This article on value investing portfolio was written by Thomas Niel. Thomas is a private investor, a financial blogger and an accountant in Washington DC. Article image (creative commons)
Do you know how to structure the perfect value investing portfolio? You’ll find many ways to capitalize on market mispricings in the value investing universe.
At any given time, hundreds of small cap stocks around the globe sell at extremely low earnings multiples. You’ll also uncover hundreds of stocks selling at large discounts to tangible book, or even net current asset value (net-nets).
By expanding your opportunity universe further, scores of small cap companies selling at large discounts to their private market value appear — bargains on the radar of strategic and financial buyers. To top it all off, special situations arise that can provide short-term, low-risk gains that further boost your long-term return.
So, what’s your gameplan? How do you build a value investing portfolio that capitalizes on these multiple strategies? Read on to see how to properly structure a value investing portfolio that generates big gains!
Table of Contents
Multiple Value Strategies: Pros and Cons
There are multiple strategies you can use to build a value investing portfolio. From low P/E stocks to net-nets and securities trading at a discount to tangible book, hundreds of opportunities for the small investor abound globally.
There are many shades of value. Developing a modicum of proficiency in all of the below-listed strategies will make you a better value investing generalist, able to scope the markets-at-large to build a value investing portfolio that leads to big long-term gains.
Opportunities that exist within each strategy will have their share of “broken legs.” The key is to put your well-developed value investing criteria ahead of any strategy in order to select ideas that historically outperform the markets.
Low P/E or Low Earnings Multiple Stocks
You could focus on low P/E stocks, buying securities around the world that trade at extremely low earnings multiples.
The advantage to focusing on low P/E stocks is that they are currently profitable businesses to which Mr. Market has applied an irrational discount (if the fundamentals check out).
Buying these types of stocks is a numbers gain. Statistically, a basket of low P/E stocks will revert to the mean, generating outsized returns for your portfolio.
The disadvantage: the fleeting nature of earnings in some small-cap securities.
The market may give a business a low earnings multiple due to the cyclicality of the company's business. The business may have bleak prospects long term, or it may even have a history of squandering earnings through bad acquisitions or outsized executive compensation.
With a well-developed value investing criteria, you can sift through low P/E stocks, finding those that are truly undervalued instead of those selling at a discount rationally set by the market.
Net-Nets/Discount to Tangible Book
Alternatively, you could consider net-nets and other securities trading at a discount to tangible book value.
While many of these companies may have weak or non-existent earnings, irrational mispricings happen often. The presence of solid catalysts on the immediate horizon (1-2 years) is a strong indicator of a winning opportunity.
Solid catalysts signal a turnaround in profitability, changes in the industry macros, or situations such as activism or the pursuance of strategic alternatives (M&A, spinoffs, divestitures). Any of these catalysts, if played out as expected, can yield big returns within a relatively short time frame.
The downside to this strategy is the lack of quality businesses among these names. Net-net and discount to book stocks typically have a solid reason behind their undervaluation. The company could be hemorrhaging money, meaning the company’s net asset value will likely decline. Insiders who control the company may not have an interest in maximizing shareholder value, or bad management may bleed the company dry with excessive compensation and related-party transactions that further impact the valuation.
Like with low-earnings multiple stocks, proper analysis will determine whether or not a stock is truly deep value. Again, well-developed value investing criteria will help you determine if a stock is an opportunity or a value trap.
Private Market Value
A private market value strategy seeks to buy undervalued stocks trading at a discount to what a private market buyer (competitor or private equity firm) would pay for the business.
This is the winning strategy detailed in Tobias Carlisle’s The Acquirer’s Multiple. Backtesting of this strategy has shown its compounding power: over a 44-year period, this strategy would compound $10,000 into $14.9 million!
This strategy proves most effective during a period of “M&A fever,” typically during the mid-to-late stages of a bull market.
With businesses at the top of the economic cycle and flush with earnings to reinvest, strategic buyers may be more aggressive in buying up competitors. If you find a company selling at an earnings discount to peers, it stands a strong chance of being acquired by a competitor at a healthy premium within a short timeframe.
Financial buyers such as private equity firms are highly active during this period in the cycle as well. With billions in “dry powder” to invest in deals, along with easy credit to finance the debt component, there will be more demand from private equity to buy up undervalued public companies.
The downside to this strategy is that it typically fares worse during economic downturns. Private market value employs relative valuation, which may inflate a company’s value during a bull market and undervalue it during a bear market.
M&A deals slow during a downturn. While activity does not completely halt, acquirers during a downturn usually take advantage of the opportunity to bulk up on the cheap. You can profit from buying beaten-down names that rebound on M&A, but buying a moribund stock hoping for a takeover catalyst during a market downturn can be like catching a falling knife.
You may pay $10/share for a company you believe is worth $15/share, only to see it fall to $5 a share. To compound the pain, a buyer comes in and offers $10/share. You didn’t “lose money,” but you lost the opportunity of deploying capital on a winning investment.
Don’t include private market value stocks in your value investing portfolio based solely on “takeover talk. They should also meet the criteria of your value investing checklist.
Special Situations
Everybody these days wants to be in “special situations.” Take a look across the value investing blogosphere, and it seems 99% of contributors claim to be scouring these opportunities.
What is a special situation? Special situations are investment opportunities driven by events as opposed to the fundamentals alone. Special situations depend on near-term catalysts — examples include a spin-off, tender offer, M&A, bankruptcy, or litigation — that, once resolved, result in a quick bump in the share price.
The special situations and value investing scenes commonly converge, as special situations were an important part of both Ben Graham and early Warren Buffett’s toolkits.
However, saying you are into “special situations” and being a specialist in them are two different beasts. Even in the small cap space, there is ample competition amongst niche “event-driven” funds to generate alpha from the strategy.
As a small investor, you may encounter special situations too small for funds (such as odd-lot tender offers) that can result in low-risk, short-term returns.
Bigger special situations require wading into “predicting the unpredictable” territory (such as litigation and bankruptcy). If you have a background in this space, carry on! Otherwise, only consider them if the opportunity meets your value investing criteria — in other words, do not speculate!
Combine Strategies Within a Single Value Investing Portfolio
“In terms of investing, I would say that there is no exact formula for what we do. We try to use all the value investing principles we know. The world is imperfect. The world doesn’t just dish up
net nets all the time. The world doesn’t dish up stocks trading below cash all the time. Doesn’t deliver fine businesses at eight timesearning . All the time.”
-Seth Klarman, The Graham + Dodd Luncheon Symposium (2008)
As Klarman put it, there are multiple avenues to success with a value investing portfolio. Opportunities are not static — at times, they appear; other times, they are harder to find.
This is where combining strategies proves fruitful when building your value investing portfolio.
Pursuing multiple strategies gives you a wider range of opportunities to analyze and consider. The ebb and flow of the market, and of the individual stocks in your portfolio, will give you an additional boost when it comes to adding and disposing of positions in your portfolio.
Are your net-net stocks trading closer to their underlying value? Consider selling them and buying up some low-multiple stocks that meet your criteria!
Are your low P/E stocks now selling at fair valuations? Consider swapping them out for some net-nets!
Understanding the Historical Performance of Your Strategies
When building your value investing portfolio, consider the historical performance of the various deep value strategies you employ. Net-net stocks globally (US, Canada, UK, Japan) have historically generated outsized returns (20% per year) for investors.
A strategy focusing on stocks selling at low earnings multiples has also performed well. As seen in the backtesting of the Acquirer’s Multiple strategy, this strategy compounded leaps and bounds ahead of the S&P 500 over a 44-year period.
The flip side to this historical outperformance is volatility. Small cap deep value stocks offer you the greatest “edge” in investing, but they also swing more wildly than blue-chip stocks and market indices.
Again, this is why diversification is key to building a portfolio that outperforms the market. While individual stock performance is out of our control, by applying what works and ignoring what doesn’t, you can build a value investing portfolio that, in the aggregate, generates big returns over the long run.
Should You Track Individual Strategies?
Tracking individual strategies can give you insight into what is working in your portfolio and what is flailing. A value investing portfolio’s success comes from utilizing historically proven strategies, but you will naturally be more proficient implementing certain strategies. Tracking individual strategies in your value investing portfolio can make you a better value investor.
Let’s say you have a strong proficiency in selecting net-net stocks. You have bought a basket of them, and in the aggregate they have met your expectations (outsized returns).
On the other hand, you have expanded your opportunity universe to include low earnings-multiple, private market value, and special situations investments. You have less experience selecting these, and as a result your picks have underperformed.
It’s human nature to avoid dwelling on painful events, and poor investment performance is no exception. But by looking at your losses head-on and assessing whether or not the results were out of your control (market declines, black swan events) or within your control (such as avoiding red flag situations, value traps, etc.), you’ll strengthen your ability to use these other other strategies when making subsequent investments, thus building a multi-strategy value investing portfolio.
Building a Value Investing Portfolio by Combining Proven Strategies
The value investing universe is not static, and at times, the number of opportunities within each strategy will fluctuate. The key takeaway from this analysis is the importance of being a generalist when building your value investing portfolio.
If there is a wider sea of low-earnings multiple stocks that meet your criteria, pounce on them.
If net-nets are as far as the eye can see, buy them while you can.
Come across a special situation that’s low risk? Take a position.
Do opportunities exist using the private market value strategy? Consider them as well.
Focusing on what works and avoiding what doesn’t comprise the important tenets of a strong value investing portfolio. The low earnings-multiple, net-net, and private market value strategies have historically produced outsized returns. Small investors have profited from special situations going back to the beginning of value investing.
By combining all deep value strategies into the scope of your investing criteria, you have a greater opportunity to capitalize on market inefficiencies.
Utilizing proper diversification that minimizes risks without sacrificing expected returns, you can build a value investing portfolio that leads to big gains over the long term.
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