09.11.13 Arnold Van Den Berg

8/9/2019 09.11.13 Arnold Van Den Berg

1/4

Po Guu

Value works! That is one o the rst lessons youlearn rom Arnold Van Den Bergs 41-year-longinvesting career. A $10,000 investment in Centu-ry Management Investment Counselors CM Val-

ue 1 Composite, ounded by Van Den Berg in 1974, wouldhave made you 80.25 times richer today (as o September30, 2009), thats $802,500 as compared to the S&P 500s$481,239 and Dow Joness $522,355.

Born in Holland in 1939, Van Den Berg survived the Nazisand World War II along with his elder brother, when botho them were smuggled into an orphanage during the War.He was only three years old then. Ater the war ended, VanDen Berg moved with his amily to the US. He went to highschool and ater completing his education took up a secu-rities salesman job at a mutual und company, Capital Re-search in 1968. But he set his ambitions higher Van DenBerg wanted to run his own investment company and in1974 he ounded Century Management, grounded on thevalue principles espoused by Benjamin Gra-ham. The perormance o his unds is evidenceo the soundness o the value approach that heardently ollows till date.Van Den Berg invests his money in stocks

only when the reward-to-risk ratio is in his a-vour. Today, he describes the US market aboveair value where bargains are hard to nd.In consonance, cash is now the largest positionin his portolio at 23.5 per cent. A stand he de-ends in his most recent newsletter: When wesee that these assets (stocks) are above our un-damental buy points, and the ratio o upside

potential versus the downside risk is not in our avor, wewill invest in cash and cash equivalent holdings irrespec-tive o the short term yield.

This is not the rst timeVan Den Berg has been long oncash. He had been warning o an impending bubble in assetprices since 2004. I past bubbles are any indication, the a-termath o this one will be doozy, he had said then.

The crash, as we all now know, eventually came three yearslater in 2007. But Van Den Berg does not overly concernhimsel with the ever puzzling question we are so ond o oc-cupying ourselves with: Are we in a bull market or are we ina bear market? He invests when he nds value in individualstocks. Period.Van Den Berg talked to Outlook Proft about the markets,

when he buys stocks and when he preers bonds. He alsorecommends some books which, he says, have had a majorinfuence on his lie and could benet others also.

How do you view the markets today?

We believe that relative to company undamentals, interestrates, and infation, and with the potential or growth, theaverage stock in the US market is now approaching the up-

per-end o its air value zone. We dene air value as the mid-point between the buy and sell point. Over our 35 years inbusiness, one o the best ways we have ound to measurewhether the US equity market as a whole is cheap or expen-sive, is to study the relationship between the Moodys Baa(investment grade) corporate bond yield and the median(mid-point) P/E o the 1,700 stocks ound in the Value LineInvestment Survey. Throughout this time we have watchedthis relationship weekly and ound it to be an excellent proxyor the average stock. The reason this relationship is impor-tant is because stocks and bonds are always in competitionor investor dollars, so monitoring this relationship helps usto arrive at what we would consider to be the best air valueP/E ratio, given the current interest rate environment.

Today, the Moodys Baa corporate bond yieldis at 6.23 per cent, which would suggest a air value P/E o 20. However, the 65-year aver-age Baa bond yield is 7.50 per cent, which isequivalent to a 16.67 air value P/E. While itsmore conservative, we think in todays envi-ronment we are better o using the long-termaverage as it helps to smooth over marketextremes. In other words, it helps preventus rom using P/E ratios and other valuationstandards and assumptions that might not besustainable in the uture. Remember, a yearago the bond yield shot up to 9.49 per cent and

today it is 6.23 per cent!Over the past couple o weeks the Value Line median P/

E has ranged between 17 and 17.5 and the Baa yield hasranged between 6.11 per cent and 6.35 per cent. So we be-lieve that just on todays numbers there is still some upsidein the market, maybe as much as 30 per cent over the next12 to 18 months. But that is on todays numbers. I we nor-malise the yield and use the long-term average, the US eq-uity market as a whole is closer to the upper end o its airvalue and on this basis we believe it has just 5 per cent to 13per cent upside.

Why use the median P/E and not the average market P/E

or your analysis?

There are several reasons why we like to use the Value Linemedian P/E versus an average market P/E. First, Value Lineuses two quarters o orward earnings and two quarters o

Oulook PrOfit 13 November 009

68

The US equitymarket as a wholeis closer to theupper end of itsfair value, so webelieve it has just5 per cent to 13per cent upside

Century Managements Arnold Van Den Berg has built a spectacular trackrecord of performance over the past 40 years, by placing his bets based on

the fair value of stocks, relative to bonds and historic valuation bands

Mohammed Ekramul Haque

Fair play


2/4

13 November 009 Oulook PrOfit

69

Arnold Van Den Berg is sure that regardless of yield,

when investments are absent of value, cash is always a

better option than permanently losing money


3/4

Po Guu

Oulook PrOfit 13 November 009

70

trailing earnings. The average market P/E in the S&P 500,or example, uses our quarters o orward looking earnings.Thus, using the median P/E helps to reduce the risk o errorswhen making projections. The second reason we like usingthe Value Line median P/E versus an average market P/E is

that average market P/E can be distorted. For example, in1998 the S&P 500 was up 28.5 per cent. While more than 50per cent o the stocks in the S&P 500 were down that year, 10o the largest stocks in the index were up so much, that theyrepresented 77.1 per cent o the S&Ps total return o 28.5per cent. Thereore, using a median P/E we have a much bet-ter idea o what the P/E is or the average stock.

So is this a good time to buy stocks?

All that depends on the reward-to-risk ratios that you arelooking or. Our avourite ratio is 5 to 1 in other words,$5 o upside or every $1 o risk. Over the past 35 years, we

have ound that when you have a basket o 30 to 40 stockswith 5 to 1 odds in your avour, youre going to have a verygood perormance over the long run. On the larger, blue chipstocks, in most cases the best you can typically get are 2.5 or3 to 1 odds. This recent bear market has been an exception,but most o the time this is the case. But on those smaller tomid-size companies, you really want to hold out or those 5to 1 odds and in some cases, i youre patient, you can geteven more.As ar as todays overall market, i we use the Baa yield o

6.23 per cent, we believe the odds are roughly $1.5 or $2 oupside or every $1 o risk. However, i we use a more nor-malised 7.50 per cent Baa yield, the odds are reversed orevery $1 o reward you have $3 to $4 dollars o risk. Either

way you look at it, the US equity market as a whole is aboveair value and bargains are hard to nd. However, this is themarket as a whole. Even in this environment, i you look at

individual companies, as we do, you are sure to nd at leasta ew values that give you the 4 or 5 to 1 odds.

So what do you do i you dont fnd enough values to get

ully invested?

We hold cash or short-term US Treasuries. Regardless oyield, when investments are absent o value, cash is alwaysa better option than permanently losing money. Think o itthis way. I we sit in cash and wait or a $15 stock to get downto our $10 buy point, then when it eventually goes back up to$15, we get a 50 per cent return on our investment. We thinkthis more than makes up or the ew months or quarters wemight have to wait in cash, even i cash paid no yield at all.

So i you are always comparing stocks and bonds, when do

you decide to go into bonds?

In short, when we can get a 3.5 per cent to 4 per cent realrate o return (above infation), we believe bonds are sellingat a pretty good value. Typically, we invest in US Treasur-

ies and US corporate bonds. Over the last couple o years,we have had opportunities to buy both in our balanced andxed income portolios.

Let me give you one example regarding corporate bonds.Over the past 47 years, the normal spread between theMoodys Baa bond yield over the 10-year US Treasury bondyield has been 193 basis points, or 1.93 per cent. Only in twoperiods, since 1962, did this spread widen to 350 basis points,or 3.50 per cent they were 1980-1981 and 2001-2002. Bothwere outstanding buying opportunities or investment gradecorporate bonds. So in the ourth quarter o 2008, when thespread widened to 617 basis points (6.17 per cent), we tookull advantage o this opportunity we sold our long-termUS Treasury bonds and reinvested the majority o these pro-ceeds and more into a basket o US corporate bonds. At thattime the Baa bond yield peaked at 9.49 per cent. For thoseinvestors that were looking or value in bonds, that was agreat opportunity. The average investment grade bond to-day yields 6.23 per cent. With headline CPI infation at 1.5per cent, this is a 4.7 per cent real rate o return. So, overall,most bonds are still a good value today.

Coming back to stocks, i you can fnd good value even in

an expensive market, would you still go ahead and buy?

We believe that i a market is so overvalued that you can onlynd a ew stocks to buy, you are probably better o not buy-ing anything. Let me give you an example. Typically we like

to have an inventory o approximately 300 stocks where wehave done our work and are ready to go; we are just waitingor the right price. Well, in 1987, in the months just preced-ing the historic October crash, we only ound about 13 stocksthat were o value. And then in one day, the Dow Jones In-dustrial Average dropped 22 per cent, and over 266 stocksout o the 300 on our inventory list became a buy.

So our advice is that when your inventory o ideas sellingat value prices begins to shrink dramatically, you are prob-ably better o just holding cash. And i history is any indi-cation, once a market really reaches that heated or manicphase, you will only have to wait a short time until you getsome wonderul buying opportunities.

Are we in a new bull market now as many people claim?We dont know all we go by is how cheap individual stocksare. Dierent people have dierent labels that they put on


4/4

the stock market to describe whether its ina bull market or bear market, and in todaysenvironment there is no shortage o opinionsas to where its going. But as ar as were con-cerned, when stocks are cheap its a bull mar-

ket, and when theyre expensive its a bearmarket. It doesnt matter to us what you call itas long as we can buy stocks that can double in3 to 5 years while having a margin o saety.

What is your buy level in terms o price/sales

(P/S), an indicator that you have oten been

credited or looking at?

On October 13, 2009, the total US equity mar-ket was selling at 108 per cent o sales. Nowthis is on the US equity market as a whole, soit could be a lot lower on individual stocks. Butin general, i we go back and look at the totalmarket price as a percentage o gross domes-

tic product (GDP), we can create a price-to-sales ratio on the entire US equity market. Onaverage, over the past 85 years, the US equitymarket has sold at 76 per cent o sales. It hit anall-time high o 186 per cent o sales in March2000 and a low o 35 per cent o sales in June1982. The low in this bear market was 77 percent o sales on March 31, 2009. Consideringthe interest rate environment, a good price-to-sales ratio to use or a buy point would be any-where between 70 per cent to 80 per cent o sales.

Moving to commodities, whats your view on gold?

I have been a student o gold going back to the early 1970s.As a matter o act, when we started Century Management,one o the investments we did very well with was gold. How-ever, today, we dont have a strong opinion about gold oneway or the other. We are not investing in it nor do we haveplans to, at this time.

I we thought we were going to have a real economic de-bacle, worse than the one weve already had, we might con-sider buying gold, but we dont think were in that situationtoday. Based on its own supply and demand undamentals,we dont believe that gold is cheap today. Furthermore, ona reward-to-risk basis, we think there are greater opportu-nities today than gold especially at these prices. Now, iwe believed that we are going to have runaway infation, we

would be a buyer o gold, but again, we dont believe this islikely to happen anytime soon. I anything, the big problemtoday is defation, not infation.

How do you approach commodity companies?

Unlike your average consumer or industrial company,where we can put more weight on ree cash fow, we wouldput more weight on book value in a commodity company be-cause cash fows fuctuate so widely. Another way, is to lookat the value o their acilities. For example, in the case o asteel company you need to nd out the value o its produc-tion acility and how much it trades or in an up-market andin a down-market. Or i you are looking at an oil company,look at the value o the reserves. Then you take this inorma-

tion and look to see what these stocks and their relevant ra-tios, acilities, and reserves traded or when the stocks werecheap and when they were expensive. When you complete

this exercise you will get a pretty good idea owhat the stock is worth.For example, i you were to take a commoditycompany and look at the yearly high and lowprice-to-book ratio that the stock has sold or

over the past 25 to 30 years, and then calculatethe average and median price-to-book ratioor all the low years and then do the same orthe high years, you will get a pretty good ideao just how cheap and expensive the stock canget. When you repeat this exercise with theother relevant ratios and valuation standardsthat are specic to the industry or companyyou are looking at, you can arrive at some air-ly accurate valuation price points. Now thereare times that extreme high prices or ratiosshould be removed rom the averaging sothey do not distort a more normal upside pic-ture. However, due to our more conservative

nature we have ound it important and wouldrecommend to you to always include all lowprice points in your averaging.

Last, a good rule o thumb when it comes tocommodities is that you buy surplus and yousell scarcity. For example, when the price ooil was real high there was a scarcity, so it wastime to sell. In other words, whenever there isa shortage, the price goes up and people cantsee that shortages dont last so it is time to sell.

And whenever there is a surplus o the commodity and com-panies are losing money, everybody thinks they are nevergoing to recover. This is the time that the shares are sellingat a discount to book, and thats when you buy them.

What books would you recommend to our readers?

Well, rst we would recommend they read The Intelligent In-vestor. We also think going back and reading Berkshire Ha-thaways annual reports is worth the time (they are on theBerkshire website). The late Philip Fisher wrote several booksthat are very good, Common Stocks and Uncommon Profts,Conservative Investors Sleep Well, and Developing an Invest-ment Philosophy. Seth Klarmans Margin o Saety: Risk-

Averse Value Investing Strategies or the Thoughtul Investor

is a good book about risk. An easy but good read or those justgetting started would be Value Investing Made Easy by JanetLowe. Then there is Roger LowensteinsWhen Genius Failed:

The Rise and Fall o Long-Term Capital Management. Thereare some real good lessons in that book. And or a more in-depth understanding, lietime study, and reerence is Secu-rity Analysis by Benjamin Graham and David Dodd.

Philosophically, I would like to recommend several booksthat have had a major infuence on my lie. They are writtenby James Allen who is my avorite author on the subject.They areFrom Poverty to Power, Eight Pillars o Prosper-ity and As a Man Thinketh. Each o these books has tre-mendous lietime principles you have to read these booksover and over and each time you do, you will get more outo them. Ive been reading James Allens From Poverty toPower or more than 30 years now. Its only ater you experi-ence something that you can go back and say Oh! Now I un-

derstand this!, so I preer to read his and other good booksmany times over rather than just reading more books thatdont seem to add more than the original great works.p

Over the past 85years, the US equitymarket has soldat 76 per cent ofsales. It hit an all-time high of 186per cent of sales inMarch 2000 and alow of 35 per centof sales in June1982. The low inthis bear marketwas 77 per cent ofsales on March 31,2009. Consideringthe interest rate

environment, agood price-to-salesratio to use for abuy point would beanywhere between70 per cent and 80per cent of sales

13 November 009 Oulook PrOfit

71

Documents

09.11.13 Arnold Van Den Berg