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All the valuationyardsticks on therelative value curverepresent valid in-vestment approachesthat can producesubstantial gains.Investors just need torealize that eachtechnique as youprogress along thecurve tends to pose agreater degree ofrisk, as measured byprice volatility.

ANALYZING STOCK INVESTMENTS:THE CONCEPT OF RELATIVE VALUE

It always used to puzzle me: Portfolio managers invariably insist, “Ofcourse, we invest in value.” But it was the last word, “value,” that really gotmy goat. If the investment teachings of Benjamin Graham were the ultimatedefinition of value, how could other, obviously successful managers withbillions of dollars of assets dare to espouse conflicting beliefs? Low price-earnings ratio approaches, growth-at-a-reasonable-price (GARP), momentumopportunities—these are all doctrines that fly directly in the face of whatGraham commended as value.

Then it hit me—it was relativity that would save the day, just as it rescuedcosmology in the 20th Century. Einstein deduced that the outcome of ob-served phenomena entirely depends on “the positions relative to the body ofreference.” Likewise, value is relative.

THE VALUE CURVE

The concept of relative value is illustrated in Figure 1, in what I call the RedChip Value Curve. The curve is essentially an elongated sine wave, which hasno finite points of measurement or staked marks of absolute value, since onecannot ever really define the absolute truth in value. The axes are price, or theinverse of value (1/value), on the y-axis, and time on the x-axis, since increas-ing price usually occurs with the passage of time. The curve starts at thebottom, with price to replacement value and nearly peaks at the top of thecurve with momentum.

The value curve describes the different stages of value a company’s sharestend to go through over time. Each point on the curve represents one yard-stick of value. The curve illustrates how each measure, depending on where itfalls on the curve, tends to justify an increasing price. It also shows clearlyhow potential future gains in value diminish as you go up the curve.

In essence, all the valuation yardsticks on the curve represent valid invest-ment approaches. All can produce substantial gains in wealth. Investors justneed to realize that each technique as you progress along the curve tends topose a greater degree of risk, particularly as measured by price volatility.

Most important, the curve provides a graphic sense of how big of a down-side risk a particular investment may carry. Stock pickers are predominantlyconcerned with the potential upside in a stock; this model may help seriousinvestors draw a better perspective on the risk/reward trade-off.

The curve is not meant to imply that the measure of worth is static; rather,it is an ever-changing statistic that can either climb up the curve to ever-increasing prices until it crests in enthusiasm and price and rolls over to alower, less lofty position; or it can roll back down on the curve if the com-pany disappoints and its hoped-for performance is dashed on the near-termrocks.

Of course, stock values need not ascend through all the phases—a coalcompany is always a coal company and may never sell at a growth-at-a-reasonable-price or momentum valuation. Nor do stock values have to move

By Marcus W. Robins

Marcus Robins is president and editor-in-chief of The Red Chip Review, a newsletterthat focuses on smaller capitalization firms; 1099 SW Columbia St., Suite 350, Portland,Oregon 97201, 503/241-1265, 888/733-2447, or visit the Web site at www.redchip.com.

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at all, but instead may remain staticat a certain level—a tightly held,low-tech electronics operation mayhave such a rapid pace of increasingearnings that it never experiences anexpansion of the multiple to becomea growth-at-a-reasonable-pricecandidate.

NOTHING BUT NET

The following discusses the severalsteps of value as they are measuredby balance sheet factors. As thepresentation points move up alongthe curve, each notation representsincrementally lesser value to thepotential investor.

Bankruptcy: How can there bevalue in bankrupt companies? Onemust remember there are really twotypes of bankruptcy. The first is trueinsolvency, where debts outmeasureall forms of value in assets and theonly remedy is to liquidate all theassets and pay off debtors. This ismarked by Chapter 7 and would notbe included as part of the curve. Theother point, Chapter 11 bankruptcy,can be a situation used as an invest-ment opportunity.

Companies that have committed toChapter 11 protection have aliquidity dilemma; that is, they owemoney to creditors, but are unableto raise the necessary funds througheither sales or the short-term dis-posal of assets. They shield them-selves from a growing crowd ofjackals while they reassemble theirresources. Because of the uncertaintyof the outcome, the potential oflosing it all, some incredible invest-ments can be made.

Replacement Value: The valuecurve starts with the point markedChapter 11 and then descends evenlower to the valuation level markedreplacement value. There are timeswhen a company may have evenmore worth when considering thecost of trying to replace its assetsthan the value resulting from abankruptcy work-out. It also reflectslower risk/higher reward prospectsfaced by an investor as one might

consider the costs and managerialattention of forging through a legalsettlement procedure versus justoperating a business through tougheconomic times or industrydowntrends—the typical reasonfirms are lowered to their financialvalue lows.

Net, Net (P/Net): Skipping for-ward to price-to-net, net workingcapital, we come to the basis ofvalue as originally defined byBenjamin Graham. We have placedthis measure above Chapter 11 andreplacement value, but still feel thereare situations that can provideincredible returns.

Graham advocated this method asa way to minimize risk and stillachieve sizable returns. The measureis based on cash (and near-cashitems) versus total indebtedness, thetwo items that managers of nearlyevery operation in the world canaccurately measure and report. Theyare also items that auditors canspecifically validate. By taking allthe near-cash items on a balancesheet (cash, liquid investments,accounts receivable, and inventories)and subtracting all short- and long-term debt items, then dividing thenet by number of shares outstand-ing, the investor has calculated price-to-net, net working capital. The realtest for share value arises when thisfigure per share exceeds thecompany’s share price. In thissituation, you are buying the shares

of a company when the near-cashvalue exceeds the net share price ofthe firm. You are virtually gettingthe operation and long-term assetsfor free.

Believe it or not, there are stillopportunities that sell this cheaply.They are a little more difficult tolocate in this market, but they canbe found. In our current universe ofsmall-cap companies, AmericanVantage Companies (ACES) almostmeasures up as a net, net workingcapital investment. The current shareprice is about $13/8 per share and thenet, net working capital value is$0.89 per share. Now, the reasonthat such balance sheet values arepossible is because operations aredepressed and prospects are notrosy. American Vantage Companiesprovides casino management con-sulting services, a reasonable busi-ness that throws off substantial cashflow. However, the downside is thatits specialty is helping to manageIndian reservation casinos, all ofwhich happen to be in California,and it seems that the governor ofthat state wishes to close down thefacilities—hence, the substantialdiscount in the share price.

Graham believed net, net was thetrue indicator of value since thebalance sheet was so well-fortifiedthat the company could outlast anymarket calamity and that the stockmarket would eventually understandits errors in analysis, thereby entic-

FIGURE 1. THE RED CHIP VALUE CURVE

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ing buyers back into the shares.Book Value (P/BV): The next

value parameter is price-to-book-value. This is another measure ofworth that depends on balance sheetfactors, but it has a little differenttwist than the previous measures andis a more direct and easily under-stood gauge.

Price-to-book-value is calculatedby netting all assets against allliabilities, resulting in what is knownas net worth or net shareholder’sequity. When this is divided by thenumber of shares outstanding, thisterm is then referred to as equity pershare or book value.

The goal is to find companies thatmaintain a positive net worth tosuch an extent that it is greater thanthe market share price. Historically,investments made in firms that soldbelow their book value were soundinvestments and typically providedtotal returns greater than the marketreturn.

The problem is that book value, asan accounting term, has no realdirect correlation with the operatingcapability of the company. Thebenefit of using book value may bedue to what the calculation does nottell investors. Quite honestly, bookvalue is a product of an accountant’simagination, and the rules may letthe range of values span anywherefrom close to the mark to unbeliev-ably understated.

The problem remains that thevalue represented in assets is basedon historical costs while liabilitiesare measured on a current basis. Ifthese terms were static, the measuremight be more accurate, but theyaren’t and this is where the diligentoutperform the hasty.

An example: Longview FibreCompany (LFB) owns tree farms andoperates the largest liner boardpaper mill west of the Mississippi.The tree farms were acquired backin the 1920s for the most part, andthe plant has been expanded almostnonstop since the company’s found-ing. The value of the forest lands hasbeen depleted, according to the

accounting rules, as trees were cutand logs sold. So, the initial cost ofthe investment has declined overtime. But, fir in the Pacific North-west grows about 3% to 5% peryear, the trees are replanted as theharvests are made, and the overallvalue of standing timber, not tomention the timberland itself, hasappreciated with time. This is not tosay one should run out and buyLongview today. But there weretimes when the shares sold at anappreciable discount to book valueand certainly a discount to assetvalue.

CADAVER ACCOUNTING

Up to this point, we have onlyfocused on a company’s value asmeasured by its balance sheet.That’s a little like shooting aracehorse so that you can micro-scopically examine the entrails ofthe cadaver, test the strength of itsbones and the elasticity of its meat,to see if it has what it takes to winthe Kentucky Derby.

Not a pretty comparison, butentirely apt. The trouble is, anyinvestor looking for capital appre-ciation is missing something vital.They are ignoring the perhapsunquantifiable value of a living,breathing, operating organism—thegoing enterprise. Given the reality ofthe stock market and the long-termtrend of the U.S. economy, increas-ing individual wealth and industrialexpansion lead us to believe ingrowth and to place value on thisaspect of a company. To measure ittakes a whole new set of tools, usingdata from the income statement aswell as the flow of funds statementto measure it—at least as embodiedin an individual small-cap companyand its stock.

Price-to-Cash-Flow (P/CF): Cashflow is an income statement itemwhose significance in valuationsrequires some reverse logic tocomprehend. Cash flow, or net cashgenerated from operations, is notthe same as income. This is because

accountants have decreed that anumber of charges are better ex-pensed over the life of an asset.When Mobile Mini, Inc., (MINI)purchases another one of its steelfreight containers, for example, itpays cash to acquire or construct thecontainer. It is an investmentrequiring complete payment for thetransaction, but the funds may eithercome out of the company’s coffersor may be borrowed, so this transac-tion requires either cash or indebted-ness to be adjusted (down for theformer, up for the latter), and theoffsetting adjustment is the additionof a new asset.

When the container is pressed intoservice, it suffers wear and tear overtime, and accountants require thatMobile Mini charge its incomestatement for the depreciation. Theexpense for a corporation is de-ducted right off of revenues, thusdiminishing profits. But the cash wasspent when the asset was bought,and Mobile Mini is now getting paidfor the use of the container. So, thisgives rise to cash flow, which isdifferent than net income or profit.

Accountants like to accrueexpenses and recognize revenues asthey occur to match the accountingrecord with the actuality of thebusiness operation. It is a basic tenetof accountancy that books areconstructed in the most conservativemanner. It makes sense. But it alsocreates unusual opportunities forinvestors.

Matria Healthcare (MATR) offersa perfect New Year’s example of anincome statement that, because ofaccounting conventions, just doesn’treflect the operating results it isgenerating. In early 1996, this firmmerged with Tokos Medical Corpo-ration at a price that was at apremium to Tokos’ book value.Because of the manner in which themerger was transacted, the combina-tion was accounted for as a pur-chase. The resulting operation wassaddled with goodwill (essentially,the premium paid over book), whichmust be amortized over time much

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the way an asset is depreciated. Soevery quarter, Matria Healthcarehas included a very large, non-cash,amortization charge in its operatingfigures. Interestingly, the company’sreported loss was nearly $0.60 pershare for 1997 and $0.40 for 1998.

When the figures are adjusted forthe non-cash amortization charge,the company was actually profitableto the tune of $0.43 for 1997 andprojected to have a profit of $0.35in 1998. This year, our estimate ofactual reported cash earnings isnearly $0.50, since the companydecided to write-off all the afore-mentioned goodwill.

What does this mean to an equityinvestor? One, the company isactually throwing off cash, which itis using to fund its growing opera-tions. Two, this cash flow is suffi-cient to pay down both long- andshort-term debt. Three, whileoutsiders are not paying attentionbecause of the reported danger signs,the company can build other balancesheet reserves and repair variousoperations that are not quite up tosnuff. Four, when the amortizationcharge goes away, the shares shouldshow a substantial pop in per-shareprofits and a subsequent jump in theshare price because the marketwould not yet have understood theaccounting shell game until it is toolate.

The opportunity with enterprisesthat have high cash flow compared

to the market price of their shares(say, cash flow that is one-third toone-fifth of the stock price) isseveral-fold. Companies can fundgrowth without diluting currentshareholders. They can buy backshares using the flow of cash tofinance the transaction. They canmore easily purchase other operatingentities to capture a competitor, orexpand into new markets, or verti-cally integrate production. Yes, afirm that is considered a cash cowmay pay (increasing) dividends. Butwith a strong cash flow fromoperations, management can affordto be incredibly flexible, whichoftentimes means an ability to showimproving growth and, hence,market value.

Price-to-Earnings (P/E): This is theindustry’s tried and true measure ofvalue. It is relatively simple tounderstand, and even novice inves-tors can quickly grasp the meaningof the valuation multiple and caneasily apply the general rule-of-thumb guides to investment deci-sions.

Everyone understands that profitsare good when it comes to com-merce. And given the level of interestrates and the expectation of earn-ings, shares of profitable companiesshould sell at some multiple of thenet income per share level. Thoseinvolved in the financial marketsgenerally understand that a price-earnings ratio in the mid-single digits

represents a fairly inexpensive shareprice. When a company’s stock isselling at 100 times current year’searnings (or even next year’s esti-mates), it’s a signal to most that theshares are expensive. But, whatguides us to generally understandthese relationships, and how it isthat we know when something ischeap or rich?

The war horse contingent amongmarket professionals use a simpleprice-earnings ratio approach toprojecting stock prices. Using currentinterest rates, particularly the five-year Treasury note yield, someinvestors take the inverse of its yieldand calculate the market capitaliza-tion rate. For example, a while agothe five-year Treasury note wasselling at an 8% yield. Given thatparameter, the market would havebeen fairly priced if the S&P 400sold at 12.5 times—that is, 1 dividedby 0.08. As interest rates havedeclined over the last five years, theoverall market multiple has risenuntil it has surpassed 25 times,which from a historical standpoint(using our recent experience of thepast 20 years) seems high. But if onecan remember back to the early1960s and 1950s, interest rates wereactually much lower (30-year ratesas low as 3%), and today’s experi-ence may not be that much out ofline.

How this rule-of-thumb approachworks with stocks that you and Ihold concerns how our stocks differfrom the make-up of the S&P. Forexample, Monaco Coach Corpora-tion (MNC) has produced exemplaryresults over the last 36 months andsells at a discount to the marketindexes—according to the January 4close, about 11.0 times our estimatefor 1998 earnings of $2.40 pershare. Given our earnings projectionfor 1999 of nearly $2.80 per share,or up almost 16%, it seems severethat a cyclical, heavy industrymanufacturer of super-motor homessells at almost a 50% discount to theS&P.

This could be compared to, say,

FIGURE 2. SKYMALL VALUE CURVE

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SkyMall, Inc. (SKYM). The com-pany is a participant in the excitingE-Commerce arena, maintaining agrowth strategy that levers off its in-plane catalog business, its acquisi-tion growth, and its nascent Internetefforts. SkyMall is generatinglegitimate profits and growth around20% to 30% and is led by a dy-namic management team. The stockat $20 with a calendar estimate ofearnings of $0.25 for 1998, andmaybe as much as $0.35 to $0.45for the new year, signals to me thatthe stock seemed cheap by as muchas 100% when it was priced at$4.00, but now at $20, whatever theprospects of the Internet, is rich.

Price-to-Sales (P/S): In a valuationapproach that plays-off somewherebetween the price-earnings andprice-to-cash-flow area of the valuecurve, price-to-sales is a handymethod for a quick rule-of-thumbguide to potential winners. The basisfor this gauge is that companies areultimately limited by competition asto how far they can push their grossprofit margins, and hence bottom-line profits. But the reverse is alsotrue. Companies that are marginallyprofitable but maintain substantialsales often have the ability to ratchetcosts downward, and sometimessneak prices upward. If the salesleverage is substantial, managerialsuccess can be translated into asnap-up in earnings per share andsubsequently a higher share price.

The point is to find companies thathave a strong and growing base ofrevenues (and low price-to-salesratio) and a management team withthe foresight and toughness to wringout the excess expenses and forwardthe top-line through brand develop-ment.

LAND OF OZ

To this point, we have addressedvaluation techniques based either onbalance sheet items or the incomestatement returns.

Now it is time to focus on theuppermost reaches of the curve and

on two valuation techniques that areeasy to explain, but defy the logicalvalue. However nebulous to define,they are the foundation of invest-ment styles used quite successfullyby investment professionals.

Growth at a Reasonable Price(GARP) from an intuitive standpointseems to make sense—more growthis always better. Indeed, in the worldof finance, growth is one determi-nant that not only can give outsidersvolumes of information about anoperation, but also can hide a worldof operating problems or cushion thedestructive impact of inflation.

Most investors subconsciously usethis method of investment and,truthfully, with spotty successbecause of the lack of fixed guide-lines. Institutional managers believeit represents a valid investment styleand claim that growth-at-a-reason-able-price is descriptive of theirprocess. The approach is quitestraightforward—growth is naturallygood, and just buy stocks that arenot expensive. Of course, this issensible, but putting it into practiceis a bit tricky.

The strategy is to buy growthstocks, but at a discount to theirprice-earnings multiples. For ex-ample, if a company is growing itsearnings at a 40%-per-year clip, thestock is considered inexpensive (Idon’t feel right calling this cheap) ifit sells at a price-earnings multipleless than 40 times—say 30 times.

In fact, today’s market suggeststhat this valuation may be fair. Withthe S&P selling somewhere aroundthe 25-times level, this price suggeststhe stock in question is not a badbuy when compared to marketvaluations and the prospects of 9%to 12% overall growth in 1998.Relative to the current market, thecomparable valuation makes thislook appealing.

There is another market precedentthat helps support the GARPphilosophy. Over time, stocks have atendency to sell at their growth rate(a 15% compounded annual growthrate should foster the expansion of

the multiple to 15 times, 20%translates into a 20-times multiple,25% into 25-times). As companiessucceed and their profiles becomebetter known, their valuationproceeds through the asset valua-tions and then income statementvaluations (up the curve, if you will),until the shares are bid up to pre-mium, growth-at-a-reasonable-price,prices (think Starbucks). As thenumbers get increasingly larger, thelikelihood that firms can keep uptheir growth pace diminishes.Further appreciation becomes lessand less likely. Offsetting thecompanies that hit this speed barrierare firms with return on equity inexcess of the high-teens and bur-dened with little debt, whose above-average operating performance keepsinvestor loyalty from flagging—forexample, Wal-Mart.

You have also witnessed theweakness in the process: At whatpoint is GARP cheap versus expen-sive? When the ratio of multiple togrowth is 15 times at 25% growth,this seems like a respectable venture.But what about 26 times at 13%growth, as with ABM Industries(ABM)? The rule gets fuzzier andmore problematic as compromisesbecome necessary, the investment listbroadens, and markets becomeextended. It is for this reason thatthe climb up the value curve beginsto decelerate.

Momentum: Investors who use themomentum style are really theultimate believers in the adage “thetrend is your friend.” Based on my20 years of professional experience, Ihave yet to discover the basis ofvalue on which these investments aregrounded.

The process is very straightfor-ward. Momentum investors arelooking for companies recordingadvancing sales, earnings, shareprice, and transaction volumes. Acombination of these traits, based ona certain level of hurdle-rate growth,indicates whether a stock is a buy ornot. Once targeted and purchased,the investors hang on to the shares

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until the first sign that the wave isfaltering. I liken it to the BigKahuna surfing in the tropics—surfers work to gain speed until thewave is caught and then hold onuntil it virtually withers away.

The problem with this investmentstyle is pretty well depicted by thevalue curve illustration. The curvetops out with these investors and,too often, the price spills over thecrest of the curve and falls substan-tially. Incidentally, the fall fromgrace, if you will, is of such magni-tude that the price decline, exacer-bated by the retreat of momentuminvestors dumping shares andrunning for cover, overreacts to thereason for the sell-off. These sell-offsturn into panics, which bring theprice cascading down, oftentimes bytwo-thirds from the previous high.

A REAL-TIME EXAMPLE

Now how can you use this in yourinvestment efforts on a day-to-daybasis?

An example is SkyMall, which Iwas particularly attracted to inOctober. The stock had donenothing but decline since the sum-mer—actually, it had done nothingbut decline since it went public. Itappeared that earnings would beflat, but up on a pretax basis, andgrowth for the year would comefrom a combination of internalgrowth, new relationships, andacquisitions—a confluence ofopportunities that looked as if theywere really taking this company to ahigher limit.

The firm has an establishedapproach of marketing its merchan-dise by placing their catalogs in theseatbacks of most domestic airliners,and the catalogs generate respectablerevenue and profits. However, in atalk to investors this fall, theSkyMall president announced thatthe company had just spent$500,000 on an Internet orderingsystem for internal use, which could

also be used to handle orders fromoutside customers, as well.

At the time, SkyMall shares were$2.13, it was an established businessthat already generated profitsquarterly, it had customers thatcould be made aware of theirInternet site with little incrementaladvertising costs, and there was nopremium in the share price for itsInternet potential.

I performed a little valuation testworking though the various valueranges to see where the company’sshares should rest on the relativevalue curve. Net, net working capitalequaled $0.71—so, at two-plustimes, this stock would be higher upon the relative value curve. The bookvalue for the company was $1.24, sothe star belongs above this. Sales pershare are nearly $7.50, or betterthan 3.5 times the share price—stillmoving up the curve. Lastly, cashflow per share was $0.35, and withthe stock priced at $2.13, the roughparameters of the valuation screenindicated that SkyMall shares were alittle pricey for this point on therelative value curve.

But finding out that the companyis investing at least $0.10 per sharein new growth strategies each yearconfirmed our belief that the pointon the curve should be no higherthan at the price-to-cash-flow level.So, given the range between price-to-sales and price-to-cash-flow, Ipositioned the SkyMall stock market(the star) between these two points(see Figure 2).

In the figure, I have included avertical dotted line representing theaverage price-earnings ratio for theindustry in which SkyMall partici-pates—the catalog retailer industrysells at roughly 20 times; the adjoin-ing box states the specific industryprice-earnings ratio figure. Given theequity market and the current stateof valuations, this industry price-earnings ratio point anchors thecurve at a certain phase of valuesand helps place the stock in question

relative to its industry peers.On December 24, 1998, the

traders independently got wind ofthe company’s Internet connectionand the shares rallied to a high of$20. On the December 28, it hit ahigh of $48. From a Red Chip ValueCurve standpoint, the firm wouldhave been appropriately priced as itrallied through the $5.00 to $6.00level (20 times the earnings per shareestimate of $0.25 to $0.30). It mayhave been acceptably priced, as acatalog retailer, as it passed the$8.00 level (25 times to 30 times theestimate based on the firm’s long-term [four-year] growth trajectory of25%). However, it obviouslytranscended its gravitational ties as asimple retailer and became anInternet darling when it landed onDecember 23, at $20 per share. Evenhere (using a bit of hindsight), thestock might have been acceptablypriced as a growth-at-a-reasonable-price valuation given that the pure,Internet sales companies are sellingwell above the 100-times earningslevel. But above this level, anythingelse would be considered certainly amomentum situation and signalingcertain caution—after rising to $48,it rolled over the valuation humpand has headed downward eversince searching for its appropriatelevel.

This single example illustrates boththe value and shortcomings of therelative value curve—it is probablytoo conservative when it comes torun-away enthusiasm, but is prettyhandy when evaluating downsiderisk.

This statement also accuratelystates the usefulness of the curve andhow it may be applicable in theinvestment arena. An A-rated stockselling at a growth-at-a-reasonable-price level is a far different equityopportunity than if it were sellingbelow a price-earnings ratio valua-tion.

I guess all new millenniumMicrosofts are created equally. ✦✦✦✦✦