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IFB52: The Art of Finding Undervalued Stocks

undervalued stocks

Alright, folks well welcome to Investing for Beginners podcast. This is episode 52 Andrew and I are going to talk about balancing the art and science of intrinsic value.

Today we’re going to talk a little bit about intrinsic value, one of my favorite subjects and Andrew’s as well and this should be a little bit of fun so Andrew why don’t you go ahead and start us off.

Andrew: yeah sure so basically you know we’ve been doing that back to the basic series this one’s going to be admittedly pretty technical so if you’re not as far along maybe skip this one save it for later go back to the back to the basic series. But this is going to be for those of you who are following along starting to look at the intrinsic value of companies trying to figure that out for ourselves and figure out how can we determine when the stocks undervalued when it’s overvalued and really just try to take that process to the next step.

Because on one side it sounds really easy to say just buy low sell high it’s really easy to say buy with a low p/e only to say it’s easy to say a lot of those things but when you really get down to it there’s a just a myriad of different ways you can evaluate intrinsic value.

Same with evaluating the margin of safety and when you just talk about value investing, in general, there’s so many moving parts and so I think it’s important for us to kind of just discussing the whole beast so to say so.

I remember when I first started out and when I was doing the blog and stuff I interviewed Jae Jun from Old-School Value and it was a great interview it’s up on YouTube still if people want to go check it out. But he basically talked about the fact that there’s a science and an art to value investing and so that’s really key and a lot of times when people talk about it they talk about the quantitative side versus the qualitative side.

You know the quantitative of just looking strictly at the numbers whereas the qualitative or things like you know things you can’t really use numbers to evaluate. So things like how’s the integrity of management how is the business kind of going along what ‘s the corporate structure look like what’s the corporate culture look like how are the competitive advantages as they as you kind of speculate them outside of a numerical market share type thing.

Yeah I mean you could go on and on and on but we’ve definitely had a couple episodes about focusing on the quant episode 10 was an example of one of those we did. Episode 12 we kind of talked qualitative stuff but I think about the art of valuation in terms of value however you want to say that to me it’s more I’m not talking about getting into the art and referring to it as a qualitative thing.

I still kind of don’t lean that way if that makes sense what I want to do is take the numbers figure out what that whole picture is and then instead of trying to break it down to an exact science. We’re looking at a business and saying you know what this business earns this much has this much cash flow as it has these many assets therefore this business is worth blank like 75 dollars a share.

I think that’s kind of going overboard on the quant stuff and on the science part of it I think where the art part comes in is where you kind of need to look at okay maybe this stocks more generally valued around sixty to ninety and you know whatever that range maybe I mean that’s a very loose range it’s obviously not going to be that maybe that loose of a range.

But I think it’s something where it’s going to be something more like that and then trying to find a stock that’s trading at a discount to that and so I think when we talk about art and science of intrinsic value. myself in particular the way I define it is as looking at buying stocks that are undervalued as a strategy and as something where you are kind of going with the flow and basically structuring a strategy where you’re not always 100% going to get it right you might not even 100% get the intrinsic value calculations right.

And so by definition, you won’t necessarily 100% be always buying undervalued stocks but the kind of art and the kind of skill that an intuition that goes behind that is making it where you’re basically trying to get that in the majority of the cases that you’re doing. Trying to and by doing that you know you’re trying to get as big of a margin of safety as you can realistically get for yourself so it’s going to be different for everybody.

But I think that’s something that we need to cover today and kind of different particular ways you can do that and how you can kind of look at valuation and look at intrinsic value is something that’s more of a range rather than specific value.

Dave: exactly and when you talk about an intrinsic value it can be as simple as figuring out exactly what the price of something is and I’ve talked about this for in the past where intrinsic value is something that we deal with on an everyday basis you know whether you go buy gas eggs or a car you’re looking at a price you think they’re worth. And deciding whether you want to pay that price or not and calculating intrinsic value there are so many different ways of going about doing that.

Whether they’re using you know evaluation models like a discounted cash flow dividend discount model or even something simple like the Benjamin Graham formula.

Any of those are you know ways that you can calculate an intrinsic value and find a specific price for that and I always come back to whenever I’ve talked about any of those kinds of metrics or models either in my blog posts or in the podcast. We’ve gotten questions about you know how do I do this and people more or less obsessing about the number part of it or the science part of it as Andrew was talking about.

And I always try to go back to when we’re doing intrinsic value calculations you have to always remember that you’re looking for a range of possible outcomes. because whenever you’re doing those you’re using numbers that include estimates so if you do an estimate of a growth value and any sort of formula it’s strictly in it it’s an estimate and as Charlie Munger says humans are very poor future you know analysts or predictors of what’s going to happen in the future I know I certainly can’t maybe Andrew can because he is special.

But I don’t have that but I don’t have that ability and so when I’m looking at those numbers I always I always generally try to do two different calculations maybe one being super conservative and maybe one being a little more aggressive. and then you could look at a range between those prices and that’s really kind of where some of the art comes into you know intrinsic value and a price of a stock is you’re really looking for a range because you’re never going to know exactly this is company going to grow five percenters are going to grow 14.2% or is it going to grow 0.8 percent.

And you have to just kind of give yourself a little break you know take a deep breath and when you’re doing these numbers just realize that you know you’re looking for you know a range.

And I love what Andrew was saying about Jae Jun and I remember when I first started reading his stuff he’s great he’s a great author and he has a great website by the way if you guys ever get a chance to check his stuff out it’s amazing. He talks a lot about that about a range of prices that he looks for and one of my favorite authors Monish Pabrai, he does the same thing in his book the Dhando Investor he has a very specific he actually has two examples in the book where he talks about how he kind of calculates intrinsic value for  two different very different companies.

He shows different ranges based on different growth rates and he talks about back up the envelope kinds of calculation so even if somebody as smart and sophisticated as he is not obsessing about finding out you know that you know Bath and Bodyworks is going to be worth exactly eighty-two dollars and forty-two cents I don’t know if it’s that price I’m just throwing out numbers here. but he doesn’t worry obsess about that he tries to find a range and then uses his you know intuition to decide whether he thinks those are overpriced or underpriced.

Based on his experience in the market looking at other companies doing analysis of other companies other retail companies with just other companies in general and that’s where some of the education comes into in the experience and those kinds of things can really help you when you’re looking at you looking at working with these models or these numbers.

I always come back to this and Andrew and I were talking about this before that Buffett and Munger always preach that it’s better to be they always come back with it’s better to be generally right than precisely wrong and I think that really strikes the heart of the core to me when I’m thinking about the art of calculating intrinsic value or value investing I think that is so profound of a statement and I really think that’s a great way to think about what you’re doing when you’re doing these kinds of things.

Andrew: I love the way you eloquently describe that and it’s key right because on the one hand it’s not like these are questions we get a lot and they’re excellent questions it really shows that you’re getting in the right direction and so I don’t want it to sound like we’re saying that these are bad things to have this is part of the learning process.

And so like Dave like you said I mean when you’re doing these blog posts where you’re describing how to do discount the dividend discount model or the or the DCF and then some of the other models when Dave writes a post like that and he does like an example it comes out with a specific number but that’s for the for the purposes of teaching.

When it comes to actually using that when they come when you’re going to go and look just to see if the stocks undervalued then that’s where you want to look for the ranges.

I kind of want to talk about how I use ranges in maybe a different fashion. I’ve talked before on the podcasts about how I like to look at obviously all three financial statements I like to look at what’s the complete picture that a company’s numbers is telling us they are painting the complete pictures just up to us to interpret it and to attain.

I know I’ve used the metaphor before where I would rather have a house that’s surrounded by ten different cameras rather than one camera pointed at the front door and HD. so I’m not focusing in on one metric model and use you know hearing is 10% as an estimate of growth for the next decade. or so laser focusing on that 10% isn’t maybe going to give you any sort of range whereas if you can say you know it’s reasonable to expect eight to twelve percent and then you run that calculation several times and now you have a more reasonable range where you can be generally correct.

I use that when I’m looking at valuations and then I will combine the valuations together. Obviously, if you want to get in depth and know exactly what I’m talking about you’re going to have to buy a Value Trap Indicator package where I show the exact numbers and metrics and all of those things but for the purposes of today’s episode, I’ll just give an example.

A lot of times I like to say and I say this in the free ebook too you want to look for a stock with a p/e under 25 I’d obviously prefer one that’s under 15. Benjamin Graham when he wrote the Intelligent Investor he talked about wanting a stock that’s under 15 PE and I believe it was under 1.5 PB somewhere in that range right. so when I say that though and then when I run these calculations and look at the company’s financials I’m you when I’m becoming intuitive is when I’m knowing when to break those rules.

I talked about this in my daily email today if I have a stock where let’s say the price to books really great the price to sales is really great there is enough cash flow and enough cash in the in the cash flow statement at the end of the year and it looks like there’s plenty of cash to be able to weather any sort of storms if the debt levels are good if the dividends growing nicely and healthily and not doing so with too high of a payout ratio.

If all those things are in place but I have a stock with a P/E of 26 just because it’s not under 25 doesn’t mean I don’t want to necessarily buy that. whereas you know I think if you talk to a lot of value investors who like to run screens and they and they like to have these filters and you know and it’s easy to write because when you do things like back tests where you’re testing the validity of a strategy.

It’s so easy to plug in these filters in the back tests and say okay well I would have just bought all these stocks I had a P/E under 25 and the PB under 1 and then see how that portfolio would have done over decades of time. But I think it’s important to kind of combine all of those things and not be so science oriented where you’re just going to have like a strict cutoff without putting any thought into is is is really a PE of 24 any different than the PE of 26. I mean we’re basically talking semantics at that point.

The whole purpose of doing an arbitrary number like 25 and saying I want to buy a stock with a PE under 25 the reason we’re doing that is if you take price to earnings its price divided by earnings what makes those things what makes that ratio go down and why do we like it.

Number one either the price is so low that it makes the PE low which is great because we want to buy low or the earnings are so high that you know that denominator is so high that the ratio Falls so basically the two things we’re looking for is are there enough earnings and is the relation of how much earnings this company has compared to how it is priced currently at the market is that generally undervalue there at least fairly valued in the ways that we like to consider it.

That’s the logic and it’s not picking the 25 and saying that’s where I’m going to stick to and the same token you know there’s a big difference between let’s say a p/e of 26 and the p/e of 46. Right now we’re talking about an almost doubling of the p/e ratio and that means that’s almost full that’s almost as little as half of the earnings that you could get by buying this stock at a p/e of 46 rather than buying a stock that’s at a p/e under 25 you know why would you buy half the earnings when there’s other stocks out there where you can get double that much.

That’s kind of the thought process and I like to take that and I did this you know when I was creating the Value Trap Indicator formula there is some like advanced math involved there there’s exponentials and you know different numbers multiplying against each other and in the relationship is very mathy.

But the general concept is still the same and to be like a good value investor who is crafting the strategy where you’re generally buying undervalued stocks I don’t think you need to use that kind of math and if you just understand things like earnings assets and cash. Then you have like 90% of the picture right.

But the devil is in the details in the sense that there does also need to be an art our portion to this investing stuff and so the way that I kind of do it is by having this fluid sort of the formula that went when the numbers get played out it’s going to basically I’ve manipulated the numbers to give to make the intuitive decisions that I would have made anyway.

For example I use the PE example as one thing another example would be like price-to-book right now we’re instead of talking about numbers that are in the 15 to 25 range now we’re talking about 1.5 to you know 3 all the way down to maybe point 1 or I’m sorry like under 1. In the case of price-to-book because that number range is so much smaller when you get below 1 the difference of that is such a higher magnitude that I made like a higher priority on it that’s basically the best way I can describe it in words.

If you have a stock with a price to book at like 0.8 what that’s telling you is I’m getting I’m getting like a 20% discount on what the assets are it’s 0.8 is 80 percent and then 20 percent makes it up to a hundred. So that is a huge advantage and arguably more of an advantage than let’s say having a p/e of 17 versus 25.

So you know those are some things that come with experience those are some things that come with analyzing the financial statements and those are some things that the Value Trap Indicator automatically incorporates because I put a lot of thought and research into it so that people can use the spreadsheet without having to go into that intricate math.

But for somebody who is looking at making an intrinsic value or calculations for themselves whether the application of what we’re talking about today is you know whether that needs to be just having that something as simple as a range or whether that goes more complex into when you’re juggling various ratios and valuations and trying to figure out how to how to get into stocks that are still undervalued in the sense that you like to consider them.

Whatever that may be I think it’s just important to understand that there this is a side to it it’s not strictly all numbers and maybe in my in a case like mine where I’m still using the formula to make an intuitive decision. it’s still using numbers but doing it in a way that’s smart and that’s not as cut-and-dry black and white as I’m going to make a cut-off here and I’m not going to buy a p/e of 26 or I’m not going to buy a price-to-book of 3.

Or even you know like I’ve talked before how even if everything kind of looks fairly valued right if it’s not one metrics really saying like man this is a screaming buy. But everything’s good and the business looks good and it’s healthy and there’s plenty of cash there’s a strong balance sheet.

To quote Warren Buffett again “that’s a situation where you have I would rather buy wonderful company at a fair price rather than a fair company at a wonderful price.”

That’s kind of I think another way to look at the art evaluation and to maybe use those type of things to really narrow down on when you’re going to look at margin of safety with an emphasis on the safety I think it’s safer in my opinion to make these kind of intuitive decisions rather than just strictly rely on quant and science and numbers that you’re not giving much thought to.

Dave: I love the way you wrap that up that you know I think that really kind of summarizes when you’re thinking about looking at intrinsic value and kind of incorporating intuition into it kind of going back to my buddy Monish Pabrai, you know he talks a lot about in his book about finding what a sale price of a company is and then he uses an intrinsic value to kind of find a range of what he thinks it’s actually worth.

But he also incorporates into it he’s looking for an upside to the company he’s also looking for a return on his investment and he will just basically look at the difference of the spread of the ranges versus what it’s actually what it’s selling for at the current price and then he decides whether he thinks there was an upside to it.

He will look at the company as its own entity but it will also look at it in relation to other parts of where it’s sitting in it’s a type of company that it is whether it’s retail whether it’s oil whether it’s shipping or whatever it may be Internet it could be anything so he looks for whether he thinks that there’s going to be ups in the up side in the retail market for example if he doesn’t think there is and he doesn’t think he’s going to be able to get his return on his money though it may still be selling for quote unquote less than the intrinsic value of whatever you calculated it for.

So there is a margin of safety there but he’s also intuiting you know that he doesn’t think he’s going to make much on it so for him it’s going to be a pass. Because it’s not just about finding a company that is selling for below its intrinsic value he’s also looking to see if he’s going to he thinks he’s going to be able to make anything on it as well.

And so when he buys into something like Southwest Airlines he he finds that it’s selling for a certain price he does his calculations the thing said it’s maybe at that point less than is selling less for what it’s thinks it’s actually worth it. But he also thinks that the company has room to grow and he’s going to be able to make his investment back he’s not going to lose his money and he’s going to make money on the investment and for him something like that could be an investment.

Whereas excuse me I may look at that and go yeah I don’t know that the airline’s going to do that great you know I think that the price of oil is going to continue to affect the fuel cost of flying an airplane and with labor unions and everything you have to deal with that I just don’t know if it’s the best investment for me personally.

I think that’s really where it comes down to the art of what Andrew was talking about is you know you’re still looking at the numbers and you’re still using those as a guideline because that is what we do but you’re also thinking beyond just the number you’re looking at all the different aspects and factors that go into making investment and it’s a little bit of the qualitative part and it’s a little bit of the unsure part of it when you look at a spreadsheet and when you look at a balance sheet in a cash flow statement the numbers are right there and when you take them out of there and use those in formulas it can doesn’t lie.

But there are other aspects of that number of how it got there and where it can go that you have to kind of use your intuition and your experience and your intellect to figure out whether you think that that is something that’s going to go up or down.

That’s really to me where the art comes into it is really figuring out you know you do the science part of it but then you also have to take some intuition and some art to it to figure out whether you think that this is going to be something worth investing in.

Andrew: yeah that’s perfect and that’s like going to give you that extra push to really make yourself feel confident in the stock if you can do that yourself then that might be the difference between confidently holding forward and letting a reversal and the trend happen and letting the recovery happen versus maybe selling out too early because you didn’t feel good enough about why you were in the stock.

so it’s definitely important to consider and I like the way you talked about Manish Pabrai and how he incorporates growth I mentioned on the in an interview I was recently on from with Nick from Sure Dividend investing you know obviously he was on the show a couple episodes ago and I was on his show as a guest.

I had a question I answered online from a beginner and it was what were the three things that you really wish he knew when you first started I remember one of the key ones that that I shared was that I wish I would see the importance in incorporating growth with value and so it’s everything Dave just said and that Manish Pabrai practices.

it’s also something that Peter Lynch refers to a lot in his book Beating the Street how he relates price to earnings which is value and how he relates it to growth and it’s one way to display that is in the PEG ratio and it’s just an extension of the p/e ratio and it’s taking growth into effect and it’s something I talk a lot about my e-letter to how I how I determine what kind of growth I like to see and then combine that with the good value type indicator score.

That’s something that’s really important to consider as well and I’m glad you brought that up Dave because that’s growth is just as mark as important when you’re talking about margin of safety as evaluation is and so combining the two is really where you can find the sweet spot and then add dividends along the way and now you’re you are expanding and compounding on those advantages even greater at the longer hold.

Alright folks well that’s going to wrap up our conversation today about the art of intrinsic value. I hope you enjoyed our conversation between Andrew and I there was a lot of fun for me to talk to about this I really get passionate about intrinsic value as does Andrew he wrote a great email today about this very process and if you are not a member of his email Club you definitely need to be because he dropped some really great stuff on a daily basis so I highly recommend you take a look at that.

So without any further ado we’re going to go ahead and sign off you guys go out and find some great intrinsic value invest with a margin of safety emphasis on a safety you have a great week and we will talk to you guys next week.