In the 30 August edition of finweek, I wrote about utilising a momentum strategy and how to maximise the exit price.
Typically, momentum is more a trading strategy, but it can sit well within a portfolio as a different style.
In this edition, I want to look at profiting from a value investment strategy.
Value is what most investors want when buying (with the exception of momentum traders), but what differs is how we define value.
Different investors will define it differently. Investor and economist Benjamin Graham’s approach to value investing is seen as classic value investing – and he was considered the father of value investing.
What I will be focusing on here, is how value investing works in terms of generating profit, and when to exit.
The first trick is to find a stock that meets the criteria of value.
I could also add quality, and here I focus on my second-tier portfolio, consisting of quality small and mid-cap stocks that I hold for as long as value exists.
This can often be for years, and sometimes a decade or more.
I’m going to use Santova* as my example. When I first found the stock, it was trading at around 90c per share, with headline earnings per share (HEPS) at 18c from the previous year.
This meant a price-to-earnings ratio (P/E) of some 5 times (a very simple value metric).
I liked the company and was happy that it was a quality operation, with quality management, and was operating in a sector with great growth potential.
These three requirements are important, as you need price and profit drivers.
After doing some digging I decided a fair value P/E for Santova would be closer to 13 times and a wild value would be around 20 times.
The fair P/E is what the sector is generally trading at in normal conditions, while the wild P/E is what it can arrive at when markets are booming, and overall valuations become stretched.
Now neither of these P/E figures are hard science, rather they provide a general idea – taking both local and international peers into account.
When looking at international stocks, be cautious as South Africa is a different market, and international stocks generally have higher valuations – but they do help with providing a ballpark figure.
So then using pure maths, if the stock could get to a P/E of 20 times on a HEPS of 18c, it would be on a price of some 360c per share.
But that depends on how long it takes to get to that P/E and on what happens to earnings on the way there.
That then feeds into the next part, where I ask myself if I feel HEPS can double in three to five years.
That’s annualised growth of 15% to 25% to ensure the doubling in that time frame. This part is important because now there are two levers working on the price – low P/E (value) moving higher and underlying HEPS improving – both feeding into a higher share price.
In the case of Santova I was happy it could double earnings in the time, with a doubling of HEPS to 36c and a P/E of 13 times, giving me a share price of 468c.
I watch the HEPS carefully because if it is not growing fast enough, I will exit and look to find the next stock.
More recently, Santova grew HEPS to 44c in the latest results, and at the current share price of 403c, it is on a P/E of just over 9 times.
So, I continue to hold (and have added some more) as I feel it can again double HEPS in the next three to five years and at least get to a P/E of 13 – which makes for a share price of 1 144c.
And if it can reach a P/E of 20, then that means an even better price of 1 760c.
My exit would be on HEPS growth weakening, or a P/E of some 20 times. Until then, as long as Santova meets my quality criteria, I continue to hold and adjust my expectations.
*The writer owns shares in Santova.