2 Dec 2009

Equity
Global Strategy
www.sgresearch.socgen.com

Popular Delusions
Bargain hunting with Ben: in search of mispriced intrinsic value

Dylan Grice The bottom-up picture confirms what is obvious from the top down – there is little in the way
(44) 20 7762 5872
dylan.grice@sgcib.com of compelling value on offer in the stock market. Using an updated version of Ben Graham’s
“Appraisal Method” to determine stocks worth at least 50% more than their market valuation
reveals a paltry eleven names. Sub-sectors worth a look include agriculture, insurance and
brewers. With four of the eleven bargains trading in the UK, it is the only market trading below
aggregate intrinsic value. On average though, aggregate intrinsic value calculations suggest
markets are worth only 70% of what they currently trade for.

Q Ben Graham defined “bargain issues” as being those with an “indicated value at least
50% more than the price.” Over the last few decades, such bargain issues have returned
around 20% per annum, yet today, there are as few of them around as there were in Q2
2007, the eve of the global credit crisis (see chart below).

Q It’s not that there is nothing to do at all. The “bargain issues” mentioned inside merit
further thought while a handful of subsectors look cheap. Here we are just picking over
scraps, which isn’t as exciting as aggressively taking on risk. In fact, it’s verging on the
boring.

Q So be it - investors aren’t paid for activity. So let’s reflect on Gerald Loeb’s wise council
instead: “Profits can be made safely only when the opportunity is available and not just
because they happen to be desired or needed ... Willingness and ability to hold funds
uninvested while awaiting real opportunities is a key to success in the battle for investment
survival.”

Vanished value: % of global stocks estimated to be worth at least 50% more than market value
20.0%

18.0%

16.0%

14.0%

12.0%

10.0%

8.0%

6.0%

4.0%

Please see important disclaimer and

2.0%
disclosures at the end of the document
0.0%
1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

Source: SG Cross Asset Research, Factset

Macro Commodities Forex Rates Equity Credit Derivatives

 Popular Delusions

What exactly is ‘value’? Buying low P/E stocks is generally better than buying high PE stocks,
as buying low PB ratios is better than high PB ratios, and there are all sorts of reasons for that.
But must a stock with a low P/E contain more value for investors than one with a high P/E?
Must a stock trading at 0.75x book be better ‘value’ than a stock trading at 2x book? The
answer is no. The multiple a stock trades is not an a priori indication of its ‘worth’.

Everyone has their own favourite chapter in Ben Graham’s “Intelligent Investor” and mine is
chapter 10. One of the reasons I like it so much is that although Graham is synonymous with
the search for “deep value” or “cigar butt” companies trading at a discount to liquidation
value, in that chapter he places far more emphasis on the earnings power of assets than he
does simply on the assets themselves. Buying stocks on a discount to liquidation value when
such situations arise is certainly a sensible way to invest money, but it’s not the be all and end
all. There is more to valuation than low multiples.

But the main reason I love that chapter is that in it, he outlines what he very functionally calls
the “Appraisal Method”. In simple terms this is nothing more than comparing the worth of a
company to that company’s price, but what switched on the light in my head the first time I
read it was the word “worth.” It’s a mustier and more honest word than the today’s totemistic
“12m price targets” and it more accurately captures the essence of what investing is surely
about. “Enterprising investors” wrote Graham, were to “obtain the best available estimate of
what a number of stocks are worth, apart from their market price” and use that estimate “as a
definitive guide to current purchase or sale only if they exceed or fall below the market
price by at least one-third.” 1

So let’s try and put this into practice. I’m going to depart from the arithmetic of Graham’s
valuation method 2 - though not the spirit - and go with Stephen Penman’s Residual Income
Model, which tells me which stocks are likely to offer a return above my hurdle rate. 3 This
model starts with a company’s book value and its RoE and takes consensus earnings
forecasts to project future book values and RoEs. 4 But for each forward period, earnings are
charged in order to account for the opportunity cost of capital employed. The income left after
taking this charge is the “residual income” and only this residual income is capitalized onto
current book value per share. The model does two things which I like:

1) By focusing on both book value and RoE it anchors valuation firmly around the earnings
power of the company’s assets. Book value isn’t to everyone’s liking because it’s an
accounting estimate that misses much of a business’s true worth. The varying nature of
‘intangibles’ across industries and even within them also hinders comparability. But when
book value is understated by accountants, then RoE (and therefore capitalized residual

1
The Intelligent Investor, Chapter 10, page 161

2
Graham estimated worth by calculating earnings power as a seven-year weighted average of earnings
and applying to them a “highly arbitrary” multiple

3
See “Financial Statement Analysis and Security Valuation” by Stephen Penman. The model is essentially
as follows: Intrinsic Value = BPSt + Σ(RoEt+i - r)*BPSt+i-1 where BPS = book val p/sh; RoE = return on eq;
and r = your required return on capital which you can set at what you like, I’ve set it at 10%.

4
You don’t have to use consensus earnings forecasts. I ran the same analysis with trailing growth rates
and achieved similar results. Each approach has it’s pros and cons.

2 2 Dec 2009
 Popular Delusions

income) must be commensurately overstated; so by focusing on the actual earnings

generated by imprecisely measured assets, we circumvent that problem.

2) By taking a charge against the opportunity cost of capital we’re guarding ourselves
against overpaying for growth. If a company I’m looking at invests its profits instead of
paying dividends it will grow earnings. But it won’t necessarily grow value. I can get mere
growth by putting £100 into a bank account and reinvesting the 5% interest rate each
year indefinitely. But I’m not adding any value. The account today is still only worth £100
and I shouldn’t pay a premium to book just because it’s growing. By charging a hurdle
rate equivalent to the return I’d hope to find elsewhere (I’ve set it at 10% in the work
which follows), I’m improving my chances of buying value creation and not just growth.

The best thing about the Residual Income Model is that it seems to work. The following chart
shows the backtested results of a strategy which sorts a universe of developed market stocks
into deciles according to the ratio of Intrinsic Value to Price (the IVP ratio). High IVP ratios are
in the top decile, low IVP ratios are in the bottom. The strategy assumes the deciles are
updated monthly and the portfolio rebalanced accordingly. It shows that the highest IVP
decile would have returned around 14% more than the lowest.

Graham was right again: higher IVP deciles outperform lower IVP deciles (1987 – present)
20 %

18 %

16 %

14 %

12 %

10 %

8%

6%

4%

2%

0%
1 2 3 4 5 6 7 8 9 10

Source: SG Cross Asset Research, Factset, CBOE

The other thing I like about the model is that it gets around the slightly puzzling ‘growth vs
value’ distinction – unless there is a type of investing which isn’t about the pursuit of value!
Someone once pointed out that for all the available genres there are only really two types of
music: good music and bad music. The same is true of investment. Warren Buffett has stated
that growth and value are joined at the hip, and Residual Income model integrates them both.
What does Graham’s ‘Appraisal Method’ tell us about where we are today?

Three points stand out. The first is that this isn’t a time to be aggressive. Nothing much
has changed since a couple of weeks ago when I wrote that from a macro perspective there
just isn’t much in the way of compelling value around currently.

But the bottom-up picture merely confirms this. The chart on the front page shows that the
percentage of stocks which Graham might define as ‘bargain issues’ is currently about as low
as it’s ever been. Regular readers know that I view subdued volatility as a warning against

2 Dec 2009 3
 Popular Delusions

aggressively taking macro risk. The following chart links that idea with the bottom-up numbers
by showing that volatility spikes present value opportunities.

The need for fear: % of ‘bargain issues’ with CBOE’s VIX index
20% 100

18% 90

16% 80

14%
70
12%
%of bargain issues 60
10% VIX index
50
8%
40
6%
30
4%

2% 20

0% 10
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

Source: SG Cross Asset Research, Factset, CBOE

The second thing is that having little to do isn’t the same as having nothing to do. There
are still some ‘bargain issues’ around. Relevant names are shown in the table below.

Some further explanation might be needed here because the screen doesn’t throw up what
you might ordinarily think of as ‘bargain issues.’ Anheuser-Busch InBev, for example, trades
on a rich 20x forward earnings. But remember, I’m using Graham’s definition of a ‘bargain
issue’ as a stock with an estimated intrinsic value at least 50% more than the current market
price. I’m not screening for the lowest multiple stocks I can find. This is not what might be
considered ‘deep value’ screen.

Ben Graham ‘bargain issues’: companies worth at least 50% more than mkt price (IVP ratio>1.5)
GIC Country Mkt Cap ($m) IVP Ratio
Chaoda Modern Agriculture Agricultural HK 2,772.5 3.1
(Holdings) Ltd. Products
Eurasian Natural Resources Diversified Metals UK 5,624.6 2.0
Corp. PLC and Mining
SLM Corp. Consumer Finance USA 5,289.3 1.8
MunichRe Reinsurance Germany 31,043.8 1.8
CNP Assurances Life & Health France 4,862.1 1.8
Insurance
Caltex Australia Ltd. Refining Australia 1,216.5 1.8
Aviva PLC Multi-line Insurance UK 18,017.4 1.8
AstraZeneca PLC Pharmaceuticals UK 65,594.1 1.8
Lincoln National Corp. Life & Health USA 7,223.0 1.7
Insurance
Standard Chartered PLC Banks UK 54,579.0 1.5
Anheuser-Busch InBev Brewers Belgium 40,763.2 1.5
Source: Factset, SG Cross Asset Research

Another point worth making is this: don’t get too hung up on the precision of these estimates
of intrinsic value because we can never know what that is. The hefty discount we demand to
our estimates of intrinsic value is our margin of safety in the face of that uncertainty. If our
discount is large enough, we don’t need to be too worried that we are likely to miss the mark

4 2 Dec 2009
 Popular Delusions

to some extent. Graham likened the appraisal of value to the appraisal of a fat man’s health -
you don’t need to know his exact weight to know he should lose weight.

The second observation is that there remain a few MSCI sub-sectors which appear to be
worth more than current market values. Further analysis on stock names might be merited.

Sub Sectors to look at – IVP ratios greater than 1

A gricult ural Product s

Reinsurance

Lif e & Healt h Insurance

M ult i-line Insurance

M anaged Healt h Care

Educat ion Services

Diversif ied Capit al M arket s

Tobacco

Invest ment B anking & B rokerage

B rewers

0.8 0.9 1 1.1 1.2 1.3 1.4 1.5 1.6

Int rinsic V alue t o Price Rat io

Source: SG Cross Asset Research, Factset

And finally, as far as aggregate valuation is concerned, the chart below shows that only the
UK market has an estimated intrinsic value higher than that currently priced by the market. In
contrast, the average IVP ratio across developed markets is around 0.7, implying stock
markets are worth only 70% of what they are currently trading for.

The UK’s intrinsic value is higher than its market value

1.2
int rinsic value higher than market value

1.0
int rinsic value lowerf t han market value
0.8

0.6

0.4

0.2

0.0
UK Nor Euro Can Sing Oz AVE USA Swit z HK Jap Chin Den Swe

Source: SG Cross Asset Research, Factset

2 Dec 2009 5
 Popular Delusions

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