How to build a margin of safety into stock portfolios (Part II)

The first part of this column, which looked at price/earnings ratios (PEs) and how to use them cited Warren Buffett a lot. With uncanny timing, the American investment legend’s annual Letter to Shareholders in his Berkshire Hathaway vehicle arrived last weekend (24 February) to provide an ideal context for the second part of our look at how to value stocks and use valuation as a means of controlling risk and protecting portfolios’ downside as well as spotting potentially profitable picks.

Given the phenomenal record that Mr Buffett and his long-term business partner Charlie Munger have accrued it is always well worth reading his Letter to Shareholders – and the great thing is there is an easily-accessible archive to back editions to be found at www.berkshirehathaway.com.

Buffett’s Berkshire Hathaway has outperformed the S&P 500 hands down since 1965

Source: Thomson Reuters Datastream, rebased to 100.

This year’s letter is particularly noteworthy for Buffett’s analysis of acquisitions. The so-called Sage of Omaha even makes it easy for investors of all levels of experience to understand how he assesses firms and their merits as an acquisition target or investment (not that he distinguishes between the two as Buffett stresses the importance of thinking like an owner and assessing any firm as if you were planning on buying the whole thing, not just a few shares which are treated as mere numbers on a screen).

Price must be right

To paraphrase, Mr Buffett says that he and Mr Munger look for:

• Durable competitive strengths (why customers go to a particular company and pay for its products and services rather than go elsewhere)
• Able and reliable management
• Good returns on net tangible assets (as this funds the reinvestment necessary to protect and strengthen the competitive position) 
• Opportunities for internal growth at attractive returns (so highly acquisitive firms will be treated with caution, those with good organic growth records, high margins and returns on capital will be looked at more favourably)

A sensible purchase price Mr Buffett places particular stress on the final point, adding “That last requirement proved a barrier to virtually all deals we reviewed in 2017, as prices for decent, but far from spectacular, businesses hit an all-time high. Indeed, price seemed almost irrelevant to an army of optimistic purchasers.”

An article in the Financial Times newspaper (27 December) revealed that global merger & acquisition activity crossed the $3 trillion mark for the fourth straight year in 2017. The 2007 peak was $2.3 trillion and seasoned market watchers will tell you that M&A tends to run at its hottest near market tops as executives lose their discipline, egged on by rising share prices and bullish sentiment.

Follow-up pieces by the same esteemed journal have since revealed that global M&A activity in January came to $273 billion, the fastest start to a year since 2000. Meanwhile private-equity buy-outs of businesses have made their fastest start to any year since the peak in 2007, with 152 deals so far at a value of $180 billion across January and February.

Think about this. 2000 marked one stock market top and 2007 marked another, so no wonder Mr Buffett is raising concerns and investors can address these concerns by focusing on valuation when they look to buy a stock or security and not just buying into a good story.

After last week’s analysis of the PE ratio, this week we shall look at a number of other valuation metrics which can help investors judge whether a stock represents good value or not, and whether its valuation builds in a sufficient margin of safety (or not) should anything go wrong.

Further tests

As discussed last week, the PE ratio has its uses, but it also has its faults and the biggest one is that it does not take a company’s debts or liabilities into account. This is especially important now when debt is cheap (and therefore widely used), share buybacks are in vogue and acquisitions are commonplace. A stock may have a low PE but there could be a good reason for this, namely that it has lots of debt, a big pension deficit or off-balance sheet liabilities, such as leases.

Debenhams is a case in point here. It looks cheap at first glance, on a forward PE of around 7.5 times with a yield of 6.7% but analysis of its balance sheet (and its trading prospects) suggests this may not be the bargain it first seems.

This is because future payments on existing leases (described in the 2017 annual report and accounts as “non-cancellable”) are estimated to be £4.5 billion, based on current terms and conditions, over the next 20-plus years. The annual lease bill of £221 million is a big burden.

Debenhams looks cheap but its balance sheet may explain why

Source: Thomson Reuters Datastream

Given the important of the balance sheet analysis and looking at companies in the round, this is where Enterprise Value (EV) multiples come into play.

1. Enterprise Value (EV) multiples

A company's Enterprise Value (EV) is determined by adding its debt, pension liabilities and contingent liabilities (such as leases) and subtracting its cash position and any pension surplus from its market capitalisation.

This adjusts for the state of a company’s balance sheet and helps to factor in the potential risk posed by a substantial debt pile and the relatively safety of a net cash position.

The EV figure tells the investor exactly what it would cost to acquire the firm, providing a useful benchmark valuation which can be measured against acquisitions made in the same sector or country.

This encourages the investor to follow Warren Buffett’s advice and think like an owner. If you would not fancy taking on Debenhams £4.5 billion lease payments in total, why would you fancy buying even one share in the retailer?

EV multiples are often used by predators such as trade buyers and private equity firms when they assess how much to pay for a firm. The EV then can be divided by sales (EV/Sales), earnings before interest taxes depreciation and amortisation (EV/EBITDA) and operating free cash flow (EV/OpFcF) to give a range of valuation multiples which can be used to compare stocks with each other.

In the case of a loss-making company, EV/Sales can be helpful and, depending on its average operating margin over a cycle and balance sheet strength, a rating below 100% could be interesting.

2. Sum-of-the-parts

A different way to look at whether a stock is cheap is to value its individual business units separately, based on the valuations afforded by the market to comparable quoted companies. The values accorded to each segment are then aggregated, and then adjusted for cash, whose worth is added, or debt, which is subtracted.

The result is then compared to the firm’s market capitalisation to see if there is a discrepancy. This is called a ‘sum-of-the-parts’ calculation and it is particularly useful for firms which are quasi-conglomerates, such as FTSE 100 bid target GKN, which, to repel Melrose Industries’ approach, now plans to break itself up into GKN Aerospace and GKN Driveline in 2019. Whether this fends off the unwanted approach or creates shareholder value remains to be seen.

GKN is now looking to break itself up, to the interest of investors who use sum-of-the-parts calculations.

Source: Thomson Reuters Datastream

However, stocks which look cheap on a ‘sum-of-the-parts’ basis are not always broken up, so that value may not emerge – if there is value there at all. Medical equipment-to-scanners-to-engineering expert Smiths Group has been the subject of break-up talk for many years but nothing has ever happened, which may suggest there is a good reason why Smiths has remained whole.

Years of break-up talk concerning Smiths Group have so far come to nothing

Source: Thomson Reuters Datastream

3. Price to Net Asset Value (P/NAV), also known as Price to Book Value (P/BV)

NAV or BV is assessed by dividing shareholders equity on the balance sheet by the number of shares in issue.

The share price is then in turn divided by this figure to get the P/NAV or P/BV ratio. Shareholders equity is total assets minus total liabilities and literally the net worth of the firm's assets today.

Any figure below one therefore suggests a firm is potentially looking cheap, although even here caution is required, as there may be good reasons why the stock is trading below the paper, or book, value of its assets:

• The assets are illiquid and therefore difficult to sell and hard to value
• Selling the assets could lead to tax liabilities
• The assets are falling or likely to fall in value

P/NAV is a popular tool for measuring the worth of certain sectors, notably real estate firms, insurance companies, banks and house builders since it gives a clear view of the actual value of their key assets.

Real Estate Investment Trusts (REITs) is one sector where price/NAV can be a useful valuation metric

	Share price (pence)	Historic NAV per share (pence)	Premium / (discount)
Safestore	509.5	329.0	54.9%
Big Yellow	842.5	640.8	31.5%
Londonmetric Property	178.6	155.7	14.7%
TRITAX Big Box	143.4	133.3	7.6%
Newriver	317.0	297.0	6.7%
SEGRO	589.8	556.0	6.1%
Shaftesbury	986.5	952.0	3.6%
Hansteen	136.8	132.5	3.2%
A & J Mucklow	522.0	506.0	3.2%
Workspace	985.5	1,014.0	(2.8%)
CLS	224.5	268.5	(16.4%)
Capital & Counties	276.4	334.0	(17.2%)
Derwent London	2,897.0	3,582.0	(19.1%)
Great Portland Estates	647.5	813.0	(20.4%)
Town Centre Securities	288.0	375.0	(23.2%)
British Land	652.8	939.0	(30.5%)
Land Securities	949.1	1,432.0	(33.7%)
Hammerson	477.0	776.0	(38.5%)
INTU	216.4	411.0	(47.3%)

Source: Based on historic dividend per share figures from the companies’ accounts and consensus analysts’ forecasts for dividend per share from Digital Look

Price-to-book is widely used when it comes to valuing Real Estate Investment Trusts (REITs). Their stated profits can be volatile owing to the sale of buildings, even if rental income will hopefully be consistent, so analysts who specialise in the sector tend to look at P/BV, as this figure tends to be less volatile but still captures changes in rents and building values.

Note from current valuations across the sector how all REITs are not the same and their business mix can drive a huge disparity in valuations.

REITs which operate in storage, such as Safestore or warehousing and logistics sites, including FTSE 100 firm Segro, currently trade at a premium to NAV.

By contrast, those REITs with big retail exposure, such as Hammerson and its bid target Intu, and to a lesser degree Land Securities and British Land, are trading at a discount as investors fear for the future of brick-and-mortar retailers (and therefore the rental and capital value of their shops to landlords). Land Securities and British Land are also currently being marked down for their exposure to the City of London amid fears over what Brexit may or may not mean for the UK’s financial services industry.

4. Discounted Cash Flow (DCF)

A Discounted Cash Flow (DCF) calculation is in theory the most scientific way of valuing a firm, although this notion has many detractors. The idea of a DCF is to establish how much a firm's future cash flow is worth in today's money. This is referred to as the company’s ‘intrinsic value’.

The four key elements of a DCF are:

• A basic operating free cash flow (OpFcF) calculation: OpFcF is operating profit plus depreciation and amortisation plus change in net working capital minus capex
• Establishing forecasts for OpFcF over the next ten years or longer
• Determining an appropriate weighted average cost of capital (WACC)
• Discounting future OpFcF using the WACC to establish fair or intrinsic value for the equity

'Deep value' investors swear by them, because of the long-time horizons involved. The discipline required to build a DCF also means an investor asks so many vital questions about risk – and not only risk to the firm's business model but general market risk too.

DCFs are often used for start-up companies that generate neither profit nor cash flow when they join the stock market - and in some cases they generate no revenues either. The assumptions that underpin the DCF must therefore be stress-tested more carefully and this is important now as interest rates and bond yield start to rise.

As this happens the rate at which future cashflows are discounted back to the present increases, in turn decreasing the net present value (NPV) of those cashflows and thus the estimated value of a company’s equity.

This is, in theory, why tech and biotech stocks, for example, could do less well if interest rates and Government bond yields keep rising – as the bulk of their profits are expected to come at some distant stage in the future, once their products gain wider acceptance, rather than in the near term.

Contrast this cyclical turnaround plays, such as banks or industrials, which may offer ‘jam today’ rather than ‘jam tomorrow’ if the global economy really does gain traction and spark a big increase in near-term profits. For the moment, however, the tech sector is still showing banks a clean pair of heels, using the S&P 1200 Global indices as benchmarks.

DCF analysis ensures investors think about risks as well as reward, including interest rates and their impact on valuation

Source: Thomson Reuters Datastream. Tech index rebased to Banks index.

Russ Mould, AJ Bell Investment Director