What Makes the Deep Value Investor When Net-Nets are Going to Disappear?

The biggest issue in finding deep bargain stocks and net-nets is the overall level of stock market valuations. We have already lived the time of high stock valuations for many years. P/E values are above average globally. One reason is certainly the low interest rates. And they also partly justify higher valuation multiples. This means for deep value investor that it is increasingly difficult to find really undervalued companies. And this is especially true if you trade only in the domestic market – and your home market is not Japan, Hong Kong or Singapore.

When investing net-nets or other deep value stocks you have to follow some basic rules. Avoiding risk and increase your odds for success you need basket of these stocks which means that availability of net-nets must be wide enough. Remember also that amount of net-nets is one thing and the quality is another. In overvalued Western markets most of these companies are smaller cap stocks with questionable businesses or without actual operating businesses.

 

So what could help us?

* Going globally

It’s easy to understand that investors may prefer try to find opportunities within their own country. Many investors don’t believe they know enough about foreign stocks to make overseas investment worthwhile. Maybe professional local investors have a more information on the specific company, but it is not decisive. No one can know everything and you just have to know enough to find the opportunities and to evaluate them. Using today’s technology, globally available information and being careful enough to avoid financial gimmicks and frauds, it should be doable job. In my opinion if you don’t look at overseas, it’s a big mistake.

The real reason to invest with a global focus is to double the number of potential deep value opportunities from which we can choose. While the US market isn’t full of net-nets a variety do exist worldwide with the biggest concentration in Japan right now. Although US market dominate investing world and its reactions impact all over the world, not all markets are moving in the same direction. There’s a downturn nearly always somewhere. So keep your eyes and mind open.

 

* Cash

Should you stay full invested or move to cash? That’s the big question for every investor. During the time when stock markets are overpriced it’s wise to increase your cash portion. When too few stocks are cheap enough to buy, you should automatic end up holding more cash. It should be normal that couple of your stocks reach overvaluation range when the overall market is expensive. In this case value investor must be prepared to sell or reduce his or her position.  And when respectively bargains are in short supply you should end holding cash. In a short time you may lose opportunity costs – an alternative to buying stock yielding 5 % dividends – but after market correction having enough money to buy quality bargains will compensate it many times.

You can plan your own system how much you want to keep in cash. Follow the most common market metrics – like P/E, Schilller P/E, P/B, Dividend Yield – and when they begin to be over long time averages, start increase your cash position. You have to decide what is the ideal balance for you. Maybe during the possible market peak you want to be 50 % in cash and 50 % in stocks. You can be more aggressive or cautious depending on your basic philosophy. Look at the value metric you chose during the dotcom peak or just before the last financial crisis to get the high figure. Then make a plan for what speed you add the amount of cash when your benchmark metric increased. You can read very instructive article on this topic from here: http://www.gurufocus.com/news/457965/should-value-investors-hold-cash-when-the-market-is-overpriced

 

* Other deep value strategies

Every now and then even the deep value investor has to be ready to modifying his selection methodology to adapt to the changing marketplace. It doesn’t mean that you give up your basic principles of value investing. You just accept the market facts and act accordingly.

During the years also very big and famous value investors have faced this situation. When deep bargains have been in short supply, they have been forced to adjust their valuation techniques. The next we will look at the methods of some of the big names.

Brandes four steps:

Chairman of Brandes Investment Partners Charles Brandes is one of the all-time greats and Ben Graham disciple.

  1. Share price is less than book value per share
  2. No losses were sustained within past 5 years
  3. Total debt is less than 100 % of total tangible equity
  4. Earning yield is at least twice the yield on long-term (20-year) AAA bonds

Note: A little looser balance sheet valuation is compensated at higher earnings and yield requirements.

Whitman safe and cheap approach (from the Third Avenue Fund literature):

Martin Whitman is Founder and Portfolio Manager of the Third Avenue Value Fund. He is a long-term value investor and also distress investing specialist.

  1. Start to check that share price is less than book value per share.
  2. The common stock is selling at price that reflect at least 20 % discount from readily ascertainable Net Asset Value (NAV) as of the latest balance sheet.
  3. There is comprehensive disclosure including reliable audited financial statements; and the common stock trades in markets where regulations provide substantial protections for minority shareholders.
  4. The prospects seem good that over the next three to seven years NAV will be increasing by not less than 10 % compounded annually after adding back dividends.

Note: In this case a little looser balance sheet valuation is compensated requiring more safety and NAV growth.

 

Peter Cundill magic six stocks:

Already deceased deep value specialist from Canada.

  1. P/E of 6 or less
  2. Dividend yield of 6 % or more
  3. 60 % or less of book value

Note: In this method is required a clear discount to book value because general book value (including intangibles such as goodwill or the values of a property and plant) is not so liquid than net current asset value. Also dividend yield of 6 % or above is unusual. Mostly the company is in some sort of distress situation or it is a REIT.

 

J. Lukas Neely adjusted liquidation value:

Young value investor and founder of Vantage Research and BetterInvestingHabits.org

– Cash                                                                         95 %

– Marketable securities                                    90 %

– Receivables                                                           75 %

– Inventory                                                                25 %

– Property, plant & equipment                       50 %

Note: The aim is conservative valuation of each asset components. In addition to current asset also other tangible assets are included to get the total asset valuation of company. Asset valuation is depending of each situation and the quality of company’s assets.

 

Low P/E, P/B or EV/EBIT

There will be also other deep value strategies. The simplest strategies are those which picks cheapest stocks according to common fundamental price ratios, such as price-to-earnings (P/E), price-to-book (P/B) or EV/EBIT. As alone method EV/EBIT seems to outperform the other price ratios following to recent back tests. You can beat the market even using those simple ratios, but in practice you have to do little extra work to form a functional portfolio. This means you use additional quantitative metrics or you make qualitative company analysis.

 

Adjusted asset valuation (Asset reproduction value)

Using this method, we are trying to get to a figure that a competitor will have to realistically pay up in order to enter the market. That’s the purpose of the asset reproduction valuation.

Book value is simply the assets minus liabilities as stated on the balance sheet. Reproduction value looks at how much it will cost a competitor to purchase the assets required to run a competing company.

Adjusted asset valuation is very much dependent on one’s circle of competence. Investors must know which balance sheet adjustments they have to make. They need the ability to evaluate selected businesses. But you don’t have to be expert on every company, you really can select them on your knowledge base. Asset reproduction valuation can present many lucrative investment opportunities, if we can find valuable hidden assets and they are offered at a reasonable margin of safety (large enough discount from estimated value).

Balance sheet adjustment in practice:

  1. Cash and marketable securities will always be 100 %. No adjustment needed.
  2. Accounts receivable probably needs some adjustments. A new firm starting out is even more likely to get stuck by customers who for some reason or another do not pay their bills, so the cost of reproducing an existing firm’s accounts receivables is probably more than the book value. Looking financial statements, you can specify how much has been deducted to arrive right net figure to be added back.
  3. Check company’s inventory method. The way to look for this is to do a search on the financial statements for “LIFO” or “FIFO” reserves and see what it says in the notes. According these do the possible adjustment.
  4. Then estimate of the present value of the deferred taxes.
  5. After current assets you need to adjust property, plant and equipment. Generally the real values of land and buildings are increasing in the course of time and often it doesn’t correspond the depreciated value on the book. From here you can sometimes find a real hidden asset value. The value of machinery, equipment and furniture etc. will be discounted sometimes, but you have to check what it requires a competitor to pay to purchase similar one.
  6. Adjusting for intangible assets and goodwill is more challenging. Goodwill means that a company has overpaid for another company’s asset over its book value, but in this context it refers to the intangible assets that a firm uses to create value. Such are its product portfolio, customer relationships, competitive advantage, licenses, patents, brands and so on. When estimating this value use selling, general and administrative (S,G&A) costs of the company between one to three years. Prefer conservative estimate.
  7. Finally we are adjusting the liabilities. Liabilities and equity are the sources of funds that support the assets. We should look at liabilities that arise from the normal conduct of the business. Most of these are current liabilities. We can simply subtract the book value of these liabilities from the reproduction value of total assets to arrive at the reproduction value of net assets.

Remember that these adjustments are always a little bit arbitrary. This means that valuation is approximate measure of the intrinsic value of a given security. Our objective is to be approximately right rather than precisely wrong. We can achieve a range of intrinsic value and doing so it is possible to value a stock within an acceptable margin of safety.

 

Final Words

When the market is expensive it is always tempting to loosen the valuation principles. In that case a big cash position can be a big risk for value investor. This can push him to take oversized risks. Above I tried to bring up different proven deep value strategies. You can use them during the time of high stock valuations without compromising safety of investing and basic value investing principles.

At the end think about what great value investor Irwing Kahn said during the tough value investing environment: “If you complain that you cannot find bargain opportunities, then that means you either haven’t looked hard enough or you haven’t read broadly enough.”

 

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