This article on winning deep value strategies you need to know was written by Josh Klein. Josh is a private investor and a commercial real estate analyst from New York City. He combines balance sheet health with operational efficiency in his personal account. Article image (Creative Commons) by StartupStockPhotos, edited by Broken Leg Investing.
In the realm of investing, there are only a few winning deep value strategies you need to know. The greats — David Dreman, Benjamin Graham, Joel Greenblatt, and Warren Buffett — all used them, amassing incredible returns in the process. More so, each built a fortune without mirroring anybody else's investment style.
These great investors diligently analyzed deeply discounted companies and then picked the best opportunities. Today, all sorts of promoters purport to show which value strategies to use to earn great returns. So, which deep value investing strategies do you really need to know?
While there's no simple answer, no one-step equation, finding a great strategy is still achievable. One hint comes from the general approach all of the greats above took: deep value investing. By focusing in on this approach to stock selection, an investor is much closer to a winning strategy and great long term returns.
Winning Deep Value Strategies You Need To Know: Margin of Safety
So, what is the common denominator with all of these winning strategies? They all maintained the golden principle — seek the margin of safety.
Margin of safety is the investor’s best friend. It is the end-all and be-all for all deep value investment opportunities. It should be at the forefront of the mind at all times, never for a moment forgotten. Having an ample margin of safety allows investors to sleep soundly at night and preserve their capital at all costs. It grants them the privilege to be called an investor instead of the loathed speculator. It underpins every opportunity and is an essential component of all the winning deep value strategies you need to know.
However, applying a margin of safety can be vastly different from one investor to the next. Investor A might like to look at cash flow and invest in stocks below the sum of the discounted future cash flows they anticipate will be generated by the company. Investor B might have a strong affinity towards the balance sheet and might like to buy undervalued stocks trading below book value or liquidation value. Two different investors, two very distinct approaches to the margin of safety principle. So, which method is best to use? Which would be defined as a timeless winning deep value strategies you need to know? This question can best be answered by breaking up valuation into two spectrums — vertical and horizontal.
Winning Deep Value Strategies You Need To Know: Vertical Valuation
Vertical valuation is a method of valuing a company by itself, alone, without comparing it to similar companies in the same industry. A valuation of this type would generally entail a deep dive analysis into a company’s balance sheet, income statement, and cash flow statement. The more popular forms of valuation in this realm are discounted cash flow (DCF) and asset analysis. Both are winning strategies you need to know that can be used to balloon portfolio returns.
Winning Deep Value Strategies You Need To Know: Discounted Cash Flow
A discounted cash flow valuation method analyzes a company's cash outflow and inflow, projects them into the future, and discounts them to present value. In order to calculate the free cash flow of a company, one needs to take the net income figure, add back depreciation, remove capital expenditure used for day-to-day operations, and adjust for the change in net working capital. On a simpler level, one is taking the net income generated by the company and readjusting that figure to add back any non-cash deductions and capital expenditures that were used to maintain standard operations of the business.
After computing the historical free cash flow, the investor projects it into the foreseeable future using a particular growth rate. He then discounts the calculated value back to the present using an agreeable discount rate. Generally, since different growth and discount rates can be used, two investors can determine drastically different intrinsic values.
Determining a company’s value using DCF and purchasing its shares when they trade significantly below that value can result in impressive long-term returns and is definitely a winning deep value strategies you need to know. This method, largely popularized by Buffett, has proven to be a successful deep value strategy. However, as stated before, altering the discount and growth rates can drastically change the calculated intrinsic value and the margin of safety. The major question that must be addressed is: how does one circumvent the uncertainty attributed to the DCF approach? To prevent this significant shortcoming, investors can use an asset-based valuation model instead of, or in tandem with, DCF.
Winning Deep Value Strategies You Need To Know: Asset-Based Valuation
There are more winning deep value strategies you need to know in the realm of net asset value (NAV). NAV strategies are another form of vertical valuation and has proven to be successful over the years. Instead of assuming growth and discount rates to calculate an appropriate share price, one can simply use a market snapshot of a company’s balance sheet. Tweedy Browne, a value-driven fund, has done extensive research on many different successful investing methods. In its article What Has Worked In Investing, it elaborates on common characteristics of stocks that historically post impressive returns. Amongst its research, it includes purchasing stocks with a low price to book (P/B) ratio as one of the essential deep value strategies that one needs to know.
The book value of a company is the sum of all assets on the balance sheet less any outstanding liabilities. Purchasing a stock with a low P/B ratio cushions the investor from any unforeseeable event. For example, if a company’s book value is $35 per share, but the stock is trading at $25, the P/B ratio would be 0.71. By purchasing these types of stocks, an investor is protected by the excess assets the company carries and is essentially buying the ongoing operations of the company for free.
To further protect downside risk, investors can purchase stocks trading below their net current asset value or net cash balances. Because assets such as goodwill or property, plant, and equipment can be overstated on the balance sheet, the book value can be misleading. One can discount these assets completely and look for companies trading below their current assets — or the assets that are likely to be turned into cash within a year. Graham famously spearheaded this investment strategy. It is known today as net-net investing. It certainly falls into the list of winning deep value strategies you need to know.
These asset-based approaches circumvent the uncertainty attached to a DCF model. By analyzing a company purely based on its net asset value, one can surely sift the markets for winners and find undervalued securities. However, one-sided vertical approaches don’t take into account industry specific metrics. The key to finding winners in the market is to compare one company to other like-companies. Doing so is called horizontal or comparative analysis.
Winning Deep Value Strategies You Need To Know: Horizontal Valuation
At times, companies can be undervalued based on their own financials — they may be in deep value territory but still be a poor investment. In order to assess a true winning deep value strategies you need to know, one needs to compare a stock against similar stocks in its industry. This form of investing is called horizontal valuation. When assessing undervalued characteristics, the overarching majority of investors boil a company’s balance sheet, cash flow statement, and income statement down into different ratios and multiples. They then cross-reference those numbers with typical industry standards. If an industrial company’s P/B ratio is 0.90, but other companies in that industry carry a 0.75, that stock is likely not an undervalued steal.
Other popular ratios investors analyze are P/E (price to earnings), P/S (price to sales), and EV/EBITDA (enterprise ratio to earnings before interest, tax, depreciation, and amortization). There is truly no end to the amount of comparative ratios the investing community considers. Each industry has its own standards, and each investor has their favorites. However, it is imperative that one compare stocks, in some sense, to others in similar industries. If one doesn’t, a seemingly undervalued stock can actually turn out to be a money-losing idea.
Conclusion
Fortunately — and unfortunately — there are many ways to succeed at investing. As mentioned before, many great investors accumulated outstanding returns by implementing distinctly different deep value strategies. However, despite their differences, they have all implemented variations of the margin of safety principle to buy dollars at deep discounts. Whether one elects to favor an asset valuation method, a discounted cash flow, a comparative ratio analysis, or all the above, as long as investors pay close attention to intrinsic value, any of these strategies can turn into winning deep value strategies every investor should know.
Enter your email address below because we’ll send you inside info on the best performing deep value investing strategies today PLUS a free copy of The Broken Leg Investment Letter.