Value Investment Fund – Status on February 28, 2021

Value Investment Fund

The Club’s Value Investment Fund leaped forward during February 2021. The Fund grew 11.31% driven by increases across the board for all investments. Total actual gain was $13,207.07 as illustrated in report below.

As stated multiple times throughout the lessons and tutorials, high quality stocks have less risk and thus react remarkably well when the market goes down and recover quickly upon market rebound. Furthermore, high quality stocks provide many opportunities to earn good rewards if properly purchased less than intrinsic value and sold upon market price recovery.

Dividends and Earnings Analysis – Railroad Stocks

Dividends and Earnings Analysis

Dividends and earnings analysis is one of the core requirements of calculating intrinsic value via security analysis. There is a relationship between dividends and earnings; one is a function of the balance sheet, the other is tied directly to the financial performance of the company as reported on the income statement. In general, there must be earnings in order to pay dividends. Investors, especially those holding common stock want rewards for their investment and often, are short-sighted when it comes to receiving dividends. Earnings reflect the power of the company to generate value for the investor. With value investing, the key tenet is to buy a security at as low of a price as allowed by the market and then sell this security at the highest price. In the interim, dividends serve as compensation for a value investor’s patience while waiting on the market price for the security to recover to a reasonable high price.

Railroad stocks are unique. This is one of the few industries whereby all the players have a very similar revenue and cost of production business matrix. There are exactly six publicly traded Class I Railways in North America. All of them have to play by the exact same set of legal compliance requirements; utilize the same physical and technological systems; and cooperate with each other to transport goods across the continent. Interestingly, all six have similar financial characteristics:

All generate a profit, the lowest net profit within the group is 22.8%;
All have positive operational cash flow and good free cash flow;
All issue dividends to their shareholders;
All have gross profit margins > 34.5% with the average over 37%;
All have low administrative overhead generating high operational profit margins; AND
All have similar 10 year growth lines related to share price.

One of the metrics that separates them from one another is their dividends and earnings relationship. Performing a dividends and earnings analysis gives a slight advantage to the value investor over traditional traders and in some cases, if the analysis is done properly and timely, a distinct advantage over professional traders. This particular article is in-depth and educates the investor about this aspect of security analysis for this one industry. The opening section introduces the relationship of dividends and earnings with business in general. There are certain key principles that bind these two financial items together. Understanding this interrelation is key to application of determining value for a company. With this understanding, the second section below develops the railways industry as a whole. It looks back over the last ten years of actual dividends and earnings for all six railroads and analyzes their trends. Here, the impact of this relationship and how it affects the stock market price for the industry as a whole is evaluated.

The final section explores each company individually and explains how this dividend and earnings analysis impacts each company’s respective intrinsic value. The goal is to assist with determining reasonable relationships to the actual stock market price for the company’s shares. The end result is security analysis for each railroad stock as it relates to the dividends and earnings.

Understanding the relationship of dividends and earnings is essential as one of the value investment metrics used by value investors when determining intrinsic value along with expected market highs and lows for a particular stock.

Value Investment Fund Status Week 17 – Three in a Row

Value Investment Fund

Three good weeks in a row, the Club’s Value Investment Fund increased another 3.6% during this past week. That’s three weeks in a row with at least 3% improvement over the prior week. This past week’s growth was driven by the banking pool of investments, specifically the gain from Wells Fargo. Wells Fargo’s total balance increased $3,659.42. As expected, Wells Fargo’s is currently being sold in the market for less than intrinsic value estimated at $38 per share. As time passes, with each week, Wells Fargo gets closer to having their Federal Reserve cap lifted. Once this cap is lifted, the company can expand their respective earnings assets portfolio and greatly improve their net interest revenue which then drives the bottom line. The cap is expected to be lifted sometime in the first half of 2022. Between now and then, Wells Fargo’s stock price should improve into the mid $40 range as buyers anticipate lifting of the cap. In the interim, the Fund will continue to maintain patience as it waits for time to pass.

During the past week, the Fund sold PUTs on Union Pacific earning $2,009, improving realized gains to $15,616. Overall, the Fund is in a positive 33.7% improvement over its starting basis of $100,000. The Fund is currently about 1/3 of the way into the fiscal year. All of the current holdings are long-term holdings and the Fund only expects them to improve marginally between now and the end of the fiscal year. The facilitator still believes the Fund’s total return will approximate 44% by fiscal year end.

Sold Union Pacific PUTs

Union Pacific

Union Pacific is a high quality stock. Over the last twenty years, this company has  never failed to earn a profit. During this time period, there have been two recessions. The simple fact is that Union Pacific is a solid investment. The company has paid a dividend for the last thirty years. Its current yield at $210 per share is 1.83%. 

Union Pacific’s intrinsic value is estimated at $185 per share. Thus, any opportunity to own Union Pacific for less than $185 per share is considered an excellent buy.

From the Lessons Learned article for the Value Investment Fund’s 2020 performance, one of the additional tools to leverage higher the Fund’s annual return is to sell PUTs. A PUT is an option for the holder of the PUT to sell an asset, in this case stock, for a preset price referred to as ‘Strike Price’. The seller of the PUT is basically selling an insurance policy that if the market price drops to the strike price, the seller of the PUT is willing to buy the stock at that price. PUTs are a viable alternative to owning stock at less than intrinsic value. 

Value Investing – Setting Buy and Sell Points (Lesson 16)

Setting Buy and Sell Points

Setting buy and sell points for any investment security determines the investment’s final return. If the buy is made too early while the security is falling in price, the value investor loses out on not only additional margin upon the sale of that security, but also reduces their margin of safety associated with the intrinsic value point. It is similar on the other side of intrinsic value. If sold too soon, the value investor leaves money on the table. Thus, setting the buy and sell points are important decisions for every investment.

There are tools available to determine these two values. In the simplest of statements, the easiest rule to follow is the Pareto Principle, the old 80/20 rule. This rule basically states that roughly 80% of all outcomes are within 20% of of the value. With security pricing, this principle is simply that 80% of the value change will occur within 20% of the starting point. Thus, if a security’s intrinsic value is $80, then the probability is that 80% of the maximum change in value will happen within 20% points of the price shift. Therefore, the buy is approximately $64 and the sell point is $96. Almost certainly, this rule isn’t pure with security investing. The conception is that if the end results are beyond this 20 percent under and over the intrinsic value point, the value investor must have additional financial support and a lot of history with the security to validate expanding the buy and sell points beyond 20% fluctuation.

This lesson first introduces a basic model to illustrate and reinforce setting the respective buy and sell points. This model emphasizes an important aspect of price change. The angle of change affects the return on the investment. The steeper the price change, the shorter the time period for the change. The shorter the holding period for any investment, the greater the return on the investment. This is illustrated with a chart in this section of the lesson.

Value Investment Fund Status Week 16 – Another Good Week

Value Investing

Another good week, the REIT pool of investments improved another $4,094 driven by Equity Residential and UDR’s actual results from the 4th quarter of 2020. Although the market responded positively to the results, the facilitator believes that UDR didn’t perform as well as Equity or Essex during the last quarter. This requires an in-depth review of UDR once their full annual report is released later this month. It might be time to dispose of this investment as the author feels that its growth to a higher value will be too slow to justify a continued hold with this investment. That report will be posted to this website prior to month’s end. For now, all three holdings are doing well with an $18,266 unrealized gain in just over three months off a $70,000 investment. This is a 26% actual gain, an approximate annual return of around 82%. 

Value Investing – History and Modern Day Concept

Value Investing

There are tens of different definitions or interpretations of value investing. There is no single finite definition as even Benjamin Graham or David Dodd didn’t even use the term in their famous book, Security Analysis. What Graham and Dodd advocated in their writings was how to use multiple different financial tools, formulas, principles and economic concepts to determine the underlying value of any of a company’s financial instruments sold in the market. Given the wide variety of financial instruments (stocks, bonds, options, preferred stock, convertible debentures and more) available for sale, an investor must understand the proper methods to determine intrinsic value for the respective instrument. Furthermore, much of this is predicated with an understanding of how to value a company’s assets, liabilities, equity and income statement sections in order to truly determine the intrinsic value of a company.

The key term used by Graham and Dodd is intrinsic value. Intrinsic value is essentially the most likely and probable price point most informed sophisticated buyers are willing to pay for the respective ownership privilege.

There are two common price points in the securities market today. The first is called ‘market price’. Market price represents the exchange value among a large group of knowledgeable buyers and sellers for a respective financial instrument (security). It is influenced by many circumstances which change daily. The key is that there must be many buyers and sellers willing and able to purchase/sell the respective asset, in this case, a financial instrument. Furthermore, all the buyers and sellers have access to all of the facts and circumstances surrounding the sale of the respective asset; thus, no single buyer or seller has a distinct advantage over others. The only modern day system that this is considered normal is the stock market which includes the sale of all kinds of financial instruments.

The second common price point and infrequently used is intrinsic value. Intrinsic value IS NOT a value determined by group input. Intrinsic value represents the most likely dollar amount a security/financial instrument will provide in a worst case scenario.

Value Investment Fund Status Week 15 – Amazing Movement Forward

What a great week! Essex Property Trust reported their 4th quarter results and as expected, the stock’s market priced jumped almost $20 higher per share. The interesting part is that it wasn’t as if Essex reported great results; actually, their financial profits were in line with the third quarter profit. The market was holding back on amping this stock because it doesn’t know how to evaluate pricing equity based apartment complex real estate investment trusts. Per the article written several weeks ago, ‘Intrinsic Value of Essex Property Trust’, Essex’s intrinsic value is approximately $255 and a reasonable market value for this stock is around $285 to $290 per share. 

On Friday the 5th of February, 2021, the stock closed at $258.10. Thus, the market price is approximately the intrinsic value of the company on a per share basis. If the first quarter results mirror the 4th quarter performance, the stock price will surpass $270 and well on its way towards the target sell price. It may take two more quarters to acheive this reasonable market recovery price. In the interim, this single stock with several thousand dollars of unrealized value will keep the investment fund on target for the fiscal year goal of more than 30% return. The other two REITs report this week; if their results are similar to Essex’s, then the Fund’s balance will have a solid foundation for the next six months.

The historical high for Essex Property Trust is $331.30 back in October of 2019.

Calculating Intrinsic Value for Bank Stocks

Intrinsic Value of Bank Stocks

Financial institutions, including banks, are highly regulated, extremely leveraged, and susceptible to interest rate fluctuations. Due to this unique exposure, calculating intrinsic value for bank stocks requires modification of the most popular valuation models. There are about five widely accepted intrinsic valuation models used with determining the core price for stock of most companies. Novice or lazy investors rely heavily on these so-called textbook models to calculate intrinsic value as the baseline for buying stock. Sophisticated investors will modify popular models to create a customized formula for each respective industry. It requires some reasoning and reasonable assumptions to design and implement a model for any industry. This article goes into detail about designing and executing an intrinsic valuation model for banks.

To cover the thought process of creating this banking model, it is first explained how banks are in their own corner of the business world. These certain business attributes are unusual and therefore demand modification to any intrinsic calculation model. Secondly, compliance regulation further complicates calculating value. In some situations, the government penalizes banks by restricting their ability to conduct business which then impacts earnings. Since most valuation models are oriented around earnings, compliance in banking demands changes to the intrinsic formula. A third dynamic with banks is the leverage issue. Most stock price valuation models assume the respective company is at least mildly leveraged. Banks are not not mildly leveraged in comparison to other industries. A bank’s asset side of the balance sheet is customarily more than 85% weighted with loans and other earning assets. Therefore, the respective intrinsic value formulas must take this into consideration. Finally, banks and other financial institutions are susceptible to net interest margins which is tied to the portfolio’s risk factors (types of loans) and the sourcing of capital to finance these earning assets. Thus, the formula for intrinsic value must adapt to this interest spread between what is earned and what is paid out for use of money.

This article goes into great detail about how banks make a profit. The intrinsic value formula is designed around this unique business model. The final section goes through an eight step procedure to determine intrinsic value of bank stock. This article is for members only of this site’s Value Investment Club. It uses Wells Fargo as its sample and sets Wells Fargo’s intrinsic value point as of February 2021. For those of you desiring to read the entire article, you must join as a member; click on the Value Investing tab above and select Membership to read about the program and join the Club.

Value Investment Fund – Status on January 31, 2021

Value Investment Fund

The symbolism of the stock market are the bear and the bull. There is a third, the sloth for slow change. January is best stated as a sloth month. The stock market as a whole retracted 2%; but, the Value Investment Fund grew a meager .4% from $116,231 on December 31, 2020 to $116,727 on January 31, 2021.

As stated multiple times throughout the lessons and tutorials, high quality stocks have less risk and thus react remarkably well when the market goes down and recover quickly upon market rebound. Furthermore, high quality stocks provide many opportunities to earn good rewards if properly purchased at intrinsic value and sold upon market price recovery.

On December 31, 2020, the Investment Fund’s balance was $116,231. During the month of January 2021, the DOW Jones Industrial Average decreased 2.04% from 30,606 to 29,983. This club’s fund, increased a meager .4%. The difference is directly associated with the REIT pool. That pool’s balance on December 31st was $67,775 and it now stands at $79,582 including an additional $10,000 of basis tied to a second tranche purchase of Essex Property Trust (see the article for Essex’s intrinsic value calcultion).