Some of the new investors piling into share markets the world over are attracted to stocks with rapidly rising share prices. Those who try to learn more about investing before pushing the “Buy” button on their favorite online trading platform discover the stocks in question are considered growth stocks.
In some cases analysts label select growth stocks as “over-priced”, citing excessive valuation. The idea of valuation exposes another broad categorisation of stocks – value stocks.
The father of value investing, Benjamin Graham defined value as assessing the intrinsic value of a common stock – such as the company’s assets, earnings, debt, and dividend payouts — independent of its market price. The share market price reflects what market participants see as the value of the company which includes expectations about future earnings. When the intrinsic value of a particular stock exceeds its market price, the stock qualifies as a value, or “bargain” stock.
The commonsense allure of both growth and value stocks entices some newer investors without considering an element common to both – risk.
Who would not want to buy a prized collectible for a price expected to double or more?
Who would not want to buy a car valued at $45,000 for $40,000 dollars?
A growth stock that has been “shooting for the moon” can fall to earth faster than it rose at the first indication the expected growth investors were willing to pay a higher price for might not come to pass. New investors would do well to learn what happened with the dot.com bubble at the turn of the century when tech stock after tech stock disappeared when the market learned the explosive growth that drove the share prices higher and higher was a myth.
Determining the intrinsic value of a company’s stock is no easy task and when overestimated the market price that seemed so cheap can drop further and further. In addition, the assumption the low share price is indicative of a fundamentally sound company unappreciated by the market could be wrong. The market may have it right —the company’s true value is low, hence the low share price. The world’s foremost value investor – Warren Buffet – uses sophisticated measures beyond the capabilities of the average retail investor to calculate, like the discounted cash flow valuation model.
While value stocks have long been touted as solid long term investments, over the past several years they have been outperformed by growth stocks. The following chart from Morningstar compares the performance of growth stocks within the S&P 500 against value stocks from 2009 to 2018.
There were some market experts pronouncing the demise of value investing as investors flooded to glamorous technology stocks, among others.
Recent trading history suggests that may have been premature. Exchange Traded Funds (ETFs) are bought and sold like individual stocks but allow investors to gain exposure to a basket of stocks. The following chart from the US NASDAQ exchange compares the year to date share price performance of an S&P 500 Growth ETF compared to a Value ETF, both offered by iShares. The second half of the figure tracks trading volumes.
The reemergence of value stocks was first noticed back in October of 2020 and now may be sliding back to normal.
The recent shift might be explained by the hefty returns posted by tech stocks benefiting from the COVID 19 Pandemic. Now that the pandemic appears to be nearing its end, the opinion of some analysts is that some forgotten stocks will benefit from an economic recovery in a post-pandemic world.
So what can the average retail investor do to find prospective value stocks?
Fortunately, the DCF (discounted cash flow) is not the only way to estimate the value of a low priced stock. The Internet offers a wealth of advice on strategies for identifying value stocks, some of it contradictory. The least painful path is to start with a stock screener with readily available search parameters like these:
- Price to Earnings ratio (P/E),
- Price to Book ratio (P/B),
- Earnings per Share Growth
- Current Ratio (C/R),
- Dividend Yield
These five criteria eliminate two of the criteria used by Benjamin Graham. Recent studies of newcomers entering share market investing suggest a marked absence of investing knowledge spurred by less attention paid to due diligence (an examination of financial and operational performance). Two of Graham’s criteria – Quality Rating and Debt to Assets Ratio — are not included since both require an examination requiring multiple steps.
Not all of these criteria appear on all stock screeners nor on all financial websites, but almost all include the most commonly selected metric for selecting a value stock – the P/E. Some market experts find the P/B a more valuable indicator; some ignore the P/E; and some ignore both. The reason is simple – these two beloved ratios have little to do with the fundamentals of the company.
Yet low values on either of both of these ratios raise the heart rate of bargain loving investors. In fact, both ratios are more indicators of what market participants think the value of the company is. The case is made with growth stocks where a stampeding herd of investors eager to buy drive up the share price and along with it the P/E because the denominator in the equation – earnings per share – has not changed. Low P/Es indicate tepid interest in buying the stock, even though the share price may be appreciating.
The P/B ratio suffers from the same problem. The denominator – the book value of the company’s assets – does not change as buying decreases and the share price drops, lowering the ratio.
The other metrics do touch on the operations of the company. The following table lists the values for each metric for two prospective value stocks – iron ore miner Grange Resources (GRR) and mining services provider Macmahon Holdings (MAH).
Some investors might look at the year over year share price performance of Grange Resources and wonder how a stock whose share price went up triple digits year over year be a bargain?
While the P/E is well below the average for the Materials Sector, it is the P/B ratio that shouts out “bargain!” Some financial websites translate the P/B ratio into the more readily understandable book value per share. Grange Resources has assets valued at $0.62 cents per share. If you bought the shares on 26 March your cost would be $0.485 per share, a discount of roughly 21%.
While the discount would be less, shares of Macmahon Holdings could also be bought at a discount. Both companies are in the Materials Sector so comparing their ratios to the average sector ratio is important. Ideally, a diligent investor would look to compare a miner like Grange against other iron ore miners with similar market caps and Macmahon against other mining service providers of similar size.
One caveat about the P/B ratio bears mentioning. Some website include a Tangible Book Value per Share value, to reflect only assets that could be converted to cash. Some companies include “goodwill” as an asset. For Grange, the value is the same — $0.62. For Macmahon, the tangible book value per share is slightly lower — $0.23.
Earnings growth, dividend yield, and the current ratio are metrics that give some indication of how well the company is run. Regardless of how low the P/B and P/E are, a company with a spotty earnings, dividend history, and high debt suggests it may not be a bargain in the long run.
Both companies have solid earnings history, although the 10 year performance at Grange reflects the “death” of the mining boom earlier in the last decade.
The Current Ratio is an indicator of a company’s ability to pay its short term (within a year) debt. The higher the ratio, the better the company’s short term debt position. The Graham criteria of the Debt to Assets ratio can be calculated by dividing a company’s total debt by its total current assets, with both figures available on the balance sheet in the financial statements. The Debt/Equity ratio is another indicator, although not as meaningful as Debt to Assets. The D/E ratio indicates how much the company is financing its operations through debt as opposed to through its own assets. Low ratios indicate low levels of debt from a company paying its own way. Higher levels indicate the company is using more debt to finance its operations. Grange Resources has a Debt to Equity Ratio of 2.3 while Macmahon’s Debt to Equity Ratio is 53.7.
Dividend payments are generally indicative of a company strong enough to share some of what it earns with the shareholders. There is a risk in stopping your search with the Dividend Yield alone as dividend payments can be cut back or eliminated altogether. Diligent investors would dig deeper to see the company’s dividend history and its Payout Ratio. The Payout Ratio shows the percentage of a company’s earnings that are paid out to shareholders. Ratios above 70% – 90% suggests the company may not be able to maintain its levels of dividend payouts.
Grange Resources and Macmahon Holdings both have relatively low Payout Ratios – 17% and 19%. This means the company is paying out a relatively small slice of its earnings. This suggests two possibilities. The company is reinvesting into growing the business, and there is room for higher dividend payments. Both companies are more recent dividend payers, with Grange having suspended its dividend as the impact of the mining boom slowdown crushed the price of iron ore. The company paid out 2 cents per share in dividends in both FY 2018 and FY 2019, increasing to 3 cents per share in FY 2020. Macmahon paid out $0.05 per share in FY 2019 and $0.06 in FY 2020.
Numbers alone never tell the full story of a stock, growth, or value. What the company does and the customers it serves require due diligence as well. Macmahon offers a full range of services to miners of all types, regardless of what they mine and how – surface or underground. The company has operations in Australia and throughout Southeast Asia.
Grange Resources has both iron ore mines and processing facilities for producing iron ore pellets, which allow smoother operation in blast furnaces. The company claims the title of “Australia’s premier producer of iron ore pellets.” Their Savage River mine in Tasmania has been producing iron ore for Grange for fifty years.
Iron ore produced at Savage is pumped through a pipeline to a processing plant at Port Latta and then exported to New South Wales and the Southeast Asian Region. The company also has a 70% interest in an iron ore mine in Western Australia.
Grange saw declines in both revenue and profit between FY 2018 and FY 2019 but rebounded strongly in FY 2020, besting 2018’s revenues of $370 million with a reported $502 million and profit rising from $113 million in 2018 to $204 million in 2020.
Macmahon Holdings increased both revenue and profit in each of the last three years. The Half Year 2021 Results showed minimal impact from the pandemic, with a 5% decline in revenues and a 56% increase in net profit after tax (NPAT).