Understanding the 'why' behind your investments...
Understanding the 'why' behind your investments... Many of you cheated on your homework... Is Markel expensive or cheap?...
We had hundreds of responses to my request for feedback about the shares of insurance firm Markel (MKL). Nearly all of them were thoughtful, too. But of course, there were a few grumps who said, in effect, "What are you asking me for? That's why I pay you."
Yes, of course... And I (Porter) embrace that responsibility. We take our work seriously. We explain our rationale for making recommendations thoroughly. We're constantly tracking our results. And we are always seeking to improve our strategies.
But I'll tell you something you might not know from experience yet...
When you're under stress – like you will be the next time the stock market falls 25% – understanding the "why" behind your investments will make a big difference in your results.
Investors who understand why they've bought something are vastly more likely to stick with the program and, therefore, find success. They're the investors who will consistently improve their decision making over time. People who aren't interested in even learning the basics will panic and sell at the exact wrong time.
Now... about Markel...
The most common answer we got was that the shares were obviously too expensive. Happily, we didn't get a single e-mail that claimed this was due to its high nominal share price (of around $775).
I was expecting at least half of the replies to say, "I would never buy a stock that's trading for more than $100 per share – that's way too expensive."
As you hopefully know, the nominal share price is completely meaningless in determining the fair value of a stock. Instead, stocks ought to be valued on the basis of their earnings. How much profit will these shares produce for their equity owners going forward? That's how you determine the current value of any business. And of course, a share of stock represents ownership in the business.
Now, the rules of this contest were simple. You were supposed to quickly decide if the stock was cheap, fairly valued, or expensive using only the contents of a Yahoo Finance key statistics page to make your judgment.
Many of you cheated.
You looked into the nature of the company's business (insurance) and you produced sophisticated answers, calculating the company's insurance float, for example. But that wasn't the point of this exercise. The only purpose here was to see if you could quickly make a reasonable judgment about valuation.
And most of you couldn't.
Most of you thought the stock was far too expensive to buy. The No. 1 reason you gave was its price-to-earnings (P/E) ratio – the ratio of its share price compared to its earnings per share.
The stats page reports Markel's stock price (as measured by its P/E ratio) to be 26 times earnings. Many of you knew that P/E ratios tend to be around 15, on average, over the long term... so you thought Markel was too expensive.
Wrong.
All of the metrics most commonly used on Wall Street to value stocks – like the P/E and price-to-book (P/B) ratios – have a huge weakness: they rely on "reported earnings."
This measure of profitability is defined by modern accounting rules, which are called GAAP – for "generally accepted accounting principles." There's nothing evil or bad about these rules per se, but it's a little absurd to believe there's only one set of accounting principles that should govern both a business like ExxonMobil (which is selling off its own balance sheet one barrel at a time) and a business like Google (which has little physical product of any kind).
Here's an easy way to think about this problem...
GAAP accounting was originally created for the first big national railroads in America. They were designed to help figure out the return on capital investments over the long term. So if you're thinking of relying on GAAP accounting for your valuation work, first ask yourself this: How similar is the business you're evaluating to a railroad? Then you'll quickly know whether the GAAP accounting figures are likely to be meaningful to you as an investor.
In this case, the GAAP accounting figures are almost completely meaningless because Markel is an insurance company.
Now, if you knew this, you would have had an advantage in our game. But even if you didn't, you still could have seen something obvious on that statistics page: Markel holds a huge amount of cash ($3.7 billion). That's nearly 40% of its entire market capitalization.
Obviously, you wouldn't want to judge this company solely on the basis of its market capitalization without taking into account all of the cash the company holds.
This cash skews the firm's metrics.
For example, even though the stats on the company's operations look pretty good (operating margins of nearly 14%), the stats on the company's capital structure look terrible (return on assets are 1.75%).
The truth, however, is clear when you look at cash flows and account for net cash on the balance sheet.
The secret to getting past the problems with GAAP accounting is to always look past these numbers to figure out 1) how much capital the business really uses and 2) how much capital the business can really produce.
Enterprise value tells us how much capital the business is actually using. In this case, it's $9.3 billion. That's all of the shares outstanding plus the net debt and minus the cash on the balance sheet.
Cash flow tells us how much capital the shareholders are actually making on this business. For Markel, that's $717 million over the last 12 months. That's a cash return on enterprise value of 7.7%.
That's not great, but it's not bad, either.
Looking at enterprise value and cash flow also gives us a more accurate way to value Markel's business. On this basis, the shares are only trading at 12.9 times cash earnings – a multiple that's cheaper than the market as a whole.
As you may know from reading our newsletters, we prefer to buy great businesses when they're trading for less than 10 times their cash flows as measured by enterprise value.
Thus, we would argue that Markel is fairly valued at its current price. It's not obviously expensive, nor is it particularly cheap – at least when measured using the information available on the Yahoo Finance key statistics page.
My dad taught me another reason to practice valuing stocks and learning more about investing: "Porter, if you can't do math at least as well as your accountant, you won't be rich for very long."
I hope this short exercise was helpful. If you have questions about it, don't hesitate to ask: feedback@stansberryresearch.com. I'll answer a representative sample of your questions in Friday's Digest.
A final note to end today's Digest...
By now, many of you have probably seen our ads and television commercials featuring Dr. Ron Paul. As I mentioned last month, Dr. Paul agreed to endorse our company, and even wrote the foreword to my new book, America 2020.
Longtime readers know my primary goal here at Stansberry Research is to tell you, our subscribers, what I would want to know if our roles were reversed. Thanks to Ron's endorsement, we're now reaching thousands of folks who otherwise never would have heard our message or had access to our research. We are incredibly grateful for his support.
If you missed my one-on-one conversation with Dr. Paul, I urge you to take a few minutes to watch it. You can view it – and learn how to get a copy of my new book – right here.
New 52-week highs (as of 6/1/15): WisdomTree Japan Hedged Equity Fund (DXJ) and eBay (EBAY).
In the mailbag, subscribers continue to turn in their homework assignments. Send your e-mails to feedback@stansberryresearch.com.
"I admit, I'm not very good at this stuff, so I was tempted to hide in the corner and not answer. But, what the heck, I looked at the stats, spending quite a bit longer than the 30 seconds you challenged us to. Let me see if I can remember my thought process.
"First, $770/share *sounds* really expensive, but I've heard you say on multiple occasions that the nominal value of a stock is irrelevant. I could easily guess that this is a trick question. I also see that it doesn't pay a dividend, which, for me, takes it out of the running. At my age I'm more interested in income than growth. But I kept looking...
"The market cap is higher than the enterprise value. I'm pretty sure that means I'd be paying more for the stock than I could buy the whole company for. Price/sales and price/book look low to me, which sounds good. And total cash is about 50% more than debt, which also sounds pretty good.
"Finally, I'm still not sure what the answer is, but following along with your lessons was difficult for me, so I'm a bit surprised that I've absorbed more than I thought I had. I think. If I've written anything worth quoting, feel free to do so, but please don't use my name. I don't want it publicized how ignorant I still am. Lastly, I want to express my sincere appreciation for all you do for us. I really do pay special attention to the Friday Digests, even if my learning is a bit slow." – Paid-up subscriber L.O.
"Hi... this is my best guess: I'd say the stock is a bit expensive based on the following: Forward P/E is 30... it would be better to buy it around 20 or less. Stock price is higher than the 50-D moving average... I'd wait for a pull back. It is also good that: Total debt (2.25 B) is less than cash (3.69 B). Quarterly earnings growth is excellent (117% yoy). No dividends, no stock splits are also disappointing. BTW, I have this stock in my portfolio (for several years now, thanks to Stansberry Research), and I have enjoyed watching it grow... up 46% since July 2013! Thanks for the adventure." – Paid-up subscriber D.P.
"I read the question and spent a few minutes on Yahoo Finance. Right off the bat, I saw that Markel is a P&C insurance company. From my reading of the insurance monitor, I believe I understand the two most important things are float and how profitable the company is in writing insurance policies. Neither of these items are reported in Yahoo Finance. If however, Markel was evaluated as a typical company (making a product or selling a service), I note that the P/E is somewhat high at 26, but lower than the competing companies listed by Yahoo Finance, one with a P/E of 1000. EV/EBITDA is reasonable around 10.
"Without looking at the information important to insurance, I wouldn't use the typical company evaluation methods. I've been burned buying what I don't understand, so with the high P/E and it being an insurance co. I'd say, stay away." – Paid-up subscriber A.R.
Regards,
Porter Stansberry
Baltimore, Maryland
June 2, 2015