You’ve heard this investing maxim near and dear to the hearts and minds of value investors everywhere – The Time to Buy is when there is blood in the streets. British Banker Baron Rothschild supposedly made this observation after making a fortune buying in the midst of the panic preceding the Battle of Waterloo.
Today there is certainly blood in the streets, yet trading volumes in share markets everywhere are dwindling as buyers are not stepping in and following Rothschild’s advice. Just how much blood is enough?
Here is a brief overview of the some recent bloody events:
• The HSBC flash Chinese PMI (Purchasing Manager Index) for November was 48 – the lowest in 32 months. The October PMI was 51. Values below 50 indicate contraction in the manufacturing sector.
• The HSBC Flash China Manufacturing Output Index also hit a 32 month low at 46.7, down from 51.4 in October.
• Share markets in Europe and the US collapsed as investors learned the catastrophic results of a German government bond auction.
• The United States may be headed for another credit downgrade as lawmakers failed to reach agreement on a long term deficit reduction plan. There is already legislation in preparation to reverse some of the automatic cuts to the defense budget agreed on in the August deal.
• France looks set to be downgraded this week, which will see its coveted AAA rating.
The inconvenient truth here is there is ample opportunity for more blood to be spilt before this is over. Australians might take heart that of the three most troublesome areas – China, Europe, and the US – China is still in the best position to continue to deliver economic growth.
The unexpected drop in the HSBC indicators is troubling. As you know, readings below 50 indicate contraction in economic activity. The world has been expecting a slowdown in the expansion in China, not a contraction.
However, other numbers provide a measure of comfort. The Chinese government has been implementing policies to slow growth to help control what they see as a bigger problem – inflation. In July of this year inflation reached a three year high of 6.5% but figures released in November show annual inflation fell to 5.5%. This gives the government room to go back to policies to stimulate growth.
Europe is a catastrophe. Germany is the Eurozone’s strongest economy and in a recent auction, bond investors responded to the government’s attempts to sell 6 billion Euros in ten year notes with a resounding yawn. Only 60% of bonds up for auction were sold. It's tough to see a way out in the near future with France set to be downgraded, UK unemployment at a 17-year high, and Spanish house prices tumbling for the 14th consecutive quarter while unemployment soared to 23%.
Perhaps the greatest concern is the possibility of yet another downgrade to the US credit rating. The rating agencies have warned of this possibility if the US did not come up with a credible long term deficit reduction plan. Not only did their politicians not do that, there is growing evidence some of the automatic cuts that were to take place in the event of a failure to reach agreement on a broader plan may be scaled back. With the concern over China’s contraction and the Eurozone debt crisis, this US threat is still under the radar of many investors.
In the face of so much blood, why are investors not looking for value shares? One could argue that market psychology drives the fear of more blood yet to come. Timid investors wait for the bottom. Value investors look for opportunities and jump in with an eye towards minimising losses.
Value investing takes many different forms, but all approaches aim to achieve the same objective – buying something for less than it is worth. The difficulty with disciplined value investing is determining the true worth of a company, or its intrinsic value. Many who consider themselves value investors use some shortcuts, including P/E and P/B ratios, dividend yield, ROE, PE/G, and Debt to Equity (Gearing) rather than the more complex discounted cash flow calculations.
A P/E less than 10 with a P/EG less than .5 would be a potential value share for any value investing methodology. The P/EG is a ratio popularised by Peter Lynch that expands on the P/E by using estimated future earnings growth in the denominator.
We searched the ASX for companies with a minimum market cap of 500 million dollars that met those two criteria along with a minimum dividend yield of 2%. Here are eight value candidates we found:
|Company ||Code ||P/E ||P/EG ||ROE ||Div Yield ||Share Price |
|Air New Zealand||AIZ ||7.96 ||.11 ||5.4% ||9.1% ||$0.67|
|Boart Longyear ||BLY ||9.36 ||.21 ||8.5% ||2.6% ||$3.03|
|Emeco Holdings ||EHL ||10.14||.46 ||9.2% ||5.7%||$1.00 |
|Fletcher Building||FBU||9.68 ||.43 ||9.8% ||6.3% ||$4.61|
|Henderson Group ||HGG ||8.61||.31 ||20.2% ||6.8% ||$1.59 |
|Mount Gibson Iron ||MGX ||4.50||.11 ||19.8% ||4.9% ||$1.18|
|One Steel||OST ||5.07 ||.49||5.3% ||10.8% ||$0.77 |
|Telecom NZ ||TEL ||11.46||.64||16.7% ||9.7% ||$1.56|
Where do we begin with this mass of numbers? Some investors forget that each number is a part of a whole and instead gravitate towards their favorite metric. Dividend yield is a major attraction of value investing as it provides a cushion in difficult markets. On that measure alone, one might zero in on OST and TEL.
When you look at the whole forest rather than individual trees OST appears to be the most undervalued. With a P/E of only 4.57 and a book value of $3.77 per share, it is trading at far below its book value with a share price of a meager $.77.
However, we have yet to look at another critical benchmark for value investing – debt. While always a concern, we are now faced with the possibility of another global credit crunch which will put companies that rely heavily on short term borrowing and excessive long term debt at significant risk. So let’s take a look at some debt and liquidity measures for our candidate shares:
| ||Quick Ratio ||Current Ratio ||Gearing 2011 - (2010) ||Long Term Debt ($m) 2011 - (2010) |
|AIZ ||.64 ||.81 ||83.4% -- (68.6%) ||851.5 - (731.2) |
|BLY ||1.12||2.09 ||23.5% -- (14.5%) ||243.5 - (147.7) |
|EHL ||1.4 ||2.34 ||48.8% -- (48.8%) ||290.5 - (298.9) |
|FBU ||.92 ||1.78 ||54.2% -- (40.3%) ||1,442 - (920.5)|
|HGG ||.91 ||1.31 ||50.5% -- (64.5%) ||272 - (325.9) |
|MGX ||.90 ||3.69 ||3.9% -- (14.4%) ||16.5 - (36.8) |
|OST ||.75 ||1.89 ||41.8% -- (23.3%) ||1,809 - (715.2) |
|TEL ||.58 ||.67 ||90.7% -- (91.2%) ||1,312 - (1,736)|
In better times some value investors might overlook higher debt levels. Right now that could be a big mistake. Long term debt is frequently restructured to get better terms. In the face of a credit freeze, that is not likely to remain a possibility. High gearing indicates a company is using more of “other people’s money” to operate than its own money. Liquidity ratios – the quick and the current – represent a company’s ability to convert assets into cash to meet short term liabilities. Ratios below 1.0 could represent a problem. If credit availability dries up, liquidity ratios become even more important.
All these indicators must be viewed in the context of the sector in which the company operates. For example, TEL’s 90.7% gearing seems outrageous until you compare it to Australia’s Telstra, with a gearing ratio of 115.3%.
Another issue with debt and gearing is the trend. Companies lever up and take on debt for expansion purposes and this is something you need to research. In our table we showed the year over year difference in gearing and long term debt for each company. You can see that OST more than doubled its debt and raised it gearing by about 40%.
On other measures, OST seems like it might be a bargain, but the bottom line is they are carrying too much debt.
Now let’s briefly review the other shares and see which ones shake out as potential bargains.
Air New Zealand (AIZ) is the premier air carrier in New Zealand. Unfortunately, it operates in an industry now dominated by rabid competition and rising fuel costs. Its debt position is no more than adequate and liquidity ratios under 1.0 could spell trouble. Compared to some of the other shares in the table, the ROE is nothing to get excited about. It does have a substantial dividend yield at 9.1%. Investors interested in AIZ need to check the company’s dividend history and payout ratio. Remember, yield is based on prior dividends paid with no guarantee of dividends going forward. In short, there are probably better options.
Boart Longyear (BLY) provides equipment, drilling services, and other consumable products to the mining industry. As such, they are at risk of a continued drop in commodity prices and a significant slowdown in China which will affect their customers – the miners. Although their dividend payout ratio is low at 2.8%, dividend payout has been spotty, with no dividend paid for FY2009. Although they modestly increased debt and gross gearing, they are still low enough to consider their balance sheet as reasonably strong. BLY is a share that bears watching.
Emeco Holdings (EHL) is another mining services company, specialising in renting heavy earth moving equipment. They are one of the few companies that actually reduced long term debt year over year although gearing remained the same. Their 5.7% dividend yield beats most term deposit rates but the most compelling thing about EHL is the share price of $1.02 compared to its book value. EHL is certainly a candidate for further review.
Fletcher Building (FBU) is a New Zealand based provider of building and construction materials. Although it has an attractive dividend yield, it has minimal exposure outside New Zealand and Australia. The company’s dividend payout has been gradually declining since the GFC. Should the building and construction business deteriorate further, FBU faces significant risk. There are other shares in our table that appaer to be better candidates.
Henderson Group (HGG) offers investment services in Europe, North America, and Asia. They are based in London. This company offers a substantial dividend of 6.8% and a solid ROE of 20%. Many value investors look for an ROE of 15% minimum to qualify for their consideration. However, considering the volatility of investment markets and the near certainty (in the opinion of many experts) the volatility will continue, the risks may be too great to look to invest in this company at this time.
Mount Gibson Iron (MGX) is a junior iron ore miner in Western Australia. Although subject to the same risks from volatile commodity prices and a Chinese slowdown, their numbers are compelling. The P/E of 4.50 and a P/EG of .11 are substantially better than the sector averages of 11.43 and .53. An ROE performance of over 19% and a share price very close to book value per share make them a prime bargain bin candidate. In addition, note they cut their long term debt more than in half and reduced gearing by approximately 70%. Although the current dividend yield is modest, analysts forecast the dividend to double in FY2012 and FY2013. MGX deserves a prime spot in the bargain bin.
Telecom NZ (TEL) was once upon a time a state run monopoly offering telecommunication services in New Zealand and parts of Australia. Although they stand to benefit from the coming broadband explosion, regulatory changes and fierce competition pose significant risks going forward. Although the dividend yield stands at a stunning 9.7%, dividend payouts have been decreasing over the past few years. There are better candidates.
Finding value shares is not for the casual investor. Today more and more investors seem to want someone to “give them a fish”, rather than “learning how to fish.” Value investing is hard work. We started with nine shares and boiled down to three – Boart Longyear, Emeco Holdings and Mount Gibson Iron. Depending on your risk tolerance, you may want to include others. However, to find real bargains you need to go beyond what we have uncovered here to look deeper into consistency of historical performance of a target share. The greatest challenge is determining the real or intrinsic value of the company, not just the stated book value per share. You need to know what goes into the accounting definition of “book.”
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