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Not all value investors are the same. Those who follow the Ben Graham (or early Warren Buffett) approach tend to be opportunistic – they buy and sell all the time. Those who follow the (contemporary) Buffett approach tend to be long-term investors – they buy and hold.
Irrespective, however, of which bucket they fall into, they all follow, in general terms, the same three-pronged process. First, they screen stocks by a number of metrics to identify those that are possibly undervalued. Second, the stocks selected in the first step are valued in depth to determine their intrinsic value (that is, how much the stock is truly worth). And third, they make a decision to buy only if the stocks are truly undervalued, namely, they satisfy a predetermined margin of safety.
One misconception of value investing is that value investors buy only stocks with a low price-to-earnings ratio. This is not accurate in a couple of ways. First, they only buy low P/E stocks (normally less than 13 times) if they are truly undervalued – they do not buy all low P/E stocks. Second, they may consider higher P/E stocks as long as these stocks have a clearly identifiable competitive advantage and sustainability. The former are the opportunistic value investors, while the latter are the true long-term value investors.
Let me explain the value investing process by way of two examples, one of which may be attractive to an opportunistic investor and the other to a long-term investor, as analyzed by my MBA students in the value investing course I teach at the Richard Ivey School of Business.
The first stock is Algoma Central Corp. (ALC). The stock has a P/E multiple of 12.76 and is a relatively small-capitalization stock. It meets the conditions of an opportunistic stock and passes the first step of the value-investing process. Having determined that Algoma Central looks as if it may be potentially undervalued, we proceed to estimate its intrinsic value. Algoma Central is a Canadian shipping company that owns and runs the largest Canadian flag fleet of dry bulk carriers and product tankers operating in the Great Lakes. Currently, it is in an unattractive industry. It has a very low return on invested capital versus its cost of capital – not a desirable condition. But it is well managed and conservatively financed. The stock's intrinsic value is estimated to be $20.50.
The third step is to determine whether the stock is truly undervalued by deriving an entry price at which we would be willing to buy the stock and compare it to the current stock price. The entry price is estimated to be $13.67 – intrinsic value less the margin of safety (33 per cent of the intrinsic value). The entry price is above the current stock price, leading to a "buy" decision. Algoma Central's purchase is opportunistic. We will keep the stock until its price rises above its intrinsic value.
The second stock is Stella-Jones Inc. (SJ), which manufactures pressure-treated industrial lumber products, such as railway ties and utility poles. The company focuses on products that are tied to infrastructure and maintenance requirements. This insulates it from extreme volatility over the business cycle.
Stella-Jones is by far the largest company of its type in Canada and expanding aggressively into the United States. This affords SJ economies-of-scale advantage. Additionally, Stella-Jones sells large volumes to a relatively small customer base, mostly large companies. Customers rely on Stella-Jones because no other company in the industry would be able to meet its ability to promptly respond to a large demand for railway timber – so high switching costs are in place as well as search costs, affording the company a demand advantage. Management, aided by an outstanding board of directors, has done an excellent job in executing the company's business model. As a result, Stella-Jones has a consistently high return on invested capital versus its cost of capital.
The company's demand advantage, in conjunction with its economies of scale, produce a formidable competitive advantage. It also sets in place the necessary conditions for sustainability. Even though Stella-Jones is a large-capitalization stock with a P/E of 23, it could still be considered potentially undervalued and worth taking to the next step of the process.
Stella-Jones' estimated intrinsic value is $64.48 and its entry price is $42.99, which is below the current stock price. The decision is to wait until the stock falls to the entry price. When this happens and the stock is purchased, it could be held for the long term as its intrinsic value normally tends to be ahead of the stock price.
It is clear that not all value investors are the same. Investors should choose the approach that suits them best. Having said that, for early investors, the opportunistic approach is more suitable, while for seasoned and older investors, the (contemporary) Buffett way works better.
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.
George Athanassakos