(Image: Zen Buddha Silence by Marilyn Barbone.)
October 14, 2018
Virtually all of the historical evidence shows that quantitative deep value investing—systematically buying stocks at low multiples (low P/B, P/E, P/S, P/CF, and EV/EBITDA)—does better than the market over time.
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One of the best papers on quantitative deep value investing is by Josef Lakonishok, Andrei Shleifer, and Robert Vishny (1994), “Contrarian Investment, Extrapolation, and Risk.” Link: http://scholar.harvard.edu/files/shleifer/files/contrarianinvestment.pdf
Buffett has called deep value investing the cigar butt approach:
…You walk down the street and you look around for a cigar butt someplace. Finally you see one and it is soggy and kind of repulsive, but there is one puff left in it. So you pick it up and the puff is free—it is a cigar butt stock. You get one free puff on it and then you throw it away and try another one. It is not elegant. But it works. Those are low return businesses.
(Photo by Sensay)
Outline for this blog post:
- Rare Temperament
- Early Buffett: Deep Value Investor
- Investors Much Prefer Income Over Assets
- Companies at Cyclical Lows
Many value investors prefer to invest in higher-quality companies rather than deep value stocks. A high-quality company has a sustainable competitive advantage that allows it to earn a high ROIC (return on invested capital) for a long time. When you invest in such a company, you can simply hold the position for years as it compounds intrinsic value. Assuming you’ve done your homework and gotten the initial buy decision right, you typically don’t have to worry much.
Investing in cigar butts (deep value stocks), however, means that you’re investing in many mediocre or bad businesses. These are companies that have terrible recent performance. Some of these businesses won’t survive over the longer term, although even the non-survivors often survive many years longer than is commonly supposed.
Deep value investing can work quite well, but it takes a certain temperament not to care about various forms of suffering—such as being isolated and looking foolish. As Bryan Jacoboski puts it:
The very reason price and value diverge in predictable and exploitable ways is because people are emotional beings. That’s why the distinguishing attribute among successful investors is temperament rather than brainpower, experience, or classroom training. They have the ability to be rational when others are not.
(Photo by Nikki Zalewski)
In The Manual of Ideas (Wiley, 2013), John Mihaljevic explains the difficulty of deep value investing:
It turns out that Graham-style investing may be appropriate for a relatively small subset of the investment community, as it requires an unusual willingness to stand alone, persevere, and look foolish.
On more than one occasion, we have heard investors respond as follows to a deep value investment thesis: ‘The stock does look deeply undervalued, but I just can’t get comfortable with it.’ When pressed on the reasons for passing, many investors point to the uncertainty of the situation, the likelihood of negative news flow, or simply a bad gut feeling. Most investors also find it less rewarding to communicate to their clients that they own a company that has been in the news for the wrong reasons.
Comfort can be expensive in investing. Put differently, acceptance of discomfort can be rewarding, as equities that cause their owners discomfort frequently trade at exceptionally low valuations.
Many investors will look at a list of statistically cheap stocks and conclude that most of them would be awful investments. But in practice, a basket of deep value stocks tends to outperform, given enough time. And typically some of the big winners include stocks that looked the worst prior to being included in the portfolio.
EARLY BUFFETT: DEEP VALUE INVESTOR
Warren Buffett started out as a cigar-butt investor. That was the method he learned from his teacher and mentor, Ben Graham, the father of value investing. When Buffett ran his partnership, he generated exceptional performance using a deep value strategy focused on microcap stocks: http://boolefund.com/buffetts-best-microcap-cigar-butts/
(Early Buffett teaching at the University of Nebraska, via Wikimedia Commons)
One reason Buffett transitioned from deep value to buying high-quality companies (and holding them forever) was simply that the assets he was managing at Berkshire Hathaway became much too large for deep value. But in his personal account, Buffett recently bought a basket of South Korean cigar butts and ended up doing very well.
Buffett has made it clear that if your assets under management are relatively small, then deep value investing—especially when focused on microcap stocks—can do better than investing in high-quality companies. Buffett has said he could make 50% a year by investing in deep value microcap stocks: http://boolefund.com/buffetts-best-microcap-cigar-butts/
In the microcap world, since most professional investors don’t look there, if you turn over enough rocks you can find some exceptionally cheap companies. If you don’t have sufficient time and interest to find the most attractive individual microcap stocks, using a quantitative approach is an excellent alternative. A good quantitative value fund focused on microcaps is likely to do much better than the S&P 500 over time. That’s the mission of the Boole Fund.
INVESTORS MUCH PREFER INCOME OVER ASSETS
Outside of markets, people naturally assess the value of possessions or private businesses in terms of net asset value—which typically corresponds with what a buyer would pay. But in markets, when the current income of an asset-rich company is abnormally low, most investors fixate on the low income even when the best estimate of the company’s value is net asset value. (Mihaljevic makes this point.)
If an investor is considering a franchise (high-quality) business like Coca-Cola or Johnson & Johnson, then it makes sense to focus on income, since most of the asset value involves intangible assets (brand value, etc).
But for many potential investments, net asset value is more important than current income. Most investors ignore this fact and stay fixated on current income. This is a major reason why stock prices occasionally fall far below net asset value, which creates opportunities for deep value investors.
(Illustration by Teguh Jati Prasetyo)
Over a long period of time, the income of most businesses does relate to net asset value. Bruce Greenwald, in his book Value Investing (Wiley, 2004), explains the connection. For most businesses, the best way to estimate intrinsic value is to estimate the reproduction cost of the assets. And for most businesses—because of competition—earnings power over time will not be more than what is justified by the reproduction cost of the assets.
Only franchise businesses like Coca-Cola—with a sustainable competitive advantage that allows it to earn more than its cost of capital—are going to have normalized earnings that are higher than is justified by the reproduction cost of the assets.
Because most investors view cigar butts as unattractive investments—despite the overwhelming statistical evidence—there are always opportunities for deep value investors. For instance, when cyclical businesses are at the bottom of the cycle, and current earnings are far below earnings power, investors’ fixation on current earnings can create very cheap stocks.
A key issue is whether the current low income reflects a permanently damaged business or a temporary—or cyclical—decline in profitability.
COMPANIES AT CYCLICAL LOWS
Although you can make money by buying cheap businesses that are permanently declining, you can usually make more money by buying stocks at cyclical lows.
(Illustration by Prairat Fhunta)
Assuming a low enough entry price, money can be made in both cheap businesses condemned to permanent fundamental decline and businesses that may benefit from mean reversion as their industry moves through the cycle. We much prefer companies that find themselves at a cyclical low, as they may restore much, if not all, of their earning power, providing multi-bagger upside potential. Meanwhile, businesses likely to keep declining for a long time have to be extremely cheap and keep returning cash to shareholders to generate a positive investment outcome.
The question of whether a company has entered permanent decline is anything but easy to answer, as virtually all companies appear to be in permanent decline when they hit a rock-bottom market quotation. Even if a business has been cyclical in the past, analysts generally adopt a ‘this time is different’ attitude. As a pessimistic stock price inevitably influences the appraisal objectivity of most investors, it becomes exceedingly difficult to form a view strongly opposed to the prevailing consensus.
If you can stay calm and rational while being isolated and looking foolish, then you can buy deeply out of favor cyclical stocks, which often have multi-bagger upside potential.
Example: Valaris plc (VAL)
This example has been updated to August 25, 2019
(The Boole Fund had a position in Atwood Oceanics, which Ensco acquired in 2017. Subsequently, Ensco completed a merger with Rowan in April 2019. The fund continues to hold the stock because it’s still absurdly cheap, with at least 11x upside—or 5x upside in the worst-case scenario. Ensco Rowan was just renamed Valaris.)
Valaris is the largest offshore oil driller in the world, with presence in six continents and nearly all major offshore markets. The company has a large and diverse customer base including major, national, and independent E&P companies.
Valaris has 16 drillships, 12 semisubmersibles, and 54 jackups. Valaris has one of the highest-quality fleets: 11 of its 16 drillships are the highest-specification. 13 of its 54 jackups are heavy duty ultra harsh and harsh environment jackups. High-spec assets are preferred by customers.
Valaris is also one of the best capitalized drillers. Valaris has a market capitalization of $807 million. The company has $2.4 billion in contracted revenue backlog (excluding bonus opportunities). It has $2.7 billion in liquidity, including $400 million in cash and $2.3 billion in credit available. And it has only $1.1 billion in debt maturities to 2024. Valaris is one of two public offshore drillers with no guaranteed or secured debt in the capital structure. With the net asset value of its fleet at $11 billion (according to third party estimates), Valaris has ample flexibility to raise additional capital if needed.
In April 2019, Ensco plc (ESV) and Rowan Companies plc (RDC) merged in an all-stock transaction. The combination (renamed Valaris) has brought together two world-class operators with common cultures. Both companies have strong track records of safety and operational excellence. And both companies have a strategic focus on innovative technologies that increase efficiencies and lower costs. Ensco was rated #1 in customer satisfaction for nine straight years according to a leading independent survey.
As a result of the merger, Valaris expects to achieve cost savings of $165 million pre-tax per year. The company may achieve additional savings through adoption of best-in-class operational processes and through economies of scale in capital purchasing.
Intrinsic value scenarios for Valaris:
- Low case: If oil prices languish below $55 (WTI) for the next 3 to 5 years, Valaris will be a survivor, due to its large fleet, globally diverse customer base, industry leading performance, low cost structure, and well-capitalized position. In this scenario, Valaris is likely worth at least one-half of current book value (which is depressed) of $51.55. That’s $25.78, about 530% higher than today’s $4.07.
- Mid case: If oil prices are in a range of $55 to $75 over the next 3 to 5 years—which is likely based on long-term supply and demand—then Valaris is probably worth at least current book value (which is depressed) of $51.55 a share, which is about 1,165% higher than today’s $4.07.
- High case: EBITDA under a full recovery is approximately $4 billion. Current EV (enterprise value) is $7 billion while the current market cap is $807 million. EV/EBITDA, assuming a full recovery of EBITDA, is 1.75. Fair value can be conservatively estimated at 6x EV/EBITDA. That would be EV of $24 billion, which implies a market cap of $17.9 billion. That works out to $94.91 a share, over 2,230% higher than today’s $4.07.
BOOLE MICROCAP FUND
An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: http://boolefund.com/best-performers-microcap-stocks/
This outperformance increases significantly by focusing on cheap micro caps. Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals. We rank microcap stocks based on these and similar criteria.
There are roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.
The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods. We also aim to outpace the Russell Microcap Index by at least 2% per year (net). The Boole Fund has low fees.
If you are interested in finding out more, please e-mail me or leave a comment.
My e-mail: firstname.lastname@example.org
Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.