Geoff Gannon September 2, 2015

Should We Care Why the Stocks We Buy are Cheap?

One of my favorite blogs, Value and Opportunity, recently did a post about how the best value stocks are often those that are not cheap by the most obvious numbers (P/E, P/B, etc.).

The post is entitled “Value Investing Strategy: Cheap for a Reason”. The basic argument of the post is that:

“…Especially in a market environment like now, cheap stocks are cheap for a reason. It is very unlikely that ‘you’ are the first and only one who knows how to run a screener and by chance you are the only one who can buy this great company at 3 times earnings which will quadruple within 6 months…The most important thing is to be really aware what the real problem is. If you don’t find the problem, then the chance is very high that you are missing something.”

This is not at all how I look at stocks.

I usually don’t know why a stock I’m buying is cheap. And I’m not sure I spend much time trying to figure out why someone else would or would not like the stock. I tend to just focus on whether I like the business and how much I’d “appraise” that business for.

I can sometimes come up with possible reasons for why a stock I like is cheap. But, I’m never sure those are the real reasons other people aren’t willing to buy the stock.

I don’t think Quan sees himself – and I know I don’t see myself – as a contrarian investor.

So, I assumed looking to see if a stock was “cheap for a reason” is something I simply don’t do.

At least that’s what I thought before looking through the textual record of what I actually said about each stock I picked.

In my last post, I mentioned 6 stocks that Quan and I picked for Singular Diligence which are now trading at a discount of 34% or greater to our original appraisal value. So, these are the 6 cheapest stocks we know of in intrinsic value – rather than traditional value metric – terms.

I decided to go through the record and check for two things.

One, how cheap are these stocks on the traditional value metrics. I will use Morningstar’s measures of P/E, P/B, and Dividend Yield for this.

Two, what reason did I give (in the issue where I picked the stock) for why that stock might be cheap.

Here are the 6 stocks.


Hunter Douglas

Discount to Appraisal Value: 58%


Forward P/E: 9.6x

P/B: 1.4x

Dividend Yield: 3.6%


Why I Said it Might Be Cheap:

“Hunter Douglas is an obscure stock. The Hunter Douglas brand is American. So, the company’s name is American. However, the stock trades in Europe. The company reports its results in U.S. dollars. But, the stock trades in Euros. The stock is 81% owned by the Sonnenberg family.”

(Note: Quan and I appraised this company – which sells shades and blinds mostly into the U.S. and European housing markets – based on its normal cyclical earnings, which we believe to be much higher than the very depressed earnings Hunter Douglas reported from 2009-2014. That could be given as a reason for why the stock is cheap. However, U.S. traded stocks tied to housing are generally priced much more in line with the idea we are at a cyclically depressed point for their earnings. Hunter Douglas isn’t.)



Discount to Appraisal Value: 55%


Forward P/E: 12.0x

P/B: 1.4x

Dividend Yield: 3.4%


Why I Said it Might Be Cheap:

“Frost has created a lot of intrinsic value since the 2008 financial panic. The stock market has not realized this because Frost has made very little on its loans and securities due to the Fed Funds Rate being near zero. In 2008, Frost had $10.5 billion in deposits. Today, Frost has $24 billion in deposits. Frost’s value comes entirely from its non-interest and very low interest bearing deposits. So, the intrinsic value of Frost as a buy and hold forever stock more than doubled from 2008 to today. The stock did not double, because reported EPS barely budged due to the yield on loans and securities being the lowest in history. When the Fed Funds Rate eventually increases from about 0% to 3% or higher – as all members of the Fed expect it will by about 2018 – Frost’s reported earnings will double. When Frost’s reported EPS doubles, its stock price will double. At that time – when the Fed Funds Rate has been 3% or higher for a year or more – investors will think Frost has become twice as valuable. That is false. Frost more than doubled its intrinsic value from 2008 to 2015, when it more than doubled its free and almost free deposits. A Fed Funds Rate near zero disguised this fact for about 7 years. Frost’s value was hidden for the last 7 years. But, Frost’s value will be obvious over the next 7 years. Frost is the clearest and best investment idea we have had since starting Singular Diligence in 2013. That fact is not obvious as I write this in 2015 with a Fed Funds rate near zero. It will be obvious in hindsight (in say 2019) with a Fed Funds rate near 3%.”



Discount to Appraisal Value: 47%


Forward P/E: 9.4x

P/B: 1.3x

Dividend Yield: 0%


Why I Said it Might Be Cheap:

“Over the last 15 years, Car-Mart’s stock has returned 16% a year versus the S&P 500’s 4% a year return. It sounds strange to propose a stock is cheap when it is at ‘normal’ levels for a typical stock and within the range of multiples it has traded for in the past. However, Car-Mart’s past returns are very high compared to most stocks. In other words, the ‘normal’ historical range of multiples that Car-Mart traded at was simply too low… In the past, the company’s enterprise value has ranged from 0.8 times retail sales to 1.5 times retail sales. This constant undervaluation is what has caused the stock to outperform the S&P 500 by more than 10 percentage points per year since it went public.“


Tandy Leather

Discount to Appraisal Value: 47%


Forward P/E: 8.9x

P/B: 1.5x

Dividend Yield: 0%


Why I Said it Might Be Cheap:

I couldn’t find any quote from our issue on Tandy explaining what might cause the stock to be undervalued. I can come up with an argument now – but I don’t find it very convincing.

Here’s the argument. Tandy is an illiquid stock. It trades less than $100,000 worth of shares on a normal trading day. As the only publicly traded leathercrafting retailer it has literally zero peers. Only one analyst covers the stock. Most investors simply haven’t heard of Tandy Leather.

I find that argument unconvincing because this is a U.S. stock. Tandy trades on the NASDAQ. It shows up on all screens that you’d run in the U.S. Institutional ownership accounts for about two-thirds of the shareholder base. That means institutions hold over $50 million of Tandy stock. It’s a visible stock. People aren’t oblivious to its existence.


Swatch (*Valuation metrics are from Stockopedia for this one)

Discount to Appraisal Value: 39%


P/E: 14.8 x

P/B: 1.9x

Dividend Yield: 2.1%


Why I Said it Might Be Cheap:

“The greatest risk of misjudging Swatch is not seeing a prolonged recession or depression coming in China. China is still much, much poorer than many of the markets it trades with. There is a lot of room for GDP per capita to grow over time. That means there is a lot of room for real wages to grow over time. However, China has several features that could be warning signs for a Japan like ‘lost decade’. It is not the point of this issue to speculate on that possibility. But it is rarely talked about by investors. And it is a potential problem. At no point in the last 35 years has Chinese economic growth been poor enough to qualify as anything like a recession. So, the biggest risk of misjudgment is assuming that the trend of the last few decades will always be normal. 

Chinese GDP growth has been in the range of 7% to 8% lately. Chinese population growth is only 0.5%. This means that GDP per capita is growing – even now – at 6.5% a year or faster. About 45% of Chinese GDP is investment in fixed capital. Meanwhile, about 15% of U.S. GDP is investment in fixed capital. This makes the risk of an overhang of long-lived assets much higher in China. There is a very high rate of growth in fixed capital per person. This is because Chinese GDP is very fast growing, almost half of Chinese GDP is investment spending, and Chinese population growth is low. As a result, China would be much less able to absorb a glut of long-lived assets. If the country builds too many apartment complexes, factories, airports, power plants, etc. they run the risk of having them be vacant or idle. Industries like construction are important in China. These are long cycle industries. They are susceptible to periods of overbuilding and then periods where they must be idle to absorb the overexpansion of previous years. China has been rapidly expanding since the late 1970s. So, there is always a risk of the sorts of problems Japan had…Quan and I have no predictions about the future growth of China. But it’s important to point out the impact a stagnant Chinese economy would have on Swatch. In the future – Swatch will likely get both the majority of its profits and the majority of its growth from Chinese consumers. If China’s economy has the kind of experience Japan’s did over the last 25 years – Chinese consumers will not increase their watch buying. Swatch’s growth will decline by at least half. If China is stagnant – Swatch may be stagnant.”


Ekornes (*Valuation metrics are from Stockopedia for this one)

Discount to Appraisal Value: 38%


P/E: 12.0x

P/B: 2.6x

Dividend Yield: 6.1%


Why I Said it Might Be Cheap:

“Ekornes is clearly cheap. There are two possible reasons for this. One, the Ekornes name is unknown worldwide because the company’s main brand – Stressless – is different from the name under which the company is listed. Two, Ekornes trades on the Oslo Stock Exchange. Norway is a tiny country of just 6 million people. Very few investors outside Norway buy shares of Norwegian companies in Oslo. For example, half of Ekornes’s shares are held by Norwegians. Only 50% of Ekornes’s shares are in foreign hands. If Ekornes listed in Frankfurt, London, or New York – it would probably get more attention from investors outside Norway. The share price might be higher…The biggest reason why a foreign investor might avoid Ekornes is concern that the stock – which is bought and sold in Krone – will fluctuate in the investor’s home currency along with the exchange rate between that home currency and the Krone. So, for example, an American investor might feel certain that Ekornes’s share price of 100 Norwegian Krone will one day expand beyond 125 Norwegian Krone, but that investor fears a 25% drop in the Krone versus the Dollar – like the drop from 17 cents to 13 cents in the past year – would more than wipe out his gain. This is a valid short‐term concern. Ekornes’s share price in dollars will fluctuate even when the price in Oslo stays the same in Krone. However, this is not a valid long‐term concern. In the long‐run, a stock’s intrinsic value will follow its earning power. Ekornes’s earning power comes from the gap between its sales – made in Euros, Dollars, Pounds, Yen, etc. – and its costs. Ekornes gets 94% of its sales in currencies other than the Krone. Only the company’s labor cost is tied to the Krone. So, it is misleading to think of Ekornes’s intrinsic value as being a primarily Krone based figure.”

We can make a few statements from the above list. One, I usually do give some reason for why a stock might be cheap. I’ve never thought of this as being an important part of my own process when it comes to picking stocks. But, apparently giving a reason “why a stock might be cheap” was important enough for me to include when writing to subscribers in 5 out of 6 cases.

Two, the stocks that look cheapest to us also look cheap based on traditional value metrics. Stockopedia tells me that the median forward P/E of all stocks in the U.S. and Europe is 15.2x.  The forward P/Es of the 6 stocks Quan and I think are cheapest ranged from 8.9x to 14.8x.

There is one other test we can run on the 6 stocks Quan and I think are cheapest. Here is a paragraph from near the end of the Value and Opportunity post:

Actually, I strongly prefer “forgotten” sectors compared to those which just have recently started to decline. Yes, everyone is looking at oil companies these days as they have declined a lot in the last months and look cheap. But I actually find better value in banks or financial companies.”

Look at the 6 stocks that are cheapest based on today’s price as a percentage of our original appraisal value for them. Two of the stocks – Frost and Car-Mart – are U.S. financial companies. And two of the stocks – Ekornes and Hunter Douglas – are furnishings stocks.

Finally, we can take a “top down” look as Value and Opportunity suggests. European stocks are cheaper than U.S. stocks. Most of the stocks we pick for Singular Diligence are U.S. stocks. But, 3 out of 6 of the stocks we think are cheapest trade in Europe. Ekornes is listed in Norway. Hunter Douglas (although more an American company than anything else) is listed in the Netherlands. And Swatch is listed in Switzerland.

In the case of Hunter Douglas, I have to admit I do think the stock would trade at a higher P/E ratio if it were listed in New York instead of Amsterdam.

So, although we consider ourselves bottom up stock pickers – there is a top down pattern at work here. European stocks are cheaper than U.S. stocks. Stocks tied to U.S. housing activity are cheap. And stocks tied to U.S. interest rates – that is, stocks that do better when rates are higher and credit tighter – are cheaper.

If you just take the stocks that trade at a 34% or greater discount to our appraisal value – they’re not very diversified at all. Half of that group is European. One third is furnishings. And one third is U.S. financials.

This means that one continent (Europe) and two industries (furniture and finance) explain most of the cheapness in the group.

The one exception is Tandy. There is no top down explanation for Tandy’s cheapness that I can see. And I don’t really have any explanation for why the market values the business so much lower than I do.

There is something else to consider. A top down explanation for why these 6 stocks are cheap may not be the only explanation. True, Hunter Douglas and Swatch are both European. But, they’re also both family controlled. Neither family has any interest in hyping their stock. And neither family is likely to sell at any price.

Which explanation is the right explanation?

Why is Hunter Douglas cheap?

Is it because the Sonnenberg family controls so much of the stock and doesn’t care about getting Wall Street’s attention? Is it because it’s a European stock instead of a U.S. stock? Or, is it because Hunter Douglas’s earnings are tied to U.S. housing and investors are pricing the stock off cyclically low earnings as if they were cyclically normal earnings?

I don’t know.

There are patterns in the “cheap” stocks we find.

They do seem to come from cheap parts of the world and to be in cheap sectors.

Now, I want to balance the numerical evidence with some purely anecdotal evidence.

I’ve never tallied up the emails. But, I get a pretty good number of them from people telling me they liked a stock I wrote about quite a bit – but they never actually bought it.

When subscribers tell me why they liked a stock a lot but never bought it – they often give one of 5 reasons:

  1. It’s illiquid
  2. The broker they currently use won’t buy it for them
  3. It trades in a currency different from their own
  4. It’s boring
  5. There’s no catalyst – they plan to wait and maybe buy it later

I have no data supporting these 5 possible explanations for “why a stock is cheap”. I think top down explanations for cheapness are often right. There are simply countries and sectors that are out of favor. But, I also think these 5 explanations may be right too. Stocks that are illiquid, boring, and lack a catalyst may always be cheaper than they deserve to be.

If that’s true – simply learning to love illiquidity, boredom, and a lack of headlines in your portfolio might be enough to improve your returns.

My own opinion is that if we are told a stock is “cheap” to start with, we’ll always find a reason why it should be cheap. We don’t value stocks blind. As value investors, we often know the P/E, P/B, the dividend yield – and maybe even the EV/EBITDA – of a stock before we’ve even read the company’s annual report. We come in expecting to find warts and so we find warts. We then tell ourselves that the cheapness of the stock must be due to these warts.

Once you’ve seen a cheap stock price – you can’t undue that kind of bias. Your mind has been tainted with the market’s view of the stock before you even read the business description.

It’s strange but true: in investing, you know other people’s views before you know your own.

The best situation would be to have no knowledge of a stock’s price when you estimate its value.

The next best situation would be to do our best to forget whatever prices we’ve seen and focus instead on calculating a truly independent appraisal of the stock’s value.