Contemporary Value Techniques

Although most value analysts use methods outlined by Graham and Dodd, they usually emphasize one set over another. According to Institutional Investor Magazine, most pension-fund consultants group value managers into four categories, by the criteria they use to determine cheap stocks.

The first category is the low P/E manager, who buys stocks with multiples below the market average. This manager normally owns out-of-favor stocks. The second is the high-yield investor, who buys stocks with higher-than-market dividend yields and future dividend potential. The third category buys low market valuation relative to book value, which often leads him to depressed cyclicals. This manager is sometimes considered the most contrarian, as he or she will buy companies with no current earnings. The last group focuses on the private or going concem value, measuring underlying assets or cash flow much the way takeover specialists do. Though the tributaries can diverge widely, all spring from methods described above.

Visions of Sugar Plums

Although all fundamental analysis sprouts from the same tree, one branch, the growth school, has dominated for considerable periods. This branch has pe Iexed value analysts back to the time of Graham and Dodd, because followers of this school often seem to tum the traditional valuation principles upside down. And, the growth analyst would say, for good reason.

Had someone put $10,000 into Microsoft, with its Windows software for PCs, on March 13, 1986, when it went public at $1.55 a share, he could have sold it for $ 1,750,000 in the third quarter of 1997. Wal-Marts eamings increased 23 times in the 1970-1980 period, and 40 times by

500 currently trades at over five times boolc. Companies priced under book, though common up to the seventies, are sighted about as frequently as unicorns in contemporary markets. Although debate rages as to whether this means markets are overvalued, a good part of the increase appears to result from absolute book value being far too conservative. With inflation putting prices up manyfold since the war, the replacement value of land, buildings, and other 1 assets is often far more than shown on its books.

1993. Anyone astute enough to buy $10,000 worth of Wal-Marts stock in 1970, when it went public, could have pocketed $10,000,000 by 1993. An investor who plunked $2,750 on Thomas J. Watsons Computing and Tabulating Company in 1914 was roUing in $20 million in IBM stock by the beginning of the 1970s. It hardly 8 18 8, then, with our economic growth depending on invention and technological change, that the growth school has so often ruled fundamental analysis.

American history is full of stories of investors who seized opportunities and made fortunes. The tradition of Microsoft, McDonalds, IBM, Compaq, and Wal-Mart is deeply rooted Americana. Participating in new, potentially vast ente rises gives us an exciting sense of communion with the Bill Gateses, the Warren Buffetts, and the John Kluges.

The growth analyst attempts to zero in on companies that can expect rapid and stable expansion. Like his more conservative value 1 8, he starts with the past, but his emphasis is on the future. He seeks companies that will continue to have superior profit margins and earn above-average returns on equity. A growth company should be less affected by economic uncertainties and should produce rising eamings through both inflationary and recessionary conditions, when many firms falter.

The analyst must successfully pinpoint trends: how well a new line of computers will do for Compaq or Hewlett Packard, how many customers America OnHne will put on the Intemet this year, or how big a market exists for Mercks newest blockbuster dmg. Extensive digging goes into determining product growth, market share, development of competition, maintenance of profit margins, and dozens of other factors. Growth stocks traditionally have traded at lofty multiples-two, three, four, or more times the P/E ratios of their more pedestrian compeers- which makes an error in projections fatal.

A growth company is believed to have remarkable control over its destiny. It normally has an entrenched position in a rapidly expanding market. Often its edge comes from exciting new technology that holds out the prospect of gigantic markets, as in the case of CompuServe, Netscape, and other Intemet access companies. At times it comes from patent protection, as with the large ethical drag companies, and sometimes from an imaginative adaptation of manufacturing, production, and marketing techniques to a service industry, such as McDonalds.

Growth companies reputedly have excellent management with the vision to create entirely new markets. Microsofts management foresaw the importance of internal software for PCs and correctiy predicted a multi-billion-dollar market. On the other hand, IBM, for which Microsoft was originally only a tiny subcontractor, beheved this software would be a

Why Dont They Work?

To judge from the record of professional investors presented in chapter 1, fundamental research has been no more successful than technical analysis. This seems strange, because the fundamental school appears to build on a much more solid foundation. Graham and Dodd, always skeptical of growth techniques, gave good reasons why this branch of analysis may not work. The first problem hes in the nature of the analysis itself. They believe that a forecast based on the measurable earnings power of the past is more secure than one built on extrapolated trends of growth. Such projections can be chancy, they repeatedly warn, even for prime growth companies. Then, too, for every real growth stock, dozens will fade in the stretch, if not at the gate.

The second problem with growth investing is that, even with accurate analysis, the question remains of what the proper P/E should be. It didnt take a genius in the 1920s to realize that the automobile would be a growth industry for decades. If anything, investors underestimated the industrys expansion. But that didnt help the analyst pick the three or four survivors from the hundreds of promising companies. Packard, Nash, Stutz-Bearcat, Duesenberg, Studebaker, and dozens of others were formidable competitors in their day. Intemet companies now present a similar jungle of possibilities. Scores of companies contend for this rapidly growing market, many with state-of-the-art technology. Which will survive? What price shall we pay for their prospects?

The third problem is: a rapidly growing company can trade at a P/E ratio of 40 or 50, then drop to 25 or even 15 as investors change their minds about its value. This happened to biotech stocks in 1993 and 1994. It also happened to Ascend Communications and 3Com in July of 1996. These stocks fell 45% or 50%, as perceptions went negative. In little more than a heartbeat, they tumed positive again and the stocks regained most of their losses within six weeks.* Evaluation, then, is just as difficult as forecasting.

* But not for long. Ascend dropped over 70% again by late 1997 on disappointing prospects.

small, commodity-like business with lackluster profit margins that it did not want to bother with. There are no billionaires at IBM.

As with basic fundamental analysis, growth stock investing has many rules. But once again, a system that appears sensible in theory has proved difficuh in practice.