This the editorial of our monthly Quant Value Investment Newsletter published on 2023-07-04. . Sign up here to get it in your inbox the first Tuesday of every month.
More information about the newsletter can be found here: This is how we select ideas for the Quant Value investment newsletter
This month you can read all about the valuation ratios used in the newsletter.
But first the portfolio updates.
Portfolio Changes
Europe – Buy One – Sell Four
One new recommendation this month as the index is above its 200-day simple moving average.
The company is a fast-growing UK-based wholesaler trading at 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 with a dividend yield of 2.3%.
Just as I wanted to send the newsletter the company announced very good interim results. The share price jumped +7%, but you can still buy it at this price – see company analysis for more information.
Stop Loss – Sell
Sell TF1 SA at a loss of 8.2%
Sell Braemar Plc at a loss of 25.8%
Sell Origin Enterprises plc at a loss of 19.6%
Sell Crest Nicholson Holdings plc at a loss of 13.7%
North America – Buy One
One new recommendation this month as the index is above its 200-day simple moving average.
The company is a US-based Human Resource company trading at a price of 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 – Buy Three – Sell One
Three new recommendations this month as the index is above its 200-day simple moving average.
The first is a Singapore-based recruitment and staffing company trading at 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 pays a dividend yield of 5.4%.
The second is a Japanese company engaged in the manufacture and sale of surface treatment agents and equipment trading at 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 with a dividend yield of 1.9%.
The third is also a Japanese company mainly engaged in the sale of electronic components and devices trading at 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 pays a dividend yield of 3.5%.
Sell – One
Sell China Telecom Corporation Limited (+44.9%) as it no longer meets the newsletter’s selection criteria.
Crash Portfolio – Sell One
No new Crash Portfolio ideas as most markets have recovered.
To date the 15 Crash Portfolio ideas, recommended since August 2022, are up an average of 16.4%.
Stop loss - Sell
Sell Somero Enterprises, Inc. at a loss of 21.0%.
Return correction – TIM SA
I apologize for the mistake in the email regarding the return on the takeover offer for TIM SA. The correct return was +37.74%, not 133.8%.
I mentioned the annualized return of 133.8% which is so high as the company was in the portfolio for only four months.
What do all the valuation ratios mean
I received an excellent question from a subscriber regarding the valuation ratios and indicators.
Specifically, she wanted to understand the significance of ratios like free cash flow to enterprise value and whether these ratios can conflict with each other.
In this month's newsletter, we'll delve deeper into these valuation numbers, explaining their meanings and what they reveal about companies.
Price to Earnings (PE)
You're probably familiar with the commonly used price to earnings ratio (PE).
It's simply the current share price divided by the company's after-tax earnings per share and tells you how many times you're paying for the company's yearly earnings.
For instance, if a company has a PE ratio of 7, it means you're currently paying seven times its after-tax profits.
The lower the PE ratio, the more undervalued the company is. A low PE ratio can stem from various reasons, such as:
- Record earnings that might not be sustained,
- A declining business, or
- An out-of-favour industry sector.
However, when investing in undervalued companies, it's crucial to make sure the undervaluation is not expected to persist and that the company is poised for future success.
Price to Free Cash Flow
Like the price to earnings ratio, the price to free cash flow ratio considers the company's share price relative to its free cash flow per share.
Free cash flow is the cash generated by the company’s operations minus capital expenditure. It thus represents the cash available for distribution to investors. It offers insights into how many times you're paying for the company's yearly free cash flow.
What is good or bad
The lower this number the more undervalued the company is. But because there's several factors that can influence free cash flow generation you have to look at this number of carefully.
Working capital investment (for example increasing accounts receivable or inventory) lowers free cash flow as does increased capital expenditure (the purchase of equipment for example).
If a company is growing or investing in a new business cash flow will be lower as increased investment is needed. So even though a company may be cheap on a price to earnings basis on a free cash flow basis it may be expensive but that's not necessarily negative.
It's simply something you must consider before investing.
EV to EBIT
Enterprise value to earnings before interest and taxes (EV to EBIT) is a valuation ratio that compares a company's total capital structure to its operating income.
Enterprise value is the sum of the company, long-term debt, minority interest, preferred capital, and excess cash.
Earnings before interest and taxes (EBIT) is used in this ratio for easy cross-country comparisons with different tax rates.
EV to EBIT gives you an idea of the pre-tax return a company generates on its total capital structure.
What is good or bad
The lower the EV to EBIT ratio the more undervalued the company is. As you can see from the formula enterprise value is impacted by the amount of debt the company has. So, for companies with a lot of debt the ratio will be higher.
For companies with a lot of cash on the other hand (like the Japanese companies we have recommended) the enterprise value will be very low. You then must make sure that the company does something sensible with all the cash, like higher dividends or even stock buybacks.
EV to Free Cash Flow
The EV to Free Cash Flow (EV to FCF) ratio is akin to the EV to EBIT ratio, but instead of EBIT, it uses free cash flow.
It thus compares the company's total capital structure to the free cash flow it generates annually. As it is expressed inversely, it can be easily compared to the EV to EBIT ratio and the price to earnings ratio.
What is good or bad
Like the EV to EBIT ratio the lower this ratio is the more undervalued the company.
But as mentioned about free cash flow and enterprise value above, you must take these factors into consideration to be able to say if your company is cheap or expensive.
Price to Book
You have most likely already heard of the price to book ratio as it’s one of the oldest valuation ratios. It is calculated by dividing the company's current share price by its book value per share.
Book value represents the company's total common shareholders' equity, including reserves.
It is generally a good valuation ratio, but it has its limitations. For example, technology companies with limited hard assets may have negligible book values, making it less applicable if you want to make a realistic valuation.
We do not use it much, but it remains a popular ratio, so we mention it.
What is good or bad
The lower the price to book ratio is the more undervalued the company. The same as the points mentioned in the PE ratio above you must consider if this undervaluation will continue.
Only if there's an indication that it will reverse does it make the company a good investment. Factors that might cause a possible reversal is sales or profit growth or both or if the sector or industry is out of favour now but that may change.
Dividend Yield
The dividend yield is calculated by dividing the dividend per share paid over the past twelve months by the current stock price.
It shows you the return you can expect in terms of dividends should you invest in the company.
While high dividend yields may appear attractive, caution is needed as high dividends are often unsustainable and can indicate underlying business deterioration.
Nonetheless, we find it valuable to include dividend yield in the newsletter, as it gives you an insight into the income you can expect while waiting for the stock price to rise.
I hope this overview clarifies the meaning and significance of these valuation ratios. Understanding them will help you to make better investment decisions.
As always, we appreciate your subscription and will of course be happy to answer any questions.
Reading Recommendations
This Time Is Different: Japan Value and Corporate Governance
The Man Group in March published an interesting paper This Time Is Different: Japan Value and Corporate Governance.
Saying:
“A years-long effort to improve corporate governance in Japan has met with limited success. However, that may all be about to change, benefiting Value stocks in particular.”
This is good news for the newsletter because as you know we've been recommending undervalued Japanese companies for a few years already.
Conclusion
A years-long effort to improve corporate governance in Japan and increase shareholder value has met with limited success. However, that may all be about to change. Indeed, footnotes in a 2023 Tokyo Stock Exchange document may just be the impetus that Japan Inc. needs to embrace better corporate governance.
The directive by the Japanese bourse for companies trading below book value to come up with capital improvement plans has huge implications for Japanese stocks – specifically Japanese Value – especially considering that almost half of stocks on the Tokyo Stock Exchange trade below book.
This time, it really is different.
Long-Only Value Investing: Size Doesn’t Matter!
Alpha Architect published this really interesting research paper Long-Only Value Investing: Size Doesn’t Matter! recently.
As you know I'm a big investor in small cap companies as I've always believed they give you a lot higher returns. So, I'll be studying the results of this paper carefully I will give you more information in future newsletters.
Summary: no difference in average returns between large-cap and small-cap portfolios.
There you have it.
The small-cap sacred cow has been slaughtered.
Conclusions
We highly recommend you study this paper in-depth because there is a high chance that the results will be shocking to many.
One can only publish so many tables and results in a peer-reviewed journal, but you can be sure that every stone was turned when Jack conducted this research.
Of course, please share your replication results and questions with our team. Our goal is to bring transparency to the long-only value investing debate.
I hope you enjoy reading this paper as much as I did. I really learned a lot, and the analysis gave me more confidence in investing in mid and large-cap value strategies, as opposed to only investing in small-cap value, which is also interesting, but not more interesting than value investing, in general.
Finally, if you love small-cap investing, you should really like equal-weight large-cap value investing — similar expected returns with almost no holdings overlap (which may provide diversification opportunities).
One should also consider that all of the results in this paper are on hypothetical portfolios that assume no trading costs.
If we believe that trading costs are higher in smaller and more illiquid stocks (Exhibit 4 in the paper highlights that large-cap value portfolios are 10x+ more liquid than small-cap value portfolios), we’d expect transaction costs to degrade small-cap portfolios relatively more than large-cap portfolios.
Wishing you profitable investing
P.S. The Quant Value newsletter is published on the first Tuesday of the month – so look for the next issue in your inbox on Tuesday 1 August 2023.
P.P.S. These articles help you get the most out of your subscription:
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