Use this Critical Concept to Pick Better Value Stocks
The following is a guest post by Danny Harper and may or may not reflect the views of anyone else at Net Net Hunter.
People fear risk to such an extent, they tend to make the bulk of their decisions based on trying not to lose— which is often the suboptimal strategy if your goal is to profit.
Many of us fear downside without properly factoring in the upside. When driven by emotion or irrational forces, there is a natural tendency to avoid risk, consequently lowering the chance for success.
This is where calculated, logical investment techniques come in handy, most specifically the concept of Positive Expected Value.
Expected value, in its most basic form, is simply the anticipated value of a given investment.
Positive EV analysis is a powerful tool individuals and businesses can use to make rational money decisions in a variety of situations by finding the long-term average outcome of a given scenario.
For investors specifically, with +EV you not only have a tried-and-true method for seeking out deep-value or net net stocks, you can even project the potential for buying entire businesses.
I'll get to how in a moment, but first let's run through the basics….
The Simple Math Behind Great Value Investing
In terms of probability mathematics, the expected value or return of a portfolio is the sum of all the possible returns multiplied by the probability of each possible return or occurrence.
Sounds tricky, but it is actually quite simple.
Take the example of rolling dice. When a 6-sided die is rolled, the expected value of the number rolled is 3.5. Although it’s impossible to roll a 3.5, the more rolls one does, the closer to this average the ultimate number will be.
So, if a single game of dice costs $10, with a $30 payout for hitting 6, $20 for a 5, and $0 for the rest of the numbers, you must list all possible results to eventually find expected value.
$0 - 1,2,3,4
$10 - 5
$20 - 6
There are 6 possible results, making the chance to roll 6 a simple 1/6, or .167. You can multiply the $ amount of one result by the chance of that result happening to find out how many dollars it contributes to the expected value.
For instance, the result of rolling a 1 is -$10, and the chance of rolling this number is 0.167, making the value of rolling a 1 (-10) * (0.167).
By adding up the value of each result together, you get the expected value.
In this case, the dice game EV is: (-10 * .167) + (-10 * .167) + (-10 * .167) + (-10 * .167) + (10 * .167) + (20 * .167), or - $1.67.
So you should expect to lose $1.67 per game played, with the implications being that the long-term average payout is not in your best interest.
An example of a neutral EV is a simple coin toss game (1$/heads, $1/tails), which the same process could be used to eventually find an expected value of $0.
But we aren't looking for negative or neutral EV, we want it positive. That's when, if you continue to make repeated bets, you can expect to profit on the bets on balance.
Let's run through a +EV Example. After hitting $10,000 on a game show, you can choose from the following scenarios:
- Take the $10k
- A 50% chance of winning $50k
- A 20% chance of winning $75k
- A 5% chance of winning $100k
Mathematically, the answer that would allow you the best chance for profit is B. A 50% chance of winning $50k will give you an EV of $25,000 (50% x $50k + 50% x $0).
EV for Great Business Decisions
Expected value has allowed many investors to purchase undervalued (i.e. deep value) stocks, and even businesses, by calculating the probability of profit.
For example, when it comes to the realm of e-commerce, EV can provide a clear picture of the probability for website ROI.
Essentially, a business makes X amount of money. Can you do the same or better? If so, you could do a quick analysis of what the business will make if you launch it. You can then attach a number to that business to provide a realistic idea of what the EV is. The next step is to identify those with the highest EV and then dig even deeper.
Take an existing ecommerce site that is for sale as a template. By researching (through SEO) the number of exact Google searches (exact keyword), and multiplying that number by the % of traffic each spot receives by what you think you can get it to rank, and then come to a number. You can then calculate estimated conversion...followed by factoring in the margins.
In very basic terms, it is Traffic x Conversions x Margins = Profit. Although this is a simple example, it shows that expected value is an important piece of the puzzle when considering the purchase of a business.
Deep Value Investing and +EV NCAV Investment Decisions
A natural bedfellow to +EV investing, deep value stocks have appealing characteristics to those looking for good ROI. These securities may at first seem unattractive, underreported, and unpromising, but in the realm stock investing, seemingly weak surface numbers and negative sentiment can be very deceiving.
An overarching financial concept that guides deep value analysis is known as Net Current Asset Value (NCAV). Created by Benjamin Graham to determine if a company was trading at a fair market price, Net Current Asset Value is calculated in the following way:
(Company’s Current Assets - [Total Liabilities + Preferred Shares]) ÷ Total Outstanding Shares.
According to Graham, investors will benefit greatly when investing in companies where stock prices are no more than 67% of their NCAV per share (deemed net net value). By purchasing stocks for less than they’re worth, you have a margin of safety that value investors love, while offering significant upside for capital gains.
He also advocated stocks that are conservatively financed and then grouped together in a diversified portfolio. His thinking was that with a strong balance sheet, your investment would be more likely to withstand adverse business developments over the long-term.
Stocks and companies that meet these prerequisites commonly contain positive EV by their very nature, which is why many of them outperform in general. Legendary investors like Warren Buffett, Walter Schloss, Tweedy Browne, and Peter Cundill commonly used NCAV in their stock analysis, lending pedigree and name recognition to the powerful, yet conservative formula.
Net Net Stocks: The Only Value Investing Strategy You Should Use
Stocks that trade for far less than their NCAV are termed Net Net Stocks, and offer one of the best value plays in the investing world.
These securities aren’t riskier than the average stock, but rather incorrectly priced, trading below the value of their current assets minus all liabilities. Savvy investors will note this discrepancy -- in essence, it's a price that's been set below a conservative estimate of liquidation value.
To qualify as a net net, the company is required to have current assets that cover all of its liabilities, as opposed to just debt or current liabilities. In this sense, the firm should be able to liquidate, pay off creditors, and have cash leftover to distribute to investors.
This allows for a built-in margin of safety, but keep in mind that when selecting these stocks, it is important to look for firms that have an adequate discount to NCAV and conservative balance sheet.
“Over the period 1985-2007, buying a global basket of net nets would have generated a return of over 35% versus an equally weighted universal return of 17%.”
Lastly, as noted above, diversification of net net stocks is also vital. While concentrating on a small number of high-quality investment opportunities may boost returns, it will also boost volatility. Some suggest that a portfolio of between 10-20+ net net stocks will help you realize statistical returns to a greater degree.
Net Net Stocks: Fantastic Value Investing Returns
Adhering to the principles of +EV by seeking out net net opportunities has been a historically successful investment strategy and my returns have been impressive after I fully converted to a net net stock strategy.
One example of strong net net stock returns comes from James Montier’s 2008 research paper, “Net-Nets: Outdated or Outstanding”, where he surveyed the investment situation relative to Graham’s net nets on a global stage.
The most interesting finding was that Japanese net nets from 1985 - 2007 (which, surprisingly, made up half of the 175 NCAV stock researched), dominated the broader Japanese stock index (5% during that time) by returning 20%.
Joel Greenblatt, a Columbia professor best known for the Magic Formula, was also deeply impressed by “the dramatic success of companies that the market priced below their value in liquidation.” By taking NCAV and PE into account, Greenblatt put four portfolios together from ‘72 to ‘78, with all four beating the OTC return, and the top performer absolutely crushing it (1.3% vs 29.2%). Here's a more detailed look at his study.
Additionally, Tweedy Browne analyzed a large number of net net stocks, and observed that from 1970 to 1981, stocks at 140%-120% of book value lagged those with 66% of net current asset value by 45.52% (53% and 98.8% vs 31.5% S&P return).
And finally, in James Montier’s essay “Painting by Numbers: An Ode to Quant” he noted that “Over the period 1985-2007, buying a global basket of net nets would have generated a return of over 35% versus an equally weighted universal return of 17%.”
Value Investing? Try Painting By Numbers
By implementing an unemotional, probability-based investment analysis, you should be able to identify undervalued assets and put your money to work with confidence. I have, and it's made a huge impact to my portfolio returns.
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