Value Index

Tomorrow is the first of July, and we will begin tracking the Value Index. For purposes of this, only S&P 500 companies are eligible. This basically keeps the number of stocks to be evaluate to a reasonable number. The index will reconstitute at the end of each month. At any rate, these are the stocks.

AKAM, AMGN, BCR, BIG, BIIB, BMY, CEPH, CF, COH, COL, DO, ESV, FII, FLIR, FLS, FRX, GD, GME, GPS, HRS, HUM, JEC, JNJ, KG, LLY, LO, MDT, MRK, MSFT, NKE, NOV, PCP, PFE, PSA, RDC, RSH, RX, SYK, TSS, ZMH.

Without going into too much detail, the companies picked are those that are profitable and will remain so, can be bought at a good price, and have what I consider good balance sheets.

EBITDA Multiple

Looking at the Dow 30, and going with 6.5 as a standard for which to judge value, there are 4 stocks that are under that multiple. The EBITDA is TTM and EV is MRQ.

Chevron (CVX), Exxon (XOM), AT&T (T), and Merck (MRK) are the four. The oil companies are on the list because of EBITDA from April to Sept. last year. Even so Chevron makes the cut based on last 2 quarters as well. AT&T has a large capital requirement which of course is disregarded in EBITDA. Merck is just an all-around good value. For one the Enterprise Value is not much more than the Market Cap, and secondly it's PE is strong.

We'll open an index tomorrow with the 4 stocks and check performance compared to the broader market. EBITDA Mult.<6.5. No weighting; just 25% for each until the index is modified. Modification will come based on (1) a stock has increased in price or has released new financials and is no longer eligible or (2) a new stock is found to be included or a previously rejected stock has either decreased in price or released more favorable financials to make it qualify.

2 new valuations

Pfizer (PFE) has been rated and is the new best value company, replacing XOM.

Boeing (BA) came in lower, ranking between Microsoft and GE.

Continuing with New Ratings

Adding to the last post of ranking some leading blue chips. This second group has fared a bit better than the last.

1. XOM
2. CVX
3. INTC
4. JNJ
5. HD
6. MSFT
7. GE
8. BAC
9. JPM
10. WMT

Some more blue chip rankings

Looking at 5 large blue chips from different sectors, a new valuation standard results in the following rankings.

1. XOM
2. MSFT
3. GE
4. JPM
5. WMT

Value in the Dow

I've gone through a valuation of each Dow component. I then split them into 5 equal groups depending on how the market value of each compares to the calculated intrinsic value. Here is the list:

Best value: BA, HD, MRK, MSFT, PFE, XOM

Next group: CVX, DD, DIS, INTC, PG, TRV

Middle group: HPQ, IBM, MCD, MMM, T, VZ

Next group: CAT, CSCO, JNJ, KFT, UTX, WMT

Worst value: AA, AXP, BAC, GE, JPM, KO

So energy and pharmaceuticals, with the exception of JNJ, are near the top. Finance stocks are right there at the bottom-which is partially attributable to the methodology and also the result of the problems in the sector over the last year.

Adding stocks to the index

Basically, I will add stocks as I find those that have a positive intrinsic value-to-market value ratio. Intrinsic value follows a specific formula. The index can add or delete holdings as conditions change or when new good value stocks are found.

Pfizer Profile

Pfizer (PFE) is next. Key stats:

Price/Book: 1.65
PE: 12.50
Price/Sales: 2.10
Price/Cash Flow: 5.50
Free Cash Flow Yield: 16.7%

Quick Ratio: 1.90
Current Ratio: 2.32
Financial Leverage: 2.04
LT Debt to Equity: 35.00%
Total Debt to Equity: 47.65%

ROA: 6.48%
ROE: 13.24%
ROIC: 16.89%

Gross Margin: 90.31%
Operating Margin: 36.16%
Net Margin: 16.80%

Profitability: A-. Best margins we've seen so far.

Financial condition: B+. On one hand there's a good percentage of investment in front of the common. But on the other, there is a lot of working capital as a percentage of price.

Value: D+. A price to sales ratio over 2 shows that even at $14 to $15, shares aren't cheap (there's a lot of them). The price to return ratios are pedestrian given the high profitability.

Overall: This is the first company who has a higher intrinsic calculation than market value. Looking deeper however, Pfizer seems to have one of the poorest growth prospects of the major pharmaceuticals, according to analysts. Since I don't consider growth in my analysis, this is an important consideration.

3M Profile

3M Corp. (MMM) is next for the profiles.

Price/Book: 4.35
PE: 14.17
Price/Sales: 1.77
Price/Cash Flow: 10.01
Free Cash Flow Yield: 6.64%

Quick Ratio: 1.05
Current Ratio: 1.83
Financial Leverage: 2.50
LT Debt to Equity: 52.25%
Total Debt to Equity: 61.97

Return on Assets: 12.29%
Return on Equity: 30.71%
ROIC: 22.11%

Gross Margin: 51.79%
Operating Margin: 20.32%
Net Margin: 12.51%

Profitability: C+. I sort of set the range for the letter grades on this with the first 2 profiles. 3M is right in between.

Financial Status: B-. There's a good bit of debt on the books, though not overwhelming. There's also a good bit of cash here.

Value: C-. It's a bit expensive, particularly the P/B.

Well, basically 3M falls right in between our first 2 profiles, GOOG and WMT in each category. However, it seems to be the best buy of the 3, though only marginally so. I still don't think we've found a qualifier for the index, but we're getting closer.

WMT Profile

Key stats:

Price/Book: 3.12
PE: 14.64
Price/Sales: 0.48
Price/Cash Flow: 8.44
Free Cash Flow Yield: 5.8%

Quick Ratio: 0.18
Current Ratio: 0.85
Financial Leverage: 2.60
LT Debt to Equity: 57.31%
Total Debt to Equity: 69.37%

Return on Assets: 8.18%
Return on Equity: 21.31%
ROIC: 15.25%

Gross Margin: 25.11%
Operating Margin: 5.70%
Net Margin: 3.28%

Profitablility: C-. The plus for the company is the sheer volume of sales, which will be reflected in value. Per sale, the margins are slim-typical of discounters.

Financial Condition: C. You'd think a store that appeals to the thrifty would keep the debt load low. They don't keep around much cash either. Nothing that has them worried about missing payments, but there's plenty of capital in front of the common.

Value: A. Sales only equaled by Exxon, and at 60% of the price.

Bottom line is Wal-Mart looks strong in all the places Google didn't. It has 20x the sales at 1.5x the price of Google. But the balance sheet is more ordinary, and there's not much pocketed on each transaction. It is similar in that it is a good play in stormy weather, not because its a cash cow, but because its sales are pretty much unphased by downturn. Indeed, they're a bit countercyclical.

GOOG Profile

The first profile is for Google (GOOG). First some key values:

Price/Book: 4.49
PE (TTM): 30.90
Price/Sales: 6.06
Price/Cash Flow: 16.12
Free Cash Flow Yield: 4.9%

Quick Ratio: 9.31
Current Ratio: 10.11
Financial Leverage: 1.12
LT Debt to Equity: 0%
Total Debt to Equity: 0%

Return on Assets: 13.0%
Return on Equity: 14.5%
ROIC: 17.1%

Gross Margin: 68.09%
Operating Margin: 32.06%
Net Margin: 19.63%

And now some evaluation of some key points:

Profitability: B+. Google's margins are very solid all the way around.

Financial Condition: A+. Google is about as good as it gets. No debt. No other equity competing with the common. And lots of extra cash.

Value: F. Unfortunately for the value investor, everyone is well aware of the stellar condition of this company. And it is expensive. Google has nowhere near the revenues of other companies in its price class.

Overall, this won't make the portfolio on the index. From the perspective of value, it simply is too expensive to have a great upside. If a big sell off were to send stocks to lower levels, this may make more sense as a safety net. But not now.

Some important disclaimers

First, this is a post about investing. Thus it is reasonable to describe who should and who shouldn't invest. Since even the best investors lose money, money put in the market should be money you can afford to lose. If someone struggles to pay their monthly bills, investing is not a way out of that situation; in fact it will make it worse. Try budgeting, reducing your consumption, finding another job, paying down your debts - these all have far better track records at improving someone's financial condition.

Second, this site is an experiment. Nothing should be viewed as a recommendation to buy or sell this or that. I have investments and they may or may not be what's included in the index. As items are added or deleted from the index, I'll post whether I have any personal position.

Third, the data I use in my calculations are publicly available. Yahoo!, CNBC, Reuters, MSN, Mornigstar, TD Ameritrade, Fidelity are some of the places I go to look at financial statements, price quotes, valuation ratios, analyst estimates, and other information. No secret or insider information and/or data available for a fee.

More intro info

While our principle goal is to create a value index through specific metrics on companies, the blog would be pretty dull if it included nothing else. So there will be commentaries on news with particular interest to the markets. There will also be explanations of some of the concepts being used to measure value. And frankly I'll probably post on many other things as well.

Welcome to my little experiment

The concept here is to create an index of investments designed to beat, on a risk-adjusted basis, the most common US equity indices. There are no restrictions on what the index may track - equities, ETFs, options, futures, currencies, commodities, bonds, etc.

With that said, investments will chosen systematically, based on the fundamental value of the underlying assets for each investment. The selection formula may change somewhat though time, but the intention is for this to be infrequent, and only when research suggests the change is a clear enhancement.

So nothing is picked on a hunch, or based on what someone said or wrote in the media. And nothing is picked with the intention of realizing some quick profits and then ditching. We don't look at charts or what the big investors are doing. There's nothing wrong with any of that, but our intention is to demonstrate lasting value in companies with certain qualities.