If you want to go through life like a one legged man in an ass-kicking contest, why be my guest. But if you want to succeed, like a strong man with two legs, you have to pick up these tricks, including doing economics while knowing psychology.
Charles T. Munger (Vice Chairman, Berkshire Hathaway)
Investing is simple, but not easy.
Warren Buffett (Chairman, Berkshire Hathaway)
INVESTING IS SIMPLE, NOT EASY
Investment results are relentlessly challenged by market noise, mob sentiment and the delusional behaviour of crowds. As William Bonner and Lila Rajiva (2007, 322) note in Mobs, Messiahs and Markets the investor “is rarely far from mass sentiments, and never far from calamity” with prices constantly in motion as market noise, which is generated “by commentators and economists, by the headlines, and by the financial industry itself”, lures the investor in one direction and then another.
However, if one is able to step away from the noise, then investment prospects improve markedly as decision making becomes investment based as opposed to sentiment or herd driven. Quoting Bonner and Rajiva (2007, 346) again:
Now imagine that there was no Financial Times, no Barron’s, no commentators, and no one writing books predicting the future [performance of markets]. You’d have to rely on your own eyes and ears, and your own wits. Investing would be a private matter. And [investment results] would be better for it.
Viewed on this canvas, the one way that the tough task of investment management can be made easier is through a disciplined application of investment rules. Inside the value investing camp, one of the earliest – and still most successful – examples of such a rule comes from Security Analysis, which Benjamin Graham and David Dodd wrote in 1934. From this origin, Graham argued that one of the best places to find value was on the balance sheet, exemplified by his net-net opportunities.
Specifically, Graham defined the net-net value of a company as: cash plus short-term investments plus 0.75 times accounts receivable plus 0.50 times inventory less total liabilities.
In other words, identifying value did not entail forecasting company prospects, something that Graham shunned. Rather, he held that by making conservative assumptions (such as writing down accounts receivable and inventory values to ensure a margin of safety) about known company data, one was able to establish, in a disciplined manner, the value of a company. Graham then looked for companies whose market value was less than two-thirds of the net-net value and, in so doing, identified attractive opportunities with wide margins of safety.
WHEN NET-NETS DISAPPEAR
Whilst Graham developed an enviable track record through the application of his net-net principle, the emergence of a vast body of copycat investors has meant that, today, net-nets are almost impossible to find compared to 1934. However, Paul D. Sonkin, a graduate of the business school at Columbia (where Benjamin Graham taught Warren Buffett about value investing), who runs the successful Hummingbird Value Fund, remains sympathetic with Graham’s view that the best place to locate value is on the balance sheet. However, to pursue Graham’s net-net principle in a more efficient world, Sonkin has refined the concept to detect companies that are cash rich and that trade at an attractive price, even if they do not meet the net-net standard.
To illustrate, Sonkin loves to spot situations like the following. Say a firm has a market capitalisation of R200 million with earnings of R10 million. Ordinarily this looks like a price-earnings ratio of 20 times, and in most cases the share is not considered a bargain – certainly not by a value investor. But if the company has net cash of R150 million (cash after all the debt has been subtracted) then the whole company can be bought for R50 million (R200 million less R150 million net cash). Thus, allowing for the interest earned on the R150 million, the real price-earnings ratio is closer to 5 times, and the company becomes a screaming buy.
The above argument gives us the basis for what Cannon Asset Managers terms the Sonkin Ratio in our investment process. The numerator in the ratio is the market value of the company’s equity plus the market value of the company’s debt minus the cash or cash equivalents on the balance sheet. The denominator is the company’s operating earnings (EBIT) less taxation.
Sonkin argues that the purpose of the metric is to expose what an investor would have to pay to own all the after-tax operating earnings of the company. Unlike more commonly used screens, such as the price-earnings ratio, this ratio differentiates among the assets and looks at operating earnings rather than net income, from which the price-earnings ratio is derived, which often can be misleading.
WHERE VALUE IS MOST LIKELY TO BE FOUND
Definitions aside, Sonkin argues that the metric is a useful tool for unearthing value situations that echo Graham’s criteria of reliance on observable balance sheet criteria and the existence of a margin of safety. Further to this, whilst market efficiency means that net-nets are exceptionally rare, attractively valued shares still can be unearthed using the ratio. That said, relative market efficiency implies that shares with the most attractive ratios are more likely to be found in the less researched – and so more inefficient – parts of the market, including the mid-, small- and micro-cap sectors. This is because that the number of analysts covering companies declines as market capitalisation falls. The smaller the number of analysts following a company, the more likely information or insights about the company will not have been incorporated in the share price.
For example, if 30 analysts follow Anglo American plc, the 31st analyst is not likely to add much to the store of information or understanding about the firm. But if only one analyst covers a company, a second one certainly has a chance of discovering something important. To boot, if the analyst does not publish the findings but uses them to make private investment decisions, then the value of that research and analysis should be found in the portfolio's performance.
SUCCESS IN PRACTICE
Indeed, Sonkin has used the metric to good effect in the case of his Hummingbird Value Fund and, in recent years, the investment team at Cannon Asset Managers has engaged the tool with great success to identify value shares among South African equities for the firm’s equity mandates, including the Cannon All Equities mandate and Cannon Equity Fund.
Given this backdrop, the balance of this note considers various aspects of the Sonkin Ratio in the case of companies listed on the Johannesburg Stock Exchange (JSE) at the end of 2007. Although the ratio has application across all market sectors, it is arguable that the tool is most effective in the case of industrial shares. Accordingly, the analysis is conducted with regard to 150 industrial counters that form part of our South African equity universe. The final share count is reduced to 139 counters as loss-making companies are ignored in the analysis.
At least three points stand out from an analysis of the descriptive statistics. First, it is interesting to note that the average of the trailing price-earnings ratio and Sonkin Ratio are materially different at 15.6 times and 18.1 times, respectively (see Table 1). This suggests that when net debt is catered for in the analysis, companies collectively are more expensive than indicated by the simple price-earnings multiple.
Second, the correlation coefficient between the two figures of 0.34 is relatively low suggesting that the series contain different information. Regressing the Sonkin Ratio on the trailing price-earnings ratio reveals that whilst the two data series are positively correlated, the explanatory power of the model is trivial. From this we can infer that the data series are independent, which means that the Sonkin Ratio carries unique information. In turn, this unique information can be used to seek value.
Third, as with the price-earnings ratio, a low Sonkin Ratio indicates a share is cheap relative to its peers. Of the 139 companies analysed, 99 shares have Sonkin Ratios that are lower than the average of 18.1 and 68 shares have ratios that are lower than the median of 13.8. In other words, in our search for value we have a fertile ground for investigation using a tool that has unique attributes.
VALUE IN DIFFERENT PLACES
From Sonkin’s argument, we know that there is a greater likelihood of finding cheap shares in the smaller-capitalisation parts of the market. Figure 1 shows the results produced by sorting the companies into quintiles by market capitalisation (with the first quintile representing the largest companies). Whilst the data presented in the figure hints that the Sonkin Ratio falls with company size – that is smaller companies, on average, are cheaper – the trend hiccups in the case of mid-sized companies. However, this result masks the fact that the number of cheap shares to be found in each quintile increases from 9 shares in Quintile One (or one in three counters) to 18 shares (two in three counters) in Quintile Four and Quintile Five. In short, the metric identifies that there are proportionally more cheap shares to be found amongst smaller companies than larger companies.
It is interesting to note that differences also arise across the industrial sector of the JSE. As shown in Figure 2, the greatest headcount of cheap shares is in the technology software sector (13 shares), followed by the services sector (10) and the food sector (nine). However, to adjust this reading to take into account the different number of shares in each sector, we calculate the percentage of shares in a sector that have attractive ratios. On this basis, in eight of 22 sectors every share in the sector has an attractive ratio. From Figure 2, the sectors with attractive populations include general industrials, packaging, automobiles and parts, all of the retailers and technology hardware.
As an aside, it is noteworthy that, in the current market climate, the out-of-favour retailers produce a full house, whilst the much-favoured construction sector scores just under 60 percent on a headcount basis.
Calculating the average Sonkin Ratio for each sector provides a further level of refinement in our search for value. On this basis, the general industrial and automobile and parts sectors have particularly attractive (low) ratios, whilst the retail and technology sectors stand next in line (see Figure 3).
IDENTIFYING SPECIFIC OPPORTUNITIES
Turning to share-specific considerations, Figure 4 shows the ratio for the share universe plotted on a logarithmic scale. As noted above, 99 counters have ratios below the average of 18.1 and 68 counters have ratios below the median of 13.1. We can now use screening criteria to help identify cheap shares in cheap sectors that are reasonably liquid and that have a reliable earnings history.
The screening criteria produce a portfolio of 15 shares, which are listed in Table 2.
The average Sonkin Ratio for this set is 9.2, which is about 35 percent lower than the market median of 13.8. The average trailing price-earnings ratio for the set is 10.1, which represents a 25 percent discount to the median price-earnings ratio of 13.7.
THE SONKIN SET
In the world of investing, the seductions of market noise and herd behaviour complicate investment decision making and contribute to the outcome that most investment managers fail to beat the market. However, with the right ingredients, success is attainable: as Groucho Marx jibed “behind every successful man is a woman”. In the same vein, behind every successful investor lies a set of clearly defined rules that, if applied with rigour and discipline, promote investment success.
The record of Benjamin Graham’s net-net principle is well known and, more recently, the Sonkin Ratio has presented itself as a clearly-guided rule that aids portfolio results. In this vein, Cannon Asset Managers has imported the Sonkin Ratio into the South African setting with great effect. As an illustration, the application of the ratio has contributed to the Cannon All Equities mandate, which covers a universe of more than 250 domestic counters, producing an average annual return over the past seven years of 30.5 percent against the market’s return of 23.7 percent.
Interestingly, this result has been achieved with 15 percent less volatility than the market, suggesting that the investment process embraces risk management through constructing margins of safety as much as it seeks return management.
The catch in achieving the above investment results, of course, is having the ability to apply clearly defined rules that ignore market noise and shun herd sentiment and, in so doing, seek under-researched or neglected companies which are cheap, but by implication also are often unpopular. This is not an easy practice to carry out – but then, as Benjamin Graham’s pupil, Warren Buffett notes, while investing is simple it is not easy.
Bonner, W. and Rajiva, L. (2007) Mobs, Messiahs and Markets: Surviving the Public Spectacle in Finance and Politics. Wiley: Hoboken, New Jersey.
Bruce C.N. Greenwald, Judd Kahn, Paul D. Sonkin and Michael Van Biema (2001) Value Investing: From Graham to Buffett and Beyond. Wiley: Hoboken, New Jersey.