Conservative investors may wish to evaluate public stocks in terms of values as they might be viewed for a private acquisition.

That would minimize the risk of buying into a bubble and the “greater fool” approach to investing, which assumes that someone will pay you more for something you paid too much for in the first place.

Of course, conservative investing based on takeover value also greatly reduces the universe of eligible stocks, because by far most stocks are priced beyond private takeover value.

While one overvalued, high multiple public company can use its inflated stock as currency to buy another overvalued company sporting a lower multiple, a cash buyer or a leverage buyer must look at affordability and cash-on-cash return, or debt service capacity of the target.

One of the measures that private acquirers look at is Enterprise Value to Earnings Before Interest, Taxes, Depreciation and Amortization (EV / EBITDA).

Private buyers (those playing with their own money) prefer to buy at an EV / EBITDA of 4 or less, and may go to 6 (maybe 7). Those multiples are based substantially on the ability of the acquired company to generate cash to pay purchase debt or to provide an attractive cash return on debt-free cash used to make the purchase.

There are other issues to consider beyond EV / EBITDA, but it is a good starting place to begin to identify companies valued such that they could make sense if purchased for money instead of stock.

Definition:

EV is the market capitalization of the company plus its long-term debt. EBITDA is similar to “cash flow”. It is operating earnings before interest on and amortization of long-term debt, and before depreciation and taxes.

What We Did:

We did a screen of approximately 9,000 stocks (including ADRs) available in the US markets, to see what kind of EV / EBITDA opportunities are out there today. We used continuing earnings in our calculation of EBITDA.

We also excluded those companies priced below $5 and excluded those that did not have a positive EBITDA in the preceding 12 months. Those two criteria reduced the universe to 4,243 stocks (more than 1/2 of stocks were eliminated.

We did not require a minimum market-cap.  If we had put a $100 million market-cap minimum into the screen, we would have excluded another 636 stocks.

The table above shows the percentage of stocks in each EV / EBITDA range along with the cumulative percentage of stocks included as the EV / EBITDA increases.

The Screen Results:

The table shows that the great middle (aproximately the 80% middle) of stocks with positive EBITDA are currently priced at an EV / EBITDA between 8 and 21.  About 16% are priced at 7 or below and less than 3% are priced at 4 or less.

Looking at quartiles, the break point multiple between the 1st and 2nd quartile was 8.2.  The median multiple was 11.8.  The break point betwen the 3rd and 4th quartile was 18.3.

Example Stocks:

Not as recommendation, but simply as markers, two stocks at each of the quartile break points were:

• EV / EBITDA 8.2  — CNOOC (CEO) and Oppenheimer Holdings (OPY)
• EV / EBITDA 11.8 — Mattel (MAT) and Diamond Offshore Drilling (DO)
• EV / EBITDA 18.3 — Smith & Nephew (SNN) and Yingli Green Energy (YGE)

Other Factors:

Of course, you will want to examine why a company carries a low multiple.  Surely, it will tend to be that way due to low expectations or some perceived flaw.

Low expectations can be a good thing, because the probability of positive surprises may be greater than for companies priced to perfection.

Perceived flaws are OK, if you know what they are and believe they are curable.  Incurable flaws are potentially fatal, but curable flaws can lead to good long term value.

Remember that great companies are not always great investments (because they may be overpriced), and mediocre companies are not always bad investments (because they may be substantially underpriced).

Moral — do your homework.

Richard Shaw
QVM Group LLC

We believe it is important to look at return and volatility risk in both absolute and relative terms. For relative performance, we think the 10-year US Treasury bond is a good base to use, because is it relevant to all asset classes.

It relates as well to stocks as to bonds, to real estate, to commodities or to just about any asset class.

Tables of numbers have their place and use, but we also believe a picture is worth a thousand words. We try to put important data into visual formats to make it easier to see meaning. Some people do better with numbers in tables and some do better with pictures. Here is our way of visualizing risk adjusted return.

We call our proprietary way of calculating returns and volatility relative to government bonds “Treasury Indexed Quotients (TIQ)”, a registered trademark.

Each month, we calculate the TIQ for the mean return and the standard deviation of a variety of asset classes and sub-classes (such as countries and industrial sectors), and then index them to the same measures for the 10-year US Treasury bond. We do it for different time periods, as well as for different classes.

Both return and volatility are different for different lengths of time; and for all period lengths, the risk and volatility levels change over time.

The chart is a sample of the work we do internally for certain of our research clients and in a monthly subscription publication of the Treasury Index Quotients.

This particular chart measures the performance of investable securities that represent major asset classes:

• US stock market (proxy SPY)
• Non-US developed stock markets (proxy EFA)
• Non-US emerging stock markets (proxy EEM)
• US REITs (proxy VNQ)
• Global commodities (proxy DJP)
• US aggregate bonds, ex muni (proxy AGG)

Securities to the right of the red vertical have a higher return than the T-bond, and those to the left have a lower return.

The higher the vertical position, the higher the volatility is relative to the T-bond.

The most favorable risk/reward position on the chart for a security is to the right of the red vertical and below the solid blue diagonal line. Securities in that area would have a higher return than the T-bond, but proportionately lower volatility.

The solid blue line represents a 1:1 relationship between return and volatility. The dotted blue lines represent 1:2 and 1:3 relationships between return and volatility.

In the last 52 weeks, emerging markets and global commodities had more favorable risk/reward attributes than US aggregate bonds, the US stock market, non-US developed markets and US REITs.

Richard Shaw
QVM Group LLC

One of the principal reasons for asset allocation is risk management. 

Market risk is generally defined as return fluctuation – volatility.  That is different than issue risk (the risk of owning a single stock or bond issue), which includes not only volatility, but also the risk of company bankruptcy or default on bonds.

While most investment professionals understand and take the risk reduction aspect of asset allocation for granted, that is not the case for all investment advisory clients.  We have been asked on more than one occasion, how we know that to be true, and for some evidence of that truth.

There are probably many ways to respond to that question, one of which is with a practical example with real market data.  We have created one such example for this article.

The image below shows the relative weekly return and weekly rate of change of six index investment funds representing six major asset classes, and an arbitrary equal parts asset allocation among those six index funds.

The six indices, asset classes and funds are:

• MSCI Broad U.S. Stock Market: proxy fund VTI
• MSCI EAFE Stocks (Europe, Australasia, and Far East): proxy fund EFA
• MSCI Emerging Market Stocks: proxy fund EEM
• MSCI REITs (U.S. REITs): proxy fund VNQ
• DJ-AIG Commodities (Global Commodities): proxy fund: DJP
• Lehman U.S. Aggregate Bonds: proxy fund AGG

The individual asset classes are all shown in thin black lines, and the equal parts allocation is shown in a bold blue line. 

This is not a recommendation for equal parts weighting, just an uncomplicated way to graphically demonstrate the risk reducing and return stabilizing attributes of asset allocation. 

The period covers about 80 weeks and does not utilize rebalancing.

The upper chart clearly shows that the allocated portfolio generates an intermediate return, compared to the separate asset classes.  The line is a less volatile (less risky) line than all but one asset class (the bond class – not labeled).

The lower chart shows that the amplitude of the weekly rate of change for the allocated portfolio is lower than the amplitude of the separate asset classes (except for the bond class – not labeled).  That chart is an alternative way to show that an allocated portfolio is less risky (less volatile) than most of the separate classes that compose the portfolio.

If you were capable of successfully predicting which class would create the highest return each period; and if you could emotionally handle the higher volatility that the highest return asset class typically generates, then asset allocation is not necessary or attractive.  The problem is that few if any people can do that consistently, period after period.  That makes asset allocation the prudent thing to do with your money.

Asset allocation is more likely to produce consistently satisfactory results in terms of both return and volatility over the long-term than any other approach you might consider.

Richard Shaw
QVM Group LLC