The Little Book of Value Investing

Book value, cheap earnings, balance sheet analysis—all these metrics are key to identifying good prospects. But if successful investing was as simple as a mathematical formula, everyone would have nothing but winners in their portfolios. There is some art to identifying the best prospects, and so you should analyze your list of companies in greater detail. You need to drill down farther to get a better sense of how these companies operate and compete. Getting answers to these questions will give you a more in-depth knowledge of a company and its potential as a successful investment.

1. What is the outlook for pricing for the company’s products? Can the company raise prices? Each dollar of price increase will increase pretax income by $1.00 if costs do not increase. A company with a product that is in demand can easily raise prices to generate more profit. If costs remain the same, every extra dollar will go straight to the bottom line. For years, Philip Morris could raise the price of a pack of cigarettes pretty much whenever it wanted. At one point, Harley Davidson could price its motorcycles at a premium to its competitors because demand was so strong. Technology companies, however, are in a highly competitive environment that makes it difficult to raise prices (there is another computer company around every corner ready to lower prices). The same holds true for grocery businesses. Wal-Mart puts downward pricing pressure on all its competitors because it buys in volume at lower prices, and its other costs are less because it is more efficient. Also, if demand for a product is waning in a particular industry, no amount of good business practices will allow for price increases.

In the past few years, some events and trends have allowed certain industries to raise prices with little ceiling pressure. Homebuilders could raise prices due to ever-increasing demand. Post Katrina, insurance companies raised prices as many people and businesses scrambled to buy extra disaster insurance. The less competition in an industry, the easier it is to increase prices.

2. Can the company sell more? What is the outlook for units? A 10 percent hike in units will increase gross profits by 10 percent if the gross profit margin does not change. Pretax income will go up by this amount if other costs do not increase. The simplest way to raise the bottom line is to sell more products or services. Assuming that costs remain about the same, every increase in the number of units sold improves the bottom line. When Johnson & Johnson sold off during the health care reform scare of the early 1990s, the underlying business conditions were not deteriorating. An aging population was going to lead to more demand not only for prescription drugs but also for over-the-counter medicines like Tylenol. When recently looking at a uniform and protective clothing business it seemed clear that ever-increasing safety regulations for employers would push up the demand for its products.

However, it is important to make sure that increased sales are not done through incentives or giveaways. In 2005, U.S. auto companies saw booming sales but they made little if any money off the increase in revenues. The friends and family pricing programs being offered to everyone hurt profit margins. And some companies will never be able to increase sales. Look at the travel agency business. Who needs them when you can book plane tickets and hotels online?

3. Can the company increase profits on existing sales? What is the outlook for the gross profit margin as a percentage of sales? How much is the gross profit margin expected to increase or decrease as a result of changes in price, mix of business, or the specific costs that make up the cost of goods sold? If it is not possible to sell more, is it possible to squeeze more profit out of what is already being sold? Can the company cut product costs by changing suppliers or shipping methods? Or, as in the case of ABC Ice Cream, can it change its product mix to focus on more profitable lines of business to raise its profit margin? In 2006, many of the major media companies are diversifying away from the mainline newspaper business as circulation flattens and ad sales decrease. Companies like the New York Times and the Tribune Company are looking to increase their presence in the more profitable online world to boost overall margins and revenues. Wal-Mart never hesitates to change suppliers if it will squeeze extra profit out of a particular product line.

4. Can the company control expenses? What is the outlook for selling, general, and administrative costs/margin as a percentage of sales? Have there been any changes and, if so, what are they? Is there any way for the company to cut costs not related to making the product? Are overhead, salaries, and other employee expenses out of line? Can the company close expensive or outdated production facilities? Is a new technology available that will allow it to raise its overall profit margin? Can it lay off employees to reduce overhead? Can it refinance debt at lower rates and let the savings accrue to the bottom line?

All too often, companies let expenses get out of control and it becomes necessary to make cutbacks to restore profitability. Every dollar saved, whether in the price of paper clips or health care costs, flows to the bottom line and helps to restore profitability.

5. If the company does raise sales, how much of it will fall to the bottom line? If sales can be grown at no additional cost, every dollar goes right to bottom line profits. If, however, a company has to hire additional salespeople, build new plants, or add additional shipping costs to gain growth, the increased sales will not all translate into bottom line profit. As mentioned, if increased sales are based on incentives and price cuts, the percentage of profit will be low. Often the cost of gaining revenue and market share can actually cause profit margins to fall or even reduce a company’s profits. This frequently happens in technology companies where the cost of gaining business may exceed the profit potential of the business. On the flip side, Wal-Mart and Harley Davidson are great examples of companies that have maintained tremendous revenue growth while holding or even increasing their pretax profit margins.

6. Can the company be as profitable as it used to be, 6. Can the company be as profitable as it used to be, or at least as profitable as its competitors? Often I will see a company where the profit margin falls well below previous levels. If this is due to a temporary problem, the company should regain its profitability. It may have stumbled due to management error, a new product that bombed in the marketplace, or expenses that temporarily got out of control. The reason for falling profits could be external—a rise in interest rates, or as I am seeing today, rising energy or raw material costs that cut into the bottom line of many companies. Once you determine the cause, you can decide whether the problem can be fixed and profits restored to previous levels. When I find a company whose profit levels are well below the rest of the industry, I want to know what its competitors are doing differently. Can management make the changes that will let the company catch up with its peers?

7. Does the company have one-time expenses that will not have to be paid in the future? Often you will find situations where earnings are temporarily depressed by a one-time expense or charge. These could be costs associated with a merger or acquisition, or the closing of a factory. Other one-time charges include the costs of lawsuits such as seen with tobacco and firearms companies, or the closing of unprofitable divisions. If it is truly a one-time expense, one can assume that earnings will return to prior levels and the stock could rise.

8. Does the company have unprofitable operations they can shed? Many times, as in our example of ABC Ice Cream, a company will have a division that is losing money while its main operations are making money. Perhaps a retail chain has stores that are not up to the level of the majority of stores. If these divisions and locations can be sold or closed, earnings will rise as the losses are eliminated, I have seen this many times with companies such as James Crean, a small Irish conglomerate that engaged in a wide variety of businesses. At first glance, the stock didn’t appear that cheap but repeated insider buying piqued my curiosity. A closer look showed that it was selling several divisions and the ensuing proceeds would firm up the balance sheet. In 1997, the company was actually selling at just 65 percent of the then adjusted book value. In 1996, I came across a small company by the name of National Education. It had two profitable divisions and two that were losing money. Once management made the needed changes, the stock doubled in price. Getting rid of the money-losing operations in many cases is all the catalyst a company needs to see substantial gains in the price of its stock.

9. Is the company comfortable with Wall Street earnings estimates? Although I rely very little on the estimates when looking for stocks or estimating their value, I like to know if management is comfortable with the earnings estimates the Street is making. If they feel they are too high or too low, I know that missing the earnings will likely cause the stock price to fall, while exceeding the estimate will often cause the price to move higher.

10. How much can the company grow over the next five years? How will the growth be achieved? I like to get some idea of just how much the company thinks it can grow the business over the next five years. The confidence, or lack thereof, of management in its ability to grow the business gives me a good idea of how much the stock could be expected to rise from depressed levels. I want to know how the company intends to achieve that growth as well. Will it open new locations and enter new markets? Will it acquire other companies to grow the earnings? Will the growth come at the expense of profit margins and return on equity? I like to know that management has a plan to achieve their growth goals and has a good handle on the costs and expenses they will need to grow. Growing revenues alone is not enough if those revenues aren’t generating additional profits.

11. What will the company do with the excess cash generated by the business? Every dollar of profit not given to shareholders in the form of dividends will be retained by the company. What does management intend to do with it? If the company is profitable and generating excess cash what is it doing with it? Does it plan to increase dividends to shareholders? Will it invest in new stores or factories? Excess cash could also be used to acquire other companies or buy back stock. I want to know what return it expects on these investments. The proper use of the excess cash flow can add substantially to corporate earnings and increase profit in the years ahead, which bodes well for the stock price. Poor use of the money could result in falling margins and returns.

12. What does the company expect its competitors to do? It is simply good business practice to know, at least generally, what competitors are planning to do. The expansion plans of Lowe’s have a huge impact on the results at Home Depot. The growth plans of Wal-Mart are very bad news for major grocery store chains. When one auto company decides to use incentives and rebates to spur sales, all of them have to respond in similar fashion or risk losing sales. If Pepsi introduces a wildly successful new drink concoction, Coca-Cola may have to spend some money to create a competing version or lose market share. As no man is an island, neither does any company operate in a vacuum. It has competition that is out to take away sales and profits.

13. How does the company compare financially with other companies in the same business? I like to see how a company stacks up against its competition. Does the competition earn the same returns on capital? Does the company have more or less debt than its peers? If it owes a lot more money than direct competitors, the cost of servicing the debt may prevent it from keeping up in the years ahead. How does the marketplace value the company? Why does Heinz sell at 20 times earnings when Kraft sells for just 15? What do other investors see that I may be missing?

14. What would the company be worth if it were sold? This question has become more and more important in the day-to-day business of evaluating stocks. I first started evaluating stock selection on this basis in the 1970s when it became obvious that some television stations were selling for far less than was being paid for similar companies. The industry standard at the time was about 10 times cash flow for an acquisition, whereas I bought stock in Storer Broadcasting for just 5 times cash flow. It was eventually bought out at a large premium to the price I paid. Calculating the buyout value of stocks became common practice. In the mid-1980s, we figured out the buyout multiples for food stocks and made several great investments in companies like General Foods. Anytime I consider a stock, I look to see at what level of earnings and book value recent takeovers and division sales have occurred.

15. Does the company plan to buy back stock? I look to see if the company announced a buyback and check the quarter-over-quarter shares outstanding to see if it is actually buying stock. Not all announcements of intention to buy back stock are implemented. Further, many buybacks are done just to offset stock and option grants. I want to see if there will be a real reduction of shares outstanding.

16. What are the insiders doing? Are insiders (company management) buying? Are they selling? I have talked about the positive impact of insider buying but selling is not always a negative. Sometimes people sell for personal reasons: They may need to pay for a one-time expense such as a new home, college education, a wedding. They may be diversifying their estate, or paying a divorce settlement. Look for patterns. An occasional sale by an insider may mean nothing; consistent sales by many officers and directors are a clear indication that management thinks the marketplace has put too high a value on the company, and they are getting out while the getting is good.

By going through this checklist, I come away with a much better understanding of the companies that passed my initial tests for value. I can see which companies are likely to increase their stock price by growing their business and controlling expenses. I can determine the faith of management in the future of the company. The stocks that pass through these questions and have a favorable potential for growth are the ones that make their way into my portfolio.