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At its core, value investing follows one simple principle – buy stocks of good companies at a discount. Unfortunately, translating that principle into practice is far from simple.  How do you define a “good” company?  And a discounted price assumes one knows the worth of the company – but how can you tell what a company is actually worth?

Value investing looks at three aspects of a business – the economy, the industry, and the company itself. The starting point for most is the company itself – and there are several metrics investors use to sort out potential bargains. 

Unfortunately, there’s no single set of universally agreed upon metrics.  The most common include ratios like Price to Earnings (P/E), Price to Book (P/B), Price to Earnings Growth (PEG) and Return on Equity (ROE).  Along with these many value investors also look for low gearing and high dividends.  Low debt is a good sign that a company can survive in tough times.  High dividends signal that a company is in good enough shape to reward its shareholders.  

The good news is that these ratios are readily available to everyday investors.  Some professional investors analyse more complicated techniques like Discounted Cash Flow Analysis. Regardless of the exact ratios used, value investors should always compare companies to their industry peers.

Ratios can be viewed as the market’s expectations for the company’s prospects.  Low price ratios mean low expectations.  The key for the value investor is gauging whether market expectations are right or wrong.  Often the herd moves in response to economic conditions beyond the control of the company – and the share price plummets as a result.  However, sometimes the market is correct and the share price is reacting to company or industry-specific events. 

The downside of value investing is the value trap.  It’s when an investor buys into a stock thinking that it’s cheap – only to watch the share price slide further.

New York University business school professor Aswath Damodaran published “Value Investing: Investing for Grown Ups?” in April last year.  Damodaran divides value investors into three groups – passive screeners, contrarians and activists.  Activists, he writes, are generally professional investors but screeners and contrarians apply to the retail crowd.  As the name suggests, screeners will screen for companies according to key criteria like price ratios and return on equity.  Contrarians, on the other hand, watch for opportunities to buy when the herd incorrectly dumps specific sectors or companies.  

The following table is a result of the screening approach.  Value investors vary in what they like to see for each measure but there are some general guidelines.  

First, a stock should have a P/E ratio under 15, with a ratio under 10 preferred.  A P/B ratio under 3 is a minimum.  The P/EG ratio should be under 1.0 as should gearing, or debt to equity ratio.  You should look for a minimum dividend yield of 2% and an R0E above 15%.  Past history is important to value investors so we looked for a minimum 5 year total shareholder return (dividends + share price appreciation) of 10%.  Finally, we added a minimum 2 year earnings growth forecast of 10%.  Here are five stocks that met these criteria:

Company

Code

P/E

P/B

P/EG

ROE

Gearing

Div Yld

5 Yr Avg Shareholder Return

2 Yr Avg Earnings Growth Forecast

Mineral Resources Ltd

MIN

10.68

2.10

0.94

19.8%

0.21

4.56%

21.3%

11.3%

Ausdrill Ltd

ASL

7.45

1.15

0.91

15.2%

0.491

4.61%

15.1%

26.8%

Forge Group Ltd

FGE

7.05

2.63

0.35

30.2%

0.16

2.91%

33.2%

19.9%

Decmil Group Ltd

DCG

8.87

1.7

0.58

17.3%

0.07

4.57%

51%

15.3%

Austin Engineering Ltd

ANG

10.44

2.63

0.98

24.1%

0.563

3.23%

14.1%

10.7%

 

Although we did not begin from a contrarian perspective, it is interesting to note every stock in our table is involved in the beaten-down resources sector in some way.  All have rewarded shareholders over the past five years.  All have attractive valuations, low to moderate debt, and respectable earnings forecasts.  Yet none should make it into your portfolio or onto your watch list without further research into the industry, the macro environment, and company specifics. 

With a market cap of $1.8 billion, Mineral Resources Limited is the largest company in our table and arguably the most diverse.  The company provides services to the mining industry as well as producing and processing iron ore and manganese through its four subsidiary companies.  In better times the company’s crushing and screening business provided defensive revenue but as commodity prices fell and mining sentiment soured, MIN suffered.  The share price was down over 40% at the height of the panic over falling iron ore prices in September 2012.  Once prices stabilised the share price recovered slightly and is now down 10% year over year, significantly underperforming the ASX 200 XJO.  Here is its chart:

This company has a 64% interest in a manganese mining operation to accompany a wholly owned iron ore producer, a crushing operation, a processing operation, and a pipeline provider.  The company is relatively new to the ASX, first listing in 2006.  By 2010, the company made it to the ASX 200. 

Mineral Resources has attractive fundamentals for value investors – plus a growth story tied to iron ore demand from China.  However, iron ore prices have been hit recently; on 18 January 2013 iron ore experienced its biggest price drop in 14 months – down to US$145.40 a tonne. 

While past performance is no guarantee for the future, a value investor interested in MIN could look back over the company’s financials for the last five years and see both revenues and net profits increased every year.  Earnings and dividends per share have increased every year for the past three years.

Ausdrill Limited provides drilling, blasting, procurement, logistics, and other services to the mining and energy industries in Australia, the UK and Africa. The stock is trading very close to its book value.  Current share price is $2.80 and its book value per share is $2.44.  The dividend yield of 5.25% looks attractive, but what about the longer term?  The company has a 10 year dividend growth rate of 15.5% and a 5 year growth rate of 10.2%. 

Ausdrill was hit as commodity prices fell, despite the fact that just 25% of its revenue stems from services to the iron ore sector.  However, 65% of revenue is generated by copper and gold operations.  In early November 2012 the company reduced 2013 guidance below analyst estimates.  Management is still projecting earnings growth of 15% on revenue growth of 20%.  

Ausdrill is expanding in Africa as well as looking to increase exposure to iron ore and coal operations in Australia, an expensive proposition.  Many value investors would ignore this otherwise attractive company because of its debt.  The gearing level is 50% and long term debt has doubled from A$126.1 million in FY 2011 to A$256.2 million in FY 2012.  The share price is now down around 12% after a November 2012 low.  Here is its chart:

Forge Group is a diversified company operating in four business segments – minerals and resources, power, construction, and asset management.  Management surprised investors with upbeat guidance for 2013, released in early November.  The forecast calls for increased net profit before tax between 28% and 43% along with increased revenue between 22% and 28%.  Investors liked what they heard.  Value investors who saw opportunity in mid 2012 have been handsomely rewarded.  Here is its year over year price chart:

Forge Group has increased earnings per share every year over the past five years, reporting $0.09 in 2008 to the current $0.57 per share.  Analysts report the company’s order book is full and a recent $105 million power contract with BHP provides more certainty to the company’s positive earnings forecast.  Despite the substantial run-up in share price in early December 2012, both Macquarie and Citi maintained OUTPERFORM and BUY ratings on the stock.

Decmil Group Limited operates in two broad segments – construction and accommodations.  Within each it offers design, civil engineering, and construction services to the oil and gas, resources and mining, and infrastructure sectors.  Clients include the likes of BHP, Rio Tinto, Woodside Petroleum, and Chevron.  

Decmil’s projects range from accommodation villages for miners to the civil engineering needs of LNG projects for both Woodside’s Pluto and Chevron’s Gorgon.  Although the company has no direct exposure to commodity prices, its highly volatile share price reflects concerns over construction project cutbacks and cancellations from affected companies; investors are nervous.  Nevertheless, the company has a solid track record with a 51% shareholder return over 5 years and a P/B ratio trading below book value.  Here is Decmil’s one year share price chart:

Austin Engineering provides a variety of services to the mining and resources sector.  The company is international in scope with operations in Australia, the United States, throughout South America, and joint ventures in the Middle East.  Services include a broad range of mining equipment as well as repair and maintenance facilities.  The customer base is broadly diversified across mining, oil and gas, aluminum, and industrials.  

The company’s Full Year Results, released in October 2012, were impressive.  Revenue increased 42% year over year.  NPAT increased 38%.  Earnings per share were up 35% and dividends per share increased 24%.  The share price is up close to 10% year over year.

Austin’s valuation and performance numbers are respectable, but a gearing level above 50% bears further investigation.  Value investors in general are more concerned about patterns over time rather than one year’s reported figures.  Looking at historical financials for Austin we learn the company’s gearing and long-term debt has increased every year for the past three years.  In addition, its liquidity ratios are weak, with a current ratio of only 1.20 and a dangerously low quick ratio of 0.8.  Finally there is the issue of cash flow from operations. 

The indicators we provided in our table should be seen as nothing more than clues for further investigation.  Debt with declining cash flow from operations is not a sign of a great company.  Digging a bit deeper, you would discover Austin Engineering is the only stock in the table that saw a year over year drop in net operating cash flows, from $43.77 million in 2011 to $24.62 million in FY 2012. 

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