Book Reviews

Book Review on The Value Connection

Book: The Value Connection: A Four-Step Market Screening Method to Match Good Companies with Good Stocks (2003) by Marc H. Gerstein, Director of Investment Research at Multex.

Review: This is a decent book. The main crux of this book is to focus on quantitative factors to the fullest extent, when choosing stocks. This minimizes the subjectivity and would effectively require a company to show (through its figures) that it is actually performing hence helps to protect against being enamoured by unproven future growth prospects (e.g. dot-coms). There is quite a focus also on analysts’ earnings estimates and how they are changing.

Key Points:

  1. “Investor-centric” approach focuses on what the investor will get. “Company-centric” approach focuses on what the company will get (hence what it is worth).
  2. Investor-centric approach
    • Three ways for corporate wealth to be transferred to shareholders: i) liquidation proceeds, ii) dividends, iii) shareholder sells his stake
    • P = D/(R – G) = (EPS * Payout Ratio) / (R – G). Hence P/EPS = Payout Ratio / (R – G) is the theoretical formula for the P/E ratio.
    • Though it is often said that the ideal PEG (P/E divided by growth G) ratio should be 1, there is no such basis. The PEG would be affected by other variables such as required rate of return and payout ratio.
  3. Company-centric approach
    • The Greenwald approach of calculating reproduction values, earnings power value, and the value of growth, are company-centric valuation approaches.
    • The only kind of growth worth incorporating into stock valuation is where the increase in earnings exceeds the additional capital necessary to support the new business.
    • While company-centric approaches are sensible, they are difficult for investors to reliably make judgments about asset replacement costs or estimate franchise values unless they have direct professional experience in the industry in question.
  4. Price is driven by supply and demand. The art of valuation is in recognizing when demand is motivated by factors that are irrational and unsustainable.
  5. Four-step screening method
    1. Step 1 – Find targets using screening software
    2. Step 2 – Analyze targets
    3. Step 3 – Buy
    4. Step 4 – Sell
  6. Step 1 – Find
    • Better to do comparative test conditions (e.g. 3 year EPS growth rate >= Industry average 3 year EPS growth rate) rather than fixed targets (e.g. EPS growth rate >= 15%). This will find companies that look good not because they are in a hot industry but because they have company-specific strengths.
    • List of some screeners
      • SmartMoney screener
      • Stock Investor Pro from American Association of Individual Investors (AAII)
      • Screener on or Multex premium screener
      • MSN Money screener
      • Premium Stock Selector
      • ProSearch by INVESTools
      • screener
    • To screen for non-mainstream parameters, can either i) create the parameter and sort the output by the parameter yourself, or ii) pre-calculate figures required to put into the test condition.
    • PEG ratios in the 1.5 to 2 range are often reasonable. Good to look for PEG <= 1.25 or PEG <= Industry average PEG
    • Use both forward-looking and historic EPS.
    • Need to screen for “footprints of success” to identify good companies
    • Use longer-term time periods and industry benchmarks (as opposed to sector or S&P500) to suss out company-specific advantages.
    • You can compare growth of parameters using a test like (TTM ROI / 5 Year ROI) > (TTM Industry Average ROI / 5 Year Industry Average ROI)
    • There are problems with ROI, ROE, ROA because the book value figure may not be correct (e.g. may have dropped, or may have increased significantly even though original investment put in was small, so the company would be unfairly penalised).
  7. Step 2 – Analyze
    • Check the price using various ratios (e.g. P/CF, P/E, dividend yield, etc.) in comparison to its Industry and the S&P500. Ratios include:
      • P/E based on estimate on next year’s EPS
      • Projected long-term EPS growth rate
      • PEG ratio
      • P/E (TTM)
      • P/E – 5 year high
      • P/E – 5 year low
      • Dividend yield
      • 5 Year dividend growth rate
      • Dividend yield + dividend growth rate
      • Payout ratio (TTM)
      • Price / sales (TTM)
      • Price / book value (TTM)
      • MRQ price / book value
      • MRQ price / tangible book value
      • MRQ price / net working capital
      • MRQ price / net cash (cash minus total debt)
      • MRQ price / cash
      • Return on enterprise value (%)
    • Assess the merchandise
      • Know what the company does, get a sense of the price charts, understand current news about the company, look at major shareholders
      • Look at analyst expectations and evaluate the credibility of their forecasts (e.g. broad range of estimates or small number of analysts are iffy), see whether the analysts are chasing the stock, whether there is an improving trend in ratings. This is done by looking at a table with rows containing EPS estimates for the current quarter, next quarter, current year, and next year, and columns showing the current estimates, the estimates 4 weeks ago, 8 weeks ago, and 13 weeks ago.
      • Look at the EPS trends of the company in terms of actual EPS figures (rows for 1st quarter, 2nd quarter, 3rd quarter, 4th quarter, whole year, columns for 3 years ago, 2 years ago, 1 year ago, and current year (with estimates)). Assess to see if the analysts’ estimates of EPS are reasonable based on historical trends.
      • Look at the sales and EPS growth trends of the company (TTM, 3 Years, 5 Years, 10 Years).
      • Compare margin data of the company vs. the industry for both TTM and 5-year average data for gross margin, EBITDA margin, operating margin, pretax margin, net margin, tax rate
      • Compare growth data of the company vs. the industry for sales and EPS using the following: MRQ vs same quarter 1 year ago, TTM vs TTM 1 year ago. Also compare the 5-year growth rate for sales, EPS, and capital spending.
      • Look at price performance vs S&P 500, and also the company’s rank in the industry in terms of price performance (over 4 weeks, 13 weeks, 26 weeks, 52 weeks, YTD).
      • Look at efficiency comparisons with the industry, TTM figures (revenue per employee, net income per employee, receivable turnover, inventory turnover, asset turnover)
      • Look at return comparisons with the industry, both TTM and 5 -year average (ROA, ROI, ROE).
      • Look at financial strength of the company vs. the industry (quick ratio MRQ, current ratio MRQ, long-term debt / equity MRQ, total debt/equity MRQ, interest coverage TTM).
      • Look at whether the stock is in or out of favour compared to benchmarkets.
      • Look at institutional presence and trading activity.
      • Look at insider presence and trading activity.
      • Look at levels and changes in short interest.
      • Review data relating to growth rates, margins, returns on capital
      • Look at trends, unusual income/expenses, non-operating income/assets
    • Getting our money’s worth
      • P = D/(R-G), hence G = R – (D/P) = R – Y where Y is the current dividend yield.
      • Calculate the implied growth rate G using R and Y, then ask yourself whether dividends can grow at least that quickly. Compare the calculated G with the historical dividend growth rate. If R is larger than Y, then the expectation is for the dividend to be shrinking.
      • Task 1 – Select a time horizon (e.g. 5 year period)
      • Task 2 – Determine the required annual return (e.g. using CAPM)
      • Task 3 – Calculate the predicted price 5 years later using the required annual return
      • Task 4 – Establish the future P/E for the market (e.g. using the Fed model by taking the reciprocal of the risk-free rate, so 5% risk-free rate means P/E of 20, another way is to simply take historical average, or average the 5-year high and 5-year low with the current P/E)
      • Task 5 – Establish the future P/E for the stock (e.g. calculate historical ratio of stock’s P/E to market’s P/E, and use the forecast for market P/E to derive the forecase for stock’s P/E, can use TTM P/Es).
      • Task 6 – Compute the required future EPS using the predicted price and future P/E for the stock.
      • Task 7 – Choose a present or near-term base level of EPS (e.g. consensus estimate of current-year EPS)
      • Task 8 – Compute the expected growth rate of EPS.
      • Estimate growth capacity to assess the doability of the growth expectation. ROC is a key indicator of growth capacity. Consider where the company is, in its lifecycle. Look at historical EPS growth, ROC, ROI, and ROA. Use discretion. You can also average all the data items or take weighted average.
      • Expectation Index = Growth Capacity / Growth Expectation. Index above 1 is bullish. Index below 1 is bearish.
  8. Step 3 – Buy
    • Analysis Key 1: Does the situation truly fit the theme you originally chose?
    • Analysis Key 2: Are there factors different from your original theme that you consider positive?
    • Analysis Key 3: Is this investment opportunity free of any factors that you consider negative? (e.g. not comfortable from the growth expectation analysis)
    • Buy Zone
      • Decision path A: Yes-Yes-Yes (YYY)
      • Decision path B: YNY
      • Decision path C: NYY
      • Decision path D: YYN
    • Avoid Zone
      • Decision path E: NNY
      • Decision path F: YNN
      • Decision path G: NYN
      • Decision path H: NNN
  9. Step 4 – Sell
    • Sell Phase A: Alert
      • Review your stocks at significant events (i.e. earnings releases, significant share price movements, mergers/acquisitions/divestitures/restructurings). Minimally review every 3 months.
      • Screen your portfolio stocks for sell signals, e.g. relative strength in latest 4 weeks < (industry average relative strength in latest 4 weeks * 0.65). Alert screens should seek performances that are not just weak but very weak.
    • Sell Phase B: Update
      • Do the same things in Step 2 – Analyze. Try to see the situation through the eyes of a hypothetical new investor who might be trying to decide whether to buy the stock.
    • Sell Phase C: Reconsider
      • Update Key 1: Is your original reason for buying the stock still valid?
      • Update Key 2: Are there any other factors you regard as positive?
      • Update Key 3: Is the situation free of other factors you regard as negative?
      • Reconsideration paths are the same as the Decision paths in Step 3 – Buy. This time, the paths in the Buy Zone in Step 3 are in the Hold Zone in Step 4. The paths in the Avoid Zone in Step 3 are in the Sell Zone in Step 4.
  10. -END-


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