I spend a lot of time thinking and tailing about valuation ratio. Buying a business at the right price can help offset many of the usual investing mistakes. As an example, my biggest weakness as an investor is probably the fact that I always sell too soon. That may sound strange, since I talk a lot about using the private equity mindset and have been known to hold stocks for years. But more often than not, no matter how long I held the shares or how much money I made, I will see the stock price continue to rise to levels I hadn't thought possible. However, because I bought the stocks at bargain levels things tend to work out in my favor anyway.
For years my favorite metric has been price to book value; however, over the past few years I have begun to use the enterprise value for non-financial companies. Tobias Carlisle and his excellent books Quantitative Value and Deep Value had a lot to do with my changing view on valuation ratios. I still use price to book, especially for financial stocks, but the EV/EBIT ratio has been a valuable addition to my arsenal.
I spent some time talking value with Tobias last week. He outlined his thinking on evaluating companies, telling me: "My favorite approach is always going to be the acquirer's multiple, which is operating earnings, EBIT operating earnings, on enterprise value. The reason is that I like to approach them the way a private equity firm or leveraged buyout firm would. Even though you can't see how the business is going to improve, or you can't see how the stock is going to go up, you can see that it is going to survive or it's likely to survive even a nuclear winter. I think in those instances, even though you don't see something good happening, my experience is that something good does happen, because management doesn't just sit there on their hands. If they do, then there are activist investors out there who are always looking to stir something up, get them to do something, pay some money out, or buy back some stock."
I sat down this morning and ran a quick screen to look for some companies that trade at very low EV/EBIT ratios but look like they can survive until something good does happen to cause the stock price to rise.
Gilead Sciences (GILD) is hardly a speculative biotech company flirting with the possibility of extinction, but the market appears to be pricing it that way. The company has $15 billion in sales and is a major player in the markets for HIV and Hepatitis C drugs. Investor concerns about slowing sales and what many view as a weak pipeline of new drugs have led to strong selling in the stock and it is down about 20% over the past year.
Management are looking to reverse course and have hired a new head of the oncology and hematology divisions and have said they are looking for M&A possibilities to add to their R&D pipeline. The stock is just 15% above a three-year low and is trading at an EV/EBOT multiple of just 5.5 right now. It probably will not be a smooth ride, but I suspect that investors who hold the stock for several years will eventually be able to sell at much higher multiples.
Home builder Lennar (LEN) has seen steady progress over the past few years, but investors don't seem to care. Fears of higher mortgage rates have also kept investors form embracing the builders. Lennar recently announced that it was buying WCI Communities to expand its presence in the Florida marketplace, which is one of the most active in the U.S. right now. It is also beginning to focus on the first time home buyer market, which is finally starting to show signs of life.
CEO Stuart Miller is pretty positive about the prospects for his company. In the most recent earnings release, he told investors: "We have consistently believed that the housing market is continuing its slow and steady recovery and we have crafted our operating strategies specifically to position our company to grow at a measured pace and to act opportunistically in these market conditions. With the anticipation of a new President focusing on accelerating economic growth, we believe that our fortified balance sheet, our diversified business model and our refined product offerings will continue to hold us in good stead in a high-growth economy, despite the potential of moderately rising interest rates over the next several years."
Lennar has an EV/EBT ratio of just 2.4, so it is one of the cheapest stocks in the nonfinancial universe right now. Patient investors should see outstanding long-term results.
Buying stocks at bargain valuations can help offset a lot of the other mistakes we might make as investors. If we buy right, then time and value should do most of the heavy lifting for us.
