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Cover photo of calculator by Nick Benjaminsz This ebook is for informational purposes only and does not constitute any form of investment advice. © Copyright 2011 Elie Rosenberg All Rights Reserved .
com . Elie Rosenberg valueslant. I hope this ebook will serve as a useful resource for you to apply in your hunt for the next great value investment. Please check ValueSlant updates for much more value investing content that is both actionable and enlightening! I invite you to join the conversation by commenting on the blog at valueslant.Thanks for joining me at ValueSlant! ValueSlant is all about the intersection between investing theory and practice and this ebook was written with that framework in mind.com with any questions or comments.com or by dropping me a line at elie@valueslant. Best regards.
I have provided an overview of the factors that create each type of opportunity and some key points to analyze in your research. The goal of this ebook is to give you a set of mental templates for mispriced stocks against which to compare the stocks you encounter. And for those experienced investors already familiar with most or all of these models. How do they do that? Here’s renowned value investor David Einhorn in his book Fooling Some of the People All of the Time: We start by asking why a security is likely to be misvalued in the market. The truth is that with the ever growing plethora of investment content on the Internet there are plenty of great places to come across potential investments. You don’t need me to tell you that your time is your most precious asset. in fact. he starts with a theory about why there is a good chance the stock is undervalued and only then dives in to calculate intrinsic value. (15) In other words. we analyze the security to determine if it is. we need to understand why the opportunity exists and believe we have a sizable analytic edge over the person on the other side of the trade. It is no coincidence that successful value investors are able to quickly identify potential value stock opportunities and only devote their research time to worthy candidates. open the Wall Street Journal.Introduction: You Got to Know How to Look Where to look for underpriced stocks? In the information age the question seems overwhelming. Another benefit of this approach to investment research is that it helps you zero in on the “edge” you have over the market in the particular investment. Once we have a theory. Rather. Einhorn doesn’t start digging through financial statements to calculate the intrinsic value of any old stock he comes across. Strategically building up a mental database of value models will enable you to quickly determine which companies are worthy of further research and which are a waste of your precious time. having them compiled in one convenient resource will serve as a refresher to maintain a constant focus on uncovering value. 1 . Additionally. Do I run a stock screen. the templates will help you focus on uncovering the investment edge that is crucial for all successful investing. cheap or overvalued. The much harder part is filtering out the wheat from the chaff by drilling down to the minute percentage of stocks that are worthy of serious due diligence. or log on to Stocktwits? The better question to be asking might not be where to look but how to look. I am confident that internalizing the mental models will help you make money by boosting your ability to identify misvalued stocks. In order to invest. We should know why the market is mispricing a stock in order to confirm our analysis of intrinsic value.
I’d love to hear about them! 2 . If you have some to add.This ebook is certainly not meant to be an exhaustive list of the ways to find value stocks.
Companies with high interest payments. (Also don’t be fooled by a high trailing year P/E ratio at the bottom of the cycle! For cyclical companies a high trailing P/E often signals the start of an upswing. Points to look for: ● Industries that are clearly cyclical and not in secular decline. When the growth rates tail off. If the core product is a fad then it will be hard for the company to reinvent themselves. For example.Value investors debate the importance of visible catalysts. high debt levels with near term maturities.Model #1: Depressed Cyclicals Many industries are prone to boom and bust cycles. or a highly fixed cost structure have less flexibility to survive a downturn through cost cutting measures. growth and momentum investors bail out and there is a decent chance the stock is sold off to below intrinsic value. Points to look for: ● Core business still healthy. Value investors can be greedy when others are fearful (as Warren Buffett likes to say) and pick up good companies at rock bottom prices because they are willing to be patient and wait for the cycle to reverse.) Model #2: Fallen Growth Angels Fallen angels are one time growth stocks whose growth has slowed. some related to broader macroeconomic cycles and some more industry specific. ● Company willing to return capital to shareholders. commodity industries are prone to cyclicality because commodity pricing is highly sensitive to relatively slight swings in supply and demand.Look for companies that will be very profitable on the high end of the cycle so that when averaged across the cycle they have above industry average earnings. Management may feel pressured to invest in risky new ventures 3 . Market often takes a short term view by forecasting the recent weakness into perpetuity.Companies with minimal financial leverage and variable cost structures can handle a downturn in revenue without losing huge amounts of money or going bankrupt. Mr. ● Companies in strong financial condition. Cyclical stocks in a downward trend can be beaten well below intrinsic value.Growth may have slowed for a myriad of reasons. Cyclical industries should not be confused with industries in secular decline where there is a structural challenge to the industry (such as outdated technology or adverse government regulation). Look at the average earnings across the cycle.If the company does not have new avenues to earn a reasonable return on investment then the company should return capital to shareholders. ● A catalyst to attract investor attention. but especially with faded stars it is better if one can discern some future event that will bring positive attention back to the company. Industry cycles can come in many forms.These are industries that have historically had regular boom and bust cycles. but the business can still sustain profitability. ● Strong normalized earnings.
This is not a must.Aside from the rare cases where activists can acquire a majority share or win an extended proxy battle. When a company cuts or eliminates its dividends these investors often exit en masse.Corporations should be paying only a portion of cash flows out as dividends while retaining at least enough cash to reinvest and sustain operations. ● Management and directors with incentives for value enhancement. causing a quick and steep drop in the stock price. Points to look for: ● An activist with a proven track record. The downside of a big name activist moving in is that often the stock price will jump quickly once they file and before you can get into the stock.Look for companies that are cutting the dividend as a result of a temporary or cyclical setback. a change in business strategy. and many activists also enclose letters explaining their investment thesis and pushing management to take value enhancing action. if the insiders have a majority (or even just a very large) stake they are 4 . Model #4: Activist Coattails Activist investors attempt to unlock shareholder value by cajoling company management to change strategies or engage in asset conversions such as asset sales or spinoffs. That usually does not end well. The underlying business may be fundamentally strong and the selling of income investors may bring the stock price well below intrinsic value. but some activists who specialize in certain industries or in forcing certain corporate actions have built track records of success.outside of the core business simply to convince Wall Street that the growth story is still intact. Often these companies are only undergoing temporary hiccups and are eliminating the dividend to provide themselves with temporary operating flexibility. Model #3: Dividend Cutters A large group of investors and funds invest primarily on the basis of dividend income. which are required to be filed when an entity purchases a five percent stake in a company. Look for cases with significant insider ownership so that management and the board are incentivized to act on behalf of shareholders. company management and board of directors will still have the final say. If the company had to cut the dividend because of reckless dividend policy and not external economic factors then that calls management aptitude into question. You can track activists through 13D SEC filings. Activists will face a protracted fight if management and the board are more interested in keeping their jobs than increasing shareholder value. Points to look for: ● Reason for cutting the dividend. The investor is required to state whether he will be going “activist” to create change in the company. ● Companies with sound dividend policy. Smaller investors can ride their coattails by investing alongside them. or to meet loan covenants and not as a result of fundamental weakness in the business. On the other hand.
Points to look for: ● A minor event in the long term perspective. If the company loses more of its market cap than warranted in your valuation (and the company wasn’t overvalued before the news broke!) then that is a buying opportunity. Model #5: Turnarounds Potential turnarounds are companies that have been beset by company specific problems and must be overhauled in order to be restored to their former glory. but often the market makes the buy decision easier by selling off the stock beyond any rational calculation.Measuring event impact on company value is not typically easy. Choose turnarounds to invest in very judiciously. ● Extreme overreaction.Activists will have a harder time unlocking value in companies with built in defenses to keep the status quo.The key to buying on bad news is to rationally measure the impact of the event on long term company value. or the loss of a key customer. Most attempted turnarounds do not succeed and margin of safety can quickly dissipate as the company tries to recover. The negative sentiment surrounding potential turnarounds is usually warranted and explains the low market valuation.Try to find situations where a large part of the purchase price value will remain even if the company’s turnaround plan fails. Value investors can profit by uncovering situations where the strong odds of a successful turnaround are being overshadowed by the current poor state of the company. ● Strong executive leadership. Behavorial finance has empirically proven what value investors already knew.Capable management that can execute the turnaround strategy is absolutely crucial. The initial sharp reaction to bad news is often corrected over time as the market puts the event in perspective. Generally avoid companies with anti-takeover defenses such as poison pills. Overreaction to bad news can cause a stock to sell off well below the rational hit to intrinsic value that can be calculated by putting the news into long term perspective. government regulatory action.● often resistant to activists attempting to force change as they fear losing control of the company. Points to look for: ● Coherent turnaround strategy.stock market participants overreact to recent company news. ● Downside protection.The company needs a strategy to restore profitability that is well defined and feasible. Model #7: The Ignored Micro Cap 5 . whether good or bad. Model #6: Buying on the Bad News Bad news for businesses can come in many forms such as a large lawsuit.
their market capitalization is simply too small. Pink sheet stocks do not typically issue audited financial statements. Individual investors without liquidity requirements can thrive on the more frequent mispricings in very small stocks. The market often associates a lack of growth with a company headed for zero in the very near future. Forensic due diligence on the company’s financials is always a good idea.Certain business models can go up in flames very quickly.I would generally avoid pink sheet stocks (though there are some noteworthy exceptions). Model #8: Cash Cows Out to Pasture Companies in decline can still be good investments in the right conditions.Sometimes companies are cheap for a very technical reason. but they are a good starting point. the ignored micro-cap doesn’t necessarily have a catalyst to unlock the value. especially in the hi-tech arena. Audited statements are certainly no guarantee the company is legitimate. One way to avoid these value traps is to look for micro caps that have potential to become larger companies. Model #9: Growth at a Reasonable Price (GARP) Warren Buffet tells us to reconsider the distinction between “growth” and “value” investing: 6 .Management often has incentive to keep the failing company alive by investing declining cash flows into new ventures that are likely to fail.Unlike some of the other value templates. Often micro cap value traps involve majority family control where the family is resistant to measures that will enhance the public market value of the company. Look for management that is committed to shrinking the company as cash flows decline by returning cash to shareholders through dividends or share buybacks. Thus cash cows with declining cash flows can often trade below the present value of those cash flows. Small companies are often thinly traded and their shares do not have enough liquidity to attract institutional investors. If the company squanders the remaining cash flows through poor reinvestment then the cash flows are of no value to shareholders. Illiquid micro caps can be value traps. but all the more so in smaller companies. They also do not usually get the time of day from Wall Street research analysts as they do not possess the potential to generate large investment banking fees. For these reasons markets tend to be less efficient in smaller stocks. Points to look for: ● Broken but not too broken. ● Management that will pull cash out of the company. ● Exit strategy. Look for situations where the cash flows will taper off gradually and the company will have the flexibility to realign their assets in an orderly manner. Points to look for: ● A legitimate enterprise. Another good idea is to look for micro caps that would be strong acquisition candidates for a larger company in the industry.
but you might be able to find a catalyst on the horizon with some research. but no good news is being priced into the stock and therefore any positive development will move it upward. If the company is trading at less than liquidation value then the odds of losing money have been minimized.This is especially important with cigar butts as management may be tempted to siphon off as much value of the failing business as they can before it shuts down entirely.Significant insider buying at the very least signals that insiders want to increase shareholder value and not run off with it themselves. labeled “cigar butts”. The idea behind cigar butts flows from Graham’s principle of margin of safety. Points to look for: ● Honest management. You can do this by formally breaking out the growth portion of your valuation (see Bruce Greenwald’s valuation approach in his book Value Investing for one way to do that).A company needs some level of competitive advantage to sustain growth in the face of competition for an extended period of time. There are several valuation formulas one can employ to find cigar butts including: net current asset value (current assets-all liabilities). Conversely. 7 . Model #10: Ben Graham’s Cigar Butts These are companies trading at a significant discount to a strict net asset valuation that the dean of value investing.For value investors employing GARP the goal is to pay as little as possible (or ideally nothing!) for the “growth” portion of the valuation. The upside is usually unclear. constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive. (1992 Berkshire Hathaway Annual Letter to Shareholders) A “growth” stock can be a good investment from a value investing perspective. and net cash (cash on balance sheet-all liabilities). Strong companies with good growth potential can be cheap even if they do not appear so upon glancing at simple valuation metrics. net/nets (current assets valued at liquidation prices-all liabilities). ● A value unlocking catalyst. there should be a margin of safety such that current operations support the present share price in case the growth plans fizzle. In theory one could just shut the company down and pull out the value through liquidation (although with public companies that value is not always unlocked for shareholders). The real issue is how much growth is priced into the stock and how that compares with your estimate of the company’s growth prospects.The two approaches are joined at the hip: Growth is always a component in the calculation of value. It is one of the best signs that value will eventually be extracted from the cigar butt. Points to look for: ● A “moat”. ● A margin of safety. ● Insider buying.Most cigar butts do not have visible catalysts (that is why they are below net asset value). Ben Graham. Businesses with significant problems still might have one last profitable “puff” in them.
Be careful with these situations.If insiders hold large portions of stock then odds are they believe in the future of the spinoff. a company that has mainly fixed costs and fewer variable costs. The spinoff company might not be in an “attractive” line of business or it might lack sufficient liquidity for a large investment fund.Look for large recipients of spinoff stock sellling for reasons unrelated to the stock’s intrinsic value. The most typical model here is a company that has reached break even. The parent company may use the spinoff to load the spin with debt or other legacy liabilities to clean up their own balance sheet. This is the concept of operating leverage in action.Operating leverage works to the downside as well. 8 . Spinoff recipients might sell for a myriad of reasons.) Spinoffs often come under initial price pressure because the recipients of spinoff stock often do not want it for noneconomic reasons.Model #11: Inflection Point Inflection point companies are smaller companies that are at a crucial junction in their maturation. providing an attractive entry price for value investors. Watch out for potential revenue declines. The beauty of inflection point companies is that they are “hidden” in the sense that glancing at their financials shows an unprofitable or minimally profitable company. Even if the operating performance of the spinoff unit improves they might still be sunk by excess debt levels. These are often companies in service or information related industries. A company with solid incremental profit margins beyond their fixed costs can be unprofitable one year and substantially profitable the next just by increasing revenues modestly. ● Model #12: Spinoffs Professors at Penn State University sampled 174 spinoffs from 1965 to 1994 and found that they outperformed the S&P 500 by an average of 31% in their first three years. ● Insider holdings. If the company can continue to grow revenues they will see their bottom line profitability soar. You can gain an edge over the market by following the company closely and honing in on when they have reached the inflection point. Managers operate more efficiently with less bureaucracy and are held more directly accountable for performance. They also are often better financially incentivized.While spinoffs often free the spin from the corporate “weight” of the parent. ● Inherited liabilities. Points to look for: ● High operating leverage. (The parent company also tends to outperform the market as well post-spin. sometimes the opposite occurs. A company with substantial operating leverage will start bleeding cash quickly even if revenues drop slightly below covering their fixed costs. Points to look for: ● Institutional selling. The corporate performance of the spinoff unit is also commonly boosted as a standalone company.In other words.
The ex-bondholders may not be interested in holding the equity for reasons similar to institutions selling post spinoff. yet the holders of the stock will be looking to sell.Are there several potential upside scenarios or at least one strong candidate? Model #15: Liquidation Seth Klarman in Margin of Safety describes company liquidations as the ultimate value unlocking catalyst. Points to look for ● Coverage in downside scenario. Liquidations can be great for value investors because we can be confident that the company value will not erode before shareholders can benefit from it. there is typically no sell side coverage and thus little institutional interest in post-reorg equities. These are situations where the current share price is supported by the current state of the business. Model #14: Free Option Monish Pabrai describes these situations as “heads I win.Viable businesses can go into bankruptcy for reasons other than a fundamentally broken business model. The company will often have a cleaner balance sheet and better prospects after going through bankruptcy. Typically pre-bankruptcy bondholders receive most of the equity value in the reorganized company.Look for large bondholders who converted debt to equity and may be dumping the stock. ● A strong upside option or multiple upside options. Look for liquid assets on the balance sheet or good visibility into future locked in cash flows through mechanisms like long term contracts. These may come about due to investors’ recency bias where the current downtrodden state of the company obscures their view of the upside option. ● Institutional selling pressure. Points to look for: ● A good (or at least average) business. and potential positive developments such as contract wins or a hit new product can be considered a free option. perhaps because a company that has failed as a 9 .the equity might not fit their investment profile or it might not be a big enough position for them. Or we might attribute the mispricing to the conflation of risk and uncertainty. tails I don’t lose that much”. The bankruptcy process allows the company to clean up its specific problems and emerge with good prospects for success if the underlying business is sound. Additionally. There is uncertainty as to whether the upside will be achieved. Be forewarned that selling overhangs can take months to clear for stocks with limited liquidity. but there is little risk of permanent impairment of investment capital.The “option” is only free if the current earnings or asset base justifies the share price.Model #13: Post-Bankruptcy Equity Post-bankruptcy equities can be structurally similar to spinoffs. Yet there is a market bias against liquidating companies. The company might have suffered from excess leverage or gross mismanagement.
These quirks can come in many forms.going concern is viewed as a risky investment even though shareholders will be recouping value as assets are sold off. These companies undergo a period of doubting by the market in which they are mispriced. an accounting oddity. Will the factor disappear at some point (like an accounting quirk being reversed) or will the company just have to prove itself through consistent earnings and cash flow? 10 . Points to look for: ● Alignment of incentives for management. this does not refer to you in high school.Have a clear take on what specific factor is causing the market to misread the company. ● The catalyst. Value investors who can see the value past the oddities can get in early before the market corrects the mispricing. Model #16: The Misunderstood No.Make sure to consider all potential liabilities relating to unwinding the company (payouts to executives. operating lease cancellation etc. Liquidating companies frequently trade below a conservative estimate of liquidation value. These are companies with unusual characteristics that cause analysts and investors to misunderstand and misprice them. Points to Look for: ● The point of misunderstanding.Ideally management should have a large stake in the equity to minimize the risk that they attempt to keep the company going longer than is necessary and erode value through operating expenditures. or a complex corporate structure.) when calculating liquidation value. ● Residual liabilities. whether it be a business model undergoing change or different from others in the industry.Hone in on what will cause the Street to wake up to the value.
Dividend Cutters 4. Depressed Cyclicals 2. Cash Cows Out to Pasture 9. Fallen Growth Angels 3. Free Option 15. Buying on the Bad News 7.Reference List: 1. Spinoffs 13. The Misunderstood 11 . Activist Coattails 5. Growth at a Reasonable Price 10. Liquidation 16. Post-Bankruptcy Equity 14. Inflection Point 12. The Ignored Micro-Cap 8. Turnarounds 6. Ben Graham’s Cigar Butts 11.
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