Monday, November 29, 2010

Price, The Conscious Investor

John Price, author of The Conscious Investor: Profiting from the Timeless Value Approach (Wiley, 2011), began his career as a research mathematician and for thirty-five years taught math, physics, and finance at universities around the world. He then morphed into an entrepreneur, developing stock screening software that emulates Warren Buffett’s investing strategies. And, as is evident from this book, he didn’t neglect his writing skills. He proceeds with the analytical precision of a mathematician but with the facility and clarity of a careful wordsmith.

Price describes over twenty methods of valuation. He explains the circumstances in which each method is most appropriate. He also evaluates each method’s strengths and weaknesses.

Here I am going to confine myself to describing the screen that underlies Price’s own investing system. He focuses on earnings forecasts, offering objective methods in place of the strategies of analysts, which are tainted with behavioral biases. Critically, he screens to find companies that are actually amenable to growth forecasts. They share three characteristics. “The first two, stable growth in earnings and stable return on equity, are based on histories of financial data taken from the financial statements. The third one, strong economic moat, is based on the ability of the company to protect itself from competitors.” (p. 292) Since many readers will be familiar with Warren Buffett’s notion of moats, I will discuss only the first two characteristics and how to measure them.

Price developed a proprietary function called STAEGR which “measures the stability or consistency of the growth of historical earnings per share from year to year, expressed as a percentage in the range of 0 to 100 percent. … STAEGR of 100 percent signifies complete stability, meaning that the data is changing by exactly the same percentage each year. The function has the feature of adjusting for data that could overly distort the result, such as one-off extreme data points, negative data, and data near zero. It also puts more emphasis on recent data.” This function is “independent of the actual growth. This means that whether a company has high or low stability of earnings is independent of whether the earnings are growing or contracting. In this way the two measures, stability and growth, complement each other in describing qualities of historical earnings.” (p. 294)

In measuring the stability of return on equity, Price assumes the clean surplus relationship which, on a per-share basis, states that the initial book value + dividends per share + earnings per share = the resulting book value. Under that assumption, “whenever return on equity is constant, … the growth rate of earnings each year is approximately equal to return on equity times the dividend retention rate. … [I]f a company pays no dividends, the growth rate of earnings and return on equity will match very closely.” (p. 297) Price does not contend that return on equity implies information about the growth of earnings since return on equity is defined in terms of earnings. Rather, he suggests that stability in return on equity and the payout ratio enable the analyst to estimate stability in the growth in earnings.

Once he screens for stability functions he then calculates margins of safety for forecasts of earnings, P/E ratios, and dividend payout ratios. I have no space here to describe his techniques. Suffice it to say that he has developed methods by which to “decrease the size and frequency of negative earnings surprises in a consistent manner for large databases of companies.” (p. 318)

The Conscious Investor serves two important functions. First, it critically assesses a range of valuation methods. Second, it is an accessible case study in the application of quantitative methods to fundamental analysis. Perhaps I should add a third: it seems that Price’s techniques are actually profitable in the real world. Using the conscious investor system, to which he sells subscriptions for a fairly hefty fee, he booked audited returns of 19.45% per year over the course of five years versus the 2.82% actual return of the S&P 500 index.

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