Five top-notch and undervalued firms ripe for investment and an in-depth look at all the assessment metrics
This is how and why we use all the valuation ratios in the newsletter
This editorial is part of our monthly Quant Value Investment Newsletter released on the 4th of July, 2023. Subscribe now to receive it in your inbox every first Tuesday of the month.
More details about the newsletter are available here: Understanding our approach in selecting prospects for the Quant Value investment newsletter
This issue covers a thorough discussion about the evaluation criteria utilized in the newsletter.
But before we delve into the nitty-gritty of assessment ratios, let’s first review the changes in our portfolio.
Portfolio Adjustments
Europe – Grab One – Shed Four
This month, one new suggestion emerges as the index exceeds its 200-day simple moving average.
The firm is a rapidly expanding UK-based wholesaler trading at a modest Price to Earnings ratio of 14.9, Price to Free Cash Flow of 8.9, EV to EBIT of 12.6, EV to Free Cash Flow of 10.7, Price to Book of 3.0 and yielding a 2.3% dividend.
As I was preparing to dispatch the bulletin, the company unveiled promising interim results. The stock surged by +7%, yet remains attainable at this level – refer to our company analysis for more insights.
Protective Dissolution – Vend
Dispose of TF1 SA incurring an 8.2% loss
Dispose of Braemar Plc incurring a 25.8% loss
Dispose of Origin Enterprises plc incurring a 19.6% loss
Dispose of Crest Nicholson Holdings plc incurring a 13.7% loss
North America – Procure One
One new recommendation emerges this month as the index exceeds its 200-day simple moving average.
The firm is a US-based Human Resource establishment trading at 6.6 times Earnings, Price to Free Cash Flow of 5.1, EV to EBIT of 5.0, EV to Free Cash Flow of 5.9, and Price to Book of 2.3.
Asia – Procure Three – Vend One
Three novel recommendations surface this month as the index surpasses its 200-day simple moving average.
The first is a Singapore-based staffing and recruitment entity trading at a Price to Earnings ratio of 10.9, Price to Free Cash Flow of 10.0, EV to EBIT of 5.7, EV to Free Cash Flow of 5.6, Price to Book of 2.0 and yielding a 5.4% dividend.
The second is a Japanese entity involved in the production and sale of surface treatment agents and equipment trading at a Price to Earnings ratio of 14.3, Price to Free Cash Flow of 12.6, EV to EBIT of 6.8, EV to Free Cash Flow of 9.2, Price to Book of 2.3 and yielding a 1.9% dividend.
The third is also a Japanese entity chiefly engaged in the vending of electronic components and devices trading at a Price to Earnings ratio of 7.3, Price to Free Cash Flow of 6.2, EV to EBIT of 4.8, EV to Free Cash Flow of 5.8, Price to Book of 1.3 and yielding a 3.5% dividend.
Vend – One
Discard China Telecom Corporation Limited (+44.9%) as it no longer aligns with the newsletter’s selection criteria.
Crash Portfolio – Vend One
No recent Crash Portfolio ideas since most markets have rebounded.
As of now, the 15 Crash Portfolio notions, advocated since August 2022, have averaged a 16.4% gain.
Protective dissolution – Vend
Vend Somero Enterprises, Inc. with a loss of 21.0%.
Return correction – TIM SA
I apologize for the error in the email concerning the return on the acquisition offer for TIM SA. The accurate return was +37.74%, not 133.8%.
I cited the annualized return of 133.8% which seems astronomical, attributable to the fact that the company was part of the portfolio for merely four months.
Understanding all the assessment ratios
A subscriber raised an insightful query about the valuation metrics and indicators.
She specifically sought to comprehend the implications of ratios like free cash flow to enterprise value and whether these metrics can contradict each other.
In this month's newsletter, we will explore the depths of these valuation figures, elucidating their meanings and the insights they offer into companies.
Price to Earnings (PE)
You are likely familiar with the widely used price to earnings ratio (PE).
It simply represents the current stock price divided by the company's post-tax earnings per share and reveals the extent to which you are paying for the company's annual earnings.
For example, if a company has a PE ratio of 7, it implies that you are currently paying seven times its post-tax profits.
The lower the PE ratio, the more undervalued the company is. A low PE ratio can arise due to various reasons, such as:
- Record profits which may not be sustainable,
- A dwindling business, or
- An out-of-favor industry sector.
However, when investing in undervalued companies, it is imperative to ensure that the undervaluation isn't likely to persist and that the company is positioned for future prosperity.
Price to Free Cash Flow
Similar to the price to earnings ratio, the price to free cash flow ratio assesses the company's stock price in relation to its available free cash flow per share.
Free cash flow denotes the cash generated by the company’s operations minus capital expenditure. Hence, it represents the cash available for allocation to investors. It offers insights into the extent to which you are paying for the company's annual free cash flow.
Interpreting the metric
The lower this value, the more undervalued the company is. However, as there are several variables influencing free cash flow generation, you must scrutinize this metric meticulously.
Working capital investment (such as a rise in accounts receivable or inventory) reduces free cash flow, as does augmented capital expenditure (e.g., purchasing equipment).
If a company is expanding or venturing into a new enterprise, the cash flow will be lower due to increased investment. Therefore, even if a company seems inexpensive according to its price to earnings ratio, it may be costly based on its free cash flow, yet that isn't necessarily negative.
This is simply a factor that must be considered prior to making an investment.
EV to EBIT
Enterprise value to earnings before interest and taxes (EV to EBIT) is a metric for estimating a company's value in relation to its earnings. It is calculated by adding a company's market capitalization, its debt, and subtracting cash, then dividing this sum by its earnings before interest and taxes.
the proportion that contrasts a company's complete capital structure with its operating income.
Enterprise value comprises the company, long-term debt, minority interest, preferred capital, and surplus cash.
Earnings before interest and taxes (EBIT) is utilized in this ratio for straightforward comparisons across different tax rate regions.
When considering EV to EBIT, you gain insight into the pre-tax yield a company generates on its complete capital structure.
What is considered favorable and unfavorable?
The lower the EV to EBIT ratio, the more underestimated the company appears. As evident from the formula, enterprise value is influenced by the extent of debt the company possesses. Therefore, companies with significant debt will have a higher ratio.
Conversely, for companies with substantial cash reserves (akin to the Japanese companies we have advocated), the enterprise value will be quite low. In such cases, it is important to ensure that the company utilizes the cash sensibly, such as through increased dividends or even stock buybacks.
EV to Free Cash Flow
The EV to Free Cash Flow (EV to FCF) ratio resembles the EV to EBIT ratio, but instead of EBIT, it employs free cash flow.
This allows for a comparison of the company's complete capital structure with the annual free cash flow it generates. Being expressed inversely, it can be directly contrasted with the EV to EBIT ratio and the price to earnings ratio.
What is considered favorable and unfavorable?
Similar to the EV to EBIT ratio, a lower ratio indicates that the company is undervalued. However, taking into account the aforementioned points concerning free cash flow and enterprise value is crucial in determining the company's valuation.
Price to Book
You are probably familiar with the price to book ratio, as it is one of the earliest valuation ratios. It is ascertained by dividing the company's current share price by its book value per share.
Book value denotes the company's entire common shareholders' equity, encompassing reserves.
It serves as a valuable valuation ratio, but it does have limitations. For instance, technology companies with limited tangible assets may have nominal book values, rendering it less applicable for a realistic valuation.
We do not typically use it extensively, but it remains a popular ratio, hence why we mention it here.
What is considered favorable and unfavorable?
The lower the price to book ratio, the more undervalued the company. As with the points highlighted in the PE ratio above, one must consider whether this undervaluation will persist.
It only becomes a favorable investment if there are signs that this trend might reverse. Potential factors that could prompt a potential reversal include sales or profit growth, or both, or a shift in the favorability of the sector or industry.
Dividend Yield
The dividend yield is computed by dividing the dividend per share paid in the last twelve months by the current stock price.
It demonstrates the yield that can be anticipated in terms of dividends when investing in the company.
Although high dividend yields might seem alluring, it is important to exercise caution, as high dividends are often unsustainable and may indicate underlying business deterioration.
Nonetheless, we find it beneficial to incorporate dividend yield in the newsletter, as it provides insight into the income that can be expected while awaiting the appreciation of the stock price.
Hopefully, this overview has illuminated the meanings and significance of these valuation ratios. Grasping these concepts will enable you to make more informed investment decisions.
As always, we value your subscription and are, of course, more than willing to address any inquiries.
Reading Recommendations
This Time Is Different: Japan Value and Corporate Governance
The Man Group recently released an intriguing paper titled “This Time Is Different: Japan Value and Corporate Governance.”
It stated:
“Despite the limited success in enhancing corporate governance in Japan over several years, the situation may be on the cusp of change, to the benefit of Value stocks in particular.”
This development is positive for the newsletter as we have been advocating for undervalued Japanese companies for a few years now.
Conclusion
Several years of effort aimed at improving corporate governance in Japan and boosting shareholder value has yielded limited results. However, this state of affairs may be about to shift. Indeed, details within a Tokyo Stock Exchange document from 2023 could be the catalyst that Japan Inc. requires to embrace improved corporate governance.
The directive by the Japanese bourse for companies trading below book value to develop plans for capital enhancement carries significant implications for Japanese stocks – particularly Japanese Value – especially considering that nearly half of the stocks on the Tokyo Stock Exchange trade below book value.
This time, it truly is different.
Long-Only Value Investing: Size Doesn’t Matter!
Alpha Architect recently published a remarkably insightful research paper, “Long-Only Value Investing: Size Doesn’t Matter!”
As a proponent of investing in small-cap companies for the higher returns they offer, I am eager to scrutinize the findings of this paper, and I will provide you with further details in upcoming newsletters.
Summary: there is no disparity in average returns between large-cap and small-cap portfolios.
There you have it.
The long-held belief in the superiority of small-cap portfolios has been dismantled.
Conclusions
We strongly urge you to thoroughly examine this paper because there is a high likelihood that the results will be surprising to many.
An exhaustive assessment was executed, ensuring that every aspect was thoroughly scrutinized by Jack as he conducted this research.
Please feel free to share your replication results and inquiries with our team. Our aim is to bring transparency to the debate surrounding long-only value investing.
I trust you will derive as much value from reading this paper as I did. It has not only expanded my knowledge but has also instilled greater confidence in investing in mid and large-cap value strategies, in addition to small-cap value, which is intriguing but not to the extent of overall value investing.
Furthermore, if you are a proponent of small-cap investing, you may find equal-weight large-cap value investing highly appealing — similar expected returns with almost no overlap in holdings (which may present diversification opportunities).
It is also crucial to bear in mind that the results in this paper pertain to hypothetical portfolios that do not account for trading costs.
If we consider that trading costs are higher for smaller, less liquid stocks (as highlighted in Exhibit 4, where large-cap value portfolios are over 10 times more liquid than small-cap value portfolios), we can anticipate that transaction costs could erode small-cap portfolios to a relatively greater extent than large-cap portfolios.
Wishing you profitable investing
P.S. The Quant Value newsletter is releasedThe next issue of our newsletter is coming your way on Tuesday, 1st August 2023. These materials will maximize the benefit of your subscription:
– Tips on selecting ideas for the Quant Value newsletter – Read the article
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– Check out the performance of the Quant Value newsletter
– Assess the pros and cons of hedging currency risk in your stock portfolio
– Discover the savvy techniques for buying and selling small illiquid companies
– Dive into how we cherry-pick ideas for the Crash Portfolio
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