Three Value Strategies That Seriously Outperform
This article on three value strategies that seriously outperform was written by Isaac Aydelman. Isaac is a student of economics and a former soldier. He was drawn to net net investing for their historical returns and how the strategy paired well with his personality. He manages his own personal account and is always looking for new opportunities. He uses Net Net Hunter's high performance net net checklist to identify his stocks. Download our net checklist right now for free. Click Here. Article image (Creative Commons) by Image Genie, edited by Net Net Hunter.
Value strategies are perhaps the oldest and most intuitive ways to invest in the market, and three have surfaced as the most promising for small investors.
The value investing premise is simple: If a company is worth X, but is trading for less than X, you stand to make money if you buy. Decades of studies have shown that value investing strategies outperform the market by between 2% and 20% a year.
That 2 to 20% is a wide range, and the difference comes down to how one assesses the value of a company. The best performing of these have been deep value investing strategies. In fact, we can narrow the top strategies down to just three deep value investing strategies. Read on for an overview of how to significantly outperform the market with these exceptional approaches.
Top Value Strategy: Benjamin Graham’s Net Nets
Graham’s Protection From Massive Loss
One cannot talk about value investing without bringing up the grandfather of the strategy: Benjamin Graham. Graham developed his deep value investing strategy as a response to the era of the Great Depression and the painful lessons it taught investors. He set out to develop a method of maximising gains while minimising the chance of total loss - a crucial factor in the crisis-filled markets of the 1930s.
Among the pessimism of that era’s markets, Graham noticed businesses were trading at a price below all of their assets minus their debts - less than what they were worth if liquidated! Graham saw the irrationality of this and proceeded to buy and hold a basket of these “net nets.”
What are Net Nets?
The term net net refers to the deep value investment strategy of buying companies that are trading below their net current asset value (NCAV). Warren Buffett later popularized the term “cigar butt” to describe these firms.
The formula for NCAV is as follows:
NCAV = (Current Assets - Total Liabilities - Preferred Shares
NCAV) / Total Shares Outstanding
This yields the NCAV per share of a company.
You can think of this valuation method as essentially a low price to book value, but where the business’s long term assets have been stripped out of the equation, giving investors a stricter idea of the business’s intrinsic value.
Benjamin Graham viewed this number as the hyper conservative assessment of the ‘liquidation value’ of a firm, meaning the most conservative estimate of what shareholders could expect to receive if the firm would be shut down. This worked because NCAV is essentially only valuing the most liquid assets a company has, net of its debts.
Graham would then seek out companies that were trading at a minimum of ⅔’s of their NCAV. This extreme pickiness awarded him a huge margin of safety when investing - handy during the volatile 30’s. Despite the risk of bankruptcy, Graham could expect to at the very least be paid the NCAV of the firm - a handy premium over the price he originally paid for the stock.
This discount to NCAV framework is the heart of net net investing. Your downside risk is minimised as liquidation becomes a source of value and the company’s intrinsic value protects investors when the growth or earnings of a company suddenly evaporate.
Net Net Investing: Large Returns, Low Risk
You would be wrong however, to assume this value strategy is only just defensive. In fact, it is one of the highest returning strategies, with numerous studies researching its effectiveness in different situations. Generally across these studies we have seen an average return of 25% per year.
One of the most recent studies by James Montier analysed the returns of a global basket of net nets from 1985-2007. It’s results speak for themselves: During this 23 year period, the basket of net-nets returned an average of 35% per year, while the index lagged at an average of 17% per year.
There is only one downside we can think of with this strategy: Most companies trading below their NCAV are tiny microcap stocks that are generally illiquid. This can be an issue for some investors, but it provides a major barrier to entry for skilled investors since they’re typically managing a significant amount of money. We estimate the upper limit for portfolio size at around $5 million USD in 2020. This makes the highly lucrative strategy perfect for small retail investors.
If you’re managing a larger amount of money, don’t worry. Next is a great strategy with high returns, and more companies to invest in.
Second Best Value Strategy: Ultra Low Price To Net Tangible Book, With a Twist
Maintaining The Focus On Conservative Value Assessment
This strategy isn’t much different from net net investing, but it does provide investors a little more leeway and isn’t as picky. Here you are still looking to buy at the deepest discount to intrinsic value you can, but instead of a discount to NCAV, you buy at a discount to Net Tangible Assets (NTA).
NTA = Book Value - (Intangibles + Goodwill)
Because you are now factoring in long term assets and not just current assets, you are likely going to find more, larger businesses trading at a discount than you would have when investing purely with NCAV. In fact, this was the exact reason Walter Schloss began relying on this strategy - there simply weren’t enough net nets for his fund’s size.
While buying at a discount to NTA is a good strategy on its own, we have our own little twist: Focusing on firms that are buying back stock, or have insiders buying with their own money. In general it is good to see management with skin in the game, but these two factors can signal a positive breakthrough.
Buying back stock not only shows us that management is confident in the business’s future (and who has a better picture of the future than management?), but it increases the value of all remaining shares. Furthermore, insiders can sell their shares for a number of reasons, it isn’t automatically a bad sign - perhaps they have a new house to pay off, or a sudden expense. However, there is only one reason an insider would be buying: they think the price is going to go up.
Rough approximation of liquidation value
But why does this strategy work? For the same reason that buying a firm below its net current asset value works. The difference is that our liquidation value here is rougher and less strict than with NCAV, as we are using the book value of long term assets. We make it more robust by discounting goodwill and intangible assets, which can be written down at a moment's notice.
While using tangible book value erodes some of our margin of safety, investors buying at steep discounts, holding for the long term, and practicing proper diversification should enjoy beating the market over the long term. In fact, from 1999-2017, a basket of all the stocks trading below NTA provided an annualised return of 17.52%.
Investors who sought much deeper discounts did even better. Focusing on companies with an enormous 60% discount to NTA produced a return in line with net nets. This is definitely the approach we’ll eventually adopt.
If NTA sounds a little too safe and you are looking for even larger returns, our next strategy should interest you.
A Value Strategy For Those With An Iron Stomach: Negative Enterprise Value
How to Get Paid to Buy Companies
Now we know, the above headline sounds too good to be true but bear with us. Before we breakdown how to find deep value opportunities like this, we need to define enterprise value (EV).
Enterprise value is a popular way to estimate how much it would cost to buy out an entire company. You find enterprise value by taking the business’s market capitalization (share price x shares outstanding), then add on the interest bearing debt. This is important because when you acquire a business, its debts are not magically forgiven, the buyer assumes them and thus become part of the cost. Finally we take all the cash the business has (cash and cash equivalents) then subtract it from that number. Excess cash that doesn’t need to be used to cover current liabilities is essentially a deal sweetener and a freebie so it decreases the EV of the business.
EV = Market Capitalization + Interest Bearing Debt - Total Cash (Cash & Cash Equivalents)
All things being equal, a smaller EV means it would take less money to buy out the entire company.
Now, the strategy headline was NEGATIVE enterprise value. Surely a company wouldn’t pay someone to acquire them right?
Well, to paraphrase John Meynard Keynes, the market can be irrational. Market capitalization is based on stock price, which as we were reminded in March 2020, can swing around. Also note that in the EV formula, we subtract cash from the total number.
If a company is sitting on a lot of cash, has low debt and has just seen its market capitalization wiped out - we get the perfect deep value storm that is Negative Enterprise Value. In these situations, a company's excess cash is larger than all of its liabilities and market capitalization. If someone were to acquire this business, theoretically they could use all that excess cash to finance all the debt and purchase, and still have some left over as a bonus.
Example: Imagine a business has a market capitalization of $100M, debt of $20M and excess cash of $50M. It’s enterprise value would stand at $70M.
Now imagine a huge scandal has erupted from within the firm combined with a nationwide recession and as a result, the market capitalization dropped 80% to $20M. Well now the Enterprise Value becomes -$10M as there is more excess cash than the market capitalization and debt of the business combined.
As with the example above, negative enterprise value doesn’t just happen randomly, otherwise investors could make a living off of buying these businesses. Like all deep value strategies, there is almost always a negative catalyst and major issue that has caused these companies to fall into negative enterprise value territory.
Volatility at an Extreme
A backtest of every negative enterprise company trading in the US from the years 1972 to 2012 found that the average return of these kinds of stocks was 50.4%. Even though this is an arithmetic average, not a compound average figure, it’s clear that this handily beats low price to NTA stocks or net nets!
Well there really are no free lunches in the market, and any investor willing to use this strategy for his portfolio better buckle up and emotionally prepare. First, while the 50.4% average performance is impressive, it doesn’t tell us much about holding a basket of these stocks and what the average annual return would be.
With another backtest checking a portfolio from the years 1999-2016, we see a compound average annual return of 27.45% per year. Still fantastic and an outperformance of 22.33% over the Nasdaq over the same period. Why the big difference in both backtests though? The max drawdown, that is, the largest amount the portfolio as a whole dropped in a year, was -58.27%.
On top of that the average standard deviation, meaning how far stock prices moved both above and below their average was 43%. That means on a given day you could find your portfolio value swinging 43% below or above its long term average value. This kind of volatility isn’t for everybody.
As always the key here is to ignore the noise, hold for the long term, and with such wide variance between each stocks performance, wide portfolio diversification is a must. But if you do have that iron stomach, this strategy seems well worth the ride.
Commonalities Between Top Value Strategies
While all of these strategies value businesses in different ways, have different levels of volatility and different returns, they do share principles which explain their relative outperformance over the broad indexes.
This goes back to Benjamin Graham’s idea of a margin of safety. Championed by future value investing legends such as Seth Klarman and Warren Buffett, valuing businesses in the most conservative way allows a lot more room for error and is a value investor’s last line of defense in case all goes wrong.
All the valuation methods mentioned in this article rely on hard assets rather than a volatile metric like cash flow, or one that requires predictions of the future like earnings. Assets are something you can touch and feel and have intrinsic value to them. A factory can close down today and have 0 sales, but its machinery, plant and other equipment still holds value, and in a worst case scenario can be sold off to raise capital.
Focusing on near-dead companies provides a lot of upside
Deep value investing strategies tend to find company’s experiencing a big issue. 99% of investors would take one glance at these companies and quickly move on. That level of pessimism gives us the expreme undervaluations and asymmetric upside potential.
Many of these companies may be going through a temporary setback, or have become unprofitable despite their asset value or cash reserves and due to that pessimism are priced for bankruptcy. This minimises our downside as the stock has already suffered a big drop in price, and had its bad news priced in, while maximising our upside as the business has so much to rise just to meet our expectation of fair value. If the business turns profitable or even into a growth company, an investor would achieve a massive return.
Small (Tiny!) Firms Make For the Best Investments
It is almost assured that in all of the three deep value investing strategies we mentioned, the vast majority of stocks you find will be micro or nano caps (<$300 Million). This has a number of inherent benefits for investors.
Firms of this size benefit from what is called the small cap premium, which has been a much researched phenomenon which shows that historically, the smaller the market capitalization, the higher the return an investor can expect. There are many explanations for this, the most accepted being that these smaller businesses are inherently more risky, though try to tell that to Enron investors.
Smaller firms tend to have larger mispricing due to lack of institutional investment. Even if a hedge fund full of the best and brightest wanted to invest in these tiny businesses, oftentimes they would be too small to invest a large amount of money in without shooting the stock price up and eroding all gains. Another issue is that it would be uneconomical to hire analysts to cover the thousands of small companies listed across the world.
These smaller firms have much more room to grow. A tiny business will have a much easier time sustainably growing its earnings by double digits for 10+ years than a billion dollar multinational Fortune 500 Company. In addition to this, as these tiny businesses grow, they move into more widely covered indices, garnering more institutional investment, further pushing up its stock price.
Summing Up the Top Value Strategies
As smaller investors we face dangers from every side of the market, be it unfair taxation, competition from algorithmic traders or from PhD-filled hedge funds - it almost seems as if we are doomed to just passively invest in index funds and be content with our returns.
But what if it didn’t have to be like that? What if smaller investors actually had the advantage of finding companies with no competition from big hedge funds, being able to hold for the long term and not deal with furious clients demanding to know why we didn’t buy the hottest names in tech? Finally, what if these deep value strategies allowed you to buy a dollar for $0.50 cents?
Bank of America put out a report that stated “...from 1926 to now, value investing has handily outperformed growth investing, notching a gain of 1,344,600% versus growth's gain of 626,600% over that same time period.” While history is no indicator of the future, 100 years is about as good a sample size as you will get in the investing world. And, with these strategies, your returns should be even better.
Well, suddenly being a deep value investor doesn’t sound so bad.
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