Google shares reach $400, still a good value?

Today, Google’s shares reached $400. It seems unlikely that any true value investor would consider Google (GOOG) to be a good “value.” Renowned fund manager Bill Miller seem to think it is. His Value Trust fund (a fund that I am considered for my US portfolio) has a good portion (4.3%) of it’s assets invested in Google. Bill Miller “follows a value discipline in selecting securities” according to Value Trust fund’s Investment Strategies statement.

Just for fun, I wanted to see if Google meets any of Graham’s basic criteria for defensive investors (or rather, how badly it fails):

  • Google’s price/book ratio from the most-recent quarter is 12.64. Graham probably wouldn’t touch Google unless it’s P/B Ratio was less than 1.5, meaning Google would have to trade in the $50 range.
  • Google does have a positive book value, which Graham considered a must.
  • Google’s current ratio from the most recent quarter is 15. Graham looked for a current ratio of at least 2.
  • Google’s growth rate has been phenomenal. About 400% from 2003 to 2004, and on pace to grow earnings about 350-400% in 2005. Graham looked for earnings growth of 33% over 10 years. Google hasn’t even been around for 10 years yet and Graham would probably classify it as a “new issue” and would stay clear of it.
  • Google has never paid a dividend. Graham looked for stocks with uninterrupted dividends over 20 years.
  • Google has not made money in each of the last 10 years. Graham liked businesses which had some earnings in each of the past 10 years. Since Google was a start-up not too long ago, there was a time within the last 10 years when it did not make money. Basically Google fails this test because it is just too new.
  • Google’s revenue was $3 billion in 2004, on pace for more than that in 2005. Graham recommends investments with annual revenue of more than $500 million (in today’s dollars).
  • GOOG’s valuation is now $119 billion. This meets Graham’s criteria of being a large-cap stock. Although if Google were valued at its book value of $9 billion it doesn’t look so big.
  • P/E ratio on trailing 12-month earnings is about 89. This is well above Graham’s recommended 15.

Google fails several of these basic criteria by such a huge margin that it makes me feel good about not owning Google, and somewhat worried about buying Bill Miller’s Fund. Apparently, in retrospect, Google’s IPO price of around $100 was a good value, and so was $200 3 months later. And it was still a good value earlier this year when it traded at $300. Google has certainly paid off for Bill Miller who apparently bought it at $85. I’m just not sure if he’s skilled or lucky. Some of his other tech stocks have not fared as well, such as Amazon and eBay, both among his top 10 holdings, and he is at risk of ending his 15 year beat-the-S&P500 streak. Miller’s Value Trust fund has only gained 1.82% this year so far, compared to 3.06% for the S&P 500.

Out of curiosity, I checked ABC Funds American Value Fund, a true value fund (no tech stocks here), and is up 6.34% year-to-date as of October 31, 2005. I am a bit more comfortable with ABC Funds’ true value investing approach, but the minimum required investment is just too high for me right now.

Growth vs. Cash

Investors (actually “288 investment professionals” according to MSNBC and “290 mutual fund managers” according to the Globe & Mail) are apparently preferring growth to cash (dividends):

About 49 per cent of the 288 investment professionals quizzed by Merrill in November said they wanted to see companies increase capital expenditure, the highest response since this question was first asked in September 2002, 11 points higher than the corresponding figure three months earlier.

I am not sure what fundamentally changed in the average business to cause this increase in three months. Here’s what Benjamin Graham had to say about this in 1949:

A company’s management may run the business well and yet not give the outside stockholders the right results for them, because its efficiency is confined to operations and does not extend to the best use of the capital. The objective of efficient operation is to produce at low cost and to find the most profitable articles to sell. Efficient finance requires that the stockholders’ money be working in forms most suitable to their interest. This is a question in which management, as such, has little interest. Actually, it almost always wants as much capital from the owners as it can possibly get, in order to minimize its own financial problems. Thus the typical management will operate with more capital than necessary, if the stockholders permit it-which they often do. [italics theirs]

Jason Zweig, in his commentary in Chapter 19 of the Intelligent Investor Revised Edition, notes two interesting pieces of research: “Surprise! Higher Dividends=Higher Earnings Growth” (Arnott and Asness) and “Dividend Changes and Future Profitability” (Nissim and Ziv). However there has been some contradictory research as well: “Dividend Changes do not signal future Profitability.” Without pouring over these papers in detail it’s impossible for me to judge who is right. Zweig does say that “even researchers who disagree with Arnnott-Asness and Nissim-Ziv agree that dividend increases lead to higher future stock returns.” Either way, I think this comment by Zweig sums it up nicely:

Paying out a dividend does not guarantee great results, but it does improve the return of the typical stock by yanking at least some cash out of the managers’ hands before they can either squander it or squirrel it away. [italics his]

ETFs to Stay Away From

With the increasing popularity of ETFs, many companies are trying to capitalize on this popularity and are coming up new sector-specific ETFs left and right. I’ve seen some recently in the home building sector and defense sector. These are both available from PowerShares. Apparently a defense sector ETF “could be used as a short-term vehicle to play geopolitical developments such as terrorist attacks.” This is not something the long-term investor saving for their retirement should be going after. If you are tired of playing the slot machine, however, this may be for you.

Then there’s the new Lux nanotech index, also from PowerShares. It is one of 8 new PowerShares (including the housing and defense ETFs) which came on the market on October 26, 2005.

Do not get caught up in the hype of ETFs and buy these sector-ETFs unless you know what you are doing. I got caught up in the technology-sector hype in 1999 and bought the TD Science & Technology mutual fund. I also bought some of the TD Health & Sciences fund. I bought them, thinking they could repeat their amazing performance in years past. How wrong I was. Here are the yearly returns for the TD Science & Technology Fund:

2004 2003 2002 2001 2000 1999
-8.2 21.4 -41.9 -38.8 -33.4 89.1

iUnits conversions approved

The iUnits unitholders of the ETFs (Exchange-traded funds) XIC, XGV, XSP, and XIN have approved changes to the underlying investment objectives (ie. they have changed the underlying index being tracked by these ETFs).

  • The new investment objectives of XIC and XGV are to replicate the S&P/TSX Capped Composite Index and the Scotia Capital Short Term Bond Index, respectively. The Funds’ new names are the “iUnits Composite Cdn Eq Capped Index Fund” and the “iUnits Short Bond Index Fund,” respectively. As of November 16, 2005, the ticker symbol for the iUnits Short Bond Index Fund will change to “XSB” on the Toronto Stock Exchange.
  • The new investment objectives of XSP and XIN are to replicate the S&P 500 Hedged to Canadian Dollars Index and the MSCI EAFE 100% Hedged to CAD Dollars Index, respectively. These are the same indexes these funds previously replicated, except the currency exposure is now hedged to reduce the risk of exchange rate fluctuations affecting the returns of XSP and XIN.

Information regarding the increase in the MER (Management Expense Ratio) for XIC is curiously absent from this press release. Not only that, but links to the original press release announcing the unitholders meeting (which mentioned the commission increase) and the information circular outlining the changes to the iUnits ETFs are now absent from the iUnits home page.

ABC Funds

I think I’ve found my dream mutual fund company: ABC Funds. From the introduction:

The most distinguishing characteristic of the ABC Funds is our firm adherence to true value investing. The funds use a “bottom up,” Graham and Dodd style in selecting securities. This style commands thorough, proprietary research on fundamentally undervalued Canadian and American securities and strong investor discipline. All three ABC Funds use this investment approach.

Before you go on and read about it, you should know that they require a minimum initial investment of $150,000 per fund (I assume that’s CAD). The MER is 2% on all their funds and they seem to have an excellent track record at beating the indexes. Some years they do worse than the indexes, but that shouldn’t worry the long-term investor.

Do not shy away from clicking on the “client area” link on the main page. It looks like everything there is publicly accessible.

It seems easy to find good active value management in Canada if you have lots of money. Another company that comes to mind is Strategic Advisors Corp (affiliated with Ross Healy).

Value Investing and the Death of Efficient Market Theory

This article by Joseph Nocera about the recent annual Graham and Dodd breakfast at Columbia University brought up a few interesting things that I hadn’t read too much about before, mostly concerning the theory behind how 95% of the world invests today. Apparently most business schools across the United States teach Modern Portfolio Theory as a way to minimize risk in a portfolio. It (MPT) holds that because the market is efficient (an assumption), it cannot be beaten, and therefore the only way to minimize risks and maximize returns is through diversification. This is essentially the theory from which banks and other financial managers from all over will tell you things like “Experts agree that the asset mix of your investments – safety, income and growth, account for more than 80% of your portfolio’s return.” This statement doesn’t even make sense to me, although I have sort of accepted it gospel for a long time, since it was posted on TD Canada Trust’s website, and of course the big banks know everything.

Bruce Greenwald, who runs a value investing course at Columbia, like Benjamin Graham and Robert Heilbrunn before him, says that “efficient market theory is basically dead.” Warren Buffet says modern portfolio theory is akin to the theory that the “world is flat.” Well that was enough for me… I guess modern portfolio theory is just a theory and the efficient market hypothesis is just a hypothesis.

There is also talk in the article about why value investing is so unpopular, even with the success of Buffett and Graham and many others and the fact that studies that have been published which show that “a portfolio of value stocks generally outperformed the market.” There are many reasons given. Jason Zweig (who wrote the updated in comments in Graham’s latest Intelligent Investor), says that value investing is “just plain hard,” (ie. takes a long time pouring over statements) and others say that there simply aren’t as many value stocks out there these days (could be true, if you look at the long term trend in P/E ratios). But Jean-Marie Eveillard, a successful value mutual fund manager said what Joseph Nocera thought was the best answer, that “It goes against human nature . . . You have to be very patient. You’re not running with the herd — and it’s much warmer inside the herd.”

Proposed Changes to XIC, XGV, XSP, XIN

Barclay’s is having a special meeting of unitholders, to decide on proposed changes to iUnits ETFs: XIC, XGV, XSP, XIN [pdf]. The most significant proposed change is to have XIC track the S&P TSX Composite rather than the TSX 60 index. Reasons given are:

  1. More securities and more diversified exposure to large-cap, mid-cap and small-cap stocks improves diversification which helps reduce volatility risk.
  2. The Composite Index is the most widely used benchmark of Canadian equity performance, which improves investors’ ability to compare results to other Canadian equity funds.
  3. Offering funds which track the S&P/TSX 60 Index and the S&P TSX Composite Index provides investors in iUnits funds with more choice.
  4. The increased fee reflects the time, expertise and expense involved in managing a portfolio of over 200 securities versus 60 securities.

XIU, the non-capped S&P TSX60-tracking ETF will still exist, it is only the capped XIC which is being changed.

XGV is becoming more diversified, to include provincial, municipal, and corporate bonds, rather than just Government of Canada bonds. It will now be tracking the Scotia Capital Short Term Bond Index.

XSP (S&P 500 tracker) and XIN (MSCI EAFE International Index tracker) will now be unaffected by exchange fluctuations. I assume this was done because of what happened in the last couple years, where Canadian investors’ in the US indexes were hurt by the falling US dollar in relation to the Canadian dollar (and every other currency for that matter).

We will know on November 15 the outcome of the vote by unitholders on the proposed changes. More detailed information can be found in the information circular.

Owning Too Many Mutual Funds a Bad Idea

I used to own many mutual funds in my account at TD Canada Trust. A glance at an old statement shows that at one time, I owned the following funds in the Canadian portion of my portfolio:

TD Canadian Equity Fund
TD Canadian Index Fund
TD Dividend Growth Fund
TD Blue Chip Equity Fund
TD Canadian Small Cap Equity

What is wrong with being invested in so many funds at once? The problem is that with 4 funds, primarily large-cap funds, I was over-diversifying and basically forming an index for myself. I was owning the entire market, which is what indexes do anyways, and diluting the active management within each of the funds. But I was not paying what I should have been paying for an index (MER <= 0.25%). These funds have MERs of at least 2%, except for the index fund. So basically I was buying the equivalent of an index, but paying through the nose for it. The effect of a high MER eating into your returns every year can be huge. Don't make the same mistake I made. Get an index for the large-caps, and no more than one other large cap fund. Perhaps owning an actively-managed small-cap fund as well. If I had to do it again at TD, I would have bought TD Canadian Index Fund and TD Canadian Small Cap Equity. The other large-cap funds (TD Canadian Equity, TD Canadian Dividend, and TD Blue Chip Equity) are not significantly better than the indexes themselves, so I would rather take the low-cost index fund. The small-cap fund gives me some exposure to smaller companies which are not owned by the index.

Selling ETFs to buy index funds a bad idea

A friend recently asked me:

I’m just about to switch my ETF‘s to mutual index funds so I can contribute monthly without the transaction fees associated with ETF’s. I found a few funds from Altamira that have MER fees of 0.54. That seems pretty good to me…not quite as good as the 0.17% that you get for the iShares S&P TSX 60 ETF’s, but I think the ability to automatically contribute monthly makes up for the additional 0.36% in MER fees.

They wanted my opinion on this before they went ahead and did it. My reply was:

I wouldn’t switch if I were you because you’ll pay commission on the sale. If you are already invested in an ETF I would just hold it and let it grow. . . Definitely if you want to contribute monthly you should put your money into a mutual fund. Obviously no one would recommend buying ETFs monthly with the kind of monthly amounts you’re probably putting in, so really you have no choice. Just don’t sell the ETFs you already own.

The only reason I could see for you wanting to sell your ETF is if the mutual funds you are interested in required some sort of initial minimum. That would have surprised me though, because all of TD‘s funds for example, only require a minimum RSP investment of $100, and minimum subsequent investment of $100.

Basically if you are putting in small amounts per month, use mutual funds, that’s what they are for, if you have large amounts, get stocks or ETF indexes. When the amounts in mutual funds are large enough, it might make sense to transfer them into an ETF. But it’s up to the individual, especially if the difference in MER is so small, you might as well just leave it in mutual funds.

The MER on those mutual funds are really low which is great, so I would say buy them every month, but just don’t sell the ETFs you already own.

REITS vs. the Stock Market

Think that real estate is hands-down a better investment than the stock market? I found some data on REITs (Real-Estate Investment Trusts) compared to the stock market, and on first glance it looks as if the stock market outperformed the real estate market from 1975-1993 and also from 1990-1996. Be wary, especially now that we are in a real estate peak, of people telling you that real estate is the best investment out there. Be also wary of those who tell you that it was the “best investment they ever made.” As David Chilton says, for many of those people, “it’s usually the only investment that they’ve ever made.”