A Quote - Joel Greenblatt

"There’s a virtuous cycle when people have to defend challenges to their ideas. Any gaps in thinking or analysis become clear pretty quickly when smart people ask good, logical questions. You can’t be a good value investor without being an independent thinker – you’re seeing valuations that the market is not appreciating. But it’s critical that you understand why the market isn’t seeing the value you do. The back and forth that goes on in the investment process helps you get at that." - Joel Greenblatt

Lockheed Martin Corporation (NYSE: LMT)

Lockheed Martin (NYSE: LMT) is a “global security company principally engaged in the research, design, development, manufacture, integration and sustainment of advanced technology systems and products.” LMT is in a sector that has been hard-hit twice in a short time span. As the markets were weighing the impact on defense stocks of a change in administration, the credit bubble burst bringing future government spend on the sector into question. LMT stock today is down 35% from its high of $120 (Q3 of 2008) while the S&P is down just 20% in the same period. This leaves LMT trading at around $75 with a P/E of 9.92, well below its long run average of 15. Throughout the current recession, LMT has remained profitable and has had no issues pertaining to credit.

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The outlook for the industry is unpredictable at the moment as the recessionary environment is the priority of governments around the world. The United States government, the company’s largest customer is also currently occupied with ongoing concerns such as health care reform and energy initiatives in addition to programs to stimulate the economy. Longer term, large annual deficits and federal debt may have an impact on government defense spending. While the ultimate size of future defense budgets is uncertain, it is currently indicated that overall defense spending will continue to increase over the next few years but at a lower rate of growth than has been seen.

LMT’s customers are split as follows: 84% of net sales to the US government, 13% to foreign governments, 3% to commercial and other customers. The US government is a very stable customer, as they have a military reputation to uphold and they can print money. Despite all the talk about decreased government spending on defense, this will not be sustained long term as our world slowly returns to a multi-polar system. These developments will only bring an increase in defense spending as governments attempt to maintain their countries’ defence capability in the global arena. This is already demonstrated by the high level of negotiated backlog LMT has; approximately $80.9 billion, of which 58% will still be remaining after one year. Regarding the uncertainty of government spending going forward, LMT feels it is well positioned to take advantage of areas where the government has already indicated increased funding; namely intelligence, surveillance, and reconnaissance (ISR) support for the warfighter, cybersecurity, helicopter maintenance and training, and lift, mobility, and refueling aircraft. LMT provides a diverse product offering to the industry and is well positioned to take advantage of these areas of increased spending while other segments may suffer. This company may have been knocked for being in an industry with such an uncertain near-term future, but it is well positioned to thrive within it. Additionally, the company is pursuing a strategy that will see it “expand and complement our existing products and services by moving into adjacent businesses in which we believe that our core competencies will enable us to successfully compete.” Areas of opportunity the company foresees are “the need for more affordable logistics and sustainment, expansive use of information technology and knowledge-based solutions, and vastly improved levels of network and cybersecurity,” all national priorities. The company expects revenue growth to exceed the growth in the Department of Defence’s budget, as LMT’s revenues historically have not been dependent on supplemental funding requests (the requests beyond those for critical recapitalization and modernization programs) where cuts are most likely to happen.

The current debt to capital ratio of approximately 57% is high due to a reliance on one major customer – this affects the estimated equity risk premium. Using 60% as the long run target debt/capital ratio, 5.2% as the cost of debt (current yield to maturity) and 11.1% as the cost of equity (equity risk premium added to cost of debt), yields a weighted average cost of capital (WACC) for the firm of 6.41%. As a quick return on invested capital (ROIC) is 24.3% for the last 12 months, earnings power on an equity value per share basis (EPV) is expected to be significantly greater than net asset value per share (NAV).

A thorough valuation of LMT shows an EPV of $85.4 and a NAV of $48.5. This is in line with ROIC (replacement value of balance sheet) of 9.27%, which is greater than WACC. The competitive advantage which gives rise to the EPV-NAV discrepancy seems highly sustainable as it is based both on relationships (government connections) and capabilities (proprietary technology). Additionally, there are high barriers to entry in this industry as the government is generally a captive customer of LMT for upgrades, parts and service. It would be very difficult if not impossible for a competitor to take away market share from any of LMT’s existing products.

The value of growth plays a part in the valuation of LMT as the company has a stated goal of growth, both organically and through acquisitions, which will add value with ROIC being greater than WACC. The 5-year average growth in net-income of 20%, while likely not sustainable in the long run, lends credibility to assuming a long-run growth rate of 3%. Applying a value of growth multiplier to EPV at this rate of growth yields an intrinsic value for LMT of $108.5 per share.

As always, I recommend incorporating a margin of safety in order to account for sensitivity in my calculations. A reasonable margin of safety implies an entry price of approximately $76. As such, I believe LMT is a great purchase at its current price of around $75.

Disclosure: Long LMT

Insiders Indicate Better Valuations Ahead

Insider selling to buying is at a new high as public company insiders are locking in profits from the recent market rally. Insider selling is currently more than 33 times the value being bought. At the same time the S&P is up almost 50% from the March 9th lows and trades at a trailing P/E of 18.5. It's interesting that insider buying has been weak since April as insiders don't seem to have jumped on board the rising market. This bearish signal sure doesn't add any strength to whatever foundation the market rally may be built on.

As mentioned in an earlier article, there may be some volatile periods coming up in the markets. Insiders aren't demonstrating the kind of confidence in their companies' prospects that the rest of the market is; this may be a sign of the volatile periods ahead as the market reevaluates its views on future earnings.

If you find value in this market then buy it. But for those that are having trouble finding value in this inflated market, there is a possibility some of the buying opportunities seen during the March lows may come around again.

Source: TrimTabs via CNBC

Waiting for the Right Time to Buy

In my last post I talked about potential buying opportunities in the near future that you might want to be ready for. Part of being ready for a pullback in the market is to have your valuations and company knowledge on standby and ready for when you should take action. Not every company I value will be an immediate "buy". As a matter of fact, most of a value investor's time may be spent valuing companies that are not attractive opportunities at their immediate market price. I still see value in bringing these companies to your attention however; as once you do the work to value a company I definitely recommend keeping it on your radar screen. You're done the hard part, now keep your model updated and wait for the right time to pounce.

If you're a knowledgeable investor you can even profit off of the work you've done to value a company that you aren't ready to buy. This can be accomplished through the writing of options, which will be discussed in a future post.

It's Well Past May; Should You Still Go Away?

The markets have seen a run-up of over 40% since their lows in March. According to Bespoke Investment Group the S&P has reached its highest P/E since the end of 2004, due to a combination of market optimism without the earnings to support it. It may be getting very difficult to find value plays out there as a result. There may be hope yet though for those of you who wish you had jumped on the many opportunities back in March.

A recent article by my friend and professor Dr. George Athanassakos brings to light the oft spoken phrase - sell in May and go away. According to Dr. Athanassakos there is no reason to believe this year will be any different than what has been seen on average over the past 50 years. Even though the recent bull market has coincided with the beginning of the notoriously difficult May to October period "we are not out of the woods yet", as Dr. Athanassakos says. Due to various market behaviors, which can be read about in the article, it may be time for institutional money managers to lock in their profits from the recent rally. He also points out that September and October are traditionally two very volatile months.

Supporting Dr. Athanassakos' views is the fact that the consumer has some heavy lifting to do for earnings to catch up to the recently inflated price levels. That may be a stretch in the midst of consumer concern over high unemployment rates.

While many opportunities to invest in solid value back in March may have been missed, opportunity may present itself again sooner than you think. I wouldn't go anywhere just yet.

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Goodfellow Inc. (TSE: GDL)

Goodfellow Inc. (TSE: GDL) is a remanufacturer and wholesaler of lumber products and hardwood flooring. They have over 7000 customers, mainly in Eastern Canada and the United States. I found them by conducting a screen querying profitable companies trading below book value per share with a trailing P/E under 10. Running some quick numbers got me very interested in this little company as not only is it trading below book value but it is trading below current assets after subtracting all liabilities. I jumped on the chance to value this company as on the surface I thought it was a definite buy at this price.

I arrived at a net asset value (NAV) for GDL of $19.67 per share assuming a replacement value of the balance sheet. This took into account my estimation of the value of customer relationships as they seem to be very important in GDL's industry and these were not previously accounted for as any sort of intangible on the balance sheet.

An earnings power value (EPV) for the company of $8.69 per share was found by extrapolating forward normalized earnings from the last 12 months. Normalized zero growth cash flows were found for the trailing 12 months and were then divided by the estimated cost of capital of 7.5% in order to obtain the value of a perpetuity with no growth.

The EPV well below NAV makes sense as GDL is currently returning approximately 5% on invested capital (replacement value of balance sheet). By comparing this to the cost of capital of 7.5% it is apparent that the company is underutilizing its assets. I like how management is focused on keeping costs down and on how management makes clear that capital expenditures are kept to the value of depreciation (essentially replenishment but not growth expenditures) - they are not trying to grow the company as this would only destroy value with the return on capital being less than its cost.

The current trading price of $7.90 per share seems to be based on the company's earnings power minus perhaps the market's own margin of safety due to the unknown prospects for GDL's industry moving out of this recession. GDL mainly serves the housing market which has been decimated over the past 12 months and it is anyone's guess what the prospects are for the industry.

The fact that GDL can be bought for less than its current assets, after satisfying all liabilities, has no implications for an investor. The company has a stable balance sheet, is profitable and operates in a viable industry - it is not going to be liquidated anytime soon. The only benefits an investor will see from this company are in the form of earnings to equity. As the shares are trading in line with EPV, buying shares in this company would essentially be speculating as to the prospects for the industry as a whole. If the industry picks up GDL will surely prosper. However if the industry prospects get even worse then you can bet that the company's shares will move in lockstep.

As a value investor I refuse to speculate on the industry and would rather know that I am buying a company for below its true worth. I see no catalyst that may bring EPV closer to NAV as management seems content with the operations (except perhaps for the suffering top-line due to current market conditions). As such my intrinsic value for the company is $8.69 per share as found for EPV. Applying a satisfactory margin of safety implies an entry price of around $5.80 per share. As shares are currently trading around $7.90 I will be staying away from this company for now.

Disclosure: None

A Quote - Seth Klarman

"So if the entire country became securities analysts, memorized Benjamin Graham’s Intelligent Investor and regularly attended Warren Buffett’s annual shareholder meetings, most people would, nevertheless, find themselves irresistibly drawn to hot initial public offerings, momentum strategies and investment fads. People would still find it tempting to day-trade and perform technical analysis of stockcharts. A country of security analysts would still overreact. In short, even the best-trained investors would make the same mistakes that investors have been making forever, and for the same immutable reason – that they cannot help it." - Seth Klarman

Comments and Valuations

In anticipation of our first company valuation, the comments links are now active for all existing and future posts. I look forward to having some good discussion on this site about recommended companies and value investing topics in general. I'm sure many of you have thoughts on existing ideas or have new ideas to share and I encourage you to do so.

As mentioned previously, I am currently in the midst of a job search which I have been devoting a lot of my time to. As such, I haven't had much time for screening potential investments never-mind conducting valuations on them. Thank you for your patience and for continuing to check this site regularly. I plan to start discussing specific companies on a regular basis sometime within the next week...

Until then please read my basics course on value investing and ask any questions you may have via the comments. Also, if you'd rather not check back here every day just subscribe with your RSS reader by using the orange link to the right. Until next time... have a great week and I look forward to your involvement either in the comments for each post or through email at jonathan (at) jonathangoldberg (dot) com.

All the best... JG

Do Value Investors Add Value?

The methodology discussed in the basics course on value investing must seem like a lot of work to implement. Many of you may be wondering if it is even worth implementing when you have no doubt read the benefits of merely investing in pre-screened (according to P/E, P/BV, etc) value stocks. Dr. George Athanassakos, my mentor and Ben Graham Chair in Value Investing at the Richard Ivey School of Business (University of Western Ontario), has written a paper with two former students, Reyer Barel and Saj Karsan, on the added premium resulted in through the additional valuation work. In this paper they compare a basket of stocks selected merely using the "academic" method of screening for low P/E and low P/BV, and a basket of stocks selected using the rigorous and time intensive process which value investors follow.

Athanassakos et al find that there was a significant value premium attributed to the basket of low P/E and P/BV stocks as compared to a basket of high P/E and P/BV stocks. This has been confirmed by other research as well. What is unique about this paper is that there was an even greater and significant value premium attributed to the basket of stocks that went a step beyond the screening process and used a "valuation technology" to find the truly undervalued of the low P/E and low P/BV basket.

The methodology used in the study is the exact methodology that I learnt under Dr. Athanassakos so not only is the paper an interesting read but it is also a great way to obtain additional insights on valuation from an expert in the field.

The students that worked on this paper with Dr. Athanassakos have a value investing site of their own, Barel Karsan. The site is an inspiration for this one and it offers up very interesting insights into the philosophy and investing in general. While ramping up slowly due to my ongoing search for employment, I hope that one day my own site will live up to the one that inspired it.

Details on the paper are below and the paper can be found HERE.

Athanassakos, G., Barel, R., Karsan, S., 2009, “Do Value Investors Add Value? Searching for and Finding Value: Canadian Evidence 1999-2007”, Working Paper, May 2009.

My Mentor - Dr. George Athanassakos

What I have shown you in the basics course on value investing should only be considered as a first look into the philosophy and how to implement it. As you can imagine, every value investor has their own metrics, views and opinions when it comes to valuation and you will develop your own methodology with study and practice. A good place to start is with the book by Bruce Greenwald that I have mentioned previously. Now this is just a start.

My own serious studies in value investing began while working on a research paper with Dr. George Athanassakos at the Richard Ivey School of Business (University of Western Ontario), where he is the Ben Graham Chair in Value Investing. While at the school I also took his highly regarded and greatly subscribed to course in value investing. In this course we spent a number of intense weeks valuing many companies in different industries so that Dr. Athanassakos' methodology would be second nature to us. On this site I will be sticking to the overview of the methodology that I have posted and will not be getting into the intricacies as our focus here will be about investment ideas. In order to learn the detailed aspects of valuation, that I use to arrive at these ideas, along with the toolkit to then go off and develop your own methodology I definitely recommend studying with an expert in the field like Dr. Athanassakos.

Dr. Athanassakos offers executive education seminars in value investing during the year. Details on these can be found HERE. He also teaches value investing to the MBA and HBA students at the Richard Ivey School of Business (University of Western Ontario).

Bruce Greenwald Interview

I recently found an excellent interview with Bruce Greenwald that I recommend reading, especially if you've been following my basics course on value investing. Over the past few weeks I have been taking you through a brief overview of a value investing methodology. In this interview Mr. Greenwald does an excellent job of explaining the necessity of following such a methodology. He sums up value investing into three things; a search process and an understanding of the extent to which markets are inefficient, a "technology" for valuing what you are considering buying, and having discipline and patience.

"So I think of value investing as three things. A search strategy, which we talked about, which is where the low P/E, low market to book comes in. But it's not all of it, by any means, even of the search strategy. A valuation strategy. And a discipline approach to taking advantage of the information that your valuation is telling you about and having a default strategy when it's telling you it doesn't look like there's anything there."

The beauty of this is that your valuation "technology" will enable you to have the discipline and patience that is required of a value investor. As he says, if you believe in your valuation and the stock you just purchased goes down, then you will buy more! In this way instead of getting caught up in the same behavioral mistakes that the average investor makes, you are taking advantage of a good deal turning into a better one as you cost-average down.

Mr. Greenwald also does a great job of explaining the importance of each step in the methodology that I have shown you, as well as the importance of the order in which they are performed.

"What you want to do is to have a technology that brings all the available information to bear, so you can cross-correlate the asset values with the earnings-power values, with your judgment about whether there's a franchise here. That if you're going to buy growth, you're absolutely certain that the franchise is there so the growth is going to be valuable... And then, only then, looking at the growth."

I highly recommend reading the interview which can be found HERE. Following is a brief biography of Bruce Greenwald as found in the Columbia Business School directory:

Professor Bruce C. N. Greenwald holds the Robert Heilbrunn Professorship of Finance and Asset Management at Columbia Business School and is the academic Director of the Heilbrunn Center for Graham & Dodd Investing. Described by the New York Times as "a guru to Wall Street's gurus," Greenwald is an authority on value investing with additional expertise in productivity and the economics of information.

Greenwald has been recognized for his outstanding teaching abilities. He has been the recipient of numerous awards, including the Columbia University Presidential Teaching Award which honors the best of Columbia's teachers for maintaining the University's longstanding reputation for educational excellence. His classes are consistently oversubscribed, with more than 650 students taking his courses every year in subjects such as Value Investing, Economics of Strategic Behavior, Globalization of Markets, and Strategic Management of Media.