The five rules of the Templeton Way
Importance of PricePurchase an investment only when you can pay less for it than it is worth today, and only if you believe that it will be worth more than tomorrow.
The principle is the same as a thrifty shopper running around with a book of coupons to redeem. "I never ask if the market is going to go up or down next month, I know that there is nobody that can tell me that. Instead, I search, country by country for stocks, asking where is the one that's lowest in price relative to what our securities analysts estimate its worth to be. Usually a stock has to be a bargain or I won't buy it."
Buy on Good News, Sell on Bad NewsLook for situations where short term factors temporarily affect a company's performance or investor's perception of the company.
Many of Templeton's stocks were the victims of deep pessimism from the market. A good example would be when Templeton bought Union Carbide following their horrible accident in Bhopal. (I studied this in chemistry at uni, a disgruntled worker fiddled with the machines at Union Carbide's giant chemical plant in Bhopal, India. The result was an explosion and a cloud of toxic gas that spread over a densely populated area, killing thousands. It was one of the worst industrial "accidents" in history). Anyway, the stock took a dive from $50 to $32.75 as the consensus was that the company would fail under the weight of litigation. Templeton figured the insurance companies would foot a large part of the bill, and the company was very well run and manufactured a product that was needed. Just over a year later Templeton sold out to another company acquiring Union Carbide, for $69 a share.
Broaden your KnowledgeWhere the possibility of a bargain appears present, the investor has the responsibility to acquire the expertise to evaluate the situation.
Buffett recommends you stay within your circle of competence, Templeton tells you to widen your circle. Either way you should never go into any investment unless you understand the industry, the economy and the company intimately. Templeton had teams of analysts on the ground in various locations around the world, and made friends of his neighbors in Lyford Cay in the Bahamas, who were among the world's great capitalist leaders, heading major banks and industries throughout the world. (When you live in a tax-haven, you get these kinds of neighbors.) Templeton made sure that if he was thinking of buying banks in Portugal, he would get to know absolutely everything there was to know on the subject. This is one area where Templeton and Buffett part company drastically, Buffet stays right away from anything he doesn't understand, Templeton gets heavily involved in in-depth research to find out what he doesn't know.
QuantificationA bargain can be expressed in terms of its true current earnings (or likely future earnings) as compared to the cost of its shares or the price it could bring on the current open market.
As a rule, instead of looking at one-year figures, Templeton prefers to analyse a company in terms of averages for the previous five years, thus eliminating much of the distortions caused by cyclical patterns, strange accounting practices and extraordinary events. He compares this to even longer term averages and decides if the 5-year PER is cheap compared to the long term PER for this stock, also Price/Cash Flow ratios and book values.
For his top-down analysis of entire countries, he finds that the best measure of a cheap economy is to compare average Price/Book Value with historical norms, finding price to book to be a better measure than PER. More important than a historical book value study is to study replacement book value, estimating that the replacement age of all non-monetary investments for U.S. corporations is about 5 years. Based on this, Templeton's analysts construct historical indexes comparing the replacement book value compared to price, determining if a market is cheap or expensive by this index.
Hard WorkInvestment is hard work, and short cuts produce second-class results.
Just knowing that an industry has a bright future is irrelevant to whether or not you should buy a stock. Templeton reckons that only a minute proportion of investors know or care how to value a stock, and as they are unable to value the stock they are unable to make worthwhile estimates of how much the company is worth. You need to assess the company's competitors, you need to look at per share earnings, dividends, assets, sales. "You have to do all those things before you can make a sound judgment. ... Yet, most investors, including many Wall Street professionals, don't want to work that hard. They become excited about something and they buy it without fully understanding the situation.".
Templeton states that investment is a battlefield, you are acting in direct competition with other investors. "But your can't buy a stock unless there's somebody wanting to sell it. And because you can't buy unless somebody sells, it's likely that a year later, or five years later, one of you will wish you hadn't done it... Because it is a contest, and is therefore different from almost every other business activity on Earth, you must not go with the majority. You can gain opportunities in investing only by doing something that the majority are against doing or something they don't know about."
Yardsticks of ValueThe first thing you should know about Templeton is that he had no fixed method that he applied to all stocks. Instead he stuck to certain principals that he held as common to all investments, employed a swag of techniques to identify bargain issues and employed large teams of analysts to search through the world's markets. He found that every market was different and required specialisation, so from a top-down point of view he would find cheap countries and send in a team of analysts (making use also of Templeton's own network of contacts around the world to get quality local information).
Templeton has never publicly revealed any of the formulae that he used as an analyst, his fund managers still use these techniques whatever they may be and he is not keen to have the whole lot revealed to the world. On the other hand, he did stress that he never did use any particular method to the exclusion of others. He would use Price Earnings Ratios, book value, discounted cash flows, price to cash flow ratios and dividend yields. John Neff had his "total returns ratio" but if Templeton ever had any original proprietary formula that he used, he never publicly admitted to it.
In fact Templeton has stated quite clearly that in fact he did not use any particular method over any other. Flexibility and contrarianism is the defining characteristic of his style. He was prepared to use whatever worked and in particular to use methods or buy securities that were unfashionable. At no stage did he buy expensive growth stocks, but he often went into cheap ones, usually after some setback had decimated the stock price. Templeton had no formula that he applied, ultimately his "secret" was simply that he was determined to look where no one else was looking. "If you buy the same stocks everyone else is buying," he would often say, "you'll get the same results." Templeton used the full spectrum of value techniques and built up a detailed profile of each stock. He qualitatively understood the company, but would never buy based on a story of any kind. All of his purchases were made based on pure arithmetic, if the stock was cheap compared to book value, earnings, cash flow and sales, and was cheaper than something else in his portfolio, he would buy that stock and get rid of his more expensive ones.
He emphasised that the differences between investing in different markets made different measures of cheapness frequently irrelevant. You can't say that because the market PER of one country is lower than another that this country is cheap. What you have to do is figure out the historical norms for this country and see if it is cheap compared to its own history, or compare it to very similar economies. It is irrelevant to compare the PER of the USA to the PER of South Korea, the economies are too different to make this measure meaningful.
Templeton applied value principals all around the world, but he recognised that you can't use the same tools everywhere without modification. Apart from major differences in the economies, there are also differences in accounting standards and disclosure requirements. What seems cheap may not be if you make the required adjustments to the company accounts to make them directly comparable against local accounting practices. There are also major differences created by different tax systems. For example in America they have cheap capital gains tax and no dividend imputation system. Here we have franked dividends and capital gains are more expensive than in America. You can't compare America's and Australia's indexes unless you make corrections for local practices. (See another article in this FAQ, "How indexes are misleading")
Templeton also loves to hunt in "information gaps". Rarely will you find hugely undervalued securities in widely followed industries. Templeton was one of the first major investors to get into a little known photographic stock called Haloid. Templeton heard about a new process developed by this company but few securities analysts bothered much with this lightly traded company. Templeton found the stock to be woefully undervalued and took advantage of the bargain. Later Templeton sold this company at a 1,000% gain. That company changed its name to Xerox Corporation, and they became one of the great growth stocks for their invention of the photocopier.
Portfolio ManagementTempleton had an average holding time of about five years. This was not a deliberate policy, it was a simple artifact of his value method, and he only discovered this in hindsight by watching the statistics of his fund. What he did instead was to examine a universe of about 3,000 stocks and filter it ruthlessly to about 600 by applying a variety of value filters.
These 600 stocks are then sorted on the basis of relative undervaluation, with the 20% most undervalued stocks being examined for possible portfolio inclusion. About 10 to 12 times a year the 3,000 stocks are reexamined as is the 600 stock shortlist. The Templeton valuations are compared to changing market prices and a moving average system kicks out of the portfolio any stocks considered less undervalued than one awaiting entry into the portfolio.
To justify the replacement of a stock, Templeton has to feel that the new stock has at least a 50% superior profit potential to the one being sold. Templeton doesn't like excessive turnover, realising how expensive it is, but his system does not include any explicit instruction to sell after a particular time. If a stock has been held for one week or 20 years he says it makes little difference to him. A stock is put in the portfolio for being a bigger bargain than the one it replaced. I have read elsewhere that Templeton considers getting rid of a stock after 6 years if it hasn't done anything, but this doesn't seem to be what Templeton says in the script of an interview he gave to Norman Berryessa (page 156 of Global Investing The Templeton Way by Berryessa and Kirzner (1993).)
Buffett’s “Business Wanted” Ad
In the 2004 Annual Letter to Shareholders Warren shared the following Acquisition Criteria:
We are eager to hear from principals or their representatives about businesses that meet all of the following criteria:
1. Large purchases (at least $75 million of pre-tax earnings unless the business will fit into one of our existing units),
2. Demonstrated consistent earning power (future projections are of no interest to us, nor are "turnaround" situations),
3. Businesses earning good returns on equity while employing little or no debt,
4. Management in place (we can't supply it),
5. Simple businesses (if there's lots of technology, we won't understand it),
6. An offering price (we don't want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown).
I did some research to generate a list of companies that have:
· Positive earnings growth for 5 years (i.e. Requirement #2)
· An ROE of 15% or greater (i.e. Requirement #3)
· And included data on Industry type, Gross Margins, Operating Margins, 5 year avg. Operating Margin, Return on Investments, Return on Assets
· And included a column for current total market cap; as per one of Mohnish Pabrai's extraordinary essays (and just common sense) I'd be happier with a company at a $100 Million market cap. vs. $100 Billion to allow for the full benefits of long-term compounding.
· The companies were sorted in ascending order of Total Debt/Equity -- -the low debt should suggest a strong balance sheet and avoid concerns that the above-average ROE is the artificially-inflated with dangerous amount of leverage.
· Additionally, I wanted to add a data on insider-ownership levels (I’d like to see ~10% - 30% or so), but wasn’t able to find an easy way to get that info into the spreadsheet. So I’ll just consult Value Line, which is always a good idea, once I find a business that is otherwise of interest.
Stocks are simple. All you do is buy shares in a great business for less than the business is intrinsically worth, with management of the highest integrity and ability. Then you own those shares forever. I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.
April 26, 2008
The five rules of the Templeton Way
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