Deep Value Investing: Old School Investing

Deep Value Investing

You already know very well that Value Investing is the most sensible, safe and profitable investment method in the long term. It is something that is beyond doubt. What not everyone knows is that there are different families within Value Investing.

In this article we will see another way of investing that, despite not being a majority, continues to beat the market. It is Deep Value Investing, a classic investment style but which is still useful and effective today.

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  • Ben graham (Graham Bargain Style), sometimes actions deep value and the companies to which they belong go through temporary problems (falling sales, the inability to make a profit, etc.), which makes them extremely cheap. The listing price may be too discounted from your intrinsic valueBut despite the problems they face, if they are deeply undervalued - hence the name Deep value - they can offer very attractive returns when they find their way back into the light.

    Among the deep value situations, we can find the famous net-nets, that mostly appear in the universes of the dwarf y micro caps, although they can also appear in the universe of small caps. Analysts do not follow them, and they tend to be second-tier companies, or as Buffett would say they are “commodity companies”; without a leadership position in the industry to which they belong, nor a moat around them to protect them even from a cold.

    Besides the net-nets, we can also find deep value situations in general, in companies in the universes of Mid y large caps; Well established companies with a reputation but with temporary problems and extremely cheap.

    Most of the companies deep value They manage to get out of their period of mediocrity, making the discount between their price and their intrinsic value close. An improvement in the industry to which they belong, the launch of a new product or service, some corporate event (liquidation, merger, acquisition, etc.) among other situations, are the reasons for this type of company to get out of its problems .

    When talking about deep value, there is also talk of shareholder activism. Like most of these types of stocks they are deeply undervalued, full of cash and carry little or no debt; activists want them to gain control over them, and shake things up for the better. This is an excellent move for shareholders to earn a premium and their returns to increase. Ben Graham was an energetic investor and advocate for using activism to drive change in these types of companies.

    Metrics used in deep value investing

    The inability of these companies to shine, causes them to present very low fundamental ratios, such as P/B, P / E, P / CF, among others. In addition, their profit margins become single digits, unlike the excellent companies at low prices, which have double-digit numbers for these types of margins.

    Together with David Dodd, Benjamin Graham coined these types of actions in his book safety margin, since fixed and intangible assets come free. The result must be greater than the company's market capitalization. These types of actions are known as net-nets o cigar butts.

    NCAV = Total Current Assets - Total Liabilities

    Net Cash Value

    In addition to NCAV, this is another Graham & Dodd subliquidation method. Net cash It is commonly used to evaluate the net amount of cash of a business, and can refer to the amount of cash remaining after a transaction has been completed once all expenses and deductions related to the transaction have been subtracted. These types of actions are known as Net Cash, and its result must be greater than the market capitalization.

    Net Cash = Total Cash (Cash & Equivalents + Short-term Investments) - Total Liabilities

    Graham & Dodd Liquidation Value

    The liquidation value is what shareholders would receive if the company in which they invest were liquidated today. The calculation of the liquidation value is only an approximation, as explained by the authors in their book Security Analysis:

    The balance sheet of a company does not provide exact information on its liquidation value, but it does provide clues or suggestions that may be useful. The first rule of thumb when calculating liquidation value is that liabilities are real, but assets are of questionable value. This means that the liabilities shown in the accounting books must be subtracted from their nominal value. However, the value to be attributed to the assets will vary according to the nature of the business.

    To calculate the liquidation value, Graham & Dodd propose the following calculation:

    • Cash assets (including market price securities) = 100%
    • Receivables (less usual reserves) = between 75% to 90% with an average of 80%. Graham noted that retail installment accounts should be valued for settlement at a lower rate, between 30% to 60%, with an average of 50%.
    • Inventories (at a lower cost or market cost) = between 50% to 75% with an average of 662/3 (66.6%).
    • Fixed y miscellaneous assets (real estate, buildings, machinery, equipment, nonmarketable investments, intangibles, etc.) = entre 1% a 50%, con un promedio de 15%.

    Therefore, the formula would look like this:

    Graham & Dodd Liquidation Value = Cash + Marketable Securities + Accounts receivables * 80% + Inventories * 66.6% + Other Assets*15%

    Wrongly, many values believe that the formula of Net Net Working Capital (NNWC) is a separate formula, but this is a synonym for calculating the liquidation value. Let's see why:

    NNWC= Cash + Short Term Marketable Investments + Accounts Receivable * 75% + Inventory * 50% – Total Liabilities

    Do you see the similarities?

    Working Capital

    The time has come when net-nets started to disappear, so Walter Castle, a former Graham worker, decided to focus on the Book Value and in the Working Capital. If the latter was greater than the capitalization bursátilIt was a bargain. Schloss called these types of actions Working Capital shares. Also called Net Working CapitalThis calculation measures the company's ability to pay its current liabilities with its current assets. If the company cannot meet its current obligations simply with its current assets, it will be forced to use its long-term assets to pay its current obligations. This can decrease operations, sales, and may even indicate more severe financial problems, such as possible bankruptcy.

    Fórmula:

    Working Capital = Current Assets – Current Liabilities

    Adjusted Working Capital = Working Capital – Long-Term Debt

    Working capital per share = Adjusted working capital / number of shares outstanding

    Obviously, a positive result is better than a negative one. A very large positive result could indicate that the business has capital available to expand rapidly without requiring new capital, additional debt, or new investors.

    Interest Coverage Ratio

    This financial ratio measures the ability of the company to meet the interest payments on its obligations with only the income obtained from the primary activity of the business. A high result is the best. A result close to 1 or less indicates that the company has serious problems paying its interest.

    Interest Coverage = Operating Income (o EBIT) / Interest Expense

    Acquirer’s Multiple

    This earnings valuation metric was created by Tobias Carlisle, one of the most respected figures in deep value investing today. Toby based the Acquirer’s Multiple in the Fórmula Mágica by Joel Greenblatt, and found that this metric helps discover which companies are candidates for acquisition by activists. The advantage is that it can be used for companies of all market capitalization universes. A result less than 7 is ideal.

    Fórmula:

    Acquirer’s Multiple = EV / EBIT (Toby prefiere Operating Earnings)

     O

     EV / EBITDA (Toby prefiere, OIBDP [Operating Income Before Depreciation and Amortization]

     On the website of Acquirer’s Multiple, Toby points out that both variations of the formula are valid, and that it is better to use Operating Earnings (Sales - [COGS + S, G & A + Depreciation + Amortization]) and OIBDP (Sales - [COGS + S, G & A] instead of EBIT and EBITDA, the latter two used by Greenblatt.

    NCAV Per Share

    Using this indicator, Graham determined whether a company was selling to his fair market price. Ben bought the stock if it traded for less than 66% of its NCAVPS, resulting in that the company was trading for less than its liquidation value, making it a bargain, providing a large margin of safety to protect against possible errors. If the candidates did not meet this requirement, they did not buy.

    NCAV Per Share = NCAV / number of outstanding shares

    Net Cash Per Share

    In addition to the NCAV Per Share, with this formula you can also calculate the intrinsic value per share. If the stock is trading for less than 66% of your Net Cash Per Share, you're at a bargain.

    Net Cash Per Share = Net Cash / # of shares outstanding

    Book Value Per Share (BVPS)

    Also called Net Asset Value Per Share (NAVPS). Again, you want the quote to be less than BVPS.

    BVPS = Common stockholder’s Equity / Share outstanding (common stock)

    Price-to-NCAV (P / NCAV)

    Some deep value They want the P / NCAV to be less than 0.5.

    P / NCAV = current stock price / NCAV Per Share

    Price-to-Net Cash (P/Net Cash)

    Some deep value They also look for the P / Net Cash to be less than 0.5.

    P/NCAV = current stock price / Net Cash Per Share

    How to Find Deep Value Stocks

    Be they net-nets, net cash, working capital o book value, we can find this type of situation by screenings, searching the lists of 52-weeks low, looking at which industries are currently struggling, or simply looking at the investors' portfolio deep value professionals.

    If you are going to carry out a process of screening, these are the main ratios you should look for in your candidates:

    1. P/B < 1.5
    2. Debt/Equity < 0.2
    3. Current Ratio > 1.5
    4. EV / EBIT <7 o negative

    When to buy Deep Value stocks

    Once your candidate meets at least 3 of the 4 points mentioned above, you must do the calculations that we saw paragraphs above. If these are greater than the market capitalization, you've found a bargain. Now what should you do next? You do the calculation per share, which we also saw earlier.

    When to sell Deep Value stocks

    First you have to be clear that the deep value investing not a long term investment style quality value investing. This means that you will only keep these types of stocks in your portfolio for no more than 2-3 years, maximum. Why? Because when they get out of their problems - if they do - the situation changes, and there is no longer any point in maintaining them. Here are some tips to help you know the right time to get rid of your positions:

    1. If the gap between intrinsic value and share price does not close within 2-3 years, sell at market price.
    2. When an external manager arrives to change things with the company and offers a premium (OPA) to shareholders.
    3. When the share price is higher than NCAV, Net Cash, Book Value Per Share.
    4. Through a catalyst that increases the price and exceeds the intrinsic value (situations event-driven, positive news about the company, etc.)

    Advantages of Deep Value Investing

    • Objectivity, since it is based on numbers and not on subjective assessments such as the quality of the business
    • Efficiency, as it takes much less time to analyze a company
    • The strategy is perfect for individual investors or those professionals managing less than 10 million euros.
    • If you are a person who likes cheap things despite their lack of quality; And you also like to suffer without even blinking in pain, the strategy is perfect for you.

    Riesgos del Deep Value Investing

    One of the main risks when investing in these types of situations is due to psychology. The deep value they must tolerate watching their investments fall and fall, without having to sell their positions; while most investors value who follow in Buffett's footsteps prefer excellent companies so they can sleep soundly. So the deep value all you have to do is be very, very patient and have faith in the laws of large numbers, as John Mihaljevic would say in his book value trap We define it as that company that seems cheap but is not. Consumers no longer demand their products, it is not seen that there is a catalyst or management plans to get out of the hole and investors are not interested in buying a stake in this type of company. So how to detect if we are facing a value trap in the deep value?

    • The business model of the company remains the same and does not change to make the company profitable, get it out of its temporary problems or keep up with technological advances.
    • El management you're selling the stock, doing things that show mistrust, or lowering your dividend payment.
    • Can't find a catalyst for business: a possible purchase of the company by another; a merger, a new product or service to meet market demand, etc.
    • Un insider ownership too tall. This can be a problem since external managers - such as activists - will not be able to participate in changing the course of the company.

    Inside the value traps in the deep value, we can come across perennial net-nets. These actions have not been NCAV outperformed by market capitalization. Jonathan Heller of KEJ Financial, recommends reviewing whether the NCAV it remains the same (or similar), over a period of 10-15 years. If there is no improvement, you are facing a net-net perennial, and it is best if you sell it immediately. Another way to know if you are dealing with this type of net-nets is to review the company's profitability history. If this one is mediocre, be very careful and think twice before putting your money there.

    Importance of diversifying a lot

    By now you will have realized that investing in situations deep value it is more quantitative than qualitative. It is because of that, diversification plays a very important role, since as you do not do an exhaustive analysis -as the quality concentrate of Buffett and company-, you must invest in dozens of stocks deep value; With the sole objective that your portfolio does well, since sometimes you will find mines that will make you look bad as an investor.

    Deep Value Investing today

    Just like him value investing has evolved in its 83 years of life, investors deep value they do it too. You can emulate having dozens of net-nets in your wallet, or up to 100, like Walter Schloss did. Currently, the analysis deep value it goes beyond the quantitative, also focusing on certain qualitative aspects. This with the aim of not exaggerating having a portfolio with 30, 50 or 100 shares. Here is a list of the deep value currently a list that will also guard against value traps:

    • Take into account off-balance sheet items (off-balance sheet ítems). Martin Whitman was the first value Grahamnian that went beyond those established by Graham. In your calculations of net-nets or actions deep value in general, it includes those assets and liabilities off the balance sheet. This gives you a more accurate value when you analyze these companies.
    • El management. Logically, if you are investing in a lousy company, the management They should not be receiving high compensation, so you should check that they have a salary and compensation according to the benefits or sales of the company. In addition, you should note that Insider buy and buy stocks. This regularly indicates that they know things will get better and as Warren would say, they have skin in the game.
    • They take into account that the operating cash flow is positive; that he Free cash flow increase over the years; in addition to metrics such as Z-Score o F-Score; High Yield FCF are important.

    Top exponents and current investors of Deep Value Investing

    Walter Schloss's 16 stock investment rules

    Walter Castle

    • Benjamin Graham(†), Graham-Newman Corp.
    • Walter Schloss(†), Walter & Edwin Schloss Associates
    • Peter Cundill(†), Cundill Value Fund
    • Irving Kahn(†), Kahn Brothers Group
    • Tobias Carlisle, Carbon Beach Asset Management
    • Carl Icahn, Icahn Capital Management
    • Martin Whitman, Third Avenue Management
    • Seth Klarman, Baupost Group
    • Francis Chou, Chou Associates Management (invests in deep value and quality stocks)
    • Charles Brandes, Brandes Investment Partners
    • Tweedy, Brown Company
    • Jeroen Bos, Deep Value Investments Fund, de Church House Investments
    • Jonathan Heller, CFA; KEJ Financial Advisors
    • James Roumell, Roumell Asset Management
    • Steven Kiel, of Arquitos Capital Management
    • Tim McElvaine, McElvaine Investment Management
    • Miguel de Juan Fernández, Argos Capital FI (invests in deep value and quality stocks)
    • Juan Matienzo, Mercor Investment Group

    Is it compatible with other investment styles?

    Of course, Deep Value Investing is not incompatible with other methods such as Quality Value Investing, focused on looking for quality companies. The same investor can have a diversified portfolio with stocks selected for their quality and profitability on the one hand and stocks at a deep discount on their assets on the other. The only important thing is that they follow the basic principles of value investing, that is, be stocks that trade below their intrinsic value with an adequate margin of safety.

    Ideally, for investors, we do not focus on a single investment style, but are also able to take advantage of the opportunities that may arise through this investment style.

    Deep Value Investing Resources

    Books on Deep value

    Deep Value Tobias CarlisleFew are the books that will be found on the value investing Graham classic. Below I add a few of them. Not all of them are unique to the topic, but some do mention it.

    • Mr. Market you are already recognizing the true value of the business. It would be very good to check NTQ from time to time to see if its listed price falls and its fundamentals do not deteriorate, it may possibly become a call option.