Situation: Buying low is what separates an investor from a saver. A stock picker has only a few ways to do that. The qualities of a company, including its future prospects, need to be considered beyond the quantities in its Balance Sheet. But those Balance Sheet numbers do help to reveal the quality of management. For example, Return on Tangible Capital Employed can be impressive (even over 40%) when the long-term bonds that a company issues account for 3 times more of its capital than common equity. But if long-term bonds provide less capital than equity, even a 20% return is evidence of a high quality management team.
I start looking for opportunities to BUY LOW by screening for metrics favored by great stock pickers. GARP (Growth At a Reasonable Price) is what Peter Lynch favored. Graham Numbers (which normalize a stock’s price to 1.5 times Book Value and 15 times earnings) and a 7-yr P/E are what Benjamin Graham favored. Warren Buffett (in the 2020 Annual Report of Berkshire Hathaway) writes that “we constantly seek to buy new businesses that meet three criteria. First they must earn good returns on the net tangible capital required for their operation. Second, they must be run by able and honest managers. Finally, they must be available at a sensible price.”
Bargain-priced companies typically are facing challenges that have caused their Return on Investment (TTM) to decline, which of course lowers their stock price while raising their dividend yield. Hopefully the challenges will be surmounted and the stock will go up in price. You, the buyer, hope to profit from that turnaround. Very large companies typically make a turnaround within 2-3 years because they have considerable advantages: 1) multiple product lines that can be repurposed efficiently, 2) Credit Lines that can be tapped at low interest rates, 3) a dominant market position, and 4) customers want to avoid the Switching Costs they’d face finding a new supplier.
To BUY LOW successfully you need to pick stocks at the right time and wait patiently for its price to rebound. Dogs of the Dow is the only time-proven system for doing that: Buy equal dollar amounts of stock in the 10 highest yielding DJIA companies at the beginning of the year and sell those shares at the end of the year. For the retail investor, the transaction costs would likely be too high. Results are better anyway if stocks are given more time to recover. So, check out the new list every January and decide which companies have the qualities needed to get on the path to recovery.
Mission: The 10 Dogs for 2021 are DOW, CVX, WBA, VZ, MRK, IBM, MMM, AMGN, KO, CSCO. The last 6 are A-rated companies. Decide which of those 6 are likely to rebound.
Bottom Line: Warren’s first point is addressed in Column Q of the Table: Return on Tangible Capital Employed. He thinks anything over 20% is a good number. MRK, CSCO, KO, AMGN, MMM pass that test. The second point is a bit harder to parse but Morningstar reports do address management (see Column AK in the Table). MRK and MMM have BUY ratings from Morningstar. The ratio of Long-Term Debt to Equity (gearing) tells you the degree to which management boosts tangible assets by issuing long-term bonds (Column U). MRK and CSCO have gearing ratios under 1.0. Warren’s third point is addressed by the 3-5 year estimated PEG Ratio (see Column M in the Table): MRK and AMGN have PEG Ratios under 2.0. Conclusion: MRK is a BUY.
All six companies (MRK, CSCO, KO, AMGN, MMM, IBM) are A-rated, meaning that S&P gives their stocks and bonds good grades, Book Value (mrq) and earnings (TTM) are positive numbers, each has a 20+ year trading history on public exchanges, and their dividend yields are stable at above-market rates. Two (CSCO and IBM) meet my definition of a Value Stock: Price (50d Moving Average) is no more than twice the Graham Number and 7-yr P/E is no more than 25.
Risk Rating: 7 (where 10-yr US Treasury Notes = 1, S&P 500 Index = 5, and gold bullion = 10)
Full Disclosure: I dollar-average into MRK, CSCO and KO, and also own shares of MMM, AMGN and IBM.
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