Value investing is at its core the marriage of a contrarian streak and a calculator.
- Seth Klarman
- Seth Klarman
Thank you for the encouraging comments that I've received in the last couple of blogs*. It's nice to find out what I write is of help to people.
Just to recap, in the first part I looked at how gathering knowledge is a good thing to start with. In essence the better researched that you are, the better chance you have of success. As Peter Lynch put it memorably, If you don’t study any companies, you have the same success buying stocks as you do in a poker game if you bet without looking at your cards.
In the second part, I began to look at value and how you can start to find those undervalued companies that have a decent chance of growing into their true value. You actually need to train yourself to think independently of the herd, because if everyone else had thought they were undervalued and had bought the stock, the price would be a lot higher than it is. This is why it pays to be a contrarian- to try and think differently to the herd. Joel Greenblatt sums this up well: You can’t be a good value investor without being an independent thinker – you’re seeing valuations that the market is not appreciating. But it’s critical that you understand why the market isn’t seeing the value you do. The back and forth that goes on in the investment process helps you get at that.
The telling phrase is it’s critical that you understand why the market isn’t seeing the value you do. Once you've cast your net and developed good knowledge of the kind of companies that you are looking for and seen that they are undervalued, you must ask the question why? If the Market is relatively efficient at pricing, then why is this stock so cheap?
As an aside, the basic yardstick of whether a share is cheap is the Profit to Earnings (P/E) ration. In other words, how many years will it take for you to get your money back on the price paid for a share in earnings (whether by dividends or cash reinvested back into the business). Generally a company on a P/E of less than 10 is considered to be cheap. If it's below five then (in my view) it's suspiciously cheap.
Another yardstick of value is dividend yield. If it is high then the share may be cheap. I have written about the lure of chunky dividends before. It's interesting that since I wrote about that in March, a number of the dividends have been slashed. Those shares were cheap for a reason.
Of course if you get into low P/Es and high dividends you are starting to enter what is known as "deep value" territory. There are a few who have made big fortunes in this. But the key is that you have to be very patient (and many investors I know aren't) and be prepared for the fact that some stocks may stay dormant in deep value territory or even go bust.
In truth, everyone can screen for deep value stocks and you will occasionally come across a gem in the bargain bin. As a student in the 1990's I remember being a regular customer of Our Price records. The particular shop I went to always had racks and racks of albums, EPs and singles at deeply discounted prices. This was before the days of eBay and Amazon and it's difficulty to describe the sheer joy you experienced at occasionally finding a limited release EP from your favourite artist at a bargain price. In order to get lucky, you had to do a lot of delving...
If you can find deep value stocks with a good margin of safety (i.e. they are not going to go bust any time soon usually due to low debt) then these are often worth a look. Ben Graham made his fortune on these and it's the origin of Berkshire Hathaway. However the focus of this piece is on an alternative approach to value.
The real knack in investing is finding stocks that don't appear to necessarily be cheap, but in fact are. Let me use an example from my own experience to illustrate.
When I bought my first house (a modest terrace), I agreed to pay the full asking price as I spotted value, based on an off-hand comment from the Seller. A builder whom my father had used for many years came to see the house and told me that I was paying "well over the odds". When I told him what the Seller had told me, he paused for thought and agreed that maybe I was paying the right price.
So what was it that the Seller had told me? Well he mentioned to me that a property developer had been interested in buying the bottom of the garden. Being someone who worked in Property at that time, I already had an instinct for what that might be worth. The Seller mentioned a figure that he'd been offered. I knew that the land was worth many times that. I sold that land some 3 years later for over 9 times what the Seller had been offered. All in all I recouped 25% of what I had paid for the entire house.
What was the key? Well, I used particular knowledge that I had to know that even though the price I was paying for the house and land was very full, that actually I was buying it for a full 25% discount. As it happened, property prices shot up anyway and I sold the house for a 67% gain 3 years after I'd bought it. However when the money I received for the extra land was aggregated, I enjoyed a 92% gain over all.
Now all of this happened long before I became involved with shares, but I've noticed this pattern replicate itself since I became involved with shares. If you can spot the hidden value before anyone else does then you can steal a march on the Market.
My favourite type of company for this is one where the Market simply can't keep pace with the growth trajectory of the Company. I had an inspired period in February 2017 when I bought shares in Boohoo (BOO), On the Beach (OTB) and Fevertree (FEVR). BOO was a retailer which had the opportunity in my view to become the new ASOS (the online clothes retailer listed on AIM that became the stock that everyone wished they had owned). In my view it had learned the lessons of ASOS and was going to become even better. It was competing with the likes of Primark (the really profitable part of Associated British Foods(ABF)) and unlike Primark was not saddled with high rents on the high street, spending its money on advertising all over London. It is only now that it's true value is starting to out. OTB was an online travel agent that I felt was going to take market share from the bricks and mortar travel agents like Thomas Cook and companies that tried to compete in the budget airline market like Monarch. So it proved later in 2017 when Monarch failed and then in 2019 when Thomas Cook failed. OTB profited from both. Finally FEVR as a premium soft drinks seller had a clever model that deployed limited working capital whilst becoming the number one choice for mixers.
All of these shares had their ups and downs, but I emerged from each with a handsome profit. I wish I still held BOO, which has done remarkably well in the present crisis. They key with all three of those was spotting the hidden value- in each case the potential to explode in profitable growth and make what I paid for the shares seem increasingly modest every time the share re-rated.
So what examples abound at present? Looking at current shares, there are a number of investors who are convinced that Anglo Asian Mining plc (AAZ) and Rockrose Energy (RRE) are both materially undervalued in the present market. They argue that both companies have a lot of cash on their balance sheets which you should deduct when calculating the share price- in a sense you are getting a lot of company for free. I hold neither yet continue to watch both stories with interest. One of them is an oil company and the other is a miner and therein lies the possible issue. The history of the stock market is littered with failed speculation in both oilers and miners and I suspect this may be the root of Market wariness. Time will tell I'm sure..
So how do you start to find these companies with "hidden value"? Well I've always been a big fan of Jim Slater and his book the Zulu Principle In that book he recommends the use of a metric called the PEG Ratio. It is calculated by taking the Price to Earnings Ratio and dividing it by the consensus forecast EPS growth for the next year. A PEG of 1 is considered fair value. If it is between 0.5 and 1 and the company is growing, further investigation is merited. If it is below 0.5 then the company may be an excellent bargain. I am a big fan of PEG as it combines both value and growth. I am of course very cautious at present as I do not believe that we have a true picture of earnings for most companies and will not do so for some time. Where companies earnings are more predictable, the share price tends to be taking out of value territory in my experience. For example shares like BOO (which have got a reasonable level of earning clarity) have a PEG of near 2.0 at present whilst OTB (which has limited clarity with the travel industry having been decimated) is down at 0.3.
So in conclusion, PEG is a one way of finding these (usually growth) companies with "hidden value". It is however just one tool in the tool kit that I use. I will be looking at another metric in the next part in a couple of weeks. Safe investing!
*As ever this is published subject to my standard disclaimer