Compounders: These are Warren Buffett "forever" stocks, or franchise businesses with durable competitive advantages that I'm willing to hold for a long time as long as the business continues to compound cash flow, dividends, and intrinsic value.
Cheap and Good: These are stocks that are not as high quality as the compounders, but are still above average businesses producing good returns on capital but are for some reason selling at a cheap price, often because of some temporary problem. These stocks are often Joel Greenblatt style Magic Formula stocks.
Cheap Assets: These are stocks that give you the opportunity to buy $1 worth of assets at a discount. Net-nets, stocks below tangible book, or stocks with hidden asset values fall into this group. Often times the businesses in this group have problems, but the market is offering you the assets for less than the value on the books, and you get the upside potential of the business improving without paying anything for it.
But I will invest in a fourth category on rare occasions that I refer to as "special situations," which is also what other value investors commonly call this area of investing.
Value Investing with a Catalyst
Joel Greenblatt wrote one of my favorite books called You Can Be a Stock Market Genius in which he expertly describes in detail (case studies included) many types of special situations. A special situation, generally defined, is a stock with some sort of corporate catalyst. such as a spinoff, reorganization or merger. Greenblatt made 40% annual returns for 20 years using the techniques he describes in the book.
However, I am not an expert in this area, and so I don't often invest in these situations, unless I'm comfortable with the underlying value. I have found that it is possible to outperform the market, potentially by a significant margin, by simply owning a diversified basket of undervalued stocks. You could potentially follow Joel Greenblatt's magic formula and do nothing else, and do extremely well over time. But there are investors who have done much better than that. Often these investors, like Greenblatt in his early years, have used special situations in their investment strategy.
I invest in spinoffs when I think the parent or the spinoff is undervalued, but I don't really buy spinoff stocks just because they've historically done very well (although an argument could be made for this simple idea as well). I occasionally invest in stocks that are involved with a merger or buyout, but again, the common thread is that I want to be comfortable with the valuation before investing. There are some investors that will invest in arbitrage strategies using the deal itself as the entire reason for investing. If the deal falls through, you're left with a sizable loss and a stock that you may or may not still want. I've never been attracted to those types of scenarios.
Value is its own Catalyst
I do spend a lot of time learning about special situations and over time, I may become more skilled in this corner of the value investing world, but for now, I prefer to maintain my diversified basket of above-average companies at below-average valuations. Just like many value investors are fascinated by trying to find franchise businesses because Buffett has done so well there, many value investors are also enthralled with stocks with catalysts, because Greenblatt and others have done extraordinarily well there. I agree with both of those camps, and both strategies can work if you become proficient at them.
But one thing I've learned over the years is that value, or cheapness, is its own catalyst. What I mean by this is that when a stock becomes cheap, that very cheapness may produce its own catalyst in the form of a corporate buyout or private equity group becoming interested. But even putting buyouts and mergers aside, when a stock becomes cheap enough, it at some point will cause other value investors to become interested. This is mean reversion, and mean reversion is the most powerful force in markets. When it is applied without leverage (this is important) within the context of an investment strategy, it can yield outstanding results for the patient, disciplined practitioner.
My favorite investor is Walter Schloss, and although I presume he invested in special situations from time to time, he built his exemplary track record (20% returns for 47 years) on the foundation of buying cheap stocks. I doubt that he thought of his strategy this way, but he was essentially using cheapness as his catalyst. He simply tried to buy stocks cheap that had low amounts of debt, with the idea that eventually, these lowly levered companies as a group would survive, and thus the stock price and the valuation would rise (revert to the mean). In some instances, the businesses improved and that represented enormous upside potential for the stocks in his portfolio.
So I try not to worry too much about catalysts. It's a buzz word on Wall Street, and many investors are obsessed with identifying a catalyst. There is certainly nothing wrong with spending time identifying, evaluating, and analyzing a catalyst if you have the skills and time to do that. There are some outstanding investors I follow that do this regularly, and I learn a lot by reading their fund letters and blogs. I am always trying to improve. But the one thing to keep in mind is that if you properly identify cheap stocks, valuation often works as your tail wind, providing you with a built-in catalyst.
Two Examples of Stocks where Value became the Catalyst
Dell Inc. (DELL) and Ebix Inc. (EBIX) are two stocks that I've followed for some time now as both have shown up on Greenblatt's screen for months. I list these together because they have numerous similarities: Both got cheap because of certain problems, both have similar quality metrics such as above-average returns on capital, both are involved in a pending buyout, and both have CEOs with large stakes in the business.
We own DELL, but unfortunately didn't take a position in EBIX. I didn't get comfortable with the accounting, but that stock represents an interesting study on its own about how markets inefficiently price event risk and other uncertainties. I'll have a post discussing these two stocks, and why I might still take a position in EBIX, which has just agreed to sell itself to Goldman Sachs for $20 per share.
But both of these stocks became extremely cheap and both turned out to be special situations, but before the mergers were announced, these stocks began to appreciate significantly. This happens a lot with stocks that have problems, but become extremely cheap. At some point, value creates its own catalyst. Water finds its level, and mean reversion kicks in. It happens over and over and there will be plenty of other opportunities to capitalize on.
- Warren Buffett Undervalued Stocks
- Warren Buffett Top Growth Companies
- Warren Buffett High Yield stocks, and
- Stocks that Warren Buffett keeps buying
- Joel Greenblatt Undervalued Stocks
- Joel Greenblatt Top Growth Companies
- Joel Greenblatt High Yield stocks, and
- Stocks that Joel Greenblatt keeps buying
- Walter Schloss Undervalued Stocks
- Walter Schloss Top Growth Companies
- Walter Schloss High Yield stocks, and
- Stocks that Walter Schloss keeps buying