In Deep Value Investing the author presents, after an introduction to the philosophy of deep value investing, a collection of case studies of his mostly successful investments in British companies applying this approach.
Deep Value Investing is a quick read, and I found it interesting to see a successful investor explain the reasons behind buying specific shares. On the other hand, I missed a discussion of his process for finding these bargains.
Introduction: Being a Deep Value Investor
The Deep Value Philosophy
Deep Value Investing
Deep value investing, at its simplest, is where assets are purchased at a deep discount to their real worth. This can require a good deal of patience. It takes time to find the right company, and it takes time for the company to come good.
[...] it is perfectly possible to find statistically cheap stocks that are nevertheless remarkably poor investments. Comparing a stock's price with its net asset value (NAV) is an important first step, but it does not tell you all that you need to know.
The nature of fixed assets [...] is that they tend to be illiquid and for that reason difficult to shift. Surplus land can be sold, for instance, but this can be quite a lengthy process, taking many years to complete, with many unknown obstacles along the way which could derail the whole process at any time. It is all very well that a lot of value seems to be there, but how can it benefit the investor?
[...] a more reliable indicator of an investment with potential is a share trading at a discount to its working capital.
Assets [...] are all well and good – but liquid assets are what we're really interested in.
By prioritising shares with healthy current assets, you find shares whose value can be readily unlocked. Current assets are by their nature a lot more liquid and for that reason can be sold off quicker than almost any kind of fixed asset.
If we can find a stock whose current assets (i.e. inventories, receivables, cash etc.) minus its total liabilities are worth more than its current share price in the stock market, than we can talk of a stock that is trading at a discount to the net-net working capital position. [...] If that is the case, then we know on a statistical basis that we are dealing with a truly cheap stock. [...] The icing on the cake is that we have not taken into account any fixed assets. They effectively can be said to come free at the price paid.
How Deep Value Investing Works
[...] deep value investing is much more concerned with the actual facts of a company than forward-looking announcements. This is because the former are largely based on reliable historic data, while the accuracy of the latter still has to be established. Deep value investing likes to deal with the facts as they exist. And it prefers to base all opinions on those facts.
Above all what we seek to establish is: What are the assets that we are now buying? Are they capable of generating attractive returns at some stage in the future?
[...] my favourite value stocks are those that are light on fixed assets and heavy on current assets. And these tend to be service companies – for example, recruitment firms, financial services, consultants, house-builders (from time to time) and so on.
Their price movements all tend to be quite cyclical (and, of course, earnings-driven), which means there will inevitably be opportunities to buy them cheaply at some point. Interestingly, cyclical stocks always look cheapest on an earnings basis (i.e. measured by their P/E level) at the top of their cycle and most expensive at the bottom of the cycle, when their P/E levels are sky-high as their earnings have collapsed. The beauty of this phenomenon for deep value investors is that exactly when they are most unattractive to the majority of investors is precisely when we want to be buying them.
Of course, if I have achieved the value investor's goal and bought a "net-net" (or something close to it), where the company's current assets are worth more than their market capitalisation, I know that I have a margin of safety. This is why deep value investing is so important in a market crisis, when the immediate outlook is still pretty unclear. [...] To sell these stocks when they hit their net asset value, as some value investors would insist, would mean that my upside might only be some 10% or so. But by waiting for the earnings to re-establish again, they can easily go up 100% or 200% (not at all uncommon).
Deep Value Successes
Recruitment companies are often ideal deep value candidates. They invariably have strong balance sheets and are highly operationally geared; profitability tends to bounce back on higher sales and better utilisation levels. On the other hand, when entering periods of contraction their share prices tend to be very vulnerable and can quickly fall to lower levels.
In my calculations I generally ignore goodwill and intangibles as they are the most unreliable of assets. They tend to evaporate as a company encounters a more difficult business environment – loss of market share, for example, can put severe pressure on goodwill valuations. For that reason, the value investor is probably better off forgetting them, instead relying on the more durable assets.
It is very important, when evaluating trade and other receivables, to look at a company's clients. Who are they? Do they have a record of non-payment or doubtful debts? If a firm's clients are also struggling then it is sensible to expect that perhaps not all receivables will actually be received. This figure should then be discounted, perhaps quite aggressively.
It is also important to see how large a company's biggest client is and what they represent to total turnover, as well as to check client concentration. If the top four clients represent more than 75% of turnover then a company is in an uncomfortable position, especially when entering a recession.
[...] service companies have far greater flexibility when they go through adverse times. The business can be shrunk very dramatically in a short space of time; there is no need to close factories.
I tend to screen for companies by comparing their net asset value to their share price and don't worry too much about the immediate earnings outlook. This means I join the party after the share price has already disappointed many investors.
A good way of finding potential value investments is regularly checking the new lists of 52-weeks lows.
Analyst coverage dries up as the share price dwindles – when a share becomes small and unloved it no longer pays to produce such material. But this also means that opportunities are created for value investors.
Buying at a discount to cash doesn't really happen in the private market; the owners of private businesses know the values of their firms. Quoted companies don't have this protection. Their owners are shareholders who often have no idea about the true value of their companies, and are regularly ruled by a herd-like mentality.
Evaluating just what the downsides might be – and their scale – is a tricky game. It's perhaps the one area in deep value investing where we can't just let the figures do the talking: the balance sheet, after all, deals with the past. Positive forward-looking statements aren't enough to base an investment on, but negative or cautious ones can be worth paying attention to when deciding just how much of a discount you need before the investment is safe inside value territory.
Once I buy shares in a company, I read all subsequent release statements carefully. In the case of loss-making companies I check that my margin of safety is not melting away. If prospects change for the worse, I do not hesitate to sell and close my position.
B.P. Marsh & Partners
Deep Value Failures
[...] as investors we must try to learn as much from our mistakes as our successes.
The lesson to be learned from this is that high debt levels have to be treated with great caution even if there seems to be a reasonable margin of safety. If the way for the company to get its performance back to its NAV levels is not reasonably assured, those debt levels can prove deadly.
Deep Value Shares of Tomorrow
The market's short-termism and obsession with earnings is a common factor in creating good cheap shares for deep value investors.
Sometimes a whole sector can become a value investor's paradise. Virtually every component stock starts showing deep value characteristics. The house-building industry is a good example of this. The industry is very cyclical and this creates lots of opportunities for value investors. However, when the sector is in crisis, risk is also at its highest – and it is still possible to get caught out. One needs to be cautious, even when a share seems to be the bargain of the century.
It often seems to be a good idea to return excess cash to shareholders – it is theirs in the first place, after all – but cash is usually squandered on bad acquisitions or inappropriate share buybacks. Value investors like share buybacks, but only when they are done at a discount to NAV, thereby increasing their investment's NAV per share. Unhappily, most share buybacks are done at a premium to NAV and are rather designed to increase the earnings per share while little regard is given to the NAV of the underlying securities. Management often likes this, as it helps them to reach earnings per share targets, as well as making the management share option scheme perform so much better.
It is always a good idea with longer-established companies to check the pension liability situation. It can be substantial. Sometimes firms can start to look like a pension fund with an operating company attached to them. And pension fund trustees have a lot of power. Most pertinently to investors in value stocks, if a company enters liquidation such trustees have priority claims on any surplus assets. In other words, they must be paid before shareholders receive any payouts. So it is always a good idea to read the total statement and look for any comments concerning the pension fund position. It can mean the difference between a comfortable margin of safety – and no margin at all.
Finding the perfect value stock is a rare experience. In many ways "perfect" and "value" are a bit of a contradiction: most value stocks come with a lot of negative baggage (hence the value).
Locating potential equity investments by seeking those trading at a discount to their net asset value, we tend to end up with many interesting opportunities. But as deep value investors we approach these from a different angle to the majority of equity investors. Unlike them we are not particularly interested in earnings or P/E levels. For us, a deep discount, liquid assets, a cyclical sector and a proven, nimble business model are the ideal. Earnings can be peanuts. In fact, shares going through a trough in their earnings are often ideal buys.
When only a few interesting value stocks can be found, it may well be that the market is at such a level that it is better to stay on the sidelines. The deep value investor does so cheerfully. It can take a lot of patience and may mean forgoing many seemingly attractive investments. But chasing earnings is one way to be sure of losing out when markets turn.
[...] I try to be fully invested when the outlook is at its most worrisome, and head into cash and short-term high-quality bonds [...] as the markets become more confident.