A reader has recently asked two very interesting questions after reading the post on Volkswagen’s potentially criminal behavior and subsequent 40% share price decline:
- Do you think it has currently dropped enough, or is this just the start, to create an excellent Margin of Safety?
- Are there any other largely unpopular companies following along the Graham model that you have kept your eye on recently?
This post outlines in detail Benjamin Graham’s strategy of buying into stocks that are relatively unpopular large companies.
As for Volkswagen and other similar opportunities in the stock market I suppose the first thing I’d say is that global equities are and have been for some time at least at fair value if not overvalued.
But that is a generalisation applied across the entire market.
Having said that though, large cap stocks can at any time – whether at stock market highs or lows – make big mistakes.
In other words large cap stocks can become relatively unpopular large companies at any time.
That means that if you choose follow Benjamin Graham’s strategy then it is good to follow during all market conditions.
Additional attention needs to be paid to how much of your capital you choose to place in stocks and how much you choose to place in bonds.
I talk more about the mix of stocks and bonds The SASM Newsletter but in essence at market highs more cash needs to be placed in bonds rather than stocks and similarly more cash needs to be placed in stocks rather than bonds at market lows.
A good example of this is the 2008 financial crisis where the share prices of all stocks whether they were relatively unpopular, large cap or otherwise were simply hammered.
Prior to the massive price declines a prudent investor at the time would have had a large proportion of his portfolio in bonds where he could have rotated cash out of bonds and into stocks.
Volkswagen’s Price Decline: Is There More To Come?
The simple and uninspiring answer to that is I don’t have a clue and neither does anyone else and if they do it would be illegal for them to profit from it.
But let’s be sensible for a minute.
Volkswagen’s share price had already begun declining well before their alleged criminality became public.
The net result is that according to Reuters Volkswagen now have a PE ratio of 4.41 which is very cheap indeed for a company that churns out the amount of profits that it does: EUR 7.6 billion pre tax as per Volkswagen’s half yearly report for the six months to June 2015.
Ben Graham insisted that large caps should have a PE ratio of no more than 20 in order to avoid growth stocks and no more than 9 for bargain stocks.
That means a margin of safety already exists according to Graham’s criteria.
Indeed there has been some frenzied selling and all you’d need to do to check that out is pull up a chart that shows volume and see the huge volume spikes since the last Friday’s announcement.
Yes Volkswagen has made a provision of EUR 6.5 billion for future legal costs but my guess is that is the tip of the iceberg simply because of the global nature of Volkswagen’s alleged criminality.
But the crunch is that nobody yet knows the full extent of Volkswagen’s criminality and the knock on effect this will have on it’s share price.
Take for example Pat Jenkins of the who FT points out that Volkswagen is as much a financial services company as a car maker:
An extraordinary 44 per cent of VW’s €374bn balance sheet is now accounted for by its finance activities. VW has more than €100bn of loans outstanding to its customers.
Put another way, of the total assets of EUR 374 billion Volkswagen has stated on its balance sheet, EUR 163 billion is from it’s financial services division:
Volkswagen Balance Sheet
Jenkins further notes that:
At the last count, 30 per cent of VW’s vehicle deliveries were VW lease or finance deals, rather than outright sales
Reputational damage could lead to fewer sales and the prospect of higher interest rates from the Fed and the EU will increase loan costs giving Volkswagen a very large headache indeed.
But since a margin of safety already exists using the PE Ratio as the basis of intrinsic valuation as per Graham’s original strategy then investors have choices available to them:
- buy now
- buy half now and half later or;
- just wait to buy it all later.
Are There More Relatively Unpopular Large Companies?
Gargantuan problems leading to subsequent share price declines by large companies such as that we have seen from Volkswagen are rare things indeed but they do happen.
Just off the top of my head past examples have included:
- BP – Gulf of Mexico disaster
- Hewlett Packard – Acquisition over payment (Autonomy)
- Dell – losing market share to Apple
- Lufthansa – strike action
If you know the background to these examples you’ll understand that the problems faced by each of these companies were not equal. For example Lufthansa’s striking workforce that helped to ground it’s fleet was less of a disaster than say BP’s oil spill.
But both BP’s and Lufthansa’s share prices reached muti-year lows.
The quickest way to find out if there are any large cap stocks that have the potential to be relatively unpopular is by use of a screener that can scan for stocks that:
- are large caps only
- have a PE ratio less than 20
I use ADVFN for this process because the awesome tech geeks there also allow you to compare each stock against its past PE ratio average as you can see from this screenshot I took from yesterday’s screen:
The other way and my preferred method to find out about when stocks become relatively unpopular is by staying tuned to the daily financial press.
The fact that companies are large makes them fodder for the mainstream press so when they make mistakes, it’s as if someone declares open season on them – the press love disaster, they love reporting it, regurgitating it and chopping it and the company up in as many different ways as possible so sell their newspapers and online subscriptions.
That means all you need to do is skim the headlines of the mainstream press looking out for mentions of large companies that have made a boo-boo.
What about you? Are you looking at any large stocks that look like bargains right now?