Value in plain sight

Ever wonder what shares on the JSE Warren Buffett, Benjamin Graham and other Guru Value Investors would consider close to the perfect share? I have scanned the JSE using the investment strategies of various Value Investment Guru’s to answer that question. In total I used 6 different strategies by, respectively, Warren Buffett, Benjamin Graham, Peter Lynch, Martin Zweig, Kenneth Fisher, and James O’Shaughnessy. The reason I chose these gentlemen is because they are all considered Gurus of Value Investing past and present. Of the 6 Value Investors Buffett and Graham are considered more traditional, or patient, investors. Lynch, Zweig and O’Shaughnessy are all considered growth Value Investors and Fisher is considered a price-to-sales Value Investor. Although all the investment approaches of the investors listed stem from Benjamin Graham’s original approach, they all have their own unique approach to valuing shares.

The broad based scan of the JSE, using the 6 approaches, yielded some interesting results. Before sharing the results let me start with some general comments. I evaluated each share on the JSE using all 6 strategies and for each strategy I sampled the top ten shares based on the strategies’ screening criteria. Thus, from the evaluation I picked a total of 60 shares. However, many strategies sampled the same shares and therefore, amongst the 60 shares, only 39 unique shares were sampled. I found little correlation between the shares sampled using the different strategies, however, I did notice distinct differences between the shares selected by the growth versus the patient value investment strategies. Also, I noticed a high resource focus using the Peter Lynch strategy.

Every investor would love to own the perfect share. But did the screening find a share that is everything to all 6 the Guru investors? The short answer is no, but almost. The primary reason for this is the different focus areas, or approaches, of the different investors. The patient investors focus on balance sheet and income statement, whereas the growth investors are slightly more income statement focussed. Furthermore, if the strategies only had one or two criteria I would find many shares complying, but the strategies followed by these Gurus are comprehensive and include, amongst other, the following important criteria:

• Earning, Sales and Book Value. Most of the Guru’s focus on consistency and stability of year-on-year earnings, sales and book value. These are critical factors for all the patient investors.
  
• Money making opportunities. Return on equity helps measure how well a firm is finding opportunities to turn its resources into profitable business endeavours.
  
• Growth. Companies following an active reinvestment strategy show healthy revenue and EBIT growth. Furthermore, firms that grow while having ROICs higher than their cost of capital create value for shareholders at an accelerated pace. The patient investors focussed on firms that are within the mature growth to mature life cycle stages, whereas the growth investors picked shares that are within the growth to mature growth life cycle stages.
  
• Balance Sheet. At businesses with a lot of debt, banks and bondholders compete with shareholders for management's attention. Firms with strong balance sheets don't have to worry about the distraction of debt.
  
• Dividends. Firms with a strong balance sheet paying consistent dividends will yield great value over time, especially if it is done without sacrificing reinvestment and thus future growth.
  
• Ratios. Various ratios used for fundamental analysis play a key role and only firms with above average values per ratio are included in the samples.
  

Given these criteria, it would be unlikely that a single share would comply perfectly with the criteria of all 6 strategies, but there are a couple of shares, in fact only 5 from the entire JSE, that come very close. My guess is that you would expect to find these 5 shares listed in the Top 40 Index, but you would be wrong. On the contrary, it is more likely that you are unfamiliar with these 5 shares. From the 5 I picked my personal favourite, Bowler Metcalf (ticker symbol BCF). No share is a sure thing, but the 6 Guru’s and I think BCF is closer to perfect that many others. Let’s take a closer look at BCF by briefly analysing it based on the Buffett, Graham and Fisher valuation criteria.

I’ll start with Buffett’s criteria:

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Factor	What the Guru wants to see	Pass or Fail
Earnings predictability	A firm with solid, stable earnings that are continually expanding	Pass
The ability to pay off debt	BCF could use its EBIT and pay off its debt in less than two years, which is considered exceptional	Pass
Consistently higher than average return on equity	A firm with above average return on equity of at least 18% or better over a ten year period.	Pass
Consistently higher than average return on total capital	Some firms can be financed with debt that is many times their equity, they can show a consistently high ROE, yet still be in unattractive price competitive businesses. Furthermore, the firms return on total capital should be consistently higher than the cost of capital to create value	Pass
Positive Free Cash Flow	The firm should not reinvest more money than the profit it generates, to ensure positive FCFs	Pass
Management's use of retained earnings	It’s important to understand how management has spent retained earnings in a way that benefits shareholders. The cumulative retained earnings over the previous ten years are used, together with the gain in EPS over the same period, to calculate a return on earnings retained.	Pass
Share buybacks	The firm should have been repurchasing shares when the opportunity presented itself, i.e., when the shares’ intrinsic value was trading at a discount to price	Pass
Expected long-term compound annual growth rate	Based on the current conservative fundamentals the firm should project an annual compounding rate of return, over the next ten years, of at least 15% or better	Pass

 

Next I analyse BCF using Graham’s criteria:

Factor	What the Guru wants to see	Pass or Fail
Sales	The firm should have annual sales greater than R 500 million	Pass
Current ratio	The current ratio must be greater than or equal to 2	Pass
Long-term debt in relation to net current assets	Long-term debt must not exceed net current assets (current assets minus current liabilities)	Pass
Long-term EPS growth	Firms must increase their EPS by at least 30% over a ten-year period and EPS must not have been negative for any year within the last 5 years	Pass
P/E ratio	The Price/Earnings (P/E) ratio, based on the greater of the current PE or the PE using average earnings over the last 3 fiscal years, must be ‘moderate’, which this methodology states is not greater than 15	Pass
P/B ratio	The Price/Book multiplied by P/E cannot be greater than 22	Pass

 

Finally I analyse BCF using O’Shaughnessy’s Cornerstone Growth Strategy criteria:

Factor	What the Guru wants to see	Pass or Fail
Market Cap	The first requirement of the strategy is that the firm has a market capitalization of at least R 500 million	Pass
Earnings per share persistence	The methodology looks for companies that show persistent earnings growth without regard to magnitude. BCF has shown long term earnings growth, except for the last financial year.	Pass
Price/sales ratio	The Price/Sales ratio should be below 1.5	Pass
Relative strength	The final criterion for the strategy requires that the Relative Strength of the firm be among the top 50 of the shares screened using the previous criterion. BCF is number 29 on this list.	Pass

 

Based on the above these three Guru’s consider BCF to be one of the few perfect shares on the JSE. BCF also complies with at least 70% of the criteria stipulated by Lynch, Zweig and Fisher, which is why its one of the 5 ‘close-to-perfect’ value investing shares on the JSE. All this said, I am one with little faith and therefore, before making a decision to invest in a share, I apply some additional criteria. This includes a qualitative valuation of the firm’s management, competitive advantage, and finally an intrinsic valuation based on a discounted cash flow valuation. If I believe the share’s intrinsic value is close to, or at a discount to, its quoted share price I will purchase it in a heartbeat and hold on to it for as long as economics dictate.

Bowler Metcalf may not be perfect, but there are always some other shares you might like better. I encourage you to join an investment club and actively participate in screening, analysing and valuing firms in search of the perfect investment.

Be Extraordinary!
Myles Rennie