There has been quite a bit of confusion between value investing and deep value investing in general. What is deep value investing and what makes it worth your while to actually practice it. If you ask me for my opinion which I have written a bit about on sites such as QUORA and on this very blog, I will tell you the same thing that I tell everybody.
But before we head down the rabbit hole here on this idea of deep value investing and value investing, I think it would make perfect sense to say what deep value investing is not. There isn’t a generally agreed upon definition of what deep value investing is so a lot of this article will be biased towards partly my learning journey and my experience as an investor.
So the million dollar question. What is deep value investing?
Deep Value Investing A Subset of Value Investing
Deep value investing is actually a subset of value investing. Value investing in particular has been popularised by Warren Buffett due to his tremendous success and prosperity. The media has a large part to play with regards to associating value investing with Warren Buffett. And of course, the countless articles and books describing in vivid detail what Warren Buffett has purchased and his style of investing have sort of shaped the general definition of value investing – that is buying companies at a price lower than the intrinsic value. And Warren Buffett is famous for saying that “value and growth are joined at the hip.”
This means that if you have the correct growth assumptions, the correct projections of the free cash flows and/or owner earnings of a business, one is able to value the company’s stream of cash flows, discount it to the present day and if the price of the company is indeed lower that the estimated intrinsic value, one could very well purchase this company. Warren calls this “buying wonderful companies at a fair price.”
The question is this. What is the fair price? That is something that is probably very hard to come to a conclusion about. For example, we know that a company like Netflix has growth but at what price are we paying for them these days?
I will give you some information on Netflix below.
Source : Google
Source : Morningstar
Yes there is growth for Netflix on all fronts of revenue and earnings. Revenue grew from 4.37 billion to 11.69 billion. That is nothing short of spectacular.
And the PE ratio that an investor is paying for it today is a whopping 230 times. That, to me is absolutely crazy!
Why would someone pay 230 times earnings for a company? Simplistically speaking, if one paid for and owned the entire company at this price, without any prospects of growth, one would take 230 years to collect back his entire purchase price.
And some value investors have bought this security quite recently and have held it in their portfolio. This makes me wonder if they have any idea what they are doing(perhaps they do) and are they putting too much growth assumptions on the valuation of the company, Netflix.
|Hold up a moment. I know that I don’t know very much regarding Netflix. I know. But just looking at the purchase price in relation to the company’s balance sheet and cash flows just makes the investment a no go zone for me.And of course in ,my books, I have stated that growth projections can be very subjective. You can find some of my books on AMAZON KINDLE.
If you want to know more about why high growth companies may fail you at some point in time, read this
So in order to justify such valuations, the company must grow. Failing which, you will inevitably see its price plummet. So there are 2 issues here when estimating growth.
- The further out your estimation, the more inaccurate your estimations of growth is going to be
- You need to have the correct growth assumptions over the next 10 years in order for your intrinsic value calculation to be correct.
And by intrinsic value calculation, I am talking about John Burr Williams here where he spoke about the value of a company being the discounted cash flows that can be generated by an entity over its life to the present day. So what is happening as we make these projections is that we are delving into the the known unknowns and the unknowns unknowns. What I am trying to say is that there is no way we would know for sure about these unknowns and this is the realm of uncertainty in which we deal with as we start to accept The Theory Of Investment Value by John Burr Williams. Not to say that it is incorrect but it sure can be extremely inaccurate for forecasters of all abilities.
When Graham spoke of these things such as forecasts of future value, he found these forecasts to be partially speculative in nature. He knew that one would have to make assumptions about interest rates, growth and terminal value of a security, all of which led Graham to doubt that such forecasts were actually accurate.
“One wonders whether there may not be too great a discrepancy between the necessarily hit-or-miss character of these assumptions and the highly refined mathematical treatment to which they are subjected.”
– Benjamin Graham
Our Forecasting Abilities Are Flawed
In 1996, when Steve Jobs came back to Apple Inc, the company had not been doing very well and was on the verge of bankruptcy. Microsoft had to inject $150 million in capital into the company for fear that it would be seen as a monopoly without competition. And you put yourself into those times of uncertainty, it is unlikely that you could predict Apple’s meteoric rise afterwards. I don’t think you could have foreseen Apple releasing the iMac in 1998 and even at that point, no one including the management had any inkling that the iMac would have been a success that Apple could build on.
In 2001, the ipod was released and then in 2007, the iphone was introduced to the world. Between those years, there was a tipping point in which Apple started to generate enormous returns on capital. But if I were to ask you to put yourself into the times in 1996 when Steve Jobs came back to Apple Inc, chances are that you would not have been able to predict the iMac, the iPod and the iPhone and other related products that became growth drivers of the company. Case in point. Hindsight is far superior to foresight if you didn’t know by now.
So if you have read till this point. Congrats! Deep value investing is not buying growth at insane, unjustifiable, irrationally high prices.
And yes I agree that buying growth stocks can be justified as value stocks but the lines are really blurred most times. In certain periods, these growth stocks seem to outperform the market especially in recent times. However, value mostly trumps growth. An article about this in another post in the future.
So what is the issue with paying up for growth stocks? Well the thing is that a number of untoward events can occur. These stocks can disappoint in terms of growth and cause share prices to plummet.
Source : Yahoo Finance
Valeant Pharmaceuticals was once a darling of many value managers touting its growth. While the story is complicated, Valeant mostly disappointed on growth expectations and this caused the stock price to plummet from $300 to $23 per share. This happens when there is a lot of baked in expectations of growth and when an investor pays a high price for that growth.
Deep Value Investing According To Graham
Ben Graham was the man that pioneered it all. The art of value investing as championed by Ben Graham was borne out of his experiences during the great depression. Then stocks could have been purchased for way less than it is worth. So here, I list the criteria that Ben set forth when it came to selecting deep value stocks. These stocks are usually clear cut bargains.
1. An earnings-to-price yield at least twice the AAA bond rate
2. P/E ratio less than 40% of the highest P/E ratio the stock had over the past 5 years
3. Dividend yield of at least 2/3 the AAA bond yield
4. Stock price below 2/3 of tangible book value per share
5. Stock price below 2/3 of Net Current Asset Value (NCAV)
6. Total debt less than book value
7. Current ratio great than 2
8. Total debt less than 2 times Net Current Asset Value (NCAV)
9. Earnings growth of prior 10 years at least at a 7% annual compound rate
10. Stability of growth of earnings in that no more than 2 declines of 5% or more in year end earnings in the prior 10 years are permissible.
An earnings-to-price yield at least twice the AAA bond rate
When it comes to defining a whether a company is undervalued, Graham had a very elegant way of doing it. Knowing that the value of a security is affected by changes in the interest rate environment, he demanded that the earnings yield of a company be twice of the AAA bond rate. What is AAA Bond rate? A AAA Bond is a bond that is considered investment grade by bond fund managers and credit rating agencies. An AAA Bond is perceived to have the lowest probability of default by credit rating agencies such as Fitch Ratings. These bonds are rated based on the strength of the issuer’s balance sheet, the levels of debt and cash and also its ability to pay off debt and withstand economic adversity. For example, Johnson and Johnson is triple A rated. Why? It’s interest cover is 20 times. So the company can comfortably service its debt. And if it issues bonds, a good amount of those bonds would probably be triple A rated.
Now if a AAA bond rate is 5%, Graham demands that the earnings yield which is (earnings/price x 100%) be at least 10%, twice that of 5 %. Now ask yourself this question. Would you prefer to buy a bond that pays 5% per annum or a stock that pays 4% per annum and still have a probability of capital appreciation in terms of a rising stock price? Where did that 4% come from? From the earnings earned by the company, the company can choose the give out a dividend payout ratio of 40% as dividends. As such, the dividend yield of the company is 4%. Who knows? It may actually be higher. So incidentally, companies with a high earnings to price yield or a low PE ratio tend to be stocks which are not appreciated by the markets.
An example would be a Greek tobacco company called Karelia Tobacco trading at a price of €60 trading at a price to earnings ratio of around 6 by December 2011. In December 2010, the company’s Enterprise Value to EBITDA was a meager 1.06. Today, the company has a share price of around €300 per share.
Source : https://simplywall.st
Now if the interest rate environment changes and now a triple A bond rate is 10%, since we know that when interest rates rise, borrowing costs tend to rise and this may affect corporate profits which can cause stock prices to fall, Graham will insist on an earnings to price yield of 20%. That means the stock must trade at a PE ratio of 5 times. That also means that he demands that the price falls further as interest rates rise. Can you fathom the brilliance of this man for a moment? To me, Ben Graham is just sheer genius! And the simplicity of it is just amazing.
Now, my problem with looking at earnings is that they tend to be volatile and the PE ratio accorded to such stocks can vary quite drastically. This works but my preference is for an asset based approach ( The net current asset value approach which I will talk about later).
P/E ratio less than 40% of the highest P/E ratio the stock had over the past 5 years
We all know that in markets exhibiting irrational exuberance, we know that that PE ratio accorded by the market tends to be quite high. Graham demands that the PE ratio be less than 40% of the highest PE ratio the stock has ever had over the past 5 years. That implies a 60% discount from the highest PE ratio recorded by the stock’s price. An example perhaps would be Moody’s Corporation.
The P/E Ratio of the stock was 22.92 in 2006 and in 2008 it was 9.37. So that was a roughly 60% decline from the 2006 high. And if you had bought then at the end of December 2008, this is what it would have looked like.
Source : Google
Every $22 invested would turn into $183. Again, I have to say that my preference is for using an asset based approach such as the net current asset value because earnings can change faster than the rate of change of assets. That is something that Walter Schloss has spoken about as well. But I have to say that once again that Ben’s approach to the stock markets have been back tested. And the thing is that it works.
Dividend yield of at least 2/3 the AAA bond yield
If the triple A bond yield is 6%, Ben Graham will insist that the company pays 4% which is two thirds of the triple A bond yield. Again, when combined with the a low PE ratio and an earnings yield that is twice that of the triple A bond, one will find statistical bargains that are cheap relative to the earnings and at the same time pays you to wait for price appreciation. To Graham the dividends is a very important factor when it came to stock purchases. However, there are many instances where the dividend yields do not matter for the opportunistic investor. Imagine an example where a company is forced to cut dividends temporarily. The stock market tends to put extremely depressed valuations on such companies and these circumstances tend to be temporary. An example of the top of my head perhaps is Anglo American. Source : marketwatch
In 2015, the company had to suspend dividends to channel funds to restructuring of its business. What happened next as you can guess was that the stock was punished severely.
Source : Google
The stock was battered and the company’s price fell by more than 70%. Incidentally, that was a chance for astute investors to get in on depressed valuations as you cans the charts above. The company eventually recovered from its low of 233 GBX to 1500 GBX in 2 years, a great return for investors who dared. Of course, the analysis of the company is a bit more complex but I would have the say that the suspension of the dividends played a part in causing the stock price to fall.
So with regards to the rule that the dividend yield of at least two-thirds the AAA bond yield, this can be bent at times. There are a variety of dividend strategies and that perhaps will require an entire book or an article on it.
Stock price below 2/3 of tangible book value per share & Stock price below 2/3 of Net Current Asset Value (NCAV)
I am going to address these two criteria here.
I have to say that I am somewhat biased when it comes to balance sheet strategies such as the low price to book/tangible book and the low price to NCAV. If you did not already know, NCAV stands for the net current asset value. The net current asset value is an approximation of the liquidation value of a company. It is essentially the paying off of all liabilities using the stated values of the current assets on the balance sheet. Hence the net current asset value is current assets less all preferred stock and liabilities. If you divide that by the the total number of shares outstanding, you will arrive at a figure called the net current asset value per share which you compare to the price per share of the company. If the net current asset value per share is 1.5 times or more of the price per share, Ben Graham would consider the company a suitable candidate for his portfolio and will place that entity under investment consideration.
So quite usually as I have seen, if a company is trading at a price less than two-thirds of the liquidation value, the company is already trading at a price less than the book value or the tangible book value. The difference is that net current asset value stocks are usually current asset rich as compared to low price to tangible book stocks.
Now the thing is that a lot of net current asset value stocks have temporary problems and uncertainty. The stock market in general does not like uncertainty and low, beaten battered prices relative to balance sheet values are the norm for net current asset value stocks and low price to tangible book stocks.
To the untrained eye, investing in such stocks is asinine. But to the astute deep value investor, it is an opportunity to make 1,2,3 or even 10 baggers if you know where to look. And this is what TheHolyFinancier is about. We are on the prowl for deeply undervalued securities which are off the radars of most investment analysts.
This remains our preferred approach for finding boring, obscure stocks which trade at prices less than the liquidation value. And we love it. We typically see the fastest returns in the net current asset value approach. Sometimes, we even find companies trading at less than net cash or companies trading at less than the total cash and cash equivalents subtracting of all liabilities. And we are not talking about chests of cash here.(We generally stay away from chests of cash with no operations) We are talking about companies that are operational and are generating high levels of cash flow relative to the market capitalization.
And the reason why we love this approach is because assets do not fluctuate as much as earnings. While earnings are the go to metric when it comes to valuing a company, if a company is trading at less than the tangible book and is temporarily loss making, there is an opportunity to pick up such securities at really cheap, distressed prices although the company may not really be distressed.
An example would be a company that has a building worth $100 million on the balance sheet and has no debt. The previous 12 months for the company may have been only $1 million in net profit compare to the previous year’s of $8 million. But, if the market capitalization of the company is $50 million, the company is definitely a bargain.
Because a buyer can buy the company’s existing shareholders out at $70 million, giving existing shareholders a premium to exit and then selling that building off to the highest bidder at $100 million or more. If the building was sold for $100 million, that astute deep value investor just made $30 million from the transaction.
And so my point is : Earnings do not always count!
If you have the fortitude to buy a basket of such stocks, inevitably over long periods of time, you will do very well relative to the markets. A few companies which are net current asset value stocks which I have purchased are listed below.
I bought this at around 29 cents and sold out near the peak in about 12 months.
Purchased this 12 months back and sold out at prices close to $2.50.
Purchased this at 298 JPY and sold out for more than a 100% profit in less than a year. This was a gem in Japan. So the net current asset value approach has performed very well for us. And the good news is that you do not need to be a genius to adopt the approach. What you need is perhaps some guidance for starters and then you are good to go.
What about the net net working capital approach?
The net net working capital approach is also an exercise to find out the approximate liquidation value of a company. It can be more conservative than the net current asset value approach. However, as mentioned, it is just an exercise and can be rather subjective in a sense that it requires a certain judgement from the investor as to how much each asset’s value should be discounted by. There is perhaps more that I can elaborate on in another article. But between the net current asset value and the net net working capital approach, it seems that the net current asset value approach has more academic backing. It has bee proven to work in a number of backtests across different markets such as USA, Thailand, UK and Japan.
The Sideshows – Debt, Growth In Earnings & Liquidity
The other criteria are what I call complements to an already sound strategy of picking stocks. Low levels of debt, growth in earnings and a good current ratio would add strength to an investment thesis. To subscribers and paid members of TheHolyFinancier, you have access to content surrounding these matters. I am going to just generalise by saying that low levels of debt in general are good and earnings growth is not a must from the standpoint of a deep value investor. But the truth is often more fluid than we think and can be rather grey. Hopefully, I have addressed these matters sufficiently within the paid section of TheHolyFinancier.
Closing Thoughts On Deep Value Investing
“The more comfortable you are with an investment, the worse your investment results are going to be.”
This is a quote from William Bernstein that perhaps sends the message home. For investors looking for alpha, they have to have that emotional fortitude that will see them through not just the ups and the downs but also give them the ability to stand apart from the crowd. So deep value investors are naturally have that contrarian streak in them that will enable them to succeed over long periods of investment time horizon.
Thank you for reading this far. May you be blessed with prosperity, health and happiness!
These books which I have written are case study driven and discuss strategies, mindsets and situational approaches to employing the net current asset value strategy.
What Is TheHolyfinancier About?
- A database of net net stocks or net current asset value stocks
- Investing ideas in members section
- Blog articles and investing education