A tired old bear

For a long time I have been amused that many value investors that I read continue to search for attractively valued securities, without ever first asking the question, ‘are the general conditions ripe for investing’? Does the equity market as a whole offer the type of value that can lead to strong compound returns from here? I fear not. The question is pertinent given that value investors hope to beat the market. But if the market is at a level where compound returns are likely to be low, then surely a value investor is better off being patient and waiting in the long grass for the ‘fat pitch.’

Since 2006 I have been particularly bearish on equities, principally due to valuation. Since then, other than a few good and some disasterous forays into the equity market, I havelargely been out of equities. Despite 5 years of bust and boom, I still maintain that markets in general do not offer good value. Secular bears follow secular bulls, and I still find that we are in a secular bear market. As someone who prefers to identify value, pounce on it and hold it till it is realised, I do not believe that this type of buy and hold strategy is a sensible one in a secular bear market. Equities have in many cases derated, and in some case quite significantly.

Bearishness aside, I can no longer ignore the valuation derating that has befallen European markets over and above most other major markets. Indeed on one of my favourite indicators of value, the Graham & Dodd PE, European markets are pretty quickly heading for the ‘fat pitch’ value opportunity that I am looking for in order to begin reinvesting back in equity markets.

Source: Schroders European Equity Team Feb 2011 Investor Presentation

It would seem that the market is not that far away from what I would call a generational opprtunity to invest. I do not suppose that we are yet there, but I am coming around to the opinion that now is as good a time as any to prepare for it and begin building a portfolio patiently. It would be unsurprsing to me, if the first market to emerge into a new secular bull market (a rerating of valaution) were the European equity markets. These markets are not without their issues, in that they are light on the market favourite of commodities and heavy on banks – an area the market has had good reason to detest. I am hopeful that when I run my stock screens that the baby has been thrown out with the bathwater so to speak.

Using my own data on MSCI Europe, it would seem that we are approaching 25 year lows in terms of P/B. The caveat here is that I am missing P/B valuation data for Europe in the 1970s and early 80s. I cant be certain, but it would be surprising if they were not lower than present levels.



So what am I searching for?

I want underlevered value, that is preferrably not trading on peak margins. Why? The biggest winners that I have had in equities, have had an ability to rerate, recover and relever. My greed and risk hurdles mean that I want all three. All of my failures in the markets have involved poor and deteriorating balance sheets.  It is for that reason that I want to avoid excessive leverage. Deleveraging is a poor way to deliver returns to an equity shareholder – it is very difficult to shrink to greatness.

I will principally run three types of stock screens and detail my findings here.

(1) Classic Graham & Dodd Value Screens: low price/book value and the classic price/net working capital. Here I am looking for distressed assets that have some semblance of a business model remaining along with an unencumbered balance sheet. This is down and dirty, looking among the dross of the market for some shiny pennies.

(2) Unrecognised Franchises: This is by and large an adaption of the Greenblat approach with some tweaking. Given that the Greenblat screen can be skewed with say one very good years profits, I will be tweaking to search for companies where the profitability has lower volatility over several years.

(3) Cashflow Monsters: I love businesses that can reinvest and pay a chunky dividend. In a former existance I managed an high yield equity fund. Reinvested they are in my opinion far superior to buybacks. I will be searching for what has been a typical level of freecashflow, and how volatile it has been. Many companies are asset light and heavy on intellectual property. I expect this to translate to higher returns and sustainable cashflow – it is unlikely that these companies will be captured in my low P/B or Net Net screens, yet for me, cashflow investing has proven to be the most rewarding.

In my professional and private investing life to date, the most important lesson that I have learned is that a bad balance sheet makes for a lousy investment. Having had an epiphany a few years back I came to realise that all of my successes had reasonable balance sheets and all of my failures have had lousy ones. It was a good lesson to learn and one that I hope that I have the discipline to stick with. Consequently I override all of my stock screens now with some balance sheet analysis and a simple scoring system, known as the Piotroski F-Score. I will augment this with a Z Score.

The glaring ommission from these stock screens is that banks and insurers are excluded. In a pevious role I actually specialised in investing in financials. It is an area that I enjoyed immensely. The present crisis will undoubtedly throw up some fascinating opportunities in the financials space. Maybe we are there already. I am prepared to wait until much of the capital raising that is required is out of the way.

The role of my stock screens will be to establish what is the magnitude of the opportunity, or is it the case that low market valuation stems from heavyweight industrials trading on peak profitability combined with banks that have not yet faced the final dilution in earnings and book value.

 So despite being a bear, I am looking forward to a time where I may hibernate and unleash my inner bull. The Graham & Dood 10 year PE in Europe is at levels, where even a bear can no longer afford to ignore the valuation disparity that is emerging. I feel that there must be the sort of value out there that I am attracted to. If it is there, it is more likely to be unearthed within Eurozone equities. The bear is old and tired but he has one or two big kills left to sustain him through hibernation.

In future posts I will detail the results of my stocks screens and compose shortlists for further research.

Comments & critiques welcome.



2 Responses to “A tired old bear”

  1. 1 gary July 27, 2011 at 9:19 am

    John, I like your train of thought! Your opening question has vexed me for a long time.
    Working in the long only fund management industry, I was always uncomfortable with the idea that a long only fund was compelled to have to put the money to work irrespective of the environment for stocks’ (accepting the get out clause that someone else was looking after the clients’ asset allocation). Equally, in an unconstrained fund, I have struggled with the idea that the value manager will always find stocks that are good value (this appears to be more a statement of relative value than absolute).
    Nevertheless, to your point “But if the market is at a level where compound returns are likely to be low, then surely a value investor is better off being patient and waiting in the long grass for the ‘fat pitch.’”, I largely agree, but is this not where a value investor builds up cash through a bottom up process of finding a paucity of compelling ideas? My understanding is that the build up of cash in this fashion is different to the assessment of the general environment as being ripe/unripe, and making a macro call to hold cash.
    The problem with the macro call relating to secular bull/ bear, the points at which bear ends and bull takes over are only ever recognisable in hindsight. Waiting for the market to hit a valuation low enough for a secular bull market to begin is a process that is fraught with danger. Is there an absolute level of the G&D PE that must be hit? What other metrics must be considered given the simplicity of the PE (as you point out). To what extent would you take the interest rate/ inflation environment in to account in assessing the market’s overall valuation?
    From my own perspective I am trying to implement a valuation informed approach to asset allocation which largely accords with the way you approach the market. However, in recognition of the fact that ‘overvalued today’ is very different to ‘going down tomorrow’, I am suggesting a minimum allocation to equities at all times, largely to avoid the emotional challenge that comes with sitting on your hands as markets continue to rise.
    I don’t think I have quite cracked it yet. Not that this can be cracked, but I think the approach to asset allocation can be improved from mere reliance on time and good fortune. I’d be interested on your thoughts about valuation informed asset allocation – along the lines of what Ben Graham outlined 60 years ago as Formula Timing.
    My position is different to yours also, in that I am dealing at a fund level – I’m not a stock picker – so clearly my approach to this will be different out of necessity.

    • 2 jmcelligott July 27, 2011 at 12:16 pm

      Thank you for the feedback. A few comments.
      (1) Having worked for most of my career in long only fund management as an equity specialist, I share your lack of comfort. I don’t believe the approach serves the client very well, but I do understand the ‘institutional imperative’. I disagree with it mind you, but accept why it happens – I am not likely to change that, unless I ever open my own fund.
      (2) regarding the secular question – I simply do not believe that investors can ignore trying to understand what type of market we live in. The type of market we live in dictates much of our compound returns, whereas our ability to stock pick is the added bonus or (lack there of). You are spot on in suggesting that we cannot know the exact point of the bottom (or top) until after the fact. However I am not trying to call the exact top or boottom. I a merely saying that I find in Europe that valuation levels have reached a point that can no longer be ignored in a broader sense. The time for me, I feel, I getting better to begin investing in earnest again – and by that I mean accumulating an investment portfolio of say 20 ideas over the next 1 to 2 years. This is to be a buy and hold type portfolio. For the past five years other than switching between funds I hold and some trading, I have eschewed investing in equities on a long term basis. That is coming to an end now. There isnt an absolute level of Graham & Dodd PE that the market must hit – no one thing. Instead, I am suggesting that a G&D PE for Europe approaching 13 will have a good chance of delivering the types of compound returns that I want. Allied to this, I find great comfort in the P/B of the Eurozone markets at present.
      In the past I was a pure bottom up value investor. Over the past 7 years I have become more focused on an holistic approach to investing that cares for the overall market valuation, bottom up stock research and technical analysis. It’s not pure Value Investing, but it suits my personality.

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