A Dearth Of Value - The Ugly European Car Index
Part II
In Part I of this note, I waxed poetic about the hidden beauty of certain under-powered and angular European sports cars. We theorized that the unexpected rise in values for some of these clunkers was due to car collectors reaching for yield. We ended the first part promising to take a look at the climate for finding value in today’s financial markets.
Since we started out by talking about how the classic car market has been appreciating at a fever pitch and that collectors are piling into less desirable models, it shouldn’t come as much of a surprise to discover that there is a notable lack of value in today’s stock market. In fact, saying there’s a “lack of value” in the market deserves a nomination for the Captain Obvious statement of the year.
Besides unlovable cars rapidly appreciating in value, what other evidence is there of a lack of value? And, by the way, what do we even mean when we speak of “value investing?” There are of course many theories and books out there, including some classic works like Securities Analysis and The Intelligent Investor (both highly recommended, along with The Interpretation of Financial Statements; you haven’t lived until you’ve read Benjamin Graham dissect a balance sheet). To keep things simple, we’ll use a two-part definition to describe value. Assets are intriguing to a Value Investor because at their price level:
They cost significantly less than they could be reasonably expected to be worth over time
Due to the fundamental condition of the asset, you have a reasonable conviction that it will not decline to zero, or otherwise become worthless
Remember the emphasis on price level. The price paid is what matters. Whether the company invested-in is popular, exciting, growing rapidly, led by a charismatic CEO, or otherwise well-positioned, is irrelevant. Price matters. Company A, a manufacturer of coffee filters, currently priced at $10 per share represents a good value. Company B, the owner of a patent for a miracle weight-loss drug, currently priced at $1,000 per share is not a good value. On the other hand, Company A priced at $20 per share may no longer represent value, but Company B could be an excellent value at $400 per share.
Value Investing is distinct from a purely contrarian approach, which The Tactical Luddite also embraces. And, of course, they often go together. For the rest of this note, we’ll continue to focus on value.
Implicit in the philosophy of Value Investing is that assets do have intrinsic value, and the market price frequently (usually?) fluctuates around the “real” value - both higher and lower. Of course, the simplest measure of value has historically been the P/E ratio, which tells us how much you have to pay in share price for a “slice” of the earnings of a publicly traded corporation. This assumes that a company actually has earnings though, which can’t always be assumed.
If we step back in time to another (fairly) recent time the stock market traded at such high valuations, people (generally crotchety old men and women, AKA Value Investors) were dismayed to witness a smorgasbord of hot technology companies going public with no history of earing a profit. It was an affront to decency that investment banks were foisting money-losing companies upon investors simply due to the limitless promise of technological hope. This fact was considered to be evidence of the excessive froth in the market. Subsequent events proved them right.
What about today? Well, it seems there’s been progress on that score. In today’s market, we have IPOs for companies that not only don’t have earnings, they don’t even have revenue. Seriously, electric vehicle maker Rivian went public with annual revenues of about $1 million. For comparison, some individual insurance salesmen-and-women gross $1 million in a year, as do successful medical practices. Pretty much nobody would dream of these “businesses” going public. It gets better, though. The company, despite not actually having produced products, managed to declare a net loss of over $1 billion, which will undoubtedly produce some tidy tax loss carry-forwards for them - assuming that the company generates net earnings in the future.
The best part? As a result of their IPO, investors gave the business (sorry, the promise of a potential, future business) a market capitalization of more than $120 billion, which happens to be more than automaker Ford, which actually makes and sells more than 1 million vehicles per year, producing genuine revenues of over $30 billion per year.
Seriously, this isn’t an actual business that came to market, it’s an idea. For which investors cranked the spigots wide open. I suppose the next wave of over-hyped, over-subscribed IPOs will be for companies that go public based on the potential for having a future idea. Although, perhaps SPACs have already taken us there . . .
In all seriousness, no, of course there’s no genuine value to be had in this market, even with the market decline since the Ukrainian conflict started. We’ve taken reaching for yield and pricing to perfection to an obsessive compulsive art form. The last time there was any genuine value to be had in the market was in March of 2020. Interestingly enough, that’s when Barrier Island Capital Partners was last able to initiate positions in the market. Back then, our propriety screen (saying it like that is about as pretentious as a company going public with no revenue) yielded 28 common stocks that met our depressed-value criteria. Remember, too, that was in the midst of a massive 40% sell-off in the market.
Today? Today there is one - and only one - candidate. Who’s the gem that made the cut? Sturm Ruger & Company (RGR). On Friday as I write this, it’s down over $5 per share, which drastically improves it as a prospect. Based on the current intra-day price, RGR is trading at a 13% discount to our barebones Target Price - the price at which we believe a company represents a great value.
Despite this opportunity, it’s difficult to enthusiastically recommend this company for at least two reasons:
2021 was a blow out year, improving the average of all kinds of financial metrics that make the stock attractive on a valuation basis. Future years may not be so great.
There are several unknowable risks relating to the nature of their firearms business
Of course, as a kind of guns and butter play for a world in turmoil, they may well have an epic 2022.
As we dive in to the details of RGR’s value characteristics, I will be discussing various metrics that I use as co-manager of Barrier Island Capital Partners, LP (BICP). So in these more technical sections, know that the use of “I”, “we”, or “our” is always in relationship to BICP.
What’s so great about RGR’s financials? Well, for one thing, they have no long term debt. This is the number one criteria I look for when considering a value play. Nothing can make you go bust quite so well as leverage, so this makes for an easy screen. If it has long term debt on the balance sheet, it doesn’t come under consideration.
Secondly, RGR has excellent Net Current Asset Value, a Benjamin Graham favorite. In the case of RGR, they’re sporting a NCAV per share of $11, taken as an average of 2020 and 2021. This makes their Price/NCAV per share 7.0 on an intra-day basis (again, using the two year average NCAV). Keep in mind that many companies don’t have any Net Current Asset Value, because they’re laden with debt and other liabilities. RGR is well-positioned here.
The third telling metric is the Price to Book ratio minus the product of the dividend yield multiplied by the dividend coverage ratio. RGRs two-year average price to book value is much higher than we’d like at 3.96, but the dividend yield multiplied by dividend coverage calculation brings this overall metric to -2.67, which is below our cut-off of 1.0.
What’s the theory behind this calculation, which we cleverly call Price-to-Book minus Dividend Yield multiplied by Dividend Coverage Ratio (P/B - DivYield for short)? It is a metric of convenience. It quickly tells us that a company has both substantial real assets (we exclude goodwill, and other intangible assets from our calculation of Book Value) and an enticing dividend yield that is comfortably supported by cash flow and net income.
What about the classic value metric, Price-to-Earnings? The P/E based on current share price and two year average net earnings is 11, well below traditional valuation guides.
So, what’s the formal recommendation? It’s two-fold:
If you’re opposed to owning a gun manufacturer, pass entirely
If you’re open to owning this kind of company, buy shares below $72
The Target Price, which is the minimum price at which I believe the stock to be a good value, is $80, so RGR is currently trading at a 14% discount to its Target Price. Keep in mind that the Target Price, according to our metrics, calls for a P/E ratio of no more than 13, so you can see what kind of value potential RGR has at it’s current price of $69 per share.
Given the balance sheet, positive cash flow, and dividend yield, we would continue to purchase shares if it declines in price along with the market at large. That’s the entire point of balance-sheet focused Value Investing - the companies you invest in are exceptionally unlikely to actually go bankrupt, so you can comfortably buy them as they decline in price. Especially during a general market decline like we’re currently experiencing.
What would change my mind on RGR? Taking on long term debt. Some kind of legislation and/or Supreme Court ruling firmly outlawing personal gun ownership. Price appreciation above $80 would cause us to stop buying new shares.
Bottom line: I will initiate a new position in RGR (I currently don’t own any shares, and neither does Barrier Island Capital Partners) after this note has been published if or when it trades for less than $72 per share.
So there you have it, The Tactical Luddite’s first recommendation. What do you think? Leave a comment and let me know, or send me an email at joe@jlarroyo.com.
Given the lack of value in the market, next week I’ll be starting a four week series highlighting a skeptical take on the lucrative self-improvement and coaching industries and offer some tongue-in-cheek suggestions for personal growth.
Great next installment! Definitely technically written and insightful in advising on value investing.