The definition of value investing is buying shares that trade below their true worth, or intrinsic value. However that definition alone offers no clue as to how to determine a publicly traded company’s true worth. The value investing strategy is steeped in sharemarket history, first coming into focus way back in 1928 when Benjamin Graham and Charles Dodd began to teach its principles at Columbia Business School in New York City.
Since then a variety of approaches to determining intrinsic value have emerged, all involving fundamental analysis. And there are plenty of big-name supporters - the best known proponent of value investing is American investing titan Warren Buffett. Any investor looking for a model or paradigm for value investing typically starts with these six Buffett principles:
1. Consistently good performance (Return on Equity) over time – from five to ten years
2. Consistently low levels of long term debt and debt to equity
3. High profit margins increasing over time
4. Publicly traded for five to ten years
5. Competitive Advantage
6. Share price reflects 20 to 25% discount over company’s intrinsic value
The challenge of value investing lies in determining the worth of a company. The starting measures most investors employ – the venerable Price to Earnings (P/E) Ratio and the Price to Book (P/B) Ratio – are really measures of how market participants perceive the value of the stock. They are measures of sentiment, not performance.
In reality, a low P/E or P/B is merely a jumping off point for further analysis to get at fundamental performance indicators that reflect true worth. Buffett follows a complex discounted cash flow model. Others use different analytic techniques. Sometimes, this kind of traditional, or “in the box” thinking can allow a potential bargain to slip by unnoticed.
As a case in point, let’s look at two engineering company shares, Cardno Limited (CDD) and GR Engineering Services Limited (GNG). GNG is more of a pure engineering play in that it provides engineering, procurement, and construction services to a limited market – resources and minerals processors.
The larger CDD operates in three different divisions, providing engineering consulting and other services. They have separate divisions for Australian/New Zealand professional services and software operations; a similar division for professional services in the Americas; and another division for International development assistance. Their main focus is infrastructure development, both physical and social.
Both these companies have Price to Earnings Ratios under 10; an ROE over 15; and dividend yields over 6%. All value investing strategies begin with indicators like these. Here are the values for both shares, compared with their Sector averages:
|P/E||P/B||Div Yield|| ROE|
As you probably know, some general “rules of thumb” for value investing derived from the work of Benjamin Graham are a P/E of 15 or lower and a P/B of 1.5 or lower. Many value investors today look for a P/E under 10 and are less concerned with P/B since the ratio can have less meaning for companies without substantial physical assets.
Using these indicators as a rough guide, both shares seem to qualify as potential value share candidates. Dividend yield is high, although CDD’s dividend is only 70% franked. While GNG’s ROE of 51.7% is impressive, the P/B calls for further research.
Profitability and debt are also metrics used to search for value shares. The following table highlights key profitability and debt measures, as well as liquidity measures:
|NPAT ($m)||Net Profit Margin||Long term debt ($m)|| Debt to Equity||Current Ratio ||Quick Ratio|
On these measures GNG appears to be the superior value candidate. It shows a higher profit margin and a more attractive looking balance sheet, with low long term debt. It is more liquid and the lower gearing ratio tells us it relies more on its own money – equity – than other people’s money – debt – to finance needed operations.
Despite the attractive numbers, a strict follower of traditional value investing orthodoxy would throw GNG into the trash heap for one reason – lack of history.
Researching the P/B for GNG shows the ratio is high due to a 30 million dollar share offering in the spring of 2011 which was reported in the annual report in June 2011. If you back out the equity raise, the P/B for GNG drops to around 1.57. The problem is the equity raise was an Initial Public Offering at $1 per share.
GNG was first listed on the ASX on 19 April 2011. As such, value investors who think “inside the box” would look no further because GNG lacks historical performance measures.
If you are willing to think “outside the box” GNG may still qualify on the only measure on which all value investors agree – the share must trade for less than it is worth.
GNG provides both engineering design and construction services to the resources and minerals processing sectors. Although newly listed on the ASX, the company has been in business since 1986 and its original founder and most of the management team are still on the job. After more than a decade of successful operation it was acquired in 2001. In 2006 the management team went out on their own, as GR Engineering.
Since their recent introduction into highly volatile markets, GNG has managed to remain largely under the radar, with only two analyst firms initiating coverage; and low trading volume, averaging 56,163 shares per day over the last three months.
In contrast, the larger company CDD has an average volume over the same period of 71,922, with coverage from a total of eight analysts.
In a research report from Macquarie Research we find some performance measures for GNG worth noting:
|7.8 || 5.4|
|14.7 || 12.5|
Privately held companies maintain financial records, just like publicly traded companies, although the general investing public is not always privy to the numbers. Note that with the exception of a drop in revenues in the aftermath of the GFC, this company has improved performance on every measure. Perhaps most noteworthy to value investors is the handsome dividend, fully franked, in the company’s first year in operation as a public company.
If value investing means looking at companies that have stood the test of time but are currently undervalued, GNG passes. Macquarie has a twelve month price target for GNG of $2.03. Argonaut Research raised its earlier revenue estimates for GNG by 11% which the company beat by over six million in their annual reporting for 2011. Argonaut now has a price target of $2.20.
Here is a share price movement chart for both GNG and CDD:
Despite its impressive early performance, GNG is lagging behind CDD in share price. If you can think outside that traditional value investing box, that may be all the more reason to take a long hard look at GNG.
Its historical performance as a private company is solid. It entered the share market flushed with cash from their IPO, virtually debt free. What’s more, the analysts covering them point out their unique business model offers a competitive advantage. Some engineering contracts are based on EPCM, or Engineering, Procurement, and Construction Management. Under this arrangement, the client company hires construction companies needed to complete projects, generally in consultation with the Engineering Services Provider.
GNG, however, operates a “turnkey” business model known in the industry as EPC (Engineering, Procurement, and Construction.) Under this arrangement, the client company leaves the hiring of needed subcontractors up to GNG. This results in higher prices and higher margins for the provider. On average, EPC contracts represent a 10% to 20% price increase over their EPCM counterparts. Client companies are willing to pay in order to transfer risk of delays and other construction problems to their engineering services providers.
The final risk to consider regarding GNG is the potential for continuing drop in commodity prices. Although GNG’s current clients are primarily in the gold and nickel mining and processing business, the company has plans to expand into copper, lead, and iron ore miners and processors.
The outlook is far from clear. After a tumultuous few weeks, yesterday the American markets shot up over 4%. Positive news on the European front is credited as a catalyst, but there was another newsworthy event that has perhaps greater implications for Australians. For the first time in three years, the Chinese government cut reserve requirements for commercial lenders. This major policy shift comes as no surprise to China watchers who saw the recent decline in the inflation rate. With inflation in check, the change in lending standards is meant to increase credit availability which should help China’s slowing economic growth.
The ASX 200 followed global markets, up a healthy 2.6%, with rising shares outpacing declining shares by more than 2 to 1. Some economists are predicting a better than expected US employment number at the end of the week, which could turn this upturn into a real “Santa Rally.” However, if you have been at this awhile, you know full well to beware the “Grinch” who may be lurking in headline news yet to come.
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