With Dr. Bud Labitan, Physician, Investor, Author of Illustrated Valuations
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To get some insights for investors, Steve talked with Dr. Bud Labitan, who is both a physician and a value-investing devotee. Bud is the author of several books on value investing, including A Fistful of Valuations, that explain his investing strategies crafted on the principles put forward by Ben Graham, Warren Buffett, and Charlie Munger.
Note: Steve made it clear to listeners that none of the stocks he and Bud discussed should be taken as recommendations. Listeners should do their own research in consultation with their financial advisor.
The Current Market Situation
To start things off, Steve asked Bud for his opinion on the current market situation, specifically, whether he believes stock prices accurately reflect the current economic situation or if stocks may be a bargain at the moment. In reply, Bud said that he sees stock prices as still slightly overvalued. His thinking on the future of the overall market is that it all depends on the rate of return to normalcy, which he sees as dependent on how quickly a coronavirus vaccine or effective treatments are developed. While he sees the overall market as overvalued, he noted that there are still individual stocks that may be a bargain. “I saw Boeing at $100 or below a hundred as a bargain at that point because, prior to the coronavirus, Boeing had been selling above $400.”
Intelligent Speculation
Steve next asked Bud to talk about the factors that go into his Intelligent Speculation Model. He noted to listeners, ”Remember, investing is investing in businesses, not just in numbers that move up and down in the market.”
Bud explained that he developed the model based on the 1946 lectures Ben Graham gave to his students, combined with the four filters that Warren Buffett and Charlie Munger use: Products, Enduring Customers, Managers, and Margin-of-Safety, along with the fifth filter of Catalyst. He noted that Graham said, “There is a real difference between intelligent and unintelligent speculation and the methods of security analysis may often be of value in distinguishing between the two kinds of speculation.”
The first factor in Bud’s Intelligent Speculation Model is understanding the basic economics of supply and demand for a company’s products. Another factor to consider is the individual investor’s time frame for investment—short-term, medium-term, or long-term. A third factor is a company’s advantages and disadvantages, which should be considered both in the long-term, as well as specifically within an investor’s investment time frame. As an example, he mentioned the fact that demand for Netflix is up right now because everyone’s home, but that investors have to consider if that demand level will drop significantly when everyone returns to work.
Steve made the point that many investors make the mistake of extrapolating to infinity based on recent stock market action. When stock prices fall dramatically, as they have recently, investors think like they’re going to keep falling all the way to zero. Conversely, when the market is strong, investors act as if prices will just continue rising infinitely higher.
A Wife, A Girlfriend, Or A One-Night Stand
Steve next asked Bud to talk about his Stock Tracking Template, which uses a stock screener to identify potential investments. Bud screens potential stocks for investments into one of three categories that he refers to as a wife, a girlfriend, or a one-night stand. He explained, “A wife is someone you want to be with forever. Thus, you’re looking for a company that has characteristics of endurance and profitability and good superior qualities. A girlfriend has some attractive qualities. Applied to a business or a stock, there might be opportunities where the business is selling at a significant bargain and you may want to buy it and hold it for a year or two. A one-night stand is a short-term speculation where you see a bargain, there is a catalyst, and you have a high confidence or probability that the catalyst will kick in.”
Steve mentioned the importance of one of the criteria that Bud uses in screening stocks. He said, “I think the first criteria that you’re using, and I think it’s incredibly important to use that today, is the amount of debt that a company has relative to their equity or relative to their assets. Because if business is going to slow down and for a protracted period, these companies need to be able to survive, so they need a decent balance sheet. They need cash on the balance sheet and access to borrowing, if necessary.”
Other criteria Bud uses include net profit margin and estimated intrinsic value. In several of his books, Bud talks about the discounted cash flow model that he uses to estimate intrinsic value.
You can find Dr. Labitan’s books on Amazon to learn more about his investing strategies.
Disclosure: The opinions expressed are those of the interviewee and not necessarily of the radio show. Interviewee is not a representative of the radio show. Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. Content provided is intended for informational purposes only, is not a recommendation to buy or sell any securities, and should not be considered tax, legal, investment advice. Please contact your tax, legal, financial professional with questions about your specific needs and circumstances. The information contained herein was obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by the radio show.
Steve Pomeranz: I’m very happy to welcome back Dr. Bud Labitan, a physician and investor who has produced books related to value investing as practiced by Warren Buffet and Charlie Munger. According to what I saw on Amazon, he’s written 23 books including The Four Filters Invention and Illustrated Valuations, which we have discussed on air, and he always has the kind of grounded insight that is sorely needed in times like this. Hey, Bud, welcome back to the program.
Dr. Bud Labitan: Good morning, Steve. Glad to be here.
Steve Pomeranz: Good morning. Where am I calling you from today? I know I’m from my new studio in my office. Where are you currently situated?
Dr. Bud Labitan: Steve, I’m actually visiting my mother in Titusville, Florida and have been sheltering in place down here for about five weeks now.
Steve Pomeranz: Wow.
Dr. Bud Labitan: Normally I live in Schererville, Indiana, which is in the Northwest corner of Indiana.
Steve Pomeranz: Strange times, aren’t they?
Dr. Bud Labitan: Yes.
Steve Pomeranz: So did I count 23 books on Amazon, including the one that stated that you’re running for president?
Dr. Bud Labitan: I believe I have about nine or 10 books, Steve, some of those are different versions. There’s a large-type version, and then four of them are audiobooks on audible.com.
Steve Pomeranz: Oh, wonderful.
Dr. Bud Labitan: So I think the count is around nine or 10.
Steve Pomeranz: Okay, that’s enough. Let’s get to the business at hand. This virus has wreaked havoc on the world economy to a point where much of the business world is shut down. I asked the question that I think is on most investors minds, would you say that current stock prices in the US accurately reflect a dire outcome or exactly where we stand in the uncertainty or do you think American businesses are on sale right now?
Dr. Bud Labitan: I’d like to break your question into two parts there, Steve. In my view, most of the market prices are still slightly overvalued but not as overvalued as they were in late January. As far as outcome, it all depends on the rate of return to normalcy, which could be accelerated if we have a viable vaccine or could be accelerated back if we have good treatments that prevent patients from going into the ICU. Those are the two factors in my view.
Steve Pomeranz: So when you’re looking at stocks to buy—and we’re going to get into some of the screens that you use and how you think—forgetting about the fact we all tend to look at the market as one thing, but it’s actually a conglomeration of many different businesses and many different industries operating on many different factors. When you look at your stocks that you’ve modeled for so many years, are you seeing particular pockets that look incredibly attractive now?
Dr. Bud Labitan: I saw a couple that I viewed as intelligent speculation a couple of weeks ago when the market had really dipped. I saw Boeing at a hundred or below a hundred as a bargain at that point because prior to the coronavirus, Boeing had been selling above $400.
Steve Pomeranz: Yeah.
Dr. Bud Labitan: The other one that has kind of attracted my eye was Ford Motor, but Ford Motor has a complicated balance, so in general, I tell folks to be careful, do your homework, and also look at their balance sheets and their long-term debt structure.
Steve Pomeranz: Yeah, I want to get into that. And also, I want to say that any stocks mentioned are not recommendations, we’re just discussing stocks. You have to do your own research, have your own advisor. Again, let me make that perfectly clear.
Dr. Bud Labitan: Oh, sure, sure.
Steve Pomeranz: You mentioned intelligence speculation. That’s just not a couple of words put together, that’s actually a thing because you developed this intelligence speculation model from your meeting of Ben Graham and Warren Buffet and Charlie Munger, and I have the chart out in front of me. I want to go through each one of these so our listeners can understand the disciplined way of thinking about investing. Remember, investing is investing in businesses. It’s not just in numbers that move up and down in the market or on the internet, Yahoo Finance page, or wherever you’re getting your quotes. There’s actual economics behind it. Let me start you off. This is the Intelligent Speculation Model.
Dr. Bud Labitan: Sure.
Steve Pomeranz: Number one: understand the economics supply and demand of the situation. Explain that for us, please.
Dr. Bud Labitan: This model that I developed is based on the 1946 lectures of Ben Graham to his students, and in that last talk when he was saying goodbye to his students, he sort of said to them, “I know some of you are going to end up on Wall Street and some of you are going to get the temptation to speculate.” And let me just read the one sentence to you that kind of summarizes everything, Steve. Ben Graham said, “There is a real difference between intelligent and unintelligent speculation and that the methods of security analysis may often be of value in distinguishing between the two kinds of speculation.” The model was imagined in a way that what if Graham had lived into the modern Buffet and Munger era and applied the four filters as well as adding the fifth filter of catalyst and conditions needed for a quicker profitable outcome. So that’s how the model came into being.
As far as number one, understand the economics of supply and demand of this situation. On that one we have to really look at the timeframe of the individual business that the person is looking at because over the short-term, demand is near zero right now.
Steve Pomeranz: Yeah.
Dr. Bud Labitan: And hopefully things will start to pick up steam and then a person who engages in this, which I don’t really promote at this point because I think most folks should just stay calm in the waters right now, but really have to think about the timeframe in which they want to lock up their money. Is it for short-term, medium-term or long-term value?
Steve Pomeranz: Right.
Dr. Bud Labitan: And then the rest of them are fairly understandable. Number two is advantages versus disadvantages. You have to really think about are there real advantages or are they just imaginary?
Steve Pomeranz: The company’s competitive advantages?
Dr. Bud Labitan: Right, right. And also advantages in the period for which they are speculating. Right now, everyone can understand that the demand on Amazon is going up because everyone’s at home. The demand on Netflix is going up because everyone’s at home watching, streaming.
Steve Pomeranz: Yeah.
Dr. Bud Labitan: But then you have to be a little bit more realistic down the road is when everyone returns to work. Will that demand still be at this level or will it be 10 or 20% less?
Steve Pomeranz: I think when things get exciting, sometimes nasty, but volatile and aggressive, people tend to extrapolate current conditions far into the future. For example, if the stock market’s going down and you get that feeling in your stomach and you want to bolt, let’s say you want to sell everything, it’s because you’re extrapolating that things are going to go to zero or they’re just going to keep going down. And, of course, they never do. On the flip side of that, when things are exciting and prices are going up and you’re feeling like you’re really a genius because somehow you’re making all this money and you have some role in that. People tend to extrapolate into infinity the earnings of some companies like an Amazon or otherwise. Psychology plays an important role in this, right?
Dr. Bud Labitan: Right. I agree. Psychology and careful thinking. I think the number one thing is to think about safety, think about defining reality and if you do those two things or the three things we talked about, people will make better decisions if they put more thought into them.
Steve Pomeranz: Talking about putting more thought into what you do. If you’re going to take an approach of investing in individual stocks, I think there are methodologies and disciplines that one should use and one of the most common types is setting up a stock screen. This is where you can actually go online or get a piece of software or use an app where you can ask or put in certain conditions of what kind of balance sheet a company should have, what type of net profit margin and so on. And you’ve done that and you do that all the time. And I want to go over one of the templates that you’re using. The Stock Tracking Template, I think you call it.
Dr. Bud Labitan: Sure.
Steve Pomeranz: What I really liked about this was that when it all came out in the wash, you would rate a particular company in three ways. Is this a wife, is this a girlfriend, or is this a one-night stand? And I got a kick out of that because at first when I looked at that I was like, “What are you talking?” You’re asking your opinions of your wife, your girlfriend, about what you should be investing in. But seriously what you’re really saying is what?
Dr. Bud Labitan: What I’m saying is if you were really digging into it and thinking about it, a wife would be someone you want to be with forever. And thus you’re looking for a company that has characteristics of endurance and profitability and superior qualities.
Steve Pomeranz: Okay.
Dr. Bud Labitan: As far as the girlfriend, the girlfriend has some attractive qualities and applied to a business or a stock you would put that category on your watch list because there might be opportunities where the business is selling at a significant bargain and you may want to buy it and hold it for a year or two. And then finally the one-night stand is the speculation where you see a bargain and it meets the criteria on the Ideal Business Speculation Model, there is a catalyst and you have a high confidence or probability that the catalyst will kick in. It’s a speculation, it’s a short-term speculation and you have to set upper limits and lower limits on your speculation. So you have to be more careful about those.
Steve Pomeranz: All right, so let’s take a look at some of the companies. I think the first criteria that you’re using, and I think it’s incredibly important to use that today, is the amount of debt that a company has relative to their equity or relative to their assets. Because if business is going to slow down and for a protracted period, these companies need to be able to survive, so they need a decent balance sheet. They’ll need cash on the balance sheet, they’ll need access to borrowings if necessary. Their relative debt to their structure has to be pretty reasonable. I noticed that that was in the first column. What kind of filter are you using to debt to assets here, Bud?
Dr. Bud Labitan: This is simply taken from a program that I wrote called StocksCalc. It gets data from multiple online sources, I think one of the examples I mentioned here is Apple has a long-term debt to asset ratio of 0.27, so that means 27% of assets or relative to the assets, 27% are in long-term debt.
Steve Pomeranz: That’s pretty low.
Dr. Bud Labitan: Yeah, it’s pretty low and some companies have a lot higher. I believe Ford’s is around 0.47. If you compare those two, Apple has a lesser proportion of debt to assets.
Steve Pomeranz: I was surprised to see on this list that ExxonMobil, which is in a really terrible industry right now—we just saw oil prices plummet once again—they only have 7% of debt to assets. This is a company that just on this one metric,—and don’t trade on this metric, folks—but it seems like a fairly strong possibility that they should be able to get through this based on this one metric.
Dr. Bud Labitan: Oh, I agree, Steve. ExxonMobil has a lot of oil in the ground and they have control of numerous large oil fields across the world, so you know they’re going to ride right through this difficult period, it’s just a matter of when prices return to near normalcy.
Steve Pomeranz: Yeah. We’re, unfortunately, running out of time this went really quickly, so I’m just going to quickly mention some of the other criteria.
Dr. Bud Labitan: Sure.
Steve Pomeranz: The net profit margin, the estimated intrinsic value. Now, intrinsic value is something that is kind of a floating figure and there are numerous ways to calculate intrinsic value. But, one way is the discounted cash-flow model, and so I think you use that in your filters?
Dr. Bud Labitan: Yes. For your listeners, I mentioned that my model in several of my books, briefly, it’s just taking an approach on the free cash flow, growing it out at a conservative growth rate for 10 years, flattening it from year 10 to 15, summing that all up, and then using the net present value method to get the present value of that amount of money, and then dividing by the number of shares outstanding. I know we’re limited for time, but it is mentioned in several of my books.
Steve Pomeranz: Actually, I invite my listeners to go onto Amazon and take a look at those books, and if you’re interested in this to purchase some of them. My guest is Dr. Bud Labitan, L-A-B-I-T-A-N, a physician and investor and, as I mentioned, he’s produced these books and as a devotee of the Buffet-Graham-Munger school, uses these metrics to measure investment quality, especially in times like this where you don’t want to be stuck with companies that can go out of business and get into serious financial trouble, you really want to go with those that are tried and true and safe. Bud, thank you so much for joining me once again.
Dr. Bud Labitan: Oh, my pleasure, Steve.
