Welcome to Value Investing School, article 1 – How to quickly exclude stocks from further research.
With this article I wish to show how investing is mostly a game of exclusion if you are a bottom up value investor and you know what to look for. I’ll analyse L’Occitane en Provence as an example.
Things to learn are:
- Investing is a game of mostly exclusion.
- Focusing on the business yield, current or future, makes things easy.
- Don’t be a relative investor, be an absolute investor.
During the week I look at lots of stocks but what makes it easy for me to separate the interesting investments from the other, is the business return or the future potential business return. I look for current or even better, future double-digit yearly business returns and if a business doesn’t show that potential it is quickly skipped. This makes me an absolute value investor and not a relative investor, a very costly and risky mistake many investors currently make. As would Buffett say, we invest in businesses and not a stock that goes up and down during a day.
I am currently researching a stock list from an Asian Value investing fund with some very interesting names but also some strange decisions like the L’Occitane en Provence stock. On this stock, I wish to explain:
- 1) the risks of not focusing on the business yield
- 2) the risks of relative versus absolute investing and,
- 3) how easy it is to say no to an investment.
The business yield
If you are an investor in businesses, not stocks, all you care about is the yield of the business, the earnings and how the same earnings are reinvested or distributed at the end of the year. The higher the return on equity, your equity, the better. When buying stocks, your equity is the price you pay for the stock and the yield is derived by comparing the price you pay with the earnings. For example, L’Occitane is a growing company with revenues (1) tripling over the last 10 years (FY (fiscal year) 2019 revenue reached 1.42 billion EUR) and net income (2) almost doubling.
However, when I look at the net income, I see that the average over the last 5 years is around 100 million EUR. I compare it to the current market capitalization (the value of all the stocks outstanding) is 20.6 billion HKD or 2.6 billion EUR. This means that the business yield the company currently provides is at 3.84% given the price earnings ratio of 26 (100/26 = 3.84%).
That is far too low for me but then I must look at the growth the company promises. I look at the growth and see that same store growth is actually very low at 2%.
And that all of the growth the management hopes for comes from acquisitions and emerging markets. From reading a bit about the company there is a new management, the company is restructuring and it is something Warren Buffett despises, a turnaround. From the conference call transcript:
When you find words like ‘new management, new strategy, build trust’ it could be truth, but it could be also lots of baloney. Not what a value investor gets in to. So, when I see that I am already at ohhhhh.
Just another one for the record. On top of the new management, the company that made about a billion in profits over the last decade, suddenly decides to make an acquisition of a cosmetics brand and pays $900 million for a company with $40 million in EBITDA.
Source: Elemis acquisition announcement
All of the above is simply too risky, it might work, I hope it works for them, but it might also backfire as that kind of corporate actions often do. The plan is to scale the brand, a totally new brand, in China.
Source: Elemis acquisition announcement
It could happen it might not, too much risk and the actual business yield is below 4%. Enough for a value investor. So, let me finish this with why are other investors investing in this? Well, they do so because they are relative and not absolute investors.
Relative vs. absolute investors
This is a concept well described in Seth Klarman’s book Margin of Safety and L’Occitane is a great example. A relative investor looks at the company and says:
“I have a great global brand growing at double digit rates that just made a potentially transformational acquisition trading at a PE ratio of just 26. A fair valuation in this market should be 40, thus the stock is undervalued by 30%.”
This might be true and the market might revalue the stock, or re-rate it as the lingo goes, in case it shows faster growth in the future and improving margins. However, as a value investor you want both future growth and good earnings or value already there, not in some future promise. Also, the fact that the stock was much higher in the past, means absolutely nothing. Actually, it confirms that it was overvalued in the past and the market is slowly but surely re-rating it.
That is it, this is how I mostly spend my time, looking at companies that are not that interesting but from time to time, there is something interesting. To finish with a nice quote that summarizes this:
“Whatever you do, do it with all your might. Work at it, early and late, in season and out of season, not leaving a stone unturned, and never deferring for a single hour that which can be done just as well now.”
That is how bottom up value investing is done. You exclude more than 99% of businesses you look at and with time it becomes a fast process. Buffett says how it takes him 5 minutes to read through a business. Therefore, the more stones you turn, the better are the investments you will find.