You are on page 1of 11

Passive Value investing: Screening for bargains

As long as there have been markets, I am sure that investors have used screens to find good
investments. It was Ben Graham, however, who systematized the process in his books on investing,
by laying out the ten criteria (screens) that could be used to find cheap stocks.
1.
An earnings to price yield > Twice the AAA bond rate (At the AAA bond rate of about 3.6%
today, that would work out to an earnings to price ratio > 7.2% or a PE< 14)
2.
PE ratio today < 40% of the highest PE ratio for the stock over the previous 5 years
3.
Dividend yield > 2/3 or the AAA bond yield (At today's AAA rate, yield >2.4%)
4.
Stock price < 2/3 (Tangible book value of equity per share), where tangible book value of
equity = Total book value of equity - Book value of intangible assets
5.
Stock price < 2/3 (Net Current Asset Value), where Net Current Asset Value = Current Assets
- (Total Liabilities + Preferred Stock)
6.
Total debt < Book Value of equity
7.
Current ratio > 2, where current ratio = Current Assets/ Current liabilities
8.
Total Debt < 2 (Net Current Asset Value)
9.
Earnings growth in prior 10 years > 7%
10.
No more that two years in the prior ten, where earnings declined more than 5%.
While we can debate the efficacy of these screens (I, for one, find that the fixation on net current asset
value is too restrictive), it is quite clear what Graham was looking for: cheap companies with low
leverage & stable and growing earnings, with liquid assets acting as a backstop and providing a
margin of safety for investors.
Do screens work?
Graham had three pricing screens among his ten criteria: PE ratios, a modified version of price to
book ratios and dividend yields. In the decades since, studies (many from academics but quite a few
from practitioners as well) have found that at least two of these screens seem to work, at least on
paper. Stocks that trade at low PE ratios and low PBV ratios deliver returns that beat the market, on a
risk adjusted basis.
Let's start by reviewing the evidence. Rather than quote from studies that are at different points in
time, I used the raw data (maintained very generously by Ken French at Dartmouth) to compute the
differential returns that stocks, in the lowest and highest deciles of PE, PBV ratio and the dividend
yield, earned on an annual basis between 1952 and 2010, relative to the overall market:

Note that low (high) PE and low (high) PBV stocks have beaten (under performed) the market by
healthy margins, before adjusting for risk, over time but that there is no discernible pattern with
dividend yields. In fact, over the period, non-dividend paying stocks beat both the highest dividend

yield and lowest dividend yield deciles in terms of returns earned. You can find more on past studies
by going to my paper on value investing.
So, what's the catch?
When it looks like you can make money easily, there is always a catch. Here are the three caveats on
the "excess returns" that a low PE, low PBV strategy seems to deliver.
1.
Time horizon matters: The returns are in the long term (five years and longer) and there are
time periods (some lasting for years) where the strategies under perform the market. For instance,
looking across the entire period, for instance, it looks like while low PE stocks dominate high PE
stocks over long periods, the latter group outperforms during periods of low economic growth (where
growth becomes scarce).
2.
A proxy for risk? While I did not adjust for risk in my computation for excess returns, most of
the studies that have looked at these screens have controlled for risk, using conventional risk and
return measures (betas, Sharpe ratio etc.). It is possible that there are other risks in buying these
stocks that may not be full reflected in these risk measures. For instance, some stocks that trade at
low price to book value ratios have high debt burdens and run a higher risk of default/distress.
3.
Transactions costs & taxes: A lot of strategies that make money on paper perform badly in
practice because they expose investors to higher transactions costs and taxes. For instance, many of
the stocks in the lowest PE ratio decile are lightly traded companies, with high bid-ask spreads and
potential for price impact. Similarly, investing in high dividend yield stocks may expose investors to
higher taxes.
In a testimonial to how difficult it is to convert paper profits to real profits, it is worth noting that
the James Rea's attempts to put Graham's principles into practice in an investment fund that he ran
from 1982 to the late 1990s was an abject failure, with the fund ranking in the bottom 20% of the fund
universe in performance. In a similar vein, Value Line's attempts to convert its screens (that also
worked exceptionally well on paper) into a mutual fund also failed.

Incorporating screens into investing


If you do buy into the effectiveness of screens at finding cheap stocks, there are two ways to
incorporate screens into your investing.
a. Bludgeon Screening: In this approach, all of the work in picking stocks is done by your screens.
Thus, you start with a large universe of stocks and screen your way (using either more screens or
tighter screens) down to a portfolio size (in terms of number of companies) that you are comfortable
with.
b. Screening plus: You use the screens to narrow the universe of stocks (which may contain
thousands of stocks) to a more manageable number, but you then follow up using one of these
approaches:
Screening plus intrinsic valuation: You value each of the screened stocks using an intrinsic
valuation model (a discounted cash flow model, excess return model or your own variant) and invest
in the most under valued companies. You can also incorporate a margin of safety into this approach
by only investing in stocks that trade at 30%,40% or 50% discounts on your intrinsic value.
Screening plus qualitative analysis: Once you have the screened list, you may be able to
apply qualitative criteria that you think separate winners from losers (moats, good management etc.)
to find the stocks for your portfolio.
A blueprint for screening
In Graham's day, screening was an arduous process, with limited access to the financial statements of
companies and no computing power. Today, screening has become easy with many sites offering
stock screeners for all, sometimes at no cost: Yahoo! Finance, Google Finance and MarketWatch all
offer simple screening tools. In fact, it has become so easy that investors sometimes get carried away,
piling on redundant screens on top of each other and sometimes undercutting their effectiveness by
doing so.
Before you start, be clear about your objective
You want to find a mismatched company, i.e, a company that is priced low, with none of the reasons
for being priced low (high risk, low growth, low quality of growth). In other words, you want a stock
trading at a low multiple, with low risk, high growth rates and high quality growth. What chance do you
have of finding such a bargain? It may be low, but there is no harm looking.

Step 1 - Screen for price


The first step is to screen for low . With stocks, this will almost always require that you scale the
market price to a common variable (revenues, earnings, book value etc.) to estimate a multiple. Here
are your choices:

In making these choices, you have to be consistent. If your numerator is an equity value (market
capitalization, stock price), your denominator should also be an equity value (net income, earnings per
share, book value of equity). If your numerator is an enterprise or overall business value (enterprise
value, value of firm), your denominator should be an overall firm number (operating income, EBITDA,
revenues, book value of invested capital). Should you use an equity multiple or an enterprise value
multiple? In some sectors, such as financial services, you have no choice but to use equity, since
defining debt is close to impossible. In others, you have a choice, and here is my simple rule. If
financial leverage varies widely across the sector (some firms have more debt than others), I would go
with an enterprise value multiple. For comparisons across the entire market, enterprise value
multiples tend to be more robust.
Once you have picked a multiple, you then have to choose your screening thresholds. In practical
terms, you have to decide how low does a stock's pricing multiple has to be to qualify for your cheap
list. There are three ways to find this threshold.
a. You can use the rules of thumb that seem to be so widely prevalent: an EV/EBITDA less than 6 is
cheap, a PE ratio in the single digits is low etc. While these rules of thumb may have made sense
when first devised, it is doubtful that they make sense today.
b. You can derive the "cheap" threshold from intrinsic valuation models. To illustrate, the PE ratio for a
firm that pays its entire earnings out as dividends and has no growth should be as follows:
Intrinsic "cheap" PE threshold = 1/ Cost of equity
In June 2012, when the cost of equity was computed to be about 8%, the threshold for a "cheap"
company would be 12.5 (=1/.08).
c. You can derive the threshold by looking at the distribution of the values of the multiple across your
sample, using the lowest decile (or lowest quartile) as your cutoff for "low". The table below lists the
deciles for key multiples for US companies in January 2012:

Thus, looking for stocks with a PE less than 5 would give you stocks in the lowest decile whereas
using a cut off of 10 for the PE would give you stocks in the top quartile, at least in early 2012.
Step 2 - Screen for risk
Companies that are very risky can look cheap, without being cheap. To screen for risk, consider first a
breakdown of risk into three categories:
(a) Operating risk, reflecting the risk that your revenues and costs can shift over time, as the market
and the sector evolve.

(b) Financial risk, coming from the use of debt, leases and other fixed commitments that can make
your residual stake as the equity investor much more volatile.
(c) Liquidity risk, that you face as as investor when trading on the stock, manifested as trading costs
(bid ask spreads, price impact) and inability to trade at the extreme.
The screens for risk can broadly be categorized as follows:
1.
Price based screens: While many value investors express disdain for betas, there are other
price based screens that are based upon prices (standard deviation, volatility in the stock price) that
they may still be willing to use as measures of composite risk. In fact, you can use screen for liquidity
risk, using market data, by looking at the bid-ask spread or the trading volume/float in a stock.
2.
Accounting based screens: Accounting statements can provide snapshots of risk, though they
are stronger in measuring some types of risk than others. You can measure exposure to financial risk
fairly well, using ratios that measure the capacity to make interest or debt payments (interest
coverage, fixed charge coverage ratios), operating risk less well (variability in earnings over time) and
liquidity risk not at all.
3.
Risk proxies: While this may be applying a broad brush, you may use the sector a firm is in as
a proxy for risk; thus technology companies may be viewed as risky companies and utilities as safe
companies. Alternatively, you may believe that large companies (measured in market capitalization or
revenues) are safer than small companies.
4.
Sector specific screens: If you are screening for cheap stocks within a sector, you may use
measures of risk that are specific to the sector. Among bank stocks, for instance, you may look at
regulatory capital ratios or exposure to problem assets/businesses; banks with lower regulatory
capital or greater exposure to toxic assets are riskier.
As with the multiples, you can see the quartiles of the distribution for these variables for US stocks in
January 2012 in the table below:

Step 3- Screen for growth


If you are a value investor who views growth as icing on the cake, you may not look for high expected
earnings growth but you may still want to screen for companies with moderate growth prospects or at
least try to avoid companies with negative earnings growth. In screening for growth, you should stay
true to the consistency principle, focusing on growth in equity earnings, if you are using an equity
multiple (like PE) or growth in operating earnings, if you are using an enterprise value multiple and
you would rather be forward looking in your growth estimates (using expected future growth, if
available) rather than backward looking (historical growth). The quartiles of growth measures for US
stocks in January 2012 is in the table below:

Step 4 - Screen for quality of growth


If you are employing a growth screen, you also want to ensure that the firm is not spending too much
to deliver that growth. To screen for quality of growth, you can employ one of two approaches:
a. Accounting return measures: Dividing the accounting earnings by accounting book value gives you
a measure of accounting returns:
Return on equity = Net Income/ Book value of equity
Return on invested capital = Operating income/ (Book value of equity + debt - cash)
While they are aggregate measures for the whole firm and accounting earnings/ book value are
susceptible to accounting manipulation, you want firms that are able to earn high returns on their

growth investments in your portfolio. At the minimum, the returns should exceed the costs (the cost of
equity, if ROE, and the cost of capital, if ROIC).
b. Sector specific measures: You can also measure efficiency of growth using sector specific
measures, such as profit margins (net or operating) in retail, capital invested per subscriber (in cable
or other subscriber-based businesses) or capital invested per kWh of power produced (for power
companies).
The quartiles for ROE, ROIC, net and operating margin for US companies in January 2012 are
reported in the table below:

Step 5: Rinse and repeat


Once you run your screens, check the stocks that come through the screens for two potential
problems. The first is sample size. If your screens return only a handful of stocks, your screens have
been set too tight and you should consider relaxing one or more of your screens (settling for lower
growth or higher risk). The second is sector concentration. If you end up with stocks that are in one or
a couple of sectors, you may want to consider modifying or adding to your screens to get more
diverse portfolios.
While you can screen for free at Yahoo! Finance and Google Finance, you get far more flexibility in
defining your own screens if you have access to a database. For US companies, you can tryValue
Line or Morningstar, both of which provide real time data for the entire universe of traded stocks and
are not unreasonably priced. For screening of stocks outside the US, you can use Capital IQ, Factset
or Bloomberg, but the price tag gets higher. There are some innovative sites out there that are offering
better screening tools and large databases, such as RobotDough, a site that combines an impressive
database with powerful screening tools, AAII and Zacks (which has a combination of free and
premium screens).
Odds of success
I have always believed that, as an investor, you need to bring something unique to the table to be able
to take something away in terms of excess returns. In other words, just as we look at competitive
moats for successful businesses, you have to think about your competitive moats as an investor. With
screening, consider the competitive advantages that Ben Graham saw for the intelligent investor in
1951, when he put together his classic screen list. The first was access. With limited access to
financial statements and no easy-to-use tools, only a few tenacious investors could use these
screens. The second was discipline. Investors had to stay away from distractions and fads and stay
true to those stocks that made it through the screens. The third was patience. Investors had to hold
the screened stocks in the long term to generate the promised returns. Today, with widespread access
to data and analysis tools , the first advantage has dissipated, leaving behind patience and discipline
as your potential advantages. It can be argued that an automated screening/investing process, with
no human input, is less likely to succumb to emotion than the most disciplined, patient human being.
Put more bluntly, if all you have to offer as an active investor is screens, you are unlikely to beat a
machine doing the same. With screening plus, whether you make money depends on the quality of
what you do after you screen. If you are skilled at intrinsic valuation or qualitative assessment, you
may generate excess returns, relative to the market.
In closing
To illustrate the screening process, I used Capital IQ data and used two sets of screens to arrive at a
list of "cheap" stocks from a universe of 7542 publicly traded companies in the US.
Equity screen: Low PE (<10.11, in bottom quartile), above-average expected EPS growth rate
(>13.50%, above median), below-average book debt to equity ratios (<27.21%, in bottom quartile),
high ROE (>13.60%,top quartile) --> See the 19 stocks that made it through these screens
Enterprise value screen: Low EV/EBITDA (<4.51, bottom quartile), above-average expected revenue
growth (>7%, above median), below-average book debt equity ratio (<27.21%, below median), aboveaverage ROIC (>9.41%, top quartile) --> See the 13 stocks that made it through these screens
I would not be rushing out to buy all of the stocks on either list, but I think it is worth following through

and doing intrinsic valuations of these companies. Anyone up for it? If so, you are welcome to use
my generic valuation spreadsheet.

Contrarian Value Investing - Going against the flow....


Nokia came out with an awful earnings report yesterday, with warnings of more bad news to come,
and its stock price, not surprisingly, plummeted.

While investors are fleeing the stock and a ratings downgrade looms, is it a contrarian play? What
about JP Morgan Chase? Or Research in Motion? Netflix or Green Mountain Coffee, anyone? By
focusing on stocks that other investors are abandoning, contrarian value investing is the "antilemming" strategy, but it takes a unique personality and a strong stomach to pull off successfully.
The basis for contrarian investing
The core belief that underlies contrarian investing is that investors over react to both good and bad
news, pushing prices up too much on the former and down on the latter. If you carry this view to its
logical conclusion, it then follows that prices will reverse in both cases as investors come to their
senses.
While you may believe that investor overreaction is the norm, is there evidence to back up the claim?
The statistical and the psychological evidence is mixed and contradictory. On the one hand, there is
significant evidence that investors under react to news stories (earnings reports, dividend
announcements), leading to momentum (and drift) in stock prices, at least over short periods. On the
other, there is also evidence that investors over react to information, with price reversals occurring
over longer periods. In behavioral finance, as well, there are two dueling "psychological"
characteristics at play: the first is that of "conservatism", where individuals, faced with new evidence,
update their prior beliefs (expectations) too little, thus creating under reaction, and the second is
"representativeness", where individuals over adjust their predictions, based upon new information. To
reconcile the co-existence of the two, you have to bring in two factors. One is time, with under
reaction dominating the short term (days, weeks, even months) and over reaction showing up in the
long term (years). The other is the magnitude of the new information, with over reaction being more
common after big events.
Contrarian investing strategies
Within the construct of contrarian investing, there are at least four variants. In the first, you invest in
the stocks that have gone down the most over a recent period, making no attempt to be a
discriminating buyer. In the second, you focus on sectors or markets that have been hard hit and try to
identify individual companies in these groups that have been "undeservedly" punished. In the third,
you look at companies that have taken hard hits to their market value but that you believe have
underlying strengths which will help them make it back to the market's good graces. In the final
approach, you buy stock in beaten up companies with the same intent (and expectations) that you
have when buying deep out of the money options. You know that you will lose much of the time but
when you do win, your payoff will be dramatic.
1. The Biggest Losers
If you believe that investors tend to over react to events and information, the effects of that over
reaction are most likely to be seen in extreme price movements, both up and down. Thus, stocks that
have gone down the most over a period are likely to be under valued and stocks that have gone up
the most over a period are likely to be over valued. It follows, therefore, that if you sell short the former

and buy the latter, you should be able to gain as the over reaction fades and stock prices revert back
to more "normal" levels.
In a study in 1985, DeBondt and Thaler constructed a winner portfolio, composed of the 35 stocks
which had gone up the most over the prior year, and a loser portfolio that included the 35 stocks which
had gone down the most over the prior year, each year from 1933 to 1978. They examined returns on
these portfolios for the sixty months following the creation of the portfolio and the results are
summarized in the figure below:

An investor who bought the 35 biggest losers over the previous year and held for five years would
have generated a cumulative abnormal return of approximately 30% over the market and about 40%
relative to an investor who bought the winner portfolio.
Looks good, right? Before you rush out and load up on the biggest losers of the last year, a few notes
of caution:
1.
Watch out for transactions costs: There is evidence that loser portfolios are more likely to
contain low priced stocks (selling for less than $5), which generate higher transactions costs and are
also more likely to offer heavily skewed returns, i.e., the excess returns come from a few stocks
making phenomenal returns rather than from consistent performance.
2.
Timing is everything: Studies also seem to find loser portfolios created every December earn
significantly higher returns than portfolios created every June. This suggests an interaction between
this strategy and tax loss selling by investors. Since stocks that have gone down the most are likely to
be sold towards the end of each tax year (which ends in December for most individuals) by investors,
their prices may be pushed down by the tax loss selling.
3.
Time horizon matters: In a test of how sensitive the results were to holding period,Jegadeesh
and Titman tracked the difference between winner and loser portfolios by the number of months that
you held the portfolios and their findings are summarized in the figure below. There are two
interesting findings in this graph. The first is that the winner portfolio actually outperforms the loser
portfolio in the first 12 months. The second is that while loser stocks start gaining ground on winning
stocks after 12 months, it took them 28 months in the 1941-64 time period to get ahead of them and
the loser portfolio does not start outperforming the winner portfolio even with a 36-month time horizon
in the 1965-89 time period.

If you feel that, in spite of these caveats, this strategy may work for you, you can take a look at a list of
the 50 companies that have gone down the most (in percentage terms) over the last 52 weeks (June
2011-June 2012). I have added a stock price constraint (to ensure that you don't end up with lowpriced stocks) and reported the dollar trading volume per day (as a red flag for trading costs). I have
compiled the list for the US (with price>$5), Europe (with price>$5), Emerging Asia (with
price>$1), Latin America (with price>$1) and global (with price>$5). Your timing is off (since it is not
January) but you can still browse for bargains. You can also adapt the screening plus strategy that I
talked about in my post on passive screening and subject the companies on these lists to follow up
analysis (intrinsic valuation or qualitative assessments)>
2. Collateral Damage
It is not uncommon for markets to turn negative on an entire sector or market at the same time. In
some cases, this is justified: a big news story that affects an entire sector, or a macro economic risk
that hurts a market. In others, it may represent either an over reaction by investors to the idiosyncratic
problems of an individual company in a sector or a failure to consider that companies within a
market/sector may have different exposures to a given macroeconomic risk. As an example of the
former, consider how banking stocks were punished on the day that JP Morgan Chase reported its big
trading loss. As an illustration of the latter, you can look at the Spanish stock market, where investors
have punished all companies (though some are less exposed to Spanish country risk than others)
over the last year.
About a decade ago, I penned a paper on measuring company risk exposure to country risk that
argued that we (as investors) were being sloppy in the way we assessed exposure to country risk,
using the country of incorporation as the basis for measuring risk exposure. With this view of the
world, US and German companies are not exposed to emerging market risk, an absurd argument
when applied to companies like Coca Cola and Siemens that derive a large chunk of their revenues
from emerging or risky economies. By the same token, all Brazilian companies are equally exposed to
country risk, though some (such as the aircraft manufacturer, Embraer) derive most of their revenues
from developed markets. This laziness in assessing country risk does provide opportunities for
perceptive investors during crises. This was the case when Brazilian markets went into a tailspin in
2002, faced with the feat that Lula, then the socialist candidate, leading in the polls, would win election
to lead the country. As Embraer fell along with the rest of the Brazilian market, you could have bought
it at a "bargain basement" price. If you are interested in following this path, here is my suggestion.
Start putting together a list of companies like Embraer, i.e., emerging market companies that have a
significant global presence and then wait for a crisis in the emerging market in question. When there
is one (it is not a question of whether, but when....), and your "global" company drops with the rest of
the market, you are well positioned to take advantage.
It is trickier, though, playing this game within a sector. Consider the JP Morgan Chase case. While the
trading loss was clearly specific to JPM, you could argue that the event affected the values of all
banks at two levels. The first is by increasing the chance that the Volcker rule, barring proprietary

trading at banks, would be adopted, it affects future profitability at all banks. The second is the fear
that in response to the loss, the regulatory authorities would require higher capital ratios be
maintained at all banks. If those are your concerns, you should focus on banks that do not make have
a large proprietary trading presence and are well capitalized. If investors have over reacted across the
board, those banks should be trading at attractive prices.
3. Comeback Bet
When stock prices drop precipitously for an individual stock, there is usually a reason. If the drop
reflects long term, intractable problems, there may be no reversal. If the drop reflects temporary or
fixable problems, you are more likely to see prices reverse. As you look at the reasons for the price
drop, you should keep in mind your overriding objective, which is to find a company whose price has
dropped disproportionately, relative to its value.
Here are some possible reasons for a stock price collapse, with the ingredients for a comeback:
a. Unmet expectations: When expectations are set too high or at unrealistic levels, it is inevitable that
investors will be confronted with reality not matching up to expectations. When that happens, they will
abandon the stock, causing stock prices to drop. (Netflix and Green Mountain Coffee, both of which
make the list of biggest losers over the last year are good examples of what happens to high flyers
when they disappoint...)
Ingredients for a comeback: Expectations have dropped not just to realistic levels but below those
levels. Investors have over adjusted.
b. Corporate governance issues: Events that lay bare failures of managers and oversight by the board
of directors shake investor faith and, by extension, stock prices. A case in point would beChesapeake
Energy, where the CEO, Aubrey McLendon, stepped down after evidence surfaced that the board of
directors had allowed him to use $800 million in personal loans to acquire stakes in companyoperated oil wells.
Ingredients for a comeback: (a) A new CEO from outside the firm, (b) with a full cleaning out of
management team and revamping of board of directors, and (c) an activist investor presence.
c. Accounting fraud/ manipulation: As investors, we start with the presumption that financial
statements, while reflecting accounting judgments that may work in the company's favor, are for the
most part true. Any suggestion of accounting fraud can lead to a meltdown in the stock price, not to
mention open the company up to legal jeopardy.
Ingredients for a comeback: (a) Full reporting of all accounting misstatements, with (b) removal of top
management, and (c) no legal jeopardy.
d. Operating/Structural problems: Operating problems can range from problems with a key product
(see Dendreon, on the list of biggest losers last year) to deeper structural problems, where the
company's products just don't match up well to consumer demands or to the competition.
Ingredients for a comeback: (a) Management that is not in denial about operating problems and (b) a
realistic plan for dealing with operating problems.
e. Financial problems: When operating problems combine with significant debt burdens, you have the
seeds of distress, which can spiral very quickly out of control, as suppliers, employees and customers
react pushing the company deeper into trouble.
Ingredients for a comeback: (a) A clear debt restructuring/repayment plan, (b) Solid operating
performance.
Whatever the reason or reasons for a price collapse, investors have to follow up by asking and
answering three questions:
1. Is "it" a one-time or continuing problem? While the line between one-time and continuing can be a
shade of grey, the answer is critical. One time problems tend to have much smaller impact on value
than continuing problems, and are easier to deal with and move on.
2. How fixable is the problem? Some problems are more easily fixable than others. In making this
judgment, you should look at three factors. The first is whether the problem is entirely an internal
problem or whether it is partly or mostly due to outside or macro factors. Internal problems are easier
to remedy than external ones. The second is whether the solution can be "quick" or will take "time".
Thus, a firm with significant debt may be able to restructure that debt quickly, whereas a firm that has
deep-rooted structural problems will need more time. The third is whether the managers of the firm
seem to have both a reading of the problem and a solution in hand.
3. Is the market decline disproportionately large? To make this assessment, you have to work through
the consequences of the problem for the determinants of value: its effect on current cash flows, the
expected value of growth (both the level and the quality) and the risk in future cash flows.

10

Using this framework, let's look at JP Morgan Chase. At first sight, it looks like a slam dunk. The
trading loss was reported to be $2 billion at the first announcement and it seems like a fixable problem
in the short term, with better risk management in place. The fact that the market capitalization went
down by more than $30 billion on the announcement of the loss seems to suggest an over reaction,
but there is more to this story than meets the eye. The first is that the trading loss of $ 2 billion is an
estimate and the actual losses may be higher (the rumor mill suggests that they could exceed $5
billion). The second is that the loss will reduce the current regulatory capital and may increase the
target regulatory capital ratio that JP Morgan aspires to reach over time; the combination of a lower
current capital ratio and an increasing target capital ratio will translate into lower returns on equity,
going forwards, and lower cash flows available to stockholders in the future (in the form of dividends
or buybacks). To make a judgment on whether the stock is a bargain at the current price, I used a
simple test. The price to book ratio for a mature bank can be written as:
Price to book ratio = (ROE - Expected growth)/ (Cost of equity - Expected growth)
Conservatively, if you assume a growth rate of 1.5% in perpetuity and a cost of equity of 9% (about
1% higher than the cost of equity for an average risk company), the return on equity implied at the
JPM's current price to book ratio of 0.73 is about 7%:
0.73 = (ROE - 1.5%)/ (9%-1.5%)
Implied ROE = 6.98%
The ROE in the most recent year for JPM, prior to its loss, was 10.34%. Even allowing for higher
regulatory capital requirements (which will increase book equity) and lower profits (perhaps from the
Volcker rule), the adjustment seems like an over reaction. I know that there are other fears hanging
over large banks, but I have a spreadsheet that I think contains a a conservative valuation of JPM that
yields a value of about $46/share, well above the current stock price of $35. You can use it to make
your own judgments for JPM or any other bank.
4. "Long odds" option
There is one final scenario: a company whose stock price has collapsed, with good reason and where
a turnaround is neither anticipated nor expected. In other words, the stock looks fairly priced, given its
prospects and problems today. However, let's assume that the firm has proprietary assets is in a risky
business, where technology shifts could make today's winners into tomorrow's losers and vice versa.
You could consider investing in this company's shares, for the same reasons that you buy an out of
the money option.
In effect, you are leveraging the fact that equity in a publicly traded company has a floor of zero and
that your losses are therefore restricted to the prevailing market value of equity. For your option
(equity investment) to have a big payoff, though, you will need the value of the firm's assets to
increase significantly from existing levels (because of a new product, market shift or an eager
acquirer) and that will require that your firm have a proprietary technology/product/licenseand operate
in a shifting, risky business. While the value of the assets could drop just as precipitously, you care
less about downside because you don't have much to lose (since your equity value is so low).
Nokia (NOK) and Research in Motion (RIM) come to mind as potential option plays. They both have
proprietary technologies and patents (though the market does not think that either technology looks
like a potential winner in the market today) and operate in a risky business where the landscape can
shift dramatically over night. While the Blackberry technology is a more reliable cash provider for RIM,
there are three factors that tip me towards Nokia. The first is Nokia's stock price has dropped far more
than RIM's over a shorter period, reducing the cost of my option. The second is that Nokia's debt
burden is a mixed blessing: it could cut my option game short, if Nokia defaults, but it also leverages
any upside in value. Small changes in Nokia's asset value will translate into big changes in equity
value. The third is that the turmoil in the Euro zone adds to the value of my option. Put differently, I like
Nokia because it is riskier than RIM, but risk is my ally, not my enemy, with an option. If you plan to
invest in Nokia, do so with the full recognition that you may have to write off the entire investment a
few months or years from now, but if the stars align, watch out!!!

11