Last week, Jeroen Bos’s exciting upcoming book Deep Value Investing was made available for pre-order over on our sister site Harriman House. It’s shaping up to be a fascinating read for any investor – especially followers of Benjamin Graham’s The Intelligent Investor or the methodology of investors like Warrren Buffett. If you’ve ever picked up MoneyWeek, Investors Chronicle or similar magazines – you’ll not only have heard about Jeroen Bos (here and here, for instance), you’ll also find the book’s style right up your street.
As said, the book is currently being edited, but we wanted to share an early version of Chapter 1 with Harriman Intelligence readers as we think it gives a really meaty idea of what the book is like.
We hope you enjoy this little snapshot of deep value investing – do comment below with any thoughts, or hit us up on Twitter @harrimanhouse …
CHAPTER 1. DEEP VALUE INVESTING
A neglected method
VALUE INVESTING HAS been around for a considerable amount of time, its investment results have been astonishing and still the majority of equity investing ignores its principles and follows a whole host of other approaches.
Value investing, at its simplest, is where assets are purchased at a 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.
So value investing is not conducive to buying no matter what the investing climate actually is. Nor is it about being a ‘busy’ investor. There is a whole advisory industry bound up with the stock market – firms and individuals whose main purpose is to advise clients on their investments. Unfortunately, this industry is structured in such a way that a lot of its income is generated on a transactional basis. This inevitably leads to a higher turnover of positions than is really justified – certainly than is conducive to a genuine value investing approach.
Investors are given wide access to opinion makers, surrounded by pundits’ latest views and market calls, while companies are encouraged (even required) to update investors on an ever more frequent basis. Without necessarily realising it, investors’ horizons are being constantly foreshortened. Short-term disappointments are seen as a reason to up and sell and look for better investments elsewhere.
This type of investment behaviour is closely associated with the market’s fixation on earning prospects, now and in the near future. There is no escaping the commentary generated by the focus on these earnings. It gains wide coverage and inevitably influences share prices. Stocks get bought up till they reach levels where they are ‘priced to perfection’; the slightest earnings disappointment is then punished with a weaker share price.
At the same time, other stocks get bought because they have underperformed others in the same sector and are therefore relatively cheaper. But this perceived value is not based on actual asset values.
Market noise like this drowns out actual facts. But this is also the deep value investor’s opportunity: it means you can find hidden gems that everyone else has missed. In fact, you can find them just as everyone else is busily throwing them away.
Bargain issues: true deep value
There are different kinds of value investing and not all are created equal. Seeking the stronger rewards of deep value investing means not settling for spurious value stocks.
After all, 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) does not tell you all that you need to know. A company’s net assets may comfortably exceed its value, but the nature of those assets can complicate things. Tweedy, Browne – a famous New York-based value investment company, workplace of Walter Schloss and broker to Benjamin Graham – found just this in its highly recommended study ‘What has worked for us in investing’ (tinyurl.com/tweedybrowne).
Many stocks merely trading at a discount to their NAV are undoubtedly cheap, but they often tend to be genuinely unexciting. They have years of declining profitability, contracting markets and little hope of a sustained turnaround. Their balance sheets tend to be light on working capital but heavy on fixed assets, where a lot of value is locked up in (obsolete) plant and buildings. They often mention, in the notes to the accounts, that there is surplus land available for sale etc.
Statistically they are cheap. But, crucially, it is difficult to see how the gap between the net asset value and share price can be closed. Often in these cases the NAV eventually joins the share price as losses continue to accumulate and the margin of safety slowly but surely evaporates.
This is obviously not a type of value investing that is particularly attractive. The trouble with this type of discount-to-net-asset-value investing is that one invests in seemingly cheap stocks but they are actually not cheap at all. The nature of fixed assets, as the name implies, 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?
And that is exactly why so many of ‘heavy fixed asset’ stocks are, on the whole, not really good investments at all. Interestingly, Tweedy, Browne found that a more reliable indicator of an investment with potential is a share trading at a discount to its working capital.
Benjamin Graham and bargain issues
Assets, then, are all well and good – but liquid assets are what we’re really interested in. The thinking of investing legend Benjamin Graham helps move us towards the full picture of what deep value investing involves.
In 1987, when world stock markets crashed and equity investing went through some very dark days, somebody mentioned to me that it was the ideal time to re-read Benjamin Graham’s The Intelligent Investor. In fact, I hadn’t yet read it for the first time, so I made a note to buy it. Once I started reading it, I knew I had found the fuller investing framework I had been looking for.
Having experimented on my own with value stocks, I could read balance sheets. But with the help of this book a whole new world opened up to me. I read the book in no time and have re-read it many times since. I find it particularly useful when the market goes through a difficult time and stocks don’t react in ways that we expect – when everything is being sold off, the good and the bad, and the future of equity investing itself is being called into question.
It is actually at such a time that the value investor should be at his or her most active. However, it can be a pretty lonely place for the stock-buyer. The Intelligent Investor is a much-needed source of sanity and support in such moments. It continues to make perfect sense.
Benjamin Graham’s classic really taught me what to look for in a balance sheet and how different assets affect the attractiveness of potential investments. The most attractive companies, according to Graham’s results, are the so called ‘netnets’ or ‘bargain stocks’.
The beauty with these value stocks is the prominence of their current assets. In the first instance, their fixed assets can be ignored completely. 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 stocks whose current assets (i.e. inventories, receivables, cash etc.) minus their total liabilities are worth more than their current share price in the stock market, than we can talk of a stock that is trading at a discount to the net working capital position. To put it a slightly different way, this is where the current assets minus current liabilities but also minus the long-term liabilities are still greater than the current market capitalisation. If that is the case, then we know on a statistical basis that we are dealing with a truly cheap stock. Even if it can never be sold off at a vastly improved share price, you still have a bargain on your hands. The assets are worth more than what you’ve paid for them.
The icing on the cake is that we have not taken in account any fixed assets. They effectively can be said to come free at the price paid.
These stocks are known as bargain issues. It is finding this kind of share that this book will focus on, as they consistently boast the highest returns. There are never that many. They can be elusive. They tend to appear, as Benjamin Graham nicely put it, “when Mr Market goes through one of his periodic depressive moods” – when stocks are being sold off with no regard to any underlying values.
But they are always out there; you just have to know where to find them.