Graham & Doddsville Fall Newsletter 2018

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The Graham & Doddsville Fall Newsletter has recently been released featuring interviews with the team at Tweedy Browne Company, Scott Miller at Greenhaven Road Capital, and JP Morgan’s Steve Tusa. Of particular interest to value investors is the interview with the folks at Tweedy Browne who discuss how Ben Graham’s investing philosophy remains beneficial today, together with their valuation process and framework.

Here’s and excerpt from the newsletter:

Graham & Doddsville (G&D): How relevant is Ben Graham’s philosophy today?

Tweedy Browne (TB): I would argue that Graham’s philosophy is still fully applicable today. He was one of the first investors to create an investing framework that made sense. Graham came from the credit side of investing and, as a fixed income investor at that time, your downside protection was either the collateral put up against the loan or the bond.

He later applied that framework to equity investing and argued that the collateral value of an equity investment is the intrinsic value of the business. The value of the business could be its net asset value, it could be its book value, or it could be an earnings-based valuation.

By thinking in terms of business value and buying at a discount from that value, a diversified portfolio of undervalued securities should earn an adequate return. That framework hasn’t changed. As markets have evolved, there are fewer net current asset stocks and book value stocks that you can invest in today.

That said, we do find them from time to time in places like Japan and Hong Kong, but our current investments are overwhelmingly trading at discounts to an earnings type valuation.

G&D: What types of valuation metrics do you use?

TB: We look for “a satisfactory owner earnings yield.” For example, if you take a company’s operating income after tax and divide that by its enterprise value, and that produces an owner earnings yield of 8-10%, you’re getting a pretty good return.

Another recent change is that tax rates have been going down around the world. One advantage of this owner earnings yield metric is that it gives a company some credit for falling tax rates. All things equal, we believe that lower tax rates lead to higher net income and higher free cash flow.

G&D: How do you use NOPAT (Net Operating Profit After Tax) to EV (Enterprise Value) in evaluating opportunities? Do you compare it to long-term government bond yields?

TB: To an extent. We also look at it relative to other companies. If you rank 100 companies on EV to NOPAT, how does it shape up in comparison to deal valuations?

However, we don’t go much below an 8% owner earnings yield. You have to be reasonable and say, “If multiples in the market are 20x EBIT, we are simply going to pass on that because it doesn’t make any economic sense, assuming some normalization in interest rates.” The analysis is both absolute and relative.

G&D: How is the process for earnings-based valuation different?

TB: Earnings are less predictable. In conducting our analysis on earnings-based businesses, we spend a lot more time today on qualitative factors, factors that might impact that earnings stream over time.

We try to estimate the earnings power of the business, the sustainability of that earnings power, and what the growth of that earnings power might look like over time. It does involve an evaluation of qualitative factors which might not have been as prevalent in our analysis 40 or 50 years ago.

Previously, you didn’t have to do that. You could find a stock that was trading at 60% of net current assets, and you might glance at the annual report – which used to be 18-20 pages instead of 250 pages – to get an idea of what the business did. All you had to do was get comfortable with the inventory or accounts receivable.

G&D: How has this impacted valuation?

TB: The valuation framework remains the same – we’re still trying to buy companies at significant discounts from a conservative estimate of the underlying intrinsic value of the business. We tend to be pretty conservative appraisers.

Today, we often value businesses at 10 – 13x pre – tax operating income – compared to 6 – 8x when I first started at Tweedy in 1991 – and try to buy those businesses somewhere between 6 – 9x. The expansion in our valuation multiples is largely due to this march to the bottom in interest rates. In 1980, when I arrived in New York, the prime rate was north of 20%. You see what has happened since then.

Interest rates, with a hiccup here and there, have been in decline for over 35 years, and that has had a significant impact on what people are willing to pay for a business.

You see it in corporate transactions and the values people are willing to pay in acquisitions. Debt to EBITDA multiples in leveraged buyouts are very high today. Invariably, if interest rates are low, people are going to borrow a lot of money, and that’s going to inflate multiples.

We’ve incrementally increased our appraisal multiples over time, although reluctantly and with a lag. I think a lot of people would still consider us relatively conservative on that front, and we demand a substantial discount off those appraisals.

You can find the newsletter here – Graham & Doddsville Fall Newsletter 2018.

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