How to Intelligently Search for Value Investing Opportunities (III)
Dear Mr. Market,
In my last letter, I addressed the rational reasoning behind why value investing works. It is clear, at least to me, that a value approach and mindset is the right long-term approach to investing. As David Abrams, Seth Klarman’s protege, puts it during the 2008 Graham and Dodd Luncheon Symposium:
I guess I would say to this that, a little bit different from Howard [Marks], I’ve actually never seen people be successful over a long period of time without being value investors. To me, it’s sort of like the E = mc² squared of money and investing. That all things equal, the lower the price of something you have both less risk and more return.
And people either get that instantaneously or they never get it…
It’s not that successful investing can be boiled down to one formula like E = mc², but the idea of buying assets that are lower in price relative to their value will result in less risk and higher return. In other words, having a Margin of Safety between price and value.
Here’s another way to go about viewing it. If a dollar is worth a dollar (and you know it’s worth a dollar) but you can get it for 50 cents, great!
What happens when it goes down to 40 cents? Even better!
But strangely enough, when it comes to stocks, most people would sell at 40 cents after buying the dollar for 50 cents. The right way to buy stocks is to buy them like you are buying groceries- on sale.
“Buy stocks like you buy your groceries, not like you buy your perfume.” -WB
Not that we have reiterated that value investing works, let’s move on to how to intelligently search for opportunities. Why? Because every time you are selling (buying), someone else is buying (selling)- one party is always on the wrong side of the trade. You want make sure that you are on the right side of the trade and have a less well-informed and less rational person on the other side of the trade.
For example, if you are buying, you should seek (as Seth Klarman puts it) motivated sellers that are selling for noneconomic reasons. As Bruce Greenwald writes in his book:
“Klarman tries to improve his chances by finding situations that exist outside the normal buy and sell world of the secondary (stock and bond) markets. The feature on which he places most emphasis is what might be called a motivated seller, someone who, as Klarman puts it, is selling for a noneconomic reason.
Motivated selling has many sources. Probably the most obvious occurs when a stock is expelled from a major index. These stocks are sold into the market by motivated sellers — funds that look not at all at the companies’ fundamentals but merely at the fact that they are no longer in the index”.
So where should you search intelligently? Well, for starters, places where other people are scared of going, where you have to hold your nose and close your eyes because everything is so ugly and disappointing and cheap. Places exhibiting the following characteristics:
- Obscure/Complicated: Small Caps, Spin-offs, Recapitalizations, Restructurings, Mergers & Acquisitions
- Boring: Low Analyst Coverage, Unexciting Industry
- Undesirable/Ugly: Distress, Low Growth, Low P/E or P/B Ratios, Industry Headwinds (bad loans, regulatory threat, overcapacity), Company Problems (lawsuit, poor performance), Disappointing (long-term underperformance)
Let’s dive into each characteristic a bit more and the reasoning behind why we should be searching there:
- Obscure/Complicated: The reasoning behind this is fairly simple. If you are looking to buy Apple or Microsoft, you are competing with hundreds of other analysts and thousands of investors who are looking at those companies too. You will have no edge there. Ideally, you would want to be the only one (or one of the few) seriously studying a particular security.
- Boring: Let boring be your friend. People like potential lottery tickets and speculative/exciting industries; being in these areas will not put you on the right side of the trade.
- Undesirable/Ugly: No one wants to hold the undesirable or ugly stocks. People instinctively dump them, leading to oversold assets and huge bargains. These “motivated sellers” are not taking into account the underlying fundamental value and are simply dumping unwanted securities and depressing stories.
There are several ways to go about systematically searching for finding disappointing and cheap stocks. For example:
- Statistical Screens: low P/E, P/B, P/FCF, EV/EBITDA, High Dividend Yield
- Market Cap Range: research all companies within a certain market cap range
- Focus on Particular Opportunities: spin-offs, mergers, recapitalizations, restructurings, etc.
- Other: News Publications, SEC Filings, Journals, etc.
Study after study has shown that buying cheap statistically puts you on the right side of the trade and by having an intelligent search strategy, you can further put the odds on your side. According to Bruce Greenwald:
If you do nothing but eliminate the high glamour growth stocks you get another one or two percent.
On the other end, high market-to-book stocks underperform by 3%. These are glamour stocks which are high growth and trade at high P/Es. And small capitalization stocks these are obscure areas whose stock values have fallen so far that there stock values are small or tiny little companies that money managers can’t pay attention to because they can only put five or six million dollars at most into them out perform by 2% to 3%. Statistically, historically, these strategies we are talking about which are the value-based search strategies, do seem to outperform.
I would like to conclude this letter by quoting a few pieces I have gathered on intelligently searching for ideas.
From Mohnish Pabrai’s The Dhando Investor:
However, here are nine other ponds where we are likely to find more of these fifty-cent dollars.
1. The Value Investors’ Club (VIC) website is open to the public, and it is loaded with a plethora of fifty-cent dollars.
2. Subscribe to Value Line (or review it at a library). Study their “bottom lists” every week. They list stocks that have lost the most value in the preceding 13 weeks, ones trading at the widest discounts to book value, lowest P/E, highest dividend yield, and so on. It is a wonderful treasure trove to dig in and discover.
3. Look at the 52-week lows on the New York Stock Exchange (NYSE) daily.
4. Subscribe to Outstanding Investor Digest and Value Investor Insight. Both carry detailed interviews and write-ups with some of the best value money managers in the United States.
5. Subscribe to Portfolio Reports. It is published by the same people as OID, and it lists the recent buying activity of some of the best money managers in North America. Alternately, you can get close to the same data on Nasdaq.com.
6. Another web site that is free and can partly replace Portfolio Reports is Guru Focus. This is a free web site that tracks the buying and selling activity of the leading value investors in North America. It is another wonderful place to go treasure hunting.
7. A sister publication of Value Investor Insight is Super Investor Insight. It too tracks the 13-F filings of the super investors of our time. This is another worthwhile subscription to get.
8. Subscribe to the major business publications — Fortune, Forbes, the Wall Street Journal, Barron’s, and BusinessWeek — at a minimum. A tremendous amount of research and brainpower goes into every page of content in these publications. It is presented in an easy- to-digest format at a super value price. The more you read up on the different companies, people, and industries in these publications, the better you’ll get at securities analysis. That’s the long-term benefit. The short-term reward is that, once in a while, things jump out at you — eventually leading to an investment.
9. Attend the biannual Value Investing Congress. It is held semiannually in New York City and Hollywood. It is well worth the price of admission. Not only do they teach you to become a better fisherman, but they also provide some fish at half price.
From Michael Burry on MSN Money Articles:
My strategy isn’t very complex. I try to buy shares of unpopular companies when they look like road kill, and sell them when they’ve been polished up a bit. Management of my portfolio as a whole is just as important to me as stock picking, and if I can do both well, I know I’ll be successful.
I care little about the level of the general market and put few restrictions on potential investments. They can be large-cap stocks, small cap, mid cap, micro cap, tech or non-tech. It doesn’t matter. If I can find value in it, it becomes a candidate for the portfolio. It strikes me as ridiculous to put limits on my possibilities. I have found, however, that in general the market delights in throwing babies out with the bathwater. So I find out-of-favor industries a particularly fertile ground for best-of-breed shares at steep discounts. MSN MoneyCentral’s Stock Screener is a great tool for uncovering such bargains.
How do I determine the discount? I usually focus on free cash flow and enterprise value (market capitalization less cash plus debt). I will screen through large numbers of companies by looking at the enterprise value/EBITDA ratio, though the ratio I am willing to accept tends to vary with the industry and its position in the economic cycle. If a stock passes this loose screen, I’ll then look harder to determine a more specific price and value for the company. When I do this I take into account off-balance sheet items and true free cash flow. I tend to ignore price-earnings ratios. Return on equity is deceptive and dangerous. I prefer minimal debt, and am careful to adjust book value to a realistic number.
I also invest in rare birds — asset plays and, to a lesser extent, arbitrage opportunities and companies selling at less than two-thirds of net value (net working capital less liabilities). I’ll happily mix in the types of companies favored by Warren Buffett — those with a sustainable competitive advantage, as demonstrated by longstanding and stable high returns on invested capital — if they become available at good prices. These can include technology companies, if I can understand them. But again, all of these sorts of investments are rare birds. When found, they are deserving of longer holding periods.
From Joel Greenblatt in You Can Be a Stock Market Genius:
“QUESTION: WHERE CAN YOU FIND THESE SPECIAL INVESTMENT OPPORTUNITIES?
Answer: Read, read, read.
While you might not think that a newspaper with a circulation in the millions would be a good place to hunt for bargains off the beaten path, it turns out that it is. In fact, The Wall Street Journal is the hands-down winner for Best Source of new investment ideas. Many big money-making opportunities (including most of the examples in this book) appear at one time or another right on the front page — sometimes for months at a time. Even though transactions and corporate changes that involve smaller companies may not make the front page, they’re still in there. It’s not that no one else will see this news, but after reading this book, you now have a better idea what to look for.
“You don’t have to read anything other than The Wall Street Journal, though you can find new ideas almost anywhere in the business press. Time and interest are your only constraints. Particularly good newspapers for scouting out new ideas include the New York Times, Barrons, and Investor’s Business Daily. Your local paper and regional business paper can also be good hunting grounds for special situations. This is because extraordinary transactions involving local companies and their subsidiaries are often covered locally in greater detail, with more background, and for a longer period of time than the same events in papers of a more national scope. Additionally, industry-specific newspapers like American Banker or Footwear News can be helpful, but if you don’t already get one — don’t bother.”
“There’s also the list of well-known business magazines to choose from. I’ve found Forbes and Smart Money to be the best sources of good ideas. However, Business Week, Fortune, Financial World, Worth, Money, Kiplingers Personal Finance, and Individual Investor can also be worth reading. You certainly can’t (and don’t want to) read everything so, just as you do with stocks, pick your spots. Remember, it’s the quality of your ideas, not the quantity, that will result in the big money. So don’t kill yourself; read when you have time and when you’re in the mood. That way, you’ll end up being much more productive.”
“If I haven’t yet given you enough to read, the next source of potential ideas is investment newsletters. These are letters that come out on a periodic basis whose annual subscription prices usually run somewhere between $50 and $500. While investment newsletters generally deserve their bad reputation, I’ve narrowed the field down to a short list of publications that can be a particularly fertile ground for new investment ideas. My favorite, which I’ve already mentioned, is Outstanding Investor Digest (phone: 212–777–3330). OID interviews mostly top-notch, value-oriented investment managers who discuss their best ideas in a usually cogent and understandable way. This letter is particularly good for finding potential LEAPS candidates and occasionally for learning about companies that are undergoing or have recently completed a restructuring.”
There you have it- a short discourse on how to intelligently search for opportunities. We’ll discuss the valuation strategy next and how we should go about disciplining ourselves in the valuation process so we can further get the odds on our side.
Until next time. Vale.
Did you enjoy this?
You might also like the other posts in this series…
- Mr. Market and Stoicism (I)
- Why Value Investing Works (II)
- Crisis Investing (IV)
- A Mean-Reverting Walk Down Wall Street (V)
Or some of my other musings…
