- Finding a bargain is a seductive prospect. And, Warrent Buffett calls this "cigar butt" approach to investing.
- “A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the ‘bargain purchase’ will make that puff all profit”
- It having a very conservative measure of intrinsic value, essentially liquidation value, and a large margin of safety
- In bull markets it can be arduous
- But, in depressed and volatile conditions like 2009, the basket of potential stock candidates tends to swell.
- How do you go about finding these kinds of deep value or bargain stocks?
- Pay less than book value
- Price-to-book on a tangible assets only
- This is only applicable for manufacturing companie
- Service businesses - depends on intagible assets which isn’t even on the balance sheet
- It may not give enough MOS if fixed assets may have been overvalued. Thus, a number of other (more extreme) metrics can be used by the deep Value Investors…
- Pay less than liquidation value (NCAV)
- Benjamin Graham advocated buying stocks that, if they were to collapse tomorrow, should still produce a positive return because of the underlying asset backing.
- He ignoring fixed assets like property and equipment and solely valuing current assets (such as cash, stock and debtors) on the basis that only these assets could easily liquidated in the event of total failure, and then subtracting the total liabilities to arrive at the so called net current asset value.
- To defend against the risk on individual failure, Graham require MOS of about 33% & diversify to at least 30 stocks.
- In a study by Henry Oppenhemier in the Financial Analysts Journal, the mean return from discounted net current asset stocks over a 13-year period was 29.4% per year versus 11.5% per year for the NYSE-AMEX Index – an astonishing outperformance.
- Pay even less than liquidation value (‘Net Nets’)
- Graham make allowance on cash due from debtors (as it might not able to collect it) and inventories (as it may have to be discounted).
- Net Net Working Capital = cash and short-term investments + (75% * debtors) + (50% * inventory) – total liabilities.
- Buy companies selling for less than their cash (Negative Enterprise Value)
- Investors can look for companies whose cash is worth more than the total value of their shares plus their long-term debt
- This investment approach is known as buying stocks with a Negative Enterprise Value and waiting for them to be revalued.
- It offer a potential arbitrage opportunity, whereby a buyer of the company could snap up the entire stock and use the cash to pay off the debt and still pocket a profit.
- New opportunities with new lows
- It was taken by Walter Schloss, another investor that studied under Graham and went on to refine his tutor’s theories into his own strategy.
- It blends the all-important book value with stocks that have fallen to new lows in terms of market price.
- Schloss saw new lows (e.g. 52W low) as an indicator of a possible bargain stock.
- He stressed the importance of distinguishing between temporary and permanent problems.
- He would look for companies trading at a price that was less than the book value per share, no long-term debt, stocks where management owned above-average stakes for the sector and, finally, a long financial history.
- Schloss preferred to invest in sectors he understood, particularly old industries like manufacturing
- Schloss believed in significant diversification although his willingness to run up to 100 stocks would have many investors reeling.
- Over the 45 years from 1956 to 2000, his fund earned an astounding compound return of 15.7%, compared to the market’s return of 11.2% annually over the same period. In the words of Buffett, Schloss “doesn’t worry about whether it’s January…whether it’s Monday…whether it’s an election year. He simply says if a business is worth a dollar and I can buy it for 40 cents, something good may happen”.
- Deep value investing is not an approach for the faint-hearted.
- Bargain Investors would invest in the most unloved stocks in the market and that leaves a bargain strategy open to significant risk.
- Investors should always back up their screening with detailed scrutiny as well.
- The original ‘bargain’ price probably will not turn out to be such a steal after all because,
- “in a difficult business, no sooner is one problem solved than another surfaces – never is there just one cockroach in the kitchen.
- Second, any initial advantage you secure will be quickly eroded by the low return that the business earns.”
- How do deep Value Investors mitigate the risk of cockroaches?
- Diversification - the successes should outweigh the catastrophes.
- For Graham, the target was upwards of 30 stocks
- For Schloss, the number could be as heady as 100.
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