When most investors think about value investing, they think of deeply discounted small-cap stocks the rest of the market has overlooked. Up until the invention of the internet, this was the case. But today, with so much information on equities freely available at the click of a button, you have to put in extra work if you want to find the market's most undervalued opportunities.
Even though the internet has made it harder to find undervalued stocks as the market has become more efficient, it has also opened up opportunities.
Value investing is no longer limited by the constraints of equities. Investors are now able to use a range of instruments to profit from mispriced assets.
In my discussions with value fund managers over the years, a range of interesting strategies have come up, which these investors use to generate excess profits -- strategies that would not have been viable 10 years ago. Below are some extracts from interviews with these investors detailing the strategies:
Value investing with exotic instruments
In an interview with Christopher Pavese, chief investment officer of Broyhill Asset Management, he shared his thesis behind buying mispriced options to generate short-term returns, how the strategy fits into the firm's value mandate and whether he frequently uses derivatives to boost these returns.
"The occasional use of options in this manner serves to reduce our risk, rather than boost short-term returns. Our use of options is not unlike our other value-driven investments. We aim to buy low and sell high. Occasionally, spikes in volatility allow us to sell high and collect rich premiums, which give us the right to buy companies we’d like to own at lower prices. And since we typically have plenty of cash on hand, these positions are always fully collateralized. Again, we view this is as an inherently lower risk proposition than owning the stock outright."
Chris Abraham,Ă‚ CIO of CVA Investment Management, uses options as part of a traditional value strategy to add alpha. He described the strategy and why he uses it:
"Regarding option positions, the way I look at the strategy is kind of like running an insurance book along with existing equity holdings — similar to Buffett’s concept at Berkshire (BRK.A, Financial) (BRK.B, Financial)...The vast majority of options trading is on ETFs, and most of that is short-term trading, for hedging and speculating. Because most traders concentrate on these limited markets, there’s very little attention focused on longer term options of individual companies. A lot of institutional investors just can’t invest in this sector, because their investment mandates won’t allow it and hedge funds are only interested in the short-term use of options to hedge positions. The great thing is you can find some options with significant mispricing across the entire market. A couple of weeks ago, I found options on a company with a $100 million market cap! So, there are definitely opportunities out there to take advantage of with these derivatives, but structural reasons prevent many investors from making the most of the opportunities available to them. There’s also a general lack of interest in this area."
Ali Meshkati,Ă‚ founder and investment manager of T11 Capital, owned Lehman Brothers Capital Trust preferred shares:
"Shortly after the Lehman bankruptcy, those in charge of the liquidation formed a company they named LAMCO to assist in the liquidation of the remaining assets. This wasn’t a small operation, as LAMCO originally had close to 500 employees. The assets in liquidation have exceeded even the most aggressive estimates. In the meantime, LAMCO has become a substantial business, although the exact numbers are difficult to ascertain.
The most logical move forward would be to create a public traded company that would take advantage of the NOLs leftover from Lehman through LAMCO initially, possibly rolling in smart acquisitions over time. This would give former equity, including the trups, a stake in the newly formed company.
The stick in the wheel is the cancellation of debt income that can nullify the NOL. There is precedent in the courts for the preservation of the NOLs working around the cancellation of debt income requirements, however.
Our position in the Capital Trust shares is basically a call option on a positive outcome for the reemergence of Lehman in a yet to be determined form."
Kyle Mowery,Ă‚ managing partner of GrizzlyRock Capital, owned a basket of credit-related securities in the business development company sector. He described his methodology behind the basket and what he is looking for in a qualifying investment.
"Business Development Companies (“BDCs”) are a type of company created by the U.S. Congress in 1980 as an amendment to the 1940 Investment Company Act. Most BDCs invest in the debt of middle market and small capitalization businesses across the United States. Similar to REITs, BDCs do not pay taxes at the corporate level and distribute their income to shareholders.
Given the fact that BDCs invest in bank loans and other credit instruments of smaller firms (typically with EBITDA between $5 and $50 million), the overall BDC sector is of moderate size. The inability to easily deploy $1 billion shifts the focus of larger investors to other investments. This leaves the BDCs as a 'sweet spot' for many medium size enterprising investors.….
Our current BDC basket is paying a 16.0% dividend yield based on run-rate dividends, covering the vast majority of this dividend with recurring income, and trading at 0.63 times price to GAAP book value."
Ori Eyal, founder and managing parter of Emerging Value Capital Management, owned a basket of South Korean preferred stocks, which was his largest position. He disclosed what he likes about these stocks:
"There’s an anomaly in South Korea that I don’t believe exists anywhere else. These shares, we call them preferred, but their correct name is preference shares. These preference shares are almost the same as common shares, but the main difference is that the preference shares don’t have voting rights — somewhat similar to Class A and Class B shares in the U.S.
Now, when you have a company, let’s say Samsung Electronics (XKRX:005930, Financial), with these two share classes, you would expect the shares to trade at roughly the same valuation, or maybe a 10% discount due to the different voting rights attached to the stock, but what we actually see is a huge a price discount, a discount of maybe 50% to 60% price difference. It makes no sense."
Disclosure: The author owns no stocks mentioned.
