Diversified Deep Value

This page will serve as a living document for things I learn related to Graham-style deep value investing.

Book Resources:

  • The Intelligent Investor by Ben Graham

I remember The Intelligent Investor being very saavy on portfolio management (splitting allocations between stocks/bonds and the like), besides just deep value stuff. I’ll have to reread his tips and post them later.

  • Margin of Safety by Seth Klarman

Webpage Resources:

Warren Buffet’s Shareholder Letters

A website which contains a screener for finding stocks selling at a discount to Net NWC

Seth Klarman’s book

History:

In The Intelligent Investor, Ben Graham’s teachings are the following.

  1. Free yourself from the market’s daily pricing/technicals and focus on fundamental value.
  2. How do you determine fundamental value? It’s hard even for the pros, but if you grab things at a huge, huge discount, then it shouldn’t matter, right?
  3. The discount we’re looking for is when stocks trade at a price less than their Net Net Working Capital (ideally less than two thirds). Sell when they realize Net Net Working Capital.

My Thesis:

In Graham’s day, finding Net NWC discounts involved piling through a ton of paperwork. Now, it’s easily performed on the grahaminvestor screens. I dub my version of his philsophy “Diversified Deep Value” and it has the following criteria.

  1. Stocks must be selling at a discount to Net NWC.
  2. Split into 8+ names to diversify idiosyncratic risk. Net NWC-discounted firms are typically small and undercovered, thus presenting significant idiosyncratic risk.
  3. Since they are small, you should also know that Net NWC stocks are often illiquid, so DO set limit orders when buying. Don’t fret about the illiquidity when selling. “In stocks as in romance, ease of divorce is not a sound basis for commitment.” – Peter Lynch.
  4. Stocks must have a “real business” . Meaning I don’t want to see some sort of complicated financial company.
  5. Likewise, stocks cannot have red flags (from being foreign to pending litigation/corporate events). A look at the Yahoo finance news, profile, and message boards usually picks up red flags.
  6. Stocks must list on a major exchange. That way, I can be sure that their filings are somewhat up to date, and reasonably reviewed.
  7. I will actually take a look at the 10-K to see the “quality” of the Working Capital on their balance sheet. If you’re Silverleaf Resorts (a timeshare) after the mortgage bubble, your working capital is very inflated by “inventory” (in order words, houses) which may be carried at acquisition cost rather than market value, so I don’t think you’re a bargain.
  8. Ideally, dividends.
  9. Reasonable size. Some of these companies are just unbearable tiny.

Why it Works:

Deep value investing is historically high returning and intuitively attractive:

  • If you know accounting, you know Net Working Capital is almost cash. So buying at a price 66% of NCAV is basically paying 66 cents for “1 dollar plus the company’s long term assets.” Even if the company’s long term assets are worth nothing and its business model is to buy Treasuries with its cash, you’re still generating alpha (superior risk-adjusted returns).
  1. To belabor the point, if management goes out and just gets any kind of market return on its cash (i.e., buy Treasuries) and long term assets, its earnings still look great relative to price. Hopefully, the price rises to reflect this or you get the earnings through dividends, or a corporate event.
  • Value investing is long-term, which minimizes the impact of transaction costs (commissions) and taxes. A short-term capital gain (on positions held <12 months) is taxed as income while long-term capital gains (>12 month positions) are taxed at 15%. My marginal rate is around 30%, so tax-wise, a long-term gain of 10% is equivalent to a short-term gain of 11.4%
  • Margin of safety. Graham basically argues that you have a “margin of safety” in the discount you’re getting on their assets. As a result, your value stocks will lose less value during economic downturns, which otherwise typically cause investors to give up whatever gains they have.
  • I think the strategy is even better nowadays because with financial data online, it’s incredibly easier to find opportunities, which allows you to spend less time doing it and diversify idiosyncratic risk better.
  • It makes sense that there are still excess returns in Net NWC strategies, because most of these Net NWC stocks are so small that no hedge fund or mutual fund could actually exploit the mispricing. They’d move the market way too much. It’s perfect for the small investor.

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