Valuation: TeliaSonera

Another day, another Q3 report, it's that time of year! Today it was the turn of the telecommunications giant and large cap stock TeliaSonera. It has been well received by the market, with the share price up 3.8% for the day.

That's a big move for this company that doesn't usually move so much. That makes it boring and potentially interesting although it is a very widely held stock by Swedish private investors. This for me is a small warning flag and probably an outcome of searching for stable yield in this low interest rate environment.

It was a slightly odd report in that both sales and net income were down for the first 9 months of this year compared with 2012. Not only that organic growth is flat. However, the report was better than expected hence the stocks rise.

Perhaps that is good news. Expectations are low for this company, so there is room for surprise on upside. Anyway lets take a look at some numbers to understand what we would get for our money when investing in Telia.

P/E 10.8, P/B 2.1 and dividend yield 5.75%. Nothing untoward here, pretty much standard for such a company. 'Owner earnings' (as described in my SKF post) comes to 24459 msek, that's a lot of money. That gives a 'cash yield' of 10% (dividing by market cap) which is good, but how confident can we be with future earnings?

I plumped for a mediocre growth rate of 2% the coming years and discounted the potential cash flows at 9%. This gave a value of 64kr with a 25% margin of safety and 43kr with a 50% margin; with a current share price of 51.5kr this looks favourable. 

The question still remains if there is a future catalyst for Telia and whether it can acheive the longterm profitability desired. If they can turn around, then I'm certain there is a lot of upside potential in this stock.

 

Valuation: SKF

Yesterday the first of the large cap big guns, SKF, released its Q3 report. The company is a leading global supplier of products, solutions and services within rolling bearings, seals, mechatronics, services and lubrication systems. Because of its global sales and business to various industries it is also seen as a bell weather for the Swedish and global economy.

The report failed to meet expectations causing the share price to drop around 7% from 184kr. It has recovered slightly with the latest US budget news and lies now at 173kr. Expectations were probably too high with the share price up 20% this year before the report came out.

Disappointing quarterly reports can provide buying opportunities, yet the question we must ask is whether a cheaper price also means good or better value. I will attempt to answer his question buy going through some numbers.

Firstly with a P/E 19.7, P/B 3.5 and ROE 18.2% it certainly isn't a classic 'value stock' and is priced for growth. How much growth and at what price is the next question. To answer this I have calculated an 'owner earnings' for the past 5 years. These earnings can be viewed as the cash generated by the company which could be returned shareholders, sometimes also referred to as a 'potential dividend'.

As it is SKF pays an reasonable dividend of 3.2%, which is 62% of earnings, the rest is kept by the company. We can try to put a value on the company by determining a current value of these potential future cash flows.

Anyway, 'owner earnings' are calculated as follows 

Owner earnings = Net income + Depreciation & Amoritisation - Capital Expenditures

As SKF is an industrial related company, I took an average of the past 5 years to capture the recession of 2009 and get a cyclically adjusted cash flow of 3896 msek. At this point I extrapolated the growth of this cash flow 20 years into the future, a lot of assumptions of course built in there!

I was fairly generous (I believe so anyway!) and gave SKF an earnings growth of 7% for the next 5 years, then 5 % up to the final 5 years which was then reduced a modest 3%. Each of these projected yearly owner earnings were then discounted at 9% to a present value.

The sum of these cash flows were added to the book value of equity and divided by the number of shares to give a value per share of 174.8kr. Pretty much the current market price!

Admittedly I probably have been anchored by the market price and adjusted the inputs accordingly. However, we now have an understanding of what expectations are required to get a share price of 174kr. If you think they are fair or even overly cautious then SKF could be a buy at these levels.

Ideally a margin of safety should be included in the valuation, such as 25%, to cover for inevitable mistakes and give us room for error. Such a margin would suggest a buy price of 131kr.

They say patience is a virtue, especially for value investors, but with the current market strength and continuing bullish sentiment I will not be holding my breathe whilst waiting for another 25% decrease in SKF's share price! The hunt continues.

Daily Bitesize: There's more than one way to skin a cat

As the saying goes "There's more than one way to skin a cat", meaning there are always several ways of achieving a task and in the end you get the same outcome, a skinned cat!

Well the same seems to be true of buy-and-hold asset allocation. Meb Faber has taken several well known and mainstream portfolios, such as the classic 60/40 equity/bond asset allocation, and compared their performances from the early 70's here and here.

The outcome is quite surprising, to me anyway, as the returns are all very similar! It doesn't really seem to matter if you pick a portfolio that is fairly simple (e.g. 33% each of US equities, bonds and real estate) or somthing more complex like the El-Erian Portfolio (containing TIPS, commodities, special situations, private equity etc).

The message is clear, diversification works but don't over complicate it or pay too much.

How to beat the pros

Let's start by taking your favourite sport, it could be football, basketball or hockey. Imagine you could turn up to play right now in any competition and you would be instantly average in your ability and performance. Not only that, you would outperform most of your peers. No training or practice would be required just a willingness to turn up and play!

Each season there would be better players than yourself but as long as you played you would put in an average performance.. To your amusement over the years these stars would come and go but you would still be there year after year outplaying the vast majority of your competitors. Your longterm performance would be one of the best in the sport.

The odd thing is whenever you get bored and try to 'improve' your game to increase your performance you would actually become worse! You would make too many mistakes. Your skill is actually the discipline to accept you don't have that much talent and that your average ability will be highly rewarded over the longterm.

This very strange and unusual situation exists in the world of investing. By simply investing in passive index funds you can guarantee yourself an average performance and beat most active fund managers, see here and here for some examples of data.

At this point I have tried to find links to the counter arguement that active management is superior to investing in index funds. The best I could do is this. Any articles/papers/suggestions welcome!

This is not to say investing in a portfolio of index funds to capture the market return is easy. It's not. Avoiding behavioral mistakes will be your biggest challenge, especially in bear markets when you see the value of you investments going down the drain. Pulling your money out at the bottom of the market and waiting until later when it feels safe again will ruin your returns as you will miss a significant part of the recovery.

Because of the strong arguments in favour of passive investing a significant part of my investments are in broad portfolios of cheap index funds. I make some exceptions though when certain indexes are not available as funds in the Swedish market e.g. small cap and value stocks. In such cases I select the cheapest 'active' alternative.

What is interesting is that there are a multitude of  strategies that have been shown to beat stock indices (e.g there is a whole book on this 'What works on wall street') as they are fundamentally flawed in that they are market cap weighted. In fact any strategy in composing an index, including random, beats market cap weighting! link

One can make use of value, such as CAPE, P/E or P/B, size i.e, small cap or momentum to beat an index. Some approaches use even a combination, such as value and momentum e.g. here. I also invest in these type of 'active' strategies.

So why do fund managers fail to beat their benchmark indices. One explanation is that any over performance gets eaten up in fees. Another may be also that any strategy will have inevitable periods of underperformance during which the manager gets moved on or the fund is closed down.

Individual investors can exploit these disadvantages, yet still have their own psychology to contend with when underperforming the market for perhaps many years. Just take a look for example at value investing during the late 90's, which then rebounded link.

Valuation: NAXS Nordic Access Buyout Fund

Firstly thanks to @financeamir on Twitter for bringing this stock to my attention.

NAX is an interesting and unusual company that is traded on the Norden Small Cap index. It allows investors access into the Nordic buyout market via funds that are normally over subscribed and 'closed' to a broad set of investors.

Since the IPO in 2007 they have steadily increased the % of equity invested in private equity funds from 7 to 86%, with the rest being in cash. The rolling 12-months earning per share is 2.83kr with NAV (July 2013) of 40,53kr per share.

The shares price is up 22% the past 12 months but has been in a trading range since around July and currently lies at 38kr, P/E 13.4 and discount to NAV 6%.

If we want to get an idea of what a reasonable price is for this stock we need to get a sense of its value. Putting a value on the underlying assets could be a tricky business especially as we don't know all the companies held plus they are not publically traded.

A simpler way, which of course introduces caveats and assumptions, is to simplfy the company down to a dividend payer and just value those cash streams. The last dividend for this year was 0.4kr with an intention to payout 0.5kr In 2014.

That's a paltry yield of 1.31%, however the long term plan is to increase the payout to shareholders to between 50-75% of earnings (currently 17.6%).

Let's assume its earnings grow at a steady 5% every year whilst the dividends paid out increase every year from the current ratio to 70% in 6 years time. The dividends received are shown below.

YEAR  Dividend

2014      0.5

2015      0.9

2016     1.25

2017     1.64

2018     2.06

2019     2.53

In 2019 we will then value the stock as if it will increase its dividend at 5% for perpetuity as earning rise at the same rate giving a terminal value. We can then discount these future cash flows and the future value of the dividend paying stock to a present value using a discount rate of 10% (many ways of calculating this but I've gone for a nice round number).

YEAR  Present value

2014      0.46

2015      0.74

2016      0.94

2017     1.11

2018     1.28

2019     1.43. Terminal present value 18.5kr

Doing the maths we get a total value per share of 24.5sek, 35.5% below the current share price. Clearly the market values this stock differently but gives us an idea of what the dividend side of the business could be worth under this scebario.

What this type of valuation misses is the 'potential dividend' of the company as it only will pay out 50-75% of it's earnings. This means there will be cash left over which can be further invested, which in turn will increase value through additional earnings and higher dividends.

Perhaps that will be a topic for a future blog entry!