How to Think About Value Investing

ExxonMobil: record earnings, again... Tilson's list looks like ours... Pickens down 60%... Banker hits jackpot... American Express fires 7,000 people... Value vs. bottom-picking...

I'm glad I recently pounded the table on ExxonMobil. The world's most profitable company reported another quarter of record earnings – $14.83 billion, up from $9.41 billion a year earlier. Revenue jumped 25% to $137.74 billion year over year, just short of last quarter's $138.07 billion. It reduced its share count by 2.1% by making $8 billion in share repurchases. And it increased capital spending 26% to $6.9 billion.

ExxonMobil is one of the best stocks you can own right now. It's got $34 billion in cash, and earnings cover interest charges 50 times over. The company made plenty of money back when oil sold for less than $11 a barrel. With oil much higher today, it's minting money. It can't possibly deploy all the cash it makes in the oil business, so it pays out dividends and makes enormous share repurchases. Gross share repurchases for the first nine months of 2008 were $26.9 billion, reducing the share count by 5.5%.

Oil is down. Natural gas is down. Refineries and chemical companies are getting squeezed at both ends. Yet ExxonMobil, which is in all of these businesses, is putting up record numbers and paying out huge cash distributions to shareholders. Very few businesses are managed with that kind of capital discipline. You should buy them when they're selling cheap.

Our friend Whitney Tilson was on TV this morning talking about his list of safe, blue-chip stocks that are selling cheap. These are stocks he thinks you can buy and hang on to for several years. You'll recognize most of the names:

Tilson's funds own all of these, except Altria and Microsoft. I've recommended Berkshire, Wal-Mart, Altria, ExxonMobil, and Microsoft. Porter has recommended Johnson & Johnson and Microsoft. Tom Dyson has recommended Wal-Mart and McDonald's.

They're all world-dominating franchises, which I've been telling folks to buy for a couple of months now.

T. Boone Pickens was on CNBC this morning talking about the destruction in his fund, which is down 60% so far this year – a $2 billion drop since it peaked in June. "We're out of the market, and have been for several weeks," Pickens said. "I want to see a little more (from) the market before we move back in again. We're not going to be in any rush."

Despite the bad performance, Pickens is still bullish on oil. He predicts it will hit $100 a barrel in 2009. He also predicts consolidation in the oil industry... "I guess I'm kind of anxious to see the first offer for a company," he said. "We may be a few months away from it."

At least one banker is making money in this market... A 33-year-old American-born, London-based banker – already a millionaire – is the first winner of the "$1 million a year for life" scratch-off lottery ticket.

"Is it going to materially change my life? No. I have been a very blessed and fortunate person," said Kenan Altunis. And because he lives in Britain, he pays New York state taxes, but not federal taxes. That means he'll net $931,500 a year for the rest of his life.

American Express announced a "reengineering" plan to realize $1.8 billion in savings in 2009. The credit-card company will cut 7,000 jobs, about 10% of the worldwide workforce, and institute a hiring freeze. It also will suspend salary increases for managers in 2009 and make cuts in travel, marketing, and technology.

American Express probably realizes the credit-card industry is the next shoe to drop in the crisis. It's already seen an increase in delinquencies, but they'll only get worse as struggling consumers turn to their credit cards as a last resort for funding. To curb the problem, Amex is dropping its riskiest customers and decreasing cardholders' credit lines. According to a New York Times article...

Lenders are shunning consumers already in debt and cutting credit limits for existing cardholders, especially those who live in areas ravaged by the housing crisis or who work in troubled industries. In some cases, lenders are even reining in credit lines after monitoring cardholders who shop at the same stores as other risky borrowers or who have mortgages from certain companies.

Now that we're finished bailing out our financial system, the Federal Reserve is pointing its hose at the rest of the world. The Fed will provide $30 billion each to the central banks of Brazil, Mexico, South Korea, and Singapore.

New highs: none.

In the mailbag... Subscribers are using our special report to find unclaimed cash. Have you found any money? Let us know: feedback@stansberryresearch.com.

"Thank you, Thank you, thank you! I did a search before, after my uncle and aunt passed away in Florida, and only came up with about $90. I tried your recommended search engine and found a $6,000 Christmas present. Guess I'll renew after all." – Paid-up subscriber P.J.

Ferris comment: We're glad to help Peter. We've found many of our subscribers have unclaimed cash they don't know about. If you'd like to check and see if money is waiting for you, click here...

"The short selling ban should have been upheld in perpetuity and expanded. Short selling should be banned all together. It's just a way for 'clever' people to make money from a negative market movement. Markets go up and down but 'clever' manipulations like short selling merely add to volatility while stripping potential from otherwise respectable long-term investments. The expectation of profit from careful and considered investment in the future growth of business in America is a laudable and a worthy pursuit deserving of respect. Short selling is pure greed." – Paid-up subscriber Mark

Ferris comment: Yours and the next message remind me of Rainer Maria Rilke, who said, "If your daily life seems poor, do not blame it; blame yourself, tell yourself that you are not poet enough to call forth its riches." Short sellers don't cause bankruptcies, they only profit from them.

"You say that wall street (lower case in intentional) did a bad job of running banks. I agree. Then you say that because there was a free market, I could avoid being affected by that mismanagement by not doing business with those banks and by not owning them. I am confused. I didn't do business with them and I didn't own them, but my portfolio is still down about 25% in value and at least one company I owned damned near went out of business, not because of doing bad loans, but because of doing good ones and getting his line of credit 'called.' I don't think that this is all sweetness and light here. I have been damaged by the misbehavior of a bunch of high-rolling bankers, and I think it is really disingenuous of you to imply that it's all my fault if I got hurt in the fall-out from the disaster." – Paid-up subscriber Roger Howe

Ferris comment: Sorry, Roger. The risk, the money, the loss, and the blame are all yours. The late Douglas Adams, author of The Hitchhiker's Guide to the Galaxy, said, "When you blame others, you give up your power to change." So you're only hurting yourself by blaming others for taking risks that went against you.

Regards,

Dan Ferris

Medford, Oregon

October 30, 2008

How To Think About Value Investing

By Dan Ferris

I get a kick out of Dan Ferris pooh-poohing market timing. In The Digest for Oct. 28, he said: 'Skeptical as I am that bottoms feel anywhere near this good, I soldier on, reveling in the myriad bargains available today, many in the greatest franchises in the world.' What makes them bargains? Buying at the lows? Dan, I'm sorry but your whole premise of value investing is based on buying when an individual stock or the market is near a bottom. I support your philosophy, but come on, call it what it is – you're buying when the price is down near a bottom, or you hope its near the bottom, or it wouldn't be a value and you're hoping that it will go back up. Sounds suspiciously like market timing to me!! – Paid-up subscriber Jerry Yohey

We received this e-mail earlier this week. Jerry seems to think value investing and bottom picking are the same. They are not. Given the enormous opportunity that exists right now for investors who understand value, I need to take this opportunity to clear up the difference.

To be fair, Jerry, I can hardly blame you for your view that value equals bottom picking, since just about every news and information source available reinforces this dangerously incorrect viewpoint.

Value investing is not an attempt to pick bottoms.

Picking bottoms isn't a skill. It's akin to buying lottery tickets, another good way to lose money. I can't time the market. You can't time the market. No one can. I'm not buying stocks because the market is down. As I've said more than once, the market indexes could easily go lower. I'm buying because stocks are cheap.

Most investors are mesmerized by that irresistible shiny object – the modern, real-time price quote. You're a member of "the Q culture," as Lawrence Cunningham calls it in the introduction to his book, How to Think Like Benjamin Graham and Invest like Warren Buffett. Cunningham writes, "Quotes of prices command instant attention in the mad, modern market where buyers and sellers of stocks have no idea of the business behind the paper they swap but precisely what the price is."

In Security Analysis, Warren Buffett's mentor Benjamin Graham makes it very clear that intrinsic value has nothing to do with "market quotations established by artificial manipulation or distorted by psychological excess." I think many current stock market quotations are showing plenty of psychological excess, which could easily increase, causing the quotations to fall farther. If they fall farther tomorrow, it won't change the fact that they were bargains today.

Graham goes on to make a further distinction between value and price, as he writes, "But it is a great mistake to imagine that intrinsic value is as definite and as determinable as is the market price." It's easy to know the price, which is why so many people are obsessed with it. It's much harder to know the value, which is why almost no one has any idea what value is or what it means.

Value investing has absolutely nothing whatsoever to do with market price quotations at all. Therefore, it can't possibly have anything to do with choosing the perfect price quotation. I didn't tell my readers to buy UPS below $45 a share because I thought it would bottom there. I can't possibly know that, and neither can anyone else.

I said to buy it there, because I think it's a 50% discount to intrinsic value. (The stock closed below $45 recently, so Extreme Value readers are in.)

Imagine paying two times earnings for a stock worth 20 times earnings. If it rose 200%, it would still be a great bargain and you should still buy it. If the same stock traded for four times earnings and fell 50%, it was still a great bargain back at four times earnings. It's merely a better bargain at two times earnings.

If the same stock sells for 60 times earnings, then falls 50% to 30 times earnings, it's not a bargain at all, even though it has fallen substantially.

That's how value works. It starts with business value, and only then does it make sense to check the price quote.

Aside from Graham and Cunningham, you should read Snowball: Warren Buffett and the Business of Life, by Alice Schroeder. It's a fantastic book about Warren Buffett. Buffett says you should find out everything about a company and estimate its value, THEN check the price quote.

Investors need to learn the assets, earnings, dividend history, capital expenditure requirements, gross margin, operating margin, pretax margin, net margin, maintenance capital requirements, interest expense, management's viewpoints and actions, the overall size of the industry, who its competitors are, and where the business you like fits in...

Intrinsic value, according to Graham, is "that value which is justified by the facts, e.g., the assets, earnings, dividends, definite prospects" of the business.

Jerry, when you write, "You're buying when the price is down near a bottom, or you hope it's near the bottom, or it wouldn't be a value," you are way off base.

Value isn't about hoping share prices go up. It's about knowing what a business is worth and paying a substantially lower amount than that.

I'm buying stocks and recommending my readers buy stocks because so many great stocks are suddenly very cheap in relation to their intrinsic values, no matter what happens tomorrow.

Could Microsoft's share price fall farther? It certainly could. But it's so dirt-cheap, the only rational thing to do is buy it.

Could ExxonMobil fall from here? Yes, but it's a world-dominating franchise trading for less than eight times trailing free cash flow.

Could Western Union's share price fall another 20% or more? Absolutely, but it's selling for about 11 times free cash flow, super-cheap for a world-dominating business that makes four to five times as much per location as its nearest competitor.

There are too many wonderful world-dominating businesses to list here, but you get the point. I cover several of these businesses every month in Extreme Value. To find out more, click here.

Good investing,

Dan Ferris

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