Book Reviews, Valuation, Value Investing

Book Review of The Conscious Investor by John Price

I haven’t been writing new posts for quite some time, though I have been learning a lot during these past few months but have not found time to sit down to record my learnings. Regardless, I picked up this book recently by John Price, titled “The Conscious Investor: Profiting from the Timeless Value Approach”. This is another book written on value investing, and John Price has written a software named Conscious Investor that he has been selling on subscription for a number of years.

This book goes through a broad number of valuation methods, introduces fundamental and technical analysis, goes through basic accounting concepts, and then moves into elaborating each valuation method and its strengths and weaknesses. Essentially it is a compilation of many different valuation methods and presents each at a high level.

Overall I think this book is good for someone starting out in investing, but may not add much value to an experienced investor familiar with value investing and finance theories. For some of the methods that were mentioned (e.g. abnormal earnings method, earnings power value, magic formula, earnings power charts), the explanations in the original books I think are much better.

One interesting quote from Buffett which the book has and I don’t recall seeing before, is that Buffett looks for companies with pre-tax returns of at least 10%. Though it is not clear whether he is referring to ROE or Owner’s Earnings / Price.

Now for some key points. The book did a good classification of the different valuation methods into 6 categories:

  1. Balance sheet methods
    • Book value, liquidation value, net current asset value (NCAV), Tobin’s q-theory
    • Tobin’s q-theory gives a pulse on the market
      • q ratio = market value of an existing asset / replacement or reproduction cost (i.e. price for a new asset that replicates the existing asset)
      • If a business consistently sells for more than it costs to replicate it, then people will keep building such businesses to float on the market which drives the price down. If it is cheaper to buy an existing business than to build a new one, no one builds a new one and the profitability of the existing businesses go up which drives the price up.
      • In theory, q ratio should hover around 1, but the average since 1945 is 0.72. The ratio is less than 1 to avoid arbitrage over the long-term because the long-term return on corporate equity (growth of denominator) is less than the long-term market return (growth of numerator), so the numerator needs to be smaller than the denominator.
      • q ratio doesn’t work well for individual companies so analysis should be done over large sectors. Book value is usually taken as a proxy for replacement cost. A q ratio of nonfarm, nonfinancial corporate businesses can be calculated using the U.S. Federal Reserve Z.1. Statistical Release B.102 Balance Sheet of Nonfarm Nonfinancial Corporate Business, dividing line 35 (corporate equities) with line 32 (net worth).
      • Andrew Smithers has an updated q ratio chart here.
  2. Discount methods
    • DCF, DDM, ROE/payout ratio (the same method in Buffettology), Residual income method
    • Discounted Cash Flow (DCF) vs Discounted Dividend Model (DDM)
      • If there is a good probability that the firm can be taken over or its management changed, DCF is the appropriate model. If changes in corporate control are difficult (e.g. firm’s size, legal or market restrictions on takeovers), then DDM is the appropriate model.
    • Residual Income Method
      • This is similar to a standard DCF, just that you initialize your valuation with the Book Value of equity, and add the income that is in excess of the required return on the book value (i.e. you take a charge on the book value using the discount rate). So for each period, the residual income = earnings – book value * discount rate. Discount all the residual income in the future, add your initial book value, and you get the value of the company.
      • Clean surplus relationship between book value, dividend, and earnings: B2 = B1 – d1 + e1
      • ROE = e1 / B1, Forward ROE = e2 / B1 = ROE / (1 – ROE + ROE*PR) where PR = payout ratio = d1/e1
      • For the Forward ROE to be greater than discount rate R, means ROE > R / (1+R – R*PR). The denominator is approximately equal to 1 so ROE > R, i.e. for a company to have valuation in excess of its book value, its residual income has to be consistently positive => the forward ROE must exceed the discount rate R => the ROE must exceed the discount rate R, which is why Buffett focuses on the ROE.
    • If the clean surplus relationship holds, then the Growth Rate of Earnings = ROE * Earnings Retention Rate
    • Abnormal Earnings Growth Method
      • Developed by James Ohlson and Beate Juettner-Nauroth.
      • Let e1 = expected EPS in the year 1, and abnormal earnings z(t) = [ e(t+1) + r * d(t) – (1+r)*e(t) ] / r
      • Intrinsic value V = e1/r + z1/(1+r)^1 + z2/(1+r)^2 + ….
  3. Payback methods
    • Earnings payback period , dividend payback period
    • Payback Period
      • John Price defines payback period as the number of years required for the discounted earnings of a company to total the current share price. This is different from the typical corporate finance definition which does not consider the time value of money.
      • There are two interesting tables showing the implied Payback Period given a P/E Ratio and EPS Growth Rate, or given  a P/B ratio and ROE. 
      • My note: I recreated the tables to investigate (i) the range of P/E Ratio and EPS Growth Rate which would give an acceptable Payback Period, and (ii) the corresponding PEG ratio. Note that when I write P/E and EPS here, I mean EV/FCFF and FCFF. Now what would be an acceptable Payback Period? Some Googling revealed that the Payback Period for U.S. private equity funds is slightly below 7 years. Mohnish Pabrai in the Dhandho Investor wrote that savvy Indian businessmen look for Payback Period of 3 years. A 15% IRR benchmark would mean that you double your money every 5 years, equivalent to a Payback Period of 5 years.
      • If we use a Payback Period threshold of 5 years, assuming 0% discount rate, means that we most likely won’t buy anything about a P/E of more than 11. At P/E of 11, the EPS Growth Rate needs to be 28% or above. At P/E of 6, 7, 8, 9, 10, you need an EPS Growth Rate of approximately 7%, 12%, 16.5%, 20.5%, 24.5% respectively. This to me seemed pretty stringent. The PEG ratios on the other hand, are 0.85, 0.6, 0.5, 0.45, and 0.4 respectively. So in a sense, if you use consider 5 years Payback Period as fair value, then you are looking at PEG ratios of around 0.6 and below.
      • If we use a Payback Period threshold of 7 years, assuming 0% discount rate and 5 years of EPS Growth Rate followed by 3% terminal growth rate, we get a wider selection to choose from. We are looking at a EPS Growth Rate of 5% if P/E is 8, all the way to a EPS Growth Rate of 27.5% if P/E is 17. The allowable PEG ratio is 1.6 at P/E of 8, 1.2 at P/E of 9, 1.0 at P/E of 10, and 0.7 for P/Es higher than 10.
      • In general, the results imply that you should require PEG ratios being less than 1.0, more like less than 0.7 if the P/E ratio is more than 10. For P/E ratios lower than 10, you can allow for PEG ratios to reach 1.6.
      • For the Buffettology P/B and ROE method, with a Payback Period of 7, you are looking at P/B ratios being 1.0 or below, and ROE generally being from 15% to 30%.
  4. Index methods
    • PEG ratio, PEGY ratio, expectations risk index
    • PEG: Peter Lynch on One Up on Wall Street wrote to “look for stocks with a PEG ratio of 0.5 and avoid those with a PEG ratio of 2.0.”
    • PEGY: Peter Lynch later defined the PEGY ratio which is P/E ratio divided by the sum of forecast EPS growth rate and dividend yield. The sum of EPS growth rate and dividend yield gives the total shareholder return for the next year when P/E ratio remains constant.
    • Expectations Risk Index (ERI): Alfred Rappaport defines ERI as follows:
      • Market’s valuation of future growth = stock price – (initial free cash flow / discount rate)
      • Future growth proportion = market’s valuation of future growth / stock price
      • Acceleration factor = (1 + forecast of future growth of free cash flow) / (1 + historical growth of free cash flow) = gauge of how difficult it is to achieve future growth
      • ERI = Future growth proportion * Acceleration factor
      • If the Future growth proportion is negative, the ERI will be negative. The Acceleration factor formula needs to be inverted so that a lower forecast vs. a higher historical will result in a larger multiplier and a more negative ERI.
      • Find companies with ERI as low as possible.
      • My note: Note that the Future growth proportion can be calculated by knowing the EV/FCF because you can take the stock price = EV/FCF ratio and initial free cash flow = 1. It will be more accurate to use Enterprise Value rather than stock price. The free cash flow should be free cash flow to the firm.
    • Rules for P/E ratios
      • Know the history of the P/E ratio over the past 10 years or a full economic cycle. Identify what historical range of P/E ratios to discard if the situations are unlikely to happen again (e.g. crazy P/E ratios during dot-com for anything remotely linked to the Internet).
      • Do not  buy unless the P/E ratio is toward the lower end of the range, else growth in earnings might be offset by a decrease in the P/E resulting in a stagnant price.
      • Compare the P/E ratio with the P/E ratio of competitors. The market is less willing to pay high P/E ratios compared to competitors because any innovation by one company would likely be copied by its competitors.
      • Compare the P/E ratio with the average P/E ratio for the same sector or the overall market.
      • Be wary about buying when the P/E ratio is high. Ben Graham set an upper limit of 16 for defensive investors.
      • The earnings yield (i.e. E/P) is what the company might be expected to earn year after year if the business coniditions prevailing during the period were to continue unchanged.
  5. Expected return methods
    • Dividend reinvestment, separate dividend reinvestment, systematic margin of safety
  6. Miscellaneous
    • Graham’s valuation formulas
      • Original intrinsic value formula, V = EPS * (8.5 + 2g) where g is the earnings grwoth rate.
      • Modified intrinsic value formula to incorporate interest rates, V = [EPS * (8.5 + 2g) * 4.4] / Y, where Y is the yield on corporate AAA bonds.
      • Graham noted that his formulas do not take into account a company’s financial structure and debt position, and should be used only on businesses that “meet criteria of financial soundness.”
    • Benchmark Valuation Method
      • Proposed by Kenneth Lee.
      • ROE (avg) = Average of the ROE over the last 10 years
      • BV (avg) = Average of the book value over the last 10 years
      • Low Price (avg) = Average of the lowest price of each year over the last 10 years (i.e. average over 10 data points)
      • High Price (avg) = Average of the highest price of each year over the last 10 years (i.e. average over 10 data points)
      • Low P/B factor = Low Price (avg) / BV (avg)
      • High P/B factor = High Price (avg) / BV (avg)
      • ROE factor = Current ROE / ROE (avg)
      • Downside target price = ROE factor * Low P/B factor * Current Book Value
      • Upside target price = ROE factor * High P/B factor * Current Book Value
      • My Note: Take note to remove any years where the P/B is very unlikely to re-occur again. Might be good to just remove years with P/B above the 3rd quartile if there are outliers.
    • CAN SLIM
      • Developed by William O’Neil
      • C = Current quarterly earnings at least 18% higher compared to the prior year’s same quarter.
      • A = Annual compounded earnings growth rate of at least 25% over the last 4-5 years. EPS should grow year over year for the last 3 years. ROE of 17% or more. Annual cash flow per share should be greater than EPS by at least 20%.
      • N = New products, management, stock price highs, or positive changes for the industry.
      • S = Supply and demand. Look for stocks with small capitalization and relatively small number of shares outsanding. Look for decreasing D/E ratios, insider buying and large % of ownership by management.
      • L = Leader or laggard. Invest in the top 2 or 3 stocks (in terms of relative price movements) in a sector.
      • I = Institutional sponsorship. Owned by at least a few institutional investors with better-than-average performance records and that have added institutional owners in recent quarters.
      • M = Market indexes or market direction. Identify and go with the market trend. Go to 25% cash when the market peaks and begins a major reversal. Heavy volume without significant price progress may signal a top.
    • Haugen Factor Model
      • Robert Haugen analyzed 71 factors to find which factors at the end of a month had the most effect on stock performance over the following month.
      • Stocks with lower P/E, higher ROE, and lower P/B are likely to have higher performance in the next month compared to the market.
      • Stocks that outperformed the market over the previous one and two months, are less likely to perform well over the next month.
    • John Price wrote about Bruce Greenwald’s Earnings Power Value method, Joel Greenblatt’s magic formula method, Hewitt Heiserman Jr.’s Earnings Power Charts, but it is much better to read those from the original books.

Other points:

  1. Technical analysis doesn’t work
    • David Aronson carried out a study which back-tested 6,402 rules using the S&P500 Index from Nov 1980 to July 2005. To test for data mining bias, he used Halbert White’s reality check and Timothy Masters’ Monte-Carlo permutation method. Aronson concluded that none of the methods showed a profit above what could be explained by chance.
  2. Stock splits give abnormal returns
    • Investors interpret stock splits as a signal from the board that there is extra value in the company which is not reflected in the price of a stock. When a stock split is announced, prices rise more than would be expected by chance.
    • Jia Ye did a study which concluded that buying and holding stocks for 2 years after they split would outperform the S&P500 Index by 5.29% per year from 1979 to 1996.
  3. Selling rule
    • The general rule to selling is when you are very confident that you will get significantly more value for your money elsewhere.
    • Brad Barber and Terrance Odean showed that when people sell, on average, the stocks they buy underperform the ones they sell. This is because investors tend to be overconfident of their ability to interpret information, and investors want to get back into the market quickly after selling and do not spend sufficient time evaluating their new investments before buying.
  4. Book value growth tracks intrinsic value growth
    • Buffett wrote in Berkshire Hathaway’s 1997 annual report that while book value is of limited use, Berkshire regularly report their book value because it is easily calculable, and the percentage change in book value in any given year is likely to ba reasonably close to that year’s change in intrinsic value.
  5. Brand value is significant
    • Interbrand Corporation and Newsweek publishes the values of many national brands each year. It is useful to see what proportion of the stock price is attributed to the value of the brand. The general range is from ~15% to 50% of the stock price.
  6. Graham’s screening criteria for industrial companies for “defensive investors”
    • Sales greater than $850M (today’s dollars) to exclude small volatile companies
    • Current assets >= 2 * current liabilities
    • Long-term debt <= (current assets – current liabilities) (for utilities, debt <= 2 * equity)
    • Continued dividends for at least 20  years
    • No earnings deficits in the past 10 years
    • 10-year growth of at least 1/3 in per-share earnings
    • Stock price <= 1.5 * net asset value
    • Stock price <= 15 * average earnings over the past 3 years
  7. Analyst forecasts are highly inaccurate
    • David Dreman and Michael Berry did studies showing that 25% of EPS forecasts are within plus/minus 5% of actual EPS, 47% are within plus/minus 10%, and 58% are within plus/minus 15%.
    • Average negative earnings surprise was significantly larger than the average positive earnings surprise, meaning that forecasts were heavily weighted towards optimism.
    • George Bulkley and Richard Harris did a study on 5-year earnings growth rate forecasts and found no correlation between the forecasts of the analysts and the actual growth of earnings.
  8. Stability and Margin of Safety
    • John Price emphasized on the stability of the valuation inputs (i.e. EPS, ROE, Payout ratio, P/E) and developed functions to estimate each of the inputs with a margin of safety applied to the inputs (i.e. the inputs should be set at a level that is likely to be reached at some point in 5 years).

Good quotes in the book from famous people:

  1. Buffett in the 1996 Berkshire Hathaway Shareholder Letter: “Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards – so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.”
  2. From Charlie Munger: “Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.”
  3. Buffett: “We love owning common stocks – if they can be purchased at attractive prices. In my 61 years of investing, 50 or so years have offered that kind of opportunity. There will be years like that again. Unless, however, we see a very high probability of at least 10 percent pretax returns (which translate to 6 percent to 7 percent after corporate tax), we will sit on the sidelines. With short-term money returning less than 1 percent after-tax, sitting it out is no fun. But occasionally successful investing requires inactivity.”


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