Contrarians at the Gate

We define Tocqueville’s investment style as contrarian value. This is the combination of two approaches that are somewhat different, but often lead to similar conclusions.

Investing on the Cheap

Value investing, a discipline into which I was indoctrinated as a junior analyst more than thirty years ago, consists of paying no more than fifty cents to buy stocks which we deem to be worth at least one dollar today.

More specifically, when Ben Graham first articulated the concept, it meant buying the liquid assets on a company’s balance sheet, net of all liabilities, for fifty cents on the dollar. Liquid assets would include cash and near-cash, such as customer receivables and saleable inventories. The value of a company’s plant and other long-term assets, or its potential for growth, would only come as “free” bonuses and thus did not deserve a whole lot of analysis. Neither was the quality of management considered very important – except as reflected in the conservatism and reliability of accounting practices, as well as a perceived ability to sustain levels of profitability and cash flow that would not endanger the balance sheet.

This is why value investing, based on simple common sense, has been so starkly opposed to “growth” investing, as advocated, for example, by Phil Fisher. In that philosophy, the quality and depth of management, as well as the company’s growth potential are paramount, and success depends to a great extent on the analyst’s judgment of those characteristics. The concept of growth investing is appealing, but it has traditionally implied paying a significant price premium for rather elusive qualities, which is why we have been less comfortable with this investment philosophy.

Unfortunately for value investors like us, both investing technology and (in developed economies at least) the corporate landscape have changed considerably since the days of Ben Graham.

Whereas identifying value used to require physically leafing through hundreds of pages of statistics in the stock guides, one can now identify a set of companies meeting basic value criteria at the push of a button, using today’s widely available screening programs and databases. The result is that the market has become more efficient – at least in that sense. Today, very few companies can be identified by computer screening, which meet simple, statistical value criteria without having some off-balance-sheet blemish precluding prudent investment (lawsuits, contingent liabilities, deepening operating losses that threaten to deplete cash reserves, etc.).

In addition, investing based largely on balance sheet values has been preempted by investment bankers and “private-equity” investors, who can take a more active role in forcing the liquidation of less-liquid assets – including whole divisions. In the process, these investors have raised market prices for everyone, to the point where even they are now looking at disappointing returns in the future.

Finally, corporate management has evolved, too. The principal liquid assets on a company’s balance sheet (cash, customer receivables and inventories) have become anathema, since modern information and management techniques now allow companies to operate with minimal levels of such “working capital”. Even large cash holdings, once viewed as a sign of conservative management are now considered a symptom of un-imaginative leadership. In recent years, this has led to aggressive programs by corporations to repurchase their shares in the market place, thus reducing or eliminating any price discounts to intrinsic values.

These developments probably are not foreign to the decision by Warren Buffet, a former value disciple of Ben Graham, to espouse the growth philosophy of Phil Fisher, a number of years ago.

Until recently, stocks meeting traditional value criteria could still be found in some emerging markets – albeit at the cost of less reliable data and questionable transparency. However, even these discounts have now largely disappeared.

Since, today, the simple (if not simplistic) value approach, based on liquid balance sheet assets, yields very few worthwhile ideas, investors must increasingly look at the income and cash flow statements to identify “value” stocks.

What is a Company’s Value?

Though it is often forgotten by speculators and financial innocents, the stock market has one overriding justification that is both moral and practical. In our modern economies, it is the entrepreneurs who create economic wealth. For the vast majority who are not entrepreneurs, the stock market offers the way to share in that wealth creation. So, it is logical for stock market investors, in assessing the value of a business, to try and emulate the entrepreneur’s approach.

When an entrepreneur looks to buy a whole company, he or she expects a financial return. That return can be defined as free cash flow – literally the cash flowing to a business owner after all expenses and the investments necessary to the survival and growth of the business have been paid.

A good approximation of free cash flow can be obtained by

- Adding back depreciation charges to reported profits (depreciation is cash put in reserve for the replacement of plant and equipment, but that is not necessarily spent immediately) and

- Deducting current capital expenditures necessary to sustain the business, as well as the net capital needed to finance increased inventories and/or customer receivables.

[I disregard dividends because, particularly in the case of a wholly-owned business, they are just one of the possible uses of cash flow].

The return acceptable to an entrepreneur depends largely on the yields available on Treasury bonds, which would represent the risk-free, long-term alternative to a business investment.

For example, if ten-year Treasury bonds currently yield 4.5%, a free cash flow yield of somewhere around 10%-15% should be acceptable to an entrepreneur, to compensate for the business risk and the lack of liquidity of his or her investment in a company. Expressed in reverse, this means that an entrepreneur would be willing to pay 7 to 10 times free cash flow to purchase a private business.

Of course, the entrepreneur may make adjustments to his or her evaluation for such factors as

- Accounting practices that may overstate or understate profits or balance-sheet values;

- Assets that are not indispensable to the basic business and could be sold;

- Facilities that are ageing or poorly maintained and may require significant capital investment to remain competitive;

- Any value the entrepreneur believes he or she may add through more astute management, either by boosting growth or effecting new savings.

Stock market investors, on the other hand, are not exactly in the same position as an entrepreneur. Particularly, they have little or no influence on a company’s strategy or operations. They also have access to less detailed information than the entrepreneur to do their due diligence. On the other hand, they usually can readily sell their shares in the market if they don’t like what is going on in a company, whereas the entrepreneur can’t. This is where the contrarian approach becomes very handy for stock market investors.

Contrarians to the Rescue

Historically, the value and contrarian approaches to investing have often been in phase with each other. This is not surprising: if an investor was able to buy shares of a company in the stock market at fifty cents on the clearly-visible dollar of balance sheet value, one can assume that his or her views on that company must have been quite contrary to those of the majority of investors.

I am not implying, here, that value investors should systematically buy into troubled companies. One of the strengths of the contrarian approach as we define it, is that it starts with the same fundamental analysis performed by an entrepreneur and then contrasts it against the perceptions of the crowd of investors.

These perceptions, as all crowd behavior, typically are subject to wide psychological swings, which occasionally can create significant disparities between what a majority of investors are willing to pay for a company and the more rational value that an entrepreneur might put on it.

Over the very long term (decades), as could be expected, stock prices tend to move along with companies’ earnings and cash flows. Over the somewhat shorter term (years), interest rates also influence stock valuations: the ratio of prices to earnings tends to move inversely to bond rates, since bonds are the principal, liquid alternative to stocks for most investors. Another factor is crowd psychology, which affects stock pricing over periods going from a few days to a few years and could accurately be described as manic depressive.

When the investing crowd becomes optimistic, more often than not, it eventually becomes wildly so. The price it is willing to pay for a stock it loves then rises to excessively high levels, incorporating much of the expected future growth in the company’s profits. When this becomes the case, even if a company’s fundamental progress materializes as expected, it is likely that the stock price will rise less than the company’s earnings. If, on the other hand, the company’s expected performance fails to materialize, the ensuing drop in the stock price will be worse than the company’s fundamental deterioration might justify, as the “hope” premium is deflated. Almost by definition, therefore, popular stocks simply offer poor risk/reward ratios while, conversely, out-of-favor stocks tend to offer favorable risk/reward ratios.

In sum, therefore, it is fair to assume that the shares of a company that is deeply out of favor with investors, while having the financial wherewithal to survive troubled times, are probably selling closer to a “value” price than those of a company being showered with the praises of the investment and media communities.

The contrarian approach to investing is not a thorough analytical process, like the value approach. It also presents risks:

- One is the time value of money. A contrarian investor, even if eventually proven right, may keep losing money (or at least not making any) until vindicated. That shortcoming, unfortunately, is shared with value investing.

- Another is the “rain factor”. When the majority says it is raining, it may be dangerous to go out without an umbrella. A company chosen through simplistic contrary thinking, instead of eventually doing better, may simply go out of business. This is why it is important to combine contrarian thinking with the more disciplined analysis of value investing.

However, when value is hard to find, as it is today, contrarian thinking is a good way of identifying a universe of stocks within which to search for value. In forthcoming papers, we will look at some of today’s possible contrarian themes.

François Sicart

March 21, 2005
^©Tocqueville Asset Management L.P.

The information contained herein has been obtained from sources believed to be reliable and to the best of our knowledge is complete. The validity and completeness however cannot be guaranteed by Tocqueville Asset Management. Nothing herein constitutes investment or any other advice and should not be relied upon as such. This document has been prepared solely for information purposes and does not constitute an offer or an invitation to buy or sell securities. Any reference to past performance is not necessarily a guide to the future. Tocqueville Asset Management L.P., their affiliates and their officers, directors, employees, advisors or members of their families as well as the clients for whom they manage portfolios; 1) May have positions in securities or options of issuers mentioned herein and may make purchases or sales of the securities or options while this publication is in circulation; 2) May hold directorships in corporations discussed in this publication. The opinions expressed in this document are those of Tocqueville Asset Management as of the date of the writing and are subject to change.