Editor’s note: This article was first published in April 2014; its outlook reflects that time, including the Fed’s tapering, indices at highs, weak short-term fixed income, the banking crisis of the day and Spain’s 2014 change to regulated electricity pricing. VIX futures, options strategies and alternative funds are complex products that can lose money quickly. This 2014 guest article is not investment advice.
As Ortega y Gasset put it, each of us is ourselves and our circumstances. That applies to every person on this planet, and it also applies to the companies that make up the economy’s industrial fabric. What we are referring to here is how multiples are chosen and used when analysing a company.
They say that if enough people follow a pattern, that pattern becomes the norm, and the problem is often working out whether we are really relying on a criterion or whether we ourselves are creating it. I could mention technical analysis as an example, where a head-and-shoulders pattern is a forecast that the market will do one thing or another. When securities are closely followed by technical analysts (such as the S&P 500), in the end everyone follows the same trail and the forecast comes true in quite a high percentage of cases. We won’t attempt to explain flags, pennants, head-and-shoulders, hanging men or hammers here.
We are going to focus on the ratios most commonly used for companies in each sector, because you often see company analyses that treat the P/E ratio as the master key to fundamental stock selection and, in our view, most of the time this amounts to comparing apples and oranges. The ratio is fine for analysing a share’s price and seeing whether it is more or less cheap, but it doesn’t come close to showing the whole picture when it comes to analysing companies.
Let’s start by making it clear that each sector has its own needs and its own way of operating. A bank doesn’t work the same way as a supermarket, so for obvious reasons it wouldn’t be right to use the same ratio for both sectors.
It’s worth pointing out that almost all multiples can be applied to most companies, but we prefer to be precise and set out the reasons for using a given multiple or not. We will also mention some factors to bear in mind for each sector in order to better understand a company’s position.
Banking is a special case. The main thing to know is that EBITDA multiples are never used to analyse banks, because paying interest is part of a bank’s intermediation business. More specific ratios are used for this sector, such as loan-to-value, which is the percentage of the property’s total value that the bank lends. It can therefore be seen as the bank’s capacity to lower the price of the home in the event of repossession without taking a loss. The lower the ratio, the less risk the bank bears. The efficiency ratio is also important: it is calculated by looking at how much of income is consumed by expenses, and in times of crisis a low ratio would allow the bank’s income to fall without it making losses.
Given the current crisis, we want to highlight the solvency ratio, a key figure for understanding a bank’s capacity to cover possible variations in expected losses. On top of everything mentioned above, one of the most widely used ratios for this type of company is price to book value, which relates the company’s price to its book value.
See also: Technical patterns: the minimum technical analysis every investor should know
For telephone and internet companies, the most common approach is to use the EV/subscriber ratio, which relates the company’s value to its number of subscribers, since the company’s value will depend on how many subscribers it has. To gauge its position relative to the competition, you should take into account, among other things, the number of lines in service per employee and the degree of liberalisation of the sector in the markets where it operates.
One sector that has recently been in the spotlight because of the new billing rules is electricity. For these companies, which have a relatively stable profile and seasonal but predictable cash flow, we should analyse the price-to-cash-flow ratio, which relates the company’s value to its cash flow. Gas companies can be considered to have the same profile. We can also use this ratio for companies with predictable, non-seasonal cash flows, such as tobacco companies or water utilities.
See also: Technical patterns, part 2
In emerging markets, a company’s ability to pay a regular dividend, and so guarantee an income, doesn’t carry as much weight as its capacity to grow. When growth is a factor to consider and growth rates differ even within the same sector, the PEG ratio is used, which takes the P/E ratio and puts the growth rate in the denominator, giving price relative to earnings growth. It’s a very useful way of finding relatively cheap companies in this kind of sector, even when each company operates in a different country.
If we turn to analysing companies with heavy depreciation and amortisation charges, such as infrastructure companies, the most advisable approach is to compare enterprise value with EBITDA, in other words EV/EBITDA, because we need to relate the company’s value to a profit figure that sits very high up in the accounts, before those depreciation and amortisation charges are deducted.
Given the current market situation, it isn’t easy to find “cheap” companies, so the recommendation would be to invest in companies with low debt and a healthy return. We know it’s far from easy to find companies like that at reasonable prices. That’s why, the way things stand, the ideal would be to diversify the portfolio, not only by geography or sector but also through different strategies in the search for alpha across the various situations our investments will face this year, 2014. Fixed income doesn’t look like a viable option in the short term, which may be one of the reasons why the major stock market indices have been trading at highs recently. With no options in that kind of asset, we can consider holding part of the portfolio long volatility, whether through VIX futures, options strategies or, most commonly for investors, through funds that run these strategies for us. Alternative investment funds can be a good source of alpha when markets become more volatile.
Be that as it may, at Aspain 11 Asesores Financieros EAFI we remain alert to a possible change in trend, but in the medium term the trend looks bullish. There’s no doubt that in the stock market you never know, and the Fed’s tapering will have a great deal to say about how our investments fare. We hope the withdrawal remains gradual and that, once those millions have been taken out of the market, a strong real economy, rising corporate profits, falling unemployment and a future rise in interest rates will be proof that things are getting better, and that markets will keep growing and breaking through resistance levels.
See also: The 5 principles of value investing
Featured image: Stsmith, CC BY-SA 4.0, via Wikimedia Commons.
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