Contrarian Value Investing - Going against the flow....

Nokia came out with an awful earnings report yesterday, with warnings of more bad news to come, and its stock price, not surprisingly, plummeted.

While investors are fleeing the stock and a ratings downgrade looms, is it a contrarian play? What about JP Morgan Chase? Or Research in Motion? Netflix or Green Mountain Coffee, anyone? By focusing on stocks that other investors are abandoning, contrarian value investing is the "anti-lemming" strategy, but it takes a unique personality and a strong stomach to pull off successfully.

The basis for “contrarian” investing

The core belief that underlies contrarian investing is that investors over react to both good and bad news, pushing prices up too much on the former and down on the latter. If you carry this view to its logical conclusion, it then follows that prices will reverse in both cases as investors come to their senses.

While you may believe that investor overreaction is the norm, is there evidence to back up the claim? The statistical and the psychological evidence is mixed and contradictory. On the one hand, there is significant evidence that investors under react to news stories (earnings reports, dividend announcements), leading to momentum (and drift) in stock prices, at least over short periods. On the other, there is also evidence that investors over react to information, with price reversals occurring over longer periods. In behavioral finance, as well, there are two dueling "psychological" characteristics at play: the first is that of "conservatism", where individuals, faced with new evidence, update their prior beliefs (expectations) too little, thus creating under reaction, and the second is "representativeness", where individuals over adjust their predictions, based upon new information. To reconcile the co-existence of the two, you have to bring in two factors. One is time, with under reaction dominating the short term (days, weeks, even months) and over reaction showing up in the long term (years). The other is the magnitude of the new information, with over reaction being more common after big events. 

Contrarian investing strategies
Within the construct of contrarian investing, there are at least four variants. In the first,  you invest in the stocks that have gone down the most over a recent period, making no attempt to be a discriminating buyer. In the second, you focus on sectors or markets that have been hard hit and try to identify individual companies in these groups that have been "undeservedly" punished. In the third, you look at companies that have taken hard hits to their market value but that you believe have underlying strengths which will help them make it back to the market's good graces. In the final approach, you buy stock in beaten up companies with the same intent (and expectations) that you have when buying deep out of the money options. You know that you will lose much of the time but when you do win, your payoff will be dramatic.

1. The Biggest Losers
If you believe that investors tend to over react to events and information, the effects of that over reaction are most likely to be seen in extreme price movements, both up and down. Thus, stocks that have gone down the most over a period are likely to be under valued and stocks that have gone up the most over a period are likely to be over valued. It follows, therefore, that if you sell short the former and buy the latter, you should be able to gain as the over reaction fades and stock prices revert back to more "normal" levels.

In a study in 1985, DeBondt and Thaler constructed a winner portfolio, composed of the 35 stocks which had gone up the most over the prior year, and a loser portfolio that included the 35 stocks which had gone down the most over the prior year, each year from 1933 to 1978. They examined returns on these portfolios for the sixty months following the creation of the portfolio and the results are summarized in the figure below:

An investor who bought the 35 biggest losers over the previous year and held for five years would have generated a cumulative abnormal return of approximately 30% over the market and about 40% relative to an investor who bought the winner portfolio.

Looks good, right? Before you rush out and load up on the biggest losers of the last year, a few notes of caution:

1. Watch out for transactions costs:  There is evidence that loser portfolios are more likely to contain low priced stocks (selling for less than $5), which generate higher transactions costs and are also more likely to offer heavily skewed returns, i.e., the excess returns come from a few stocks making phenomenal returns rather than from consistent performance.
2. Timing is everything:   Studies also seem to find loser portfolios created every December earn significantly higher returns than portfolios created every June. This suggests an interaction between this strategy and tax loss selling by investors. Since stocks that have gone down the most are likely to be sold towards the end of each tax year (which ends in December for most individuals) by investors, their prices may be pushed down by the tax loss selling.
3. Time horizon matters: In a test of how sensitive the results were to holding period, Jegadeesh and Titman tracked the difference between winner and loser portfolios by the number of months that you held the portfolios and their findings are summarized in the figure below.  There are two interesting findings in this graph. The first is that the winner portfolio actually outperforms the loser portfolio in the first 12 months. The second is that while loser stocks start gaining ground on winning stocks after 12 months, it took them 28 months in the 1941-64 time period to get ahead of them and the loser portfolio does not start outperforming the winner portfolio even with a 36-month time horizon in the 1965-89 time period. 

If you feel that, in spite of these caveats, this strategy may work for you, you can take a look at a list of the 50 companies that have gone down the most (in percentage terms) over the last 52 weeks (June 2011-June 2012). I have added a stock price constraint (to ensure that you don't end up with low-priced stocks) and reported the dollar trading volume per day (as a red flag for trading costs).  I have compiled the list for the US (with price>$5), Europe (with price>$5), Emerging Asia (with price>$1), Latin America (with price>$1) and global (with price>$5). Your timing is off (since it is not January) but you can still browse for bargains. You can also adapt the screening plus strategy that I talked about in my post on passive screening and subject the companies on these lists to follow up analysis (intrinsic valuation or qualitative assessments)>

2. Collateral Damage
It is not uncommon for markets to turn negative on an entire sector or market at the same time. In some cases, this is justified: a big news story that affects an entire sector, or a macro economic risk that hurts a market. In others, it may represent either an over reaction by investors to the idiosyncratic problems of an individual company in a sector or a failure to consider that companies within a market/sector may have different exposures to a given macroeconomic risk. As an example of the former, consider how banking stocks were punished on the day that JP Morgan Chase reported its big trading loss. As an illustration of the latter, you can look at the Spanish stock market, where investors have punished all companies (though some are less exposed to Spanish country risk than others) over the last year.

About a decade ago, I penned a paper on measuring company risk exposure to country risk that argued that we (as investors) were being sloppy in the way we assessed exposure to country risk, using the country of incorporation as the basis for measuring risk exposure. With this view of the world, US and German companies are not exposed to emerging market risk, an absurd argument when applied to companies like Coca Cola and Siemens that derive a large chunk of their revenues from emerging or risky economies. By the same token, all Brazilian companies are equally exposed to country risk, though some (such as the aircraft manufacturer, Embraer) derive most of their revenues from developed markets. This laziness in assessing country risk does provide opportunities for perceptive investors during crises. This was the case when Brazilian markets went into a tailspin in 2002, faced with the feat that Lula, then the socialist candidate, leading in the polls, would win election to lead the country. As Embraer fell along with the rest of the Brazilian market, you could have bought it at a "bargain basement" price. If you are interested in following this path, here is my suggestion. Start putting together a list of companies like Embraer, i.e., emerging market companies that have a significant global presence and then wait for a crisis in the emerging market in question. When there is one (it is not a question of whether, but when....), and your "global" company drops with the rest of the market, you are well positioned to take advantage.

It is trickier, though, playing this game within a sector. Consider the JP Morgan Chase case. While the trading loss was clearly specific to JPM, you could argue that the event affected the values of all banks at two levels. The first is by increasing the chance that the Volcker rule, barring proprietary trading at banks, would be adopted, it affects future profitability at all banks. The second is the fear that in response to the loss, the regulatory authorities would require higher capital ratios be maintained at all banks. If those are your concerns, you should focus on banks that do not make have a large proprietary trading presence and are well capitalized. If investors have over reacted across the board, those banks should be trading at attractive prices.

 3. Comeback Bet
When stock prices drop precipitously for an individual stock, there is usually a reason. If the drop reflects long term, intractable problems, there may be no reversal. If the drop reflects temporary or fixable problems, you are more likely to see prices reverse. As you look at the reasons for the price drop, you should keep in mind your overriding objective, which is to find a company whose price has dropped disproportionately, relative to its  value.

Here are some possible reasons for a stock price collapse, with the ingredients for a comeback:
a. Unmet expectations: When expectations are set too high or at unrealistic levels, it is inevitable that investors will be confronted with reality not matching up to expectations. When that happens, they will abandon the stock, causing stock prices to drop. (Netflix and Green Mountain Coffee, both of which make the list of biggest losers over the last year are good examples of what happens to high flyers when they disappoint...)
Ingredients for a comeback: Expectations have dropped not just to realistic levels but below those levels. Investors have over adjusted.
b. Corporate governance issues: Events that lay bare failures of managers and oversight by the board of directors shake investor faith and, by extension, stock prices. A case in point would be Chesapeake Energy, where the CEO, Aubrey McLendon, stepped down after evidence surfaced that the board of directors had allowed him to use $800 million in personal loans to acquire stakes in company-operated oil wells.
Ingredients for a comeback: (a) A new CEO from outside the firm, (b) with a full cleaning out of management team and revamping of board of directors, and (c) an activist investor presence.
c. Accounting fraud/ manipulation: As investors, we start with the presumption that financial statements, while reflecting accounting judgments that may work in the company's favor, are for the most part true. Any suggestion of accounting fraud can lead to a meltdown in the stock price, not to mention open the company up to legal jeopardy.
Ingredients for a comeback: (a) Full reporting of all accounting misstatements, with (b) removal of top management, and (c) no legal jeopardy.
d. Operating/Structural problems: Operating problems can range from problems with a key product (see Dendreon, on the list of biggest losers last year) to deeper structural problems, where the company's products just don't match up well to consumer demands or to the competition.
Ingredients for a comeback: (a) Management that is not in denial about operating problems and (b) a realistic plan for dealing with operating problems.
e. Financial problems: When operating problems combine with significant debt burdens, you have the seeds of distress, which can spiral very quickly out of control, as suppliers, employees and customers react pushing the company deeper into trouble.
Ingredients for a comeback: (a) A clear debt restructuring/repayment plan, (b) Solid operating performance.

Whatever the reason or reasons for a price collapse, investors have to follow up by asking and answering three questions:
1. Is "it" a one-time or continuing problem? While the line between one-time and continuing can be a shade of grey, the answer is critical. One time problems tend to have much smaller impact on value than continuing problems, and are easier to deal with and move on.
2. How fixable is the problem? Some problems are more easily fixable than others. In making this judgment, you should look at three factors. The first is whether the problem is entirely an internal problem or whether it is partly or mostly due to outside or macro factors. Internal problems are easier to remedy than external ones. The second is whether the solution can be "quick" or will take "time". Thus, a firm with significant debt may be able to restructure that debt quickly, whereas a firm that has deep-rooted structural problems will need more time. The third is whether the managers of the firm seem to have both a reading of the problem and a solution in hand.
3. Is the market decline disproportionately large? To make this assessment, you have to work through the consequences of the problem for the determinants of value: its effect on current cash flows, the expected value of growth (both the level and the quality) and the risk in future cash flows.

Using this framework, let's look at JP Morgan Chase. At first sight, it looks like a slam dunk. The trading loss was reported to be $2 billion at the first announcement and it seems like a fixable problem in the short term, with better risk management in place. The fact that the market capitalization went down by more than $30 billion on the announcement of the loss seems to suggest an over reaction, but there is more to this story than meets the eye. The first is that the trading loss of $ 2 billion is an estimate and the actual losses may be higher (the rumor mill suggests that they could exceed $5 billion). The second is that the loss will reduce the current regulatory capital and may increase the target regulatory capital ratio that JP Morgan aspires to reach over time; the combination of a lower current capital ratio and an increasing target capital ratio will translate into lower returns on equity, going forwards, and lower cash flows available to stockholders in the future (in the form of dividends or buybacks). To make a judgment on whether the stock is a bargain at the current price, I used a simple test. The price to book ratio for a mature bank can be written as:
Price to book ratio = (ROE - Expected growth)/ (Cost of equity - Expected growth)
Conservatively, if you assume a growth rate of 1.5% in perpetuity and a cost of equity of 9% (about 1% higher than the cost of equity for an average risk company), the return on equity implied at the JPM's current price to book ratio of 0.73 is about 7%:
0.73 = (ROE - 1.5%)/ (9%-1.5%)
Implied ROE = 6.98%
The ROE in the most recent year for JPM, prior to its loss, was 10.34%. Even allowing for higher regulatory capital requirements (which will increase book equity) and lower profits (perhaps from the Volcker rule), the adjustment seems like an over reaction.  I know that there are other fears hanging over large banks, but I have a spreadsheet that I think contains a a conservative valuation of JPM that yields a value of about $46/share, well above the current stock price of $35. You can use it to make your own judgments for JPM or any other bank.

4. "Long odds" option
There is one final scenario: a company whose stock price has collapsed, with good reason and where a turnaround is neither anticipated nor expected. In other words, the stock looks fairly priced, given its prospects and problems today. However, let's assume that the firm has proprietary assets is in a risky business, where technology shifts could make today's winners into tomorrow's losers and vice versa. You could consider investing in this company's shares, for the same reasons that you buy an out of the money option.

In effect, you are leveraging the fact that equity in a publicly traded company has a floor of zero and that your losses are therefore restricted to the prevailing market value of equity. For your option (equity investment) to have a big payoff, though, you will need  the value of the firm's assets to increase significantly from existing levels (because of a new product, market shift or an eager acquirer) and that will require that your firm have a proprietary technology/product/license and operate in a  shifting, risky business. While the value of the assets could drop just as precipitously, you care less about downside because you don't have much to lose (since your equity value is so low).

Nokia (NOK) and Research in Motion (RIM) come to mind as potential option plays. They both have proprietary technologies and patents (though the market does not think that either technology looks like a potential winner in the market today) and operate in a risky business where the landscape can shift dramatically over night. While the Blackberry technology is a more reliable cash provider for RIM, there are three factors that tip me towards Nokia. The first is Nokia's stock price has dropped far more than RIM's over a shorter period, reducing the cost of my option. The second is that Nokia's debt burden is a mixed blessing: it could cut my option game short, if Nokia defaults, but it also leverages any upside in value. Small changes in Nokia's asset value will translate into big changes in equity value. The third is that the turmoil in the Euro zone adds to the value of my option. Put differently, I like Nokia because it is riskier than RIM, but risk is my ally, not my enemy, with an option. If you plan to invest in Nokia, do so with the full recognition that you may have to write off the entire investment a few months or years from now, but if the stars align, watch out!!!

The Value Investing Series

Where is the value in value investing? (Downloadable paper on value investing)

Blog post 1: Value Investing: An Identity Crisis?

Blog post 2: Value Investing I: Screening for bargains

Blog post 3: Value Investing II: Contrarian Investing

Read More

Passive Value investing: Screening for bargains

As long as there have been markets, I am sure that investors have used screens to find good investments. It was Ben Graham, however, who systematized the process in his books on investing, by laying out the ten criteria (screens) that could be used to find cheap stocks. 

1. An earnings to price yield > Twice the AAA bond rate (At the AAA bond rate of about 3.6% today, that would work out to an earnings to price ratio > 7.2% or a PE< 14)
2. PE ratio today < 40% of the highest PE ratio for the stock over the previous 5 years
3. Dividend yield > 2/3 or the AAA bond yield (At today's AAA rate, yield >2.4%)
4. Stock price < 2/3 (Tangible book value of equity per share), where tangible book value of equity = Total book value of equity - Book value of intangible assets
5. Stock price < 2/3 (Net Current Asset Value), where Net Current Asset Value = Current Assets - (Total Liabilities + Preferred Stock)
6. Total debt < Book Value of equity
7. Current ratio > 2, where current ratio = Current Assets/ Current liabilities
8. Total Debt < 2 (Net Current Asset Value)
9. Earnings growth in prior 10 years > 7%
10. No more that two years in the prior ten, where earnings declined more than 5%.

While we can debate the efficacy of these screens (I, for one, find that the fixation on net current asset value is too restrictive), it is quite clear what Graham was looking for: cheap companies with low leverage & stable and growing earnings, with liquid assets acting as a backstop and providing a margin of safety for investors.

Do screens work?

Graham had three pricing screens among his ten criteria: PE ratios, a modified version of price to book ratios and dividend yields. In the decades since, studies (many from academics but quite a few from practitioners as well) have found  that at least two of these screens seem to work, at least on paper. Stocks that trade at low PE ratios and low PBV ratios deliver returns that beat the market, on a risk adjusted basis.

Let's start by reviewing the evidence. Rather than quote from studies that are at different points in time, I used the raw data (maintained very generously by Ken French at Dartmouth) to compute the differential returns that stocks, in the lowest and highest deciles of PE, PBV ratio and the  dividend yield, earned on an annual basis between 1952 and 2010, relative to the overall market:

Note that low (high) PE and low (high) PBV stocks have beaten (under performed) the market by healthy margins, before adjusting for risk, over time but that there is no discernible pattern with dividend yields. In fact, over the period, non-dividend paying stocks beat both the highest dividend yield and lowest dividend yield deciles in terms of returns earned. You can find more on past studies by going to my paper on value investing.

So, what's the catch?
When it looks like you can make money easily, there is always a catch. Here are the three caveats on the "excess returns" that a low PE, low PBV strategy seems to deliver.

1. Time horizon matters: The returns are in the long term (five years and longer) and there are time periods (some lasting for years) where the strategies under perform the market. For instance, looking across the entire period, for instance, it looks like while low PE stocks dominate high PE stocks over long periods, the latter group outperforms during periods of low economic growth (where growth becomes scarce).
2. A proxy for risk? While I did not adjust for risk in my computation for excess returns, most of the studies that have looked at these screens have controlled for risk, using conventional risk and return measures (betas, Sharpe ratio etc.). It is possible that there are other risks in buying these stocks that may not be full reflected in these risk measures. For instance, some stocks that trade at low price to book value ratios have high debt burdens and run a higher risk of default/distress.
3. Transactions costs & taxes: A lot of strategies that make money on paper perform badly in practice because they expose investors to higher transactions costs and taxes. For instance, many of the stocks in the lowest PE ratio decile are lightly traded companies, with high bid-ask spreads and potential for price impact. Similarly, investing in high dividend yield stocks may expose investors to higher taxes.

In a testimonial to how difficult it is to convert paper profits to real profits, it is worth noting that the James Rea's attempts to put Graham's principles into practice in an investment fund that he ran from 1982 to the late 1990s was an abject failure, with the fund ranking in the bottom 20% of the fund universe in performance. In a similar vein, Value Line's attempts to convert its screens (that also worked exceptionally well on paper) into a mutual fund also failed.

Incorporating screens into investing
If you do buy into the effectiveness of screens at finding cheap stocks, there are two ways to incorporate screens into your investing.
a. Bludgeon Screening: In this approach, all of the work in picking stocks is done by your screens. Thus, you start with a large universe of stocks and screen your way (using either more screens or tighter screens) down to a portfolio size (in terms of number of companies) that you are comfortable with.

b. Screening plus: You use the screens to narrow the universe of stocks (which may contain thousands of stocks) to a more manageable number, but you then follow up using one of these approaches:

• Screening plus intrinsic valuation: You value each of the screened stocks using an intrinsic valuation model (a discounted cash flow model, excess return model or your own variant) and invest in the most under valued companies. You can also incorporate a margin of safety into this approach by only investing in stocks that trade at 30%,40% or 50% discounts on your intrinsic value.
• Screening plus qualitative analysis: Once you have the screened list, you may be able to apply qualitative criteria that you think separate winners from losers (moats, good management etc.) to find the stocks for your portfolio.

A blueprint for screening

In Graham's day, screening was an arduous process, with limited access to the financial statements of companies and no computing power. Today, screening has become easy with many sites offering stock screeners for all, sometimes at no cost: Yahoo! Finance, Google Finance and MarketWatch all offer simple screening tools. In fact, it has become so easy that investors sometimes get carried away, piling on redundant screens on top of each other and sometimes undercutting their effectiveness by doing so.

Before you start, be clear about your objective
You want to find a mismatched company, i.e, a company that is priced low, with none of the reasons for being priced low (high risk, low growth, low quality of growth). In other words, you want a stock trading at a low multiple, with low risk, high growth rates and high quality growth. What chance do you have of finding such a bargain? It may be low, but there is no harm looking.

Step 1 - Screen for price
The first step is to screen for low . With stocks, this will almost always require that you scale the market price to a common variable (revenues, earnings, book value etc.) to estimate a multiple. Here are your choices:

In making these choices, you have to be consistent. If your numerator is an equity value (market capitalization, stock price), your denominator should also be an equity value (net income, earnings per share, book value of equity). If your numerator is an enterprise or overall business value (enterprise value, value of firm), your denominator should be an overall firm number (operating income, EBITDA, revenues, book value of invested capital). Should you use an equity multiple or an enterprise value multiple? In some sectors, such as financial services, you have no choice but to use equity, since defining debt is close to impossible. In others, you have a choice, and here is my simple rule. If financial leverage varies widely across the sector (some firms have more debt than others), I would go with an enterprise value multiple. For comparisons across the entire market, enterprise value multiples tend to be more robust.

Once you have picked a multiple, you then have to choose your screening thresholds. In practical terms, you have to decide how low does a stock's pricing multiple has to be to qualify for your cheap list. There are three ways to find this threshold.
a. You can use the rules of thumb that seem to be so widely prevalent: an EV/EBITDA less than 6 is cheap, a PE ratio in the single digits is low etc. While these rules of thumb may have made sense when first devised, it is doubtful that they make sense today.
b. You can derive the "cheap" threshold from intrinsic valuation models. To illustrate, the PE ratio for a firm that pays its entire earnings out as dividends and has no growth should be as follows:

Intrinsic "cheap" PE threshold = 1/ Cost of equity

In June 2012, when the cost of equity was computed to be about 8%, the threshold for a "cheap" company would be 12.5 (=1/.08).
c. You can derive the threshold by looking at the distribution of the values of the multiple across your sample, using the lowest decile (or lowest quartile) as your cutoff for "low". The table below lists the deciles for key multiples for US companies in January 2012:

Thus, looking for stocks with a PE less than 5 would give you stocks in the lowest decile whereas using a cut off of 10 for the PE would give you stocks in the top quartile, at least in early 2012.

Step 2 - Screen for risk
Companies that are very risky can look cheap, without being cheap. To screen for risk, consider first a breakdown of risk into three categories:
(a) Operating risk, reflecting the risk that your revenues and costs can shift over time, as the market and the sector evolve.
(b) Financial risk, coming from the use of debt, leases and other fixed commitments that can make your residual stake as the equity investor much more volatile.
(c) Liquidity risk, that you face as as investor when trading on the stock, manifested as trading costs (bid ask spreads, price impact) and inability to trade at the extreme.

The screens for risk can broadly be categorized as follows:

1. Price based screens: While many value investors express disdain for betas, there are other price based screens that are based upon prices (standard deviation, volatility in the stock price) that they may still be willing to use as measures of composite risk. In fact, you can use screen for liquidity risk, using market data, by looking at the bid-ask spread or the trading volume/float in a stock.
2. Accounting based screens: Accounting statements can provide snapshots of risk, though they are stronger in measuring some types of risk than others. You can measure exposure to financial risk fairly well, using ratios that measure the capacity to make interest or debt payments (interest coverage, fixed charge coverage ratios), operating risk less well (variability in earnings over time) and liquidity risk not at all.
3. Risk proxies: While this may be applying a broad brush, you may use the sector a firm is in as a proxy for risk; thus technology companies may be viewed as risky companies and utilities as safe companies. Alternatively, you may believe that large companies (measured in market capitalization or revenues) are safer than small companies.
4. Sector specific screens: If you are screening for cheap stocks within a sector, you may use measures of risk that are specific to the sector. Among bank stocks, for instance, you may look at regulatory capital ratios or exposure to problem assets/businesses; banks with lower regulatory capital or greater exposure to toxic assets are riskier. 

As with the multiples, you can see the quartiles of the distribution for these variables for US stocks in January 2012 in the table below:

Step 3- Screen for growth
If you are a value investor who views growth as icing on the cake, you may not look for  high expected earnings growth but you may still want to screen for companies with moderate growth prospects or at least try to avoid companies with negative earnings growth. In screening for growth, you should stay true to the consistency principle, focusing on growth in equity earnings, if you are using an equity multiple (like PE) or growth in operating earnings, if you are using an enterprise value multiple and you would rather be forward looking in your growth estimates (using expected future growth, if available) rather than backward looking (historical growth). The quartiles of growth measures for US stocks in January 2012 is in the table below:

Step 4 - Screen for quality of growth 
If you are employing a growth screen, you also want to ensure that the firm is not spending too much to deliver that growth. To screen for quality of growth, you can employ one of two approaches:
a. Accounting return measures: Dividing the accounting earnings by accounting book value gives you a measure of accounting returns:
Return on equity = Net Income/ Book value of equity
Return on invested capital = Operating income/ (Book value of equity + debt - cash)
While they are aggregate measures for the whole firm and accounting earnings/ book value are susceptible to accounting manipulation, you want firms that are able to earn high returns on their growth investments in your portfolio. At the minimum, the returns should exceed the costs (the cost of equity, if ROE, and the cost of capital, if ROIC).
b. Sector specific measures: You can also measure efficiency of growth using sector specific measures, such as profit margins (net or operating) in retail, capital invested per subscriber (in cable or other subscriber-based businesses) or capital invested per kWh of power produced (for power companies).
The quartiles for ROE, ROIC, net and operating margin for US companies in January 2012 are reported in the table below:

Step 5: Rinse and repeat
Once you run your screens, check the stocks that come through the screens for two potential problems. The first is sample size. If your screens return only a handful of stocks, your screens have been set too tight and you should consider relaxing one or more of your screens (settling for lower growth or higher risk). The second is sector concentration. If you end up with stocks that are in one or a couple of sectors, you may want to consider modifying or adding to your screens to get more diverse portfolios.

While you can screen for free at Yahoo! Finance and Google Finance, you get far more flexibility in defining your own screens if you have access to a database. For US companies, you can try Value Line or Morningstar, both of which provide real time data for the entire universe of traded stocks and are not unreasonably priced. For screening of stocks outside the US, you can use Capital IQ, Factset or Bloomberg, but the price tag gets higher. There are some innovative sites out there that are offering better screening tools and large databases, such as RobotDough, a site that combines an impressive database with powerful screening tools, AAII and Zacks (which has a combination of free and premium screens).

Odds of success

I have always believed that, as an investor, you need to bring something unique to the table to be able to take something away in terms of excess returns. In other words, just as  we look at competitive moats for successful businesses, you have to think about your competitive moats as an investor. With screening, consider the competitive advantages that Ben Graham saw for the intelligent investor in 1951, when he put together his classic screen list. The first was access. With limited access to financial statements and no easy-to-use tools, only a few tenacious investors could use these screens. The second was discipline. Investors had to stay away from distractions and fads and stay true to those stocks that made it through the screens. The third was patience. Investors had to hold the screened stocks in the long term to generate the promised returns. Today, with widespread access to data and analysis tools , the first advantage has dissipated, leaving behind patience and discipline as your potential advantages. It can be argued that an automated screening/investing process, with no human input, is less likely to succumb to emotion than the most disciplined, patient human being. Put more bluntly, if all you have to offer as an active investor is screens, you are unlikely to beat a machine doing the same. With screening plus, whether you make money depends on the quality of what you do after you screen. If you are skilled at intrinsic valuation or qualitative assessment, you may generate excess returns, relative to the market.

In closing
To illustrate the screening process, I used Capital IQ data and used two sets of screens to arrive at a list of "cheap" stocks from a universe of 7542 publicly traded companies in the US.

Equity screen: Low PE (<10.11, in bottom quartile), above-average expected EPS growth rate (>13.50%, above median), below-average book debt to equity ratios (<27.21%, in bottom quartile), high ROE (>13.60%,top quartile)    --> See the  19 stocks that made it through these screens

Enterprise value screen: Low EV/EBITDA (<4.51, bottom quartile), above-average expected revenue growth (>7%, above median), below-average book debt equity ratio (<27.21%, below median), above-average ROIC (>9.41%, top quartile)   --> See the 13 stocks that made it through these screens
I would not be rushing out to buy all of the stocks on either list, but I think it is worth following through and doing intrinsic valuations of these companies. Anyone up for it? If so, you are welcome to use my generic valuation spreadsheet.

The Value Investing Series
Where is the value in value investing? (Downloadable paper on value investing)
Blog post 1: Value Investing: An Identity Crisis?

Blog post 2: Value Investing I: Screening for bargains

Read More

Value Investing: An Identity Crisis?

Any post about value investing always evokes strong responses, but I thought I would start this one by turning the focus inwards. So, here are a few questions for you :
1. Would you classify yourself as a "value investor"?
a. Yes
b. No

2. If yes, what makes you a value investor?
a. I try to estimate the value of a stock before I invest in it
b. I only buy stocks that trade at attractive multiples (low PE, low PBV etc.)
c. I do my homework, looking at the fundamentals, before I invest
d. I don't know. I just am.

3. Finally, do you think that value investors collectively do better than other investors in the market?
a. Yes
b. No
c. Not Sure
If yes, what is the source of their advantage? If not, why do you think they fail?

• On the first question, I would not be surprised if the preponderance of visitor to this site classify themselves as value investors. After all, value investing has become so broadly defined that everyone seems to be in this camp, and when everyone is a value investor, no one is a value investor. For value investing to work as an investment philosophy, it needs foils, preferably in the form of investors who know little about fundamentals and care about them even less. Paraphrasing Warren Buffett, if investing is a game of poker and value investors are the card counters, you need suckers at the table who will supply the winnings.
• On the second question,  as value investing has expanded well beyond the Ben Graham school of strict (and passive) value investing to include different and seemingly contradictory strands of investing, there is less consensus about what comprises a good "value” stock. In a recent paper on value investing (which, in turn, is closely modeled on a chapter in my book on investment philosophies), I presented my take on these issues.
• On the third question, it does seem to be taken for granted, at least in the value investing community, that value investors are not only more virtuous than other, more fickle investors (growth investors, momentum investors) but that their "hard work" pays off in the form of higher returns, at least over long periods. It would be vindication of the "ant and the grasshopper" fable, if it were true, but is it?

What is the key characteristic that separates value investors from the rest of the world? In my view of the world, and I understand that yours might be different, the key to understanding value investing comes from breaking down a business into assets in place and growth assets.

It is this mechanism that I used to my posts on estimating how much you are paying for growth and how much that growth is worth. If you are a value investor, you make your investment judgments, based upon the value of assets in place and consider growth assets to be speculative and inherently an unreliable basis for investing. Put bluntly, if you are a value investor, you want to buy a business only if it trades at less than the value of the assets in place and view growth, if it happens, as icing on the cake.

It is how you find investments that sell for less than the value of assets in place that provides a framework to understanding the different strands of value investing, and there are three ways you can go about this mission:
a. Passive value investing: The oldest strand of value investing traces its lineage back to Ben Graham and his use of screens to find cheap stocks. Reviewing those screens, which combine market and accounting data, from Graham's book on security analysis, you are looking at stocks that trade at low multiples of earnings, pay a high proportion of these earnings as dividends and have a high proportion of assets that can be liquidated for close to their book value. In the years since, investors have added other screens (good management, stable earnings, strong competitive advantages etc.) that are all designed to reduce the potential for downside on the investment.
b. Contrarian value investing: In contrarian value investing, you adopt a different tack. You look for companies whose stock prices have collapsed for one reason on another. In its least sophisticated variant, you just buy the biggest losers (at least in terms of stock price), on the assumption that markets generally over react and that the portfolio of these losers will bounce back over time. In its more refined forms, you add other criteria to the mix. Thus, you may buy stocks that have gone down but only if they have a strong brand name and/or little debt.
c. Activist value investing: In activist value investing, you focus on poorly performing companies and look at the value of its assets in place, with better management in place. You then try to change the way the company is run by either acquiring control of the firm or putting pressure on existing management. Activist investing requires far more resources than either passive or contrarian value investing.

The skills and strengths you need to succeed in each of these value investing approaches is different and it is not clear than an investor who succeeds using one strand of value investing will be comfortable with the others. In the next three posts, I will focus on each of these strands of value investing. In the last post, I will examine the most contentious issue of all, which is whether value investors collectively generate value from their efforts or whether this too is "fool's gold".  

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How much is growth worth?

In my last post, I looked at the price being paid for growth by valuing the assets in place in a business. To make this judgment, I assumed that the business would pay its entire operating income to claim holders (as dividends to stockholders and interest expenses to lenders). The value of assets in place then becomes the value of the earnings in perpetuity, discounted back at the cost of capital.

So, what is the effect of growth on value? To grow in the long term, you have to reinvest some or a big portion of your earnings back into the business, and the amount you have to reinvest will depend upon the return on capital you earn on your new investments:

Reinvestment Rate = Expected Growth rate/ Return on Capital

Thus, a firm with a return on capital of 15% that wants to grow 3% a year will have to reinvest 20% (= 3%/15%) of its operating income back each year. Investors will thus get less in cash flows up front but have higher cash flows in future years.

Consider an example. A firm that generates $ 10 million in after-tax operating income, and has a cost of capital of 10%, will have a value of assets in place of $100 million, if it pursues a "no growth" policy:

Value of assets in place = $10 million/ .10 = $100 million

If it decides to pursue a 3% growth rate and invest 20% of its after-tax income (based upon the return on capital of 15%), its value can be computed as follows:

Value of firm = 10 million (1-.20) / (.10-.03) = $114.28 million
The difference between the two values then becomes the value added by growth:

Value of growth = Value of firm – Value of assets in place = $114.28 - $100 = $14.28 million

Determinants of the value of growth

            If you accept the proposition that growth creates a trade off of lower cash flows today for higher ones in the future, you have the three ingredients that determine the value of growth. The first is the level of growth, with higher growth rates in the future generating higher earnings over time. The second is how long these high growth rates can be sustained before the company becomes too big to keep growing (at least at rates higher than that of the economy). The third and most critical is the return on capital you generate on new investments.

To see why the last ingredient is so critical, revisit the last example and make the return on capital = cost of capital. If you do so, the reinvestment rate has to be 30% to sustain the expected growth rate of 3%. The value of growth then becomes zero:

Value of firm = 10 million (1-.30) / (.10-.03) = $100 million

Value of growth = Value of firm – Value of assets in place = $100 - $100 = $ 0

In fact, if the return on capital generated on new investments is less than the cost of capital, growth can destroy value.

The process of valuing growth does get a little more complicated when you set higher growth rates, but the logic and conclusions do not change. If the return on capital > cost of capital, the value of growth will increase as the growth rate increases and the length of the growth period expands. If the return on capital = cost of capital, neither the growth rate nor the length of the growth period affect value and if the return on capital < cost of capital, the value will move inversely with the growth rate and the length of the growth period. If you want to take this concept out for a trial run, this spreadsheet can help you. 

Comparing the value of growth to the price paid for growth

If you are paying a price for growth, it is always useful to know the value of this growth. If you accept the reasoning in the last section, it follows that it is not growth that you should be paying a premium for but “quality growth”, with quality defined as the excess return you generate over and above the cost of capital. To illustrate this concept, we compute “intrinsic” PE ratios at varying growth rates for three firms, all of which share a cost of capital of 10% but vary in the returns on capital that they earn on new investments (one has a return on capital of 8%, the second has a return on capital of 10% and the third has a return on capital of 12%).

The PE ratio for just the assets in place is 11.63 and remains unchanged, even if you introduce growth, for a firm that earns its cost of capital. For the firm that generates a return on capital < cost of capital, the PE ratio decreases as growth increases, reflecting value destruction in action. For a firm that generates a return on capital > cost of capital, the PE ratio does increase (the growth premium) as growth increases. It is this premium that you would compare to what you actually pay to make a judgment on whether the added PE you are paying for growth is justified.

Price of Growth versus Value of Growth

Using the spreadsheet on growth as a device for deconstructing growth (and its value), I looked at Microsoft, Kraft, Google and Linkedin. In the table below, I have listed my base assumptions for each company and the value of assets in place and expected growth in each one:

This table can be used to address several issues relating to growth:

a. Price of growth versus value of growth: You can compare the price you are paying for growth with the value of growth, and you come to different conclusions. For Microsoft, where the value of assets in place covers the market price you are paying, the value of growth is a pure bonus. For Kraft, the value of growth is negative, since the firm earns less than its cost of capital, and the price you are paying for growth is therefore too high. For Google, the price of growth is almost exactly equal to the value of growth, making it the only fair priced stock in this grouping. Finally, for Linkedin, the price paid for growth is more than twice the value of that growth, making the stock over valued. For investors who believe in growth at a reasonable price (GARP), this is the statistic worth watching.

b. Implied growth rates: An alternative approach is to solve for that growth rate (Look at the spreadsheet and follow the instructions), holding the return on capital and length of growth period fixed, that would yield the price you paid for that growth. Linkedin, for instance, would have to maintain a compounded growth rate of 73% a year (instead of the estimated growth rate of 60% a year) for the next ten years to justify the price you are paying for the growth. (The spreadsheet provides instructions on how to back out the implied growth rate using the Goal seek function in Excel.)

Growth, in summary, does not yield itself easily to rules of thumb or broad generalizations. In some firms, it can be worth nothing, as is argued by strict value investors, whereas in others, it can be worth a great deal, lending credence to the arguments of growth investors. 

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How much are you paying for growth?

The debate about Facebook’s valuation is interesting on many dimensions, but one that is worth focusing on is how much growth is worth, and what you are paying for it. At one extreme are some value investors who argue that growth is “speculative” and that it is  worth very little or nothing. At the other are those who argue that growth is priceless and that you should therefore be willing to pay a “fortune” for it. Both groups seem to be in agreement that valuing growth is pointless, because it requires estimates that will be wrong in hindsight.  I had a series of posts on growth a few months ago looking at the limits of growth, the scaling up of growth, the value of growth and how management credibility affects that value. In this post, I offer a simple technique for assessing how much you are paying for growth in a company. In the next one, I address how to value that growth.

Growth Assets and Assets in Place
To provide a perspective on how growth and value interact, it is best to start with what I would call a financial balance sheet.

While it is structured like an accounting balance sheet, it is different on two counts. First, rather than break assets down into fixed, current and financial assets, as accounting balance sheets do, assets are broken down into two categories: “assets in place”, representing the value of investments already made and “growth assets”, measuring the value added by expected future growth. Second, accounting balance sheets are rooted in the past, with numbers representing capital originally invested in assets, whereas financial balance sheets are forward looking, with the values of these assets being based on their capacity to generate cash flows or on market values.

The value of assets in place
To understand the price you are paying for growth, consider a simple experiment. A business that has existing assets that are generating earnings has two choices. It can pay the entire income out to claimholders (as dividends to stockholders and interest to lenders ) and forsake future growth. Alternatively, it can reinvest some (or all) of its earnings back into new investments and generate growth for the future. If you adopt the no growth alternative, your earnings from the most recent period will be your cash flow each year in perpetuity.  The value of these cash flows can be computed by discounting back at a cost of capital to yield a value for assets in place:
Value of assets in place = After-tax Operating Income from most recent period/ Cost of capital
Note that the depreciation & amortization from the most recent period is reinvested back into the business to keep its earnings power intact.

There are only three estimation inputs that you need to derive this value. The first is the operating income. While it is convenient to use the operating income from the most resent year as the base value, you may choose to use an average over a few years for cyclical and commodity companies. The second is the tax rate. Again, while the effective tax rate is the easiest to access, you may decide to replace it with a marginal tax rate, if you feel that the company will revert to that rate over time. The third is the cost of capital. While you can compute the cost of capital for the firm in question, it may be far simpler to use the average cost of capital for the sector in which the firm operates. There is one variant worth considering. If you feel that the assets of the face obsolescence, you may decide to assume that the earnings from these assets will be available only for a finite period rather than forever. The equation for value of assets in place has to be modified to be an annuity, instead of a perpetuity.

Price paid for growth: DCF
Once you have derived a value for assets in place, you can estimate what you are paying for growth by looking at the traded value of the firm, computed as the enterprise value of the business (market value of equity plus debt minus cash). The difference between the traded enterprise value and the value of the assets in place can be considered the price paid for growth.

In the table below, we look at four firms, Microsoft, Kraft, Google and Linkedin, to illustrate this concept.

For each firm, we report the after-tax operating income and the cost of capital used to derive the value of the assets in place. By comparing this number to the enterprise value of the firm, we then compute, on a percent basis, the proportion of the price that goes towards growth.  What are we to make of these numbers? For Microsoft, you can justify the entire market value of the firm with the value of just assets in place.  For Kraft and Google, about 40% of the price paid is for expected future growth. For Linkedin, it is almost 99% of the value. Does the fact that Microsoft's entire value is justified by assets in place make it  a better investment than Linkedin? Not necessarily, since we have not valued growth explicitly and growth can destroy value. In my next post, I will look at the value of growth at each of these companies and consequences for investors who have paid much higher prices.

Note that this entire analysis can also be done in purely equity terms, with net income divided by cost of equity to derive the growth value in equity in assets in place. If you do so, you can compare the market capitalization (rather than enterprise value) of the firm to the assets in place. The difference will be the price paid for growth.

Price paid for growth: Relative valuation
High growth companies often trade at high multiples of earnings, book value or revenues and the “premium’ is usually justified as the price for growth.  This premium can be in enterprise value multiples, such as EV/EBITDA, EV/Sales or EV/Invested capital:
EV growth premium = Actual EV multiple - EV multiple for assets in place
With Google, for instance, the EV/EBIT multiple for just assets in place can be computed to be 7.90, obtained by dividing the intrinsic value of assets in place ($92,761 million) by the operating income ($11,742 million). It's actual EV/EBIT multiple is 13.01, estimated by dividing the actual enterprise value of $152,784 million by the same operating income. The growth premium in the EV/EBIT multiple is therefore 5.11 (13.01- 7.90).

The premium can also be stated in terms of price earnings ratios, as the difference between the PE ratio that you actually pay compared to the PE ratio that you would pay for just the assets in place.
PE premium = Actual PE ratio - PE ratio for assets in place
You can estimate the PE ratio for assets in place, either from the cost of equity directly (PE ratio for assets in place = 1/ Cost of equity) or by backing the equity value from the intrinsic value of assets in place (and subtracting out the debt and adding back cash). Using Google as an example again (with debt of $4,204 million, cash of $44,460 million and net income of $9,737 million):
Intrinsic value of equity in assets in place = $ 92,761 - $4,204 + $ 44,460 = $132,818
PE for assets in place = $132,818/ $9,737 = 13.64
Actual PE = $192,840/$9,737 = 19.80
Growth premium in PE = 19.80 - 13.64 = 6.26

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Facebook: Sowing the wind, reaping the whirlwind

        Last Thursday, about 24 hours prior to the initial public offering, I posted on what I thought would happen on the opening day. I argued that this was the most pre-priced IPO in history, with transactions in the private share market providing information on what investors would be willing to pay for the stock. That was the basis for my view that those expecting a large jump on the opening day were likely to be disappointed and that this would be the Goldilocks IPO, with a 10-15% bump at open. I also felt that the stock was overvalued by about a third and that what happened on the opening day would be revealing not just for Facebook, but for all social media companies. The stock did open up about 12% and faded very quickly to the offering price by the end of the day. In fact, without active support from the investment banks, it would have dropped below. In the last few days, the stock has cratered, declining to about $32 at the time of this post. Here are the lessons I am taking away from this process:

Pricing versus Valuation
Pricing is an exercise of gauging demand and supply, reading investor moods and determining what people will pay for an asset, rather than what it is worth. Valuation is about estimating what an asset is worth, given its earning potential, growth and risk. You can tell whether an investor or analyst is a “pricer” or “valuer” by looking at the tools that he or she uses. The tools of choice for most pricers are relative valuation (multiples such as PE or EV multipes), where you assess how much you will pay for an asset by looking at what others are paying for similar assets (usually other companies in the same business), and technical analysis (where you use charts and indicators to gauge shifts in demand). The tools of choice for “valuers” are either discounted cash flow (DCF) or accounting based (building off book value) models.

A great deal of what passes for valuation in corporate board rooms, investment banks and portfolio management is pricing, not valuation, and the evidence is clear, especially with Facebook. In the weeks leading up to the IPO, an army of banks, led by Morgan Stanley, was working on setting an “offering” price for Facebook. While I am sure that there was an intrinsic valuation done somewhere along the way, I will also wager that it was done to preserve appearances and that it had little or nothing to do with the price that was eventually set. To set that price, my guess is that the banks used two variables: the prices at which investors were transacting in the private share market for Facebook (in the mid-40s) and the feedback that they were getting from institutional investors on how much they would be willing to pay for the stock. Much of the chatter about whether Facebook was a good buy or not was framed in terms of pricing, with the optimists arguing that it was a bargain because you were paying less per user than you were at other social media companies and the pessimists arguing that it was expensive because it was trading at a much higher multiple of earnings or revenues than Google or Apple. Any attempt at full-fledged valuation, where you confronted the uncertainty and attempted to make estimates, was viewed as an exercise in speculation and guesswork.  I also think that this is why the conspiracy theories, where Morgan Stanley fed inside information about future growth to institutional investors prior to the IPO and where the poor retail investors were the last ones to know, are misplaced. I am convinced that the growth rate and the prospects of the company were never key drivers in how this stock was priced and that if there is a story here, it is one of ineptitude and arrogance, rather than malice.

Momentum is fragile and requires illusions
Momentum is a strong force in markets but it is one that we don’t understand yet and don’t believe that we ever will. It is after all not only the basis for the madness of crowds and behavioral finance, but also of that most feared phenomenon in markets, the dreaded bubble. Not only is momentum driven by market moods and perceptions, but it is fragile and based ultimately upon an illusion. After all, most momentum investors don’t view themselves as such, and choose to rationalize their behavior using “fundamental’ factors. Thus, in the midst of every bubble, investors delude themselves that it is not a bubble by looking for a good reason: that tulip bulbs would become scarcer in the future, that dot com companies would dominate every business that the operated in and that the demand for real estate would always outstrip supply.

In their ideal scenario, I am sure that the investment banks hoped that the momentum that they were detecting in the private share markets and in their conversations with institutional investors would continue into the opening day and the weeks after. So, what happened on the opening day? I believe that the momentum shifted and that the hubris of the company and the bankers in the days leading up to opening day contributed significantly to it happening. Rather than maintain the illusion that the offering price was justified by fundamentals, nebulous though they might have been, the parties involved seemed to completely abandon any illusions about value and made it a starkly momentum game. This was manifested in the hiking of the offering price to $ 38 on Thursday evening and in insiders in the company publicly bailing out at the offering price. Even the maddest of crowds, when constant confronted with proof that they are being viewed as suckers, will wake up, and to the dismay of the company and the banks, it happened an hour into the offering.

What now?
Much as I would like to believe that what has happened in the last couple of days to Facebook stock is a vindication of valuation, I am a realist. There is no fury that matches that of a disillusioned crowd and I believe that what you are seeing is momentum investors, who were promised quick riches if they bought Facebook stock, bailing out. Will they stop selling at fair value? Since they have no idea what it is, why should they? If momentum shifts in the past are any indicator, you should see the price of Facebook drop not just to its intrinsic value (you have mine, but yours may be different), but to below that value. Since the company is the poster-child for the “social media” sector, I think that you will see this momentum shift play out on other social media companies.

Would I buy Facebook, Linkedin, Groupon or any other social media company? Social media is an umbrella under which you have diverse firms, some with more clearly defined business models than others and some with stronger barriers to entry than others, and when momentum shifts, investors tend not be discriminating. In the words of that eminent philosopher, Justin Bieber, you “never say never” and some of these stocks are likely to be bargains, sooner rather than later. If you are a value investor, you should be ready.

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Facebook and "Field of Dreams": Hoodies, Hubris and Hoopla

In mid-February, I posted my valuation of Facebook and my thoughts on what would happen at the IPO. Since the actual offering date is tomorrow and the frenzy mounts, I thought it would make sense to revisit those posts.

1. Valuation Update
In my February 16 post on the company, I attached my valuation of the company, based on the S-1 filing as of that date. Quickly reprising that valuation, I valued the equity in the company at $29/share (assigning an overall value of about $72 billion for Facebook's equity), with the following key assumptions:
a. Revenues growing to $44 billion in ten years, with a compounded revenue growth rate of 40% for the next 5 years, fading down over time
b. A pre-tax operating margin of about 35%, higher than Google's 30% and on par with Apple
c. Reinvestment (in internal projects and acquisitions) that generate a $1.50 in revenue for every dollar in capital.
d. A cost of capital of 11.42% initially, fading down to 6.50% in steady state

So, what have we learned about Facebook in the last three months that may change this valuation?
a. Facebook wants growth and will pay for it: Facebook has acquired three companies in the last couple of months, Instagram, Tagtile and Glancee. While the Tagtile and Glancee deals were a continuation of a long term strategy of buying small firms with technologies that augment the Facebook experience, Instagram represented a new front: a "more" expensive acquisition of a company that brought with it potential "new users". My guess is that a publicly traded Facebook, with access to far more capital, will continue making acquisitions with the intent of delivering promised revenue growth and that the pace (and the size) of acquisitions will pick up if (or as) internal growth slackens. That is mixed news for investors: the good news is that it increases the odds that the predicted growth in revenues will be delivered but the bad news is that Facebook may pay more for this growth than anticipated.

b. Mark Zuckerberg is lord and master of this company: While there has never been any doubt about the autocratic power structure at Facebook, the last three months have brought home that this is Zuckerberg's company. If news stories are to be believed, the decision to buy Instagram (at least at the final price) was made by Zuckerberg, with little input from the board. If you are going to be a stockholder in Facebook, you should get used to this scene being played out in small and big ways over the next few years.

c. The "Field of Dreams" business model: Finally, Facebook's value still lies in its promise, rather than in actual numbers. Remember the line from the movie, "Field of Dreams", where Kevin Costner wanders through a corn field and hears a voice that tells him that "if you build it, he will come". With Facebook and other social media companies, this line can paraphrased as "if you get the users, they (products, advertising) will come". While I do not want too much of a single story, the news story of GM abandoning its Facebook advertising should provide a cautionary note to the optimistic view that Facebook can easily convert its monstrously large user base into advertising fodder.

Bottom line: Revisiting the valuation, there is not a great deal I would change as a result of news over the last few weeks: a higher revenue growth rate (45% compounded with revenues growing to $ 56 billion) accompanied by lower margins (30%) and more reinvestment ($1.25 of revenues for every dollar invested) delivers an estimate of value that stays at the $70-$80 billion range. 

2. Pricing (IPO) Update
When I labeled this the "IPO of the century" in February, I was speaking tongue in cheek. After all, the century is young and there are other IPOs to come. While there is little that you will learn about the value of the company from the IPO process, there is a great deal that we can learn about human behavior and the ecosystem that feeds off big deals.

a. The bankers will do anything to be part of a "big deal": As you track the news stories, it is quite clear that the bankers need the Facebook deal more than Facebook needs the bankers. In fact, I am quite surprised that Facebook did not follow the Google model and bypass the investment bankers entirely and set up an auction. I think that the only reason that they chose to follow the conventional route is because investment banks are essentially doing this deal at cut rate prices and bending to Facebook's will at every turn..

b. And Mark Zuckerberg know it:  As someone who has never been comfortable wearing a tie or a suit, I must confess that I found the brouhaha over Zuckerberg's hoodie to be hilarious. I don't particularly care for Zuckerberg's corporate governance, but I, for one, have never believed that your professionalism is determined by what you wear. I am sure that Bruno Iskil, who lost billions for JP Morgan, wore a very expensive suit, while making his trades. I think Zuckerberg, in addition to mimicking one of his idols, Steve Jobs, was sending a message to Wall Street about who has the upper hand in this game.

c. Investors are replaying an age-old phenomenon: Individual investors are clearly caught up in the mood of the moment, lining up to get allotments of Facebook shares. Is it a bubble? Who knows? If those who forget history are destined to repeat it, it sure looks like a replay of events from the past, and for those who do no remember them, I have a reading suggestion.

d. The insiders: While I don't assume that insiders are infallible, it is telling that they are heading for the exits at the same time as individuals are piling in. Is it possible that they think that the stock is being priced at the top end of the value range? Do they not trust Mark Zuckerberg? Inquiring minds want to know and i guess we will find out as events unfold.

Bottom line: I don't think that there has ever been an IPO where investment bankers have had more information (from private share market prices to institutional investor feedback) to work with, when pricing the stock, than this one. I would be very surprised, if the stock were overpriced; the bankers and the company have too much too lose. I would be equally surprised if the stock were dramatically under priced; a pop of 50% or even 25% would reflect very badly on the bankers' pricing skills. In short, this is shaping up to be a Goldilocks IPO, at least in the initial hours: a pop of about 10-15% (just right for both the bankers and the company). The question is how long the pop will last. This company is too big and too public to stage manage in the weeks after the IPO. If the pop fades quickly, perhaps even by the end of trading tomorrow, I think it is a very bad sign for the momentum game in all social media stocks. 

3. Investment strategies
So, what should investors do about Facebook? You can play the IPO game, and I have described some of the ways you could do it, in an earlier post.  Generically, here are the four strategies you can adopt:
a. Short term buy: It may be too late for you to get in at the offering price, but if you believe in the short term momentum story, you can buy right as the market for Facebook opens tomorrow morning, hope to ride the crest of the price move up as other investors doing the same and exit before they do.
b. Short term sell: If you think that the hype is overdone and that disappointment will set in very soon, you can sell short right after the market opens tomorrow, especially if it does not open with a significant pop, with the intent of covering in the next week or two.
c. Long term buy: You may be a believer in Facebook's potential and its capacity to dominate the advertising market and to sell products to its users. If so, you should buy sometime in the near future and hold for the long term. How long will you have to wait to see profits? It depends on how quickly Facebook converts its potential to large revenues and profits... could be a year.. could be five..
d. Long term sell:  If you do buy into my "Goldilocks IPO" scenario and come up with an estimate of intrinsic value close to mine, though, the investment with the best odds of success on Facebook would be a "long term, short" position on the stock.

Bottom line: I think that the hype is overdone, that disappointment will set in sooner or later and that the stock has far more downside than upside. You can put me in the last group (long term sell) though I am still searching for the most efficient (and least costly) way to execute this. 

4. Broader implications
Does the Facebook IPO have broader implications for the overall equity market? I have heard arguments that a successful Facebook IPO will lead to a rebirth of faith in equities among investors and be a shot in the arm for financial service firms. I think that is nonsense.

• If Facebook does launch successfully tomorrow and the stock price goes up 10%, 20% or even 30%, I don't see how it will cause risk averse investors to come back to stocks. In fact, it will probably feed into their suspicion that the stock market has become a casino that they cannot trust their savings in. 
• As for investment banks, a successful Facebook IPO may bring in some fees and commissions but it will not be a reflection of their skills at pricing or deal making. This is a stock that priced and marketed itself, with little or no help from the investment bankers.

In the same vein, a failed IPO (and I will leave you to define what failure means) will have implications for the pricing of social media companies but not much more.

Bottom line: Facebook, in spite of its ubiquitous presence in our lives, is just one company and not a very big one (at least in terms of revenues and earnings) yet. The market will obsess about it tomorrow but it will move on very quickly to the next worry, fear or fad.  

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