The value world is enthralled with Warren Buffett (Trades, Portfolio) and moats, but does that mean you should buy deep value?
Value investing is a contrarian sport, but many small value investors are following the herd into moat investing and growth at a reasonable price (GARP). By doing so, they’re competing against the best investors when they don’t need to as well as taking on the limitations of having too much capital. Charlie Munger (Trades, Portfolio) explains in a 2017 interview that a younger guy should find smaller niches to invest money and even told his own grandson to look at smaller companies!
Why small companies?
Munger’s statement reinforces the fact that many of the best deep value opportunities can be found in small companies. These types of companies generally do not have moats and are often struggling — not the typical good companies at great prices. This is where deep value analysis comes in. Deep value investors look for deep discounts to the most conservative estimates of fair value, such as net tangible assets or even net current asset value, and this overall strategy can achieve amazing returns.
Take a look at this table below:
This table was taken from the legendary investors Tweedy and Browne’s "What Has Worked in Investing" and assesses the relationship between market cap, price to book value, and associated return that investors experience. Smaller companies beat larger companies on a price to book value basis over the 27 years studied. You may also note that the lower the price to book value, the higher the returns. Deep value companies have the potential to make a massive impact on your portfolio. Ultimately, the cheaper you buy a company, the better the returns.
Buffet agrees with Munger
Munger is not the only one recommending tiny deep value firms. Buffett has also repeated on numerous occasions that he made his best gains when managing small amounts of money and invested in small cigar-butt companies. He crushed the markets. It was not until he became so successful and his stash grew so large that he needed to change his investment strategy to buying great companies at good prices.
To this day, Buffett reminisces about the gains he made in his early years. He has long been a proponent of US stocks but began to see opportunities in international markets. Buffett began to relive his days as a deep value investor by investing in some Korean stocks in the mid 2000s when he was handed a book reminiscent of the Moody’s manual he used to read in his 20s.
The interesting Korean stock market
The Korean stock market was interesting in a number of ways. The valuations were extremely low, and the companies had incredible financial strength. These companies benefited from little debt and a hard-working population. Buffett could easily find deep value companies that were priced very attractively compared to companies in similar industries and bought them for dirt cheap prices. Unfortunately, he could only invest a small amount in these Ben Graham-like deep value investments because he just has so much money to invest these days.
Buffett generally invests in GARP and moat companies because he has too much capital for smaller companies with lots of opportunity. His investments in Korean stocks were different. He did not invest in companies with moats — he invested in companies that traded at dirt cheap prices relative to a conservative assessment of their value. One of these companies that Buffett identified was Daehan Flour Mills. The shares when Buffett noticed it were trading at two times earnings, 40% of cash assets and 20% of book value. This means the company was selling for a small fraction of what it was worth!
What does Korea and small cap stocks have to do with your own investment strategy? Many investors in the American markets are enamored with large businesses. They are bidding them up to extraordinary prices based on perceived long-term growth, pushing down future returns. And that assumes that growth actually materializes — private investors have a habit of spotting moats that don’t actually exist. However, serious opportunities exist in the world of Graham deep value stocks, even in today’s markets.
Example of stock similar to the Korean stock market
New York & Co. (NWY, Financial) is a great example of the sort of of firms we look for. This company faced pressure from the retail apocalypse in the U.S. Many consumers are not going to malls or shopping in person. Instead, more and more consumers are opting to shop online. New York & Co. suffered years of losses, a trend management attempted to address through sales campaigns to drive customer traffic and optimize square footage.
But with all the negativity surrounding the sector and firm, there was one thing investors forgot: valuation. At the time of recommendation by the Broken Leg investment letter, New York & Co. had a market cap of just $120 million. Using our acquirers multiple strategy, we discovered the firm was deeply undervalued, according to the FTSE Russell Global Valuation Summary. New York and Co had an acquirer’s multiple 61% less than the market’s valuation. New York & Co. was also below book value and presented a 107% upside on a B/V basis. Owning a firm this deeply undervalued offers any investor safety of principle in the form of the company’s assets.
But a deep discount is not the only thing we look for in a cheap stock. It’s important for us to increase the likelihood that our investments work out and we’ve put together a scorecard to help assess the best picks, such as: low price to NCAV, debt to equity, adequate earnings, existing operations or liquidation, not selling shares, past price above NCAV and small market capitalization.
Valuation, deep discounts and catalyst
But, another positive we look for is a catalyst. Catalysts can come in many forms and this was really New York & Co.’s hidden ace. New York & Co. it had an activist investor, David Kanen, who purchased the stock and then began making life hell for management. Once Kanen had purchased a sizable amount of New York & Co.’s stock he blamed management for the company’s underperformance and got to work on a list of demands: reducing management salaries, buying back stock, and appointing new board members. Management agreed and Kanen’s pressure forced the company to deliver on those promises. All of these measures cumulatively resulted in the stock’s appreciation.
The Broken Leg Investment Letter recommended New York & Co. in September 2017. Since that time, New York and Co. has returned over 132% in 9 months.
New York & Co. was an Acquirer’s Multiple stock, but we focus on a number of high-performance deep value strategies based on either earning power or net asset value. We hunt for the best opportunities available and send 3 of them out in the investment letter on a monthly basis.
If you’re new to value investing or you don’t have the time needed to invest well, The Broken Leg Investment Letter is the easiest way for you to find high-quality deep value stocks.
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