stock fans. They're the ones who rumble trashcans hoping to find a good tuna sandwich. I'd never tell you that. Because I never use those guidelines except as a general screen, and with good reason.
If you shop around for stocks with a P/E of 12 or less, you will come up with mostly real estate investment trusts, regulated utilities, and grocery stores. If you want to collect a big dividend, a utility or a REIT may be good, for part of your portfolio. But these are all abominably slow growth companies. They have low P/E ratios because they have low earnings capacity. Let me be clearer: they're cheap because they should be cheap.
Occasionally, you will find a vigorous, growing company at these low levels. That usually happens when there's been some bad news that scared all the chickens away. But don't expect to find one a week. I know. I look!
On the other hand, I have sometimes bought a stock that had a P/E ratio as high as 40 or 50. Again, it has to do with the quality of the E and the future expectations.
If a company for some reason has much lower earnings than it did previously, its P/E ratio will rise. But if you can, with a high probability, expect it to get back to its usual business, the high P/E is not a red flag... unless you are prone to putting red flags on safe investments. Sometimes, a stock going for a P/E of 50 is cheaper than one going for a P/E of 20... looking forward, that is. But if you don't look forward, you have no business buying stock in the first place.
Another time that a fairly high P/E stock may be a value is when profits are delayed for some reason or special charges, particularly costs for an acquisition, expansion or research and development, reduce the bottom line for a limited time. Because investors have a Pavlovian-dog reaction to acquisitions-thinking that they always cause unexpected trouble before they benefit the company-you can often get a good deal on a stock right after it acquires another company. In fact, many companies do acquisitions quite smoothly, but the market keeps forgetting that.
A company with new products emerging may also have a high P/E ratio today and still be a value. This is often the case with drug companies, for instance. As long as the new product is really ready to roll out, stable, salable and definitely capable of gaining market share (no wishful thinking here), then tomorrow's earnings should be higher. Which means that today's P/E ratio is not a good guide.
I always evaluate a "forward P/E" when I look at a stock. That is, I estimate the next year's earnings, very conservatively, against the current price. That's like looking at a stock in 3-D, it gives you a much more lifelike picture.
The other test I run is to compare the current P/E ratio with the EPS growth rate. That's called the PEG, and a powerful tool it is. If the PEG ratio is 1, the stock is priced exactly in line with its earnings rate. If it's under 1, it's a bargain and a value, so long as there are no bogeymen in its closet.
Complicated, Yes, And Fully Within Your Grasp
A few weeks ago, I did some workshops with investors on finding value stocks. We went through all this and then some. I taught them how to look at cash flow, spot earnings bubbles, evaluate growth and profitability and much more. After each workshop, people crowded around to say, "I didn't know you did all that to find value."
Finding value in a stock is at least as much work as finding value in a spouse, a car or a business. In fact, assuming you are a successful and intelligent person in all other aspects of your life, it should be a lot easier. After all, you don't have to marry your stocks. (You can reach Lynn Carpenter by e-mail at firstname.lastname@example.org.)
Margaritaville, Gold and Vancouver
I am finishing this on Wednesday night, as I am off tomorrow morning with my bride to Puerto Vallarta. I hope to have a copy of my book, Bull's Eye Investing, in my hands when I get back next mid-week, or by Friday at the latest. I will let you know when to go to Amazon or BarnesandNoble.com to buy and not have to wait for weeks to have the book shipped. It should be in the stores in late April.
I will be speaking in San Antonio next Thursday night, April 15. Contact Maynard Burstein at email@example.com for details.
I have also agreed to speak at the World Gold Show in Vancouver on June 13-14, sponsored by Joe Martin of Cambridge House International Inc. This is a fairly big conference with 150 exhibitors (mostly gold mining companies).
Again, if anyone has contacts with established media or publications who would be interested in reviewing my book or interviewing me, please feel free to write me.
Let me wish you a blessed Easter and/or Passover. #1 daughter is on sabbatical in Israel this week, celebrating the Holy Week in services there. Dad gets a little nervous, and will be glad to have her home.
Your can't wait to get his book in his hands analyst,