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Buckingham's Pillars of Value
08/27/2004 12:00 am EST
The Hulbert Financial Digest ranksThe Prudent Speculator as the best performing financial newsletter for ten, 15, and 20 years. Here, editor John Buckingham discusses his four pillars of his value investing as well as some of his current favorite investment ideas.
"We rely on what has worked historically. And the best performing asset class, historically, has been equities. Within this asset class, value stocks—those trading at lower prices-to-book value— have outperformed growth stocks. And within this value group, small caps have outperformed large caps. This pattern of outperformance by small cap value can be seen going back to 1925.
"We’d also point to the miracle of compounding. There was a Picasso painting that recently sold for $95 million. It was bought in 1950 for $30,000. People say, ‘Wow, what a great investment!’ Was it? Yes, but it was only 16.1% compounded annually. The point is that you don’t have to make 100%. It’s okay to make 15% a year, because your money will double in five years. Based on our portfolio's 20.8% return, a $30,000 in stocks would have become $810 million over those 54 years. That’s a pretty powerful number. So the bottom line is that you want to invest in stocks, you want to be invested in value stocks, you want favor small cap over large, and you want to be a long term investor because you money compounds over time.
"Our philosophy is based on patience, diversification, and selection— in that order. We’re not market timers. Nobody can predict the market. We hold our average stock for six and a half years. Why? Because it reduces risk. And, of course, you defer your taxes and pay a lower long-term tax rate. If you go out and buy one stock and hold it for six months, our strategy won’t work. That’s not what we are about. I would also mention diversification. We are not right all the time. The key to successful investing is to buy a broad basket of undervalued stocks. We like to buy companies when others are shunning them, and we like to sell them when others are excited. Our process is essentially numbers-driven. We look at 10Qs, Ks, earnings releases, news releases, etc. We assign a target price to each company in our universe. If it is trading at less than half of what we think it is worth, we buy it. We also have what we call our four pillars of value investing.
"The first pillar is traditional value, which can be seen a company such as D. R. Horton (DHI NYSE). It has the best growth record of any company in America, with rising revenues and earnings for 27 straight years. And its p/e ratio is among the lowest. Some say, we are in a housing bubble. They’ve been saying that for five years now. Eventually home prices will cool off, particularly on the coasts. But D.R. Horton is geographically diversified. Industry trends in the home building sector are very favorable, with a shortage of housing. Meanwhile, if interest rates rise, it will be because the economy is getting strong and incomes are growing. That doesn’t strike me as a bad situation for housing. Over the past five years, earnings and the stock price are up 500%. Homebuilding stocks have been the ultimate growth vehicles. Horton seems like a no-brainer.
"The next pillar of value is a strong balance sheet. We call these ‘cash is king’ businesses. Surprisingly, many of these stocks are in the technology area. Integrated Silicon (ISSI NASDAQ) is a maker of integrated circuits. The stock went from $20 down to the $8 level because they were supposed to earn 16 cents in the most recent quarter and they earned 15 cents. They did a secondary offering at $16.50 in the first quarter for 6 million shares. And that money went into their bank and they still have the cash. This company has about $7 a share in cash and investments. It is a profitable company with no long-term debt. Earnings may not be what the experts suggested, but so what? We like to strip out the cash, and if you do that with Integrated Silicon, you have a $1 stock that earned 15 cents in the last quarter. Generally speaking, our friends out there—the greater fools— hate semiconductors, with a passion. But they will love them again. Here, you are able to buy a value-priced growth stock at a ridiculously low, fire sale price. This is an excellent value investment.
"The third pillar is what we call economically-sensitive stocks. We are contrarians and like to buy economically sensitive stocks when the cycle is low. The cycle in railroads has improved significantly, as the economy has rebounded. But CSX (CSX NYSE) has been left behind. I don’t think that will last for too long. I think the economy will continue to gain strength over time and recover, and that the railroads—which move everything in the country along with trucks—will continue to benefit as the pricing improves and as volumes are strong. But CSX is trading at a low price to book value. And it has a 1.3% yield, which is better than a money market fund. And it’s at an inexpensive valuation— about 13 or 14 times projected earnings. I think CSX is an excellent value investment.
"Finally, our fourth pillar is to look at companies that have high dividend yields, in addition to meeting our other criteria. American Software (AMSW NASDAQ). They own 86% of another company called Logility, which is publicly-traded. Altogether, they have roughly $4 or so in cash and investments per share, with no debt. In addition, the stock offers a 5% dividend yield. So you are able to get a profitable company with excellent growth potential at an extremely attractive valuation. In addition, you are getting paid a 5% yield while you wait. Nothing is ever certain in this business— and management could always burn through the cash or make a lousy acquisition, or decide not to pay the dividend anymore. However, I’m tempted to call this a no-brainer. It’s an excellent value investment."