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

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. 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.com or by dropping me a line at elie@valueslant.com with any questions or comments. Best regards, Elie Rosenberg valueslant.com

Introduction: You Got to Know How to Look Where to look for underpriced stocks? In the information age the question seems overwhelming. Do I run a stock screen, open the Wall Street Journal, or log on to Stocktwits? The better question to be asking might not be where to look but how to look. 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. 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. You don’t need me to tell you that your time is your most precious asset. 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. 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. Once we have a theory, we analyze the security to determine if it is, in fact, cheap or overvalued. In order to invest, 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. (15) In other words, Einhorn doesn’t start digging through financial statements to calculate the intrinsic value of any old stock he comes across. Rather, 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. 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. We should know why the market is mispricing a stock in order to confirm our analysis of intrinsic value. 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. I have provided an overview of the factors that create each type of opportunity and some key points to analyze in your research. 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. Additionally, the templates will help you focus on uncovering the investment edge that is crucial for all successful investing. I am confident that internalizing the mental models will help you make money by boosting your ability to identify misvalued stocks. And for those experienced investors already familiar with most or all of these models, having them compiled in one convenient resource will serve as a refresher to maintain a constant focus on uncovering value.

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This ebook is certainly not meant to be an exhaustive list of the ways to find value stocks. If you have some to add, I’d love to hear about them!

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Model #1: Depressed Cyclicals Many industries are prone to boom and bust cycles. Industry cycles can come in many forms, some related to broader macroeconomic cycles and some more industry specific. Mr. Market often takes a short term view by forecasting the recent weakness into perpetuity. Cyclical stocks in a downward trend can be beaten well below intrinsic value. 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. Points to look for: ● Industries that are clearly cyclical and not in secular decline- These are industries that have historically had regular boom and bust cycles. For example, commodity industries are prone to cyclicality because commodity pricing is highly sensitive to relatively slight swings in supply and demand. 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). ● Companies in strong financial condition- Companies with minimal financial leverage and variable cost structures can handle a downturn in revenue without losing huge amounts of money or going bankrupt. Companies with high interest payments, high debt levels with near term maturities, or a highly fixed cost structure have less flexibility to survive a downturn through cost cutting measures. ● Strong normalized earnings- 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. (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. Look at the average earnings across the cycle.) Model #2: Fallen Growth Angels Fallen angels are one time growth stocks whose growth has slowed. When the growth rates tail off, 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- Growth may have slowed for a myriad of reasons, but the business can still sustain profitability. If the core product is a fad then it will be hard for the company to reinvent themselves. ● A catalyst to attract investor attention- Value investors debate the importance of visible catalysts, but especially with faded stars it is better if one can discern some future event that will bring positive attention back to the company. ● Company willing to return capital to shareholders- If the company does not have new avenues to earn a reasonable return on investment then the company should return capital to shareholders. Management may feel pressured to invest in risky new ventures

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outside of the core business simply to convince Wall Street that the growth story is still intact. That usually does not end well. Model #3: Dividend Cutters A large group of investors and funds invest primarily on the basis of dividend income. When a company cuts or eliminates its dividends these investors often exit en masse, causing a quick and steep drop in the stock price. Often these companies are only undergoing temporary hiccups and are eliminating the dividend to provide themselves with temporary operating flexibility. The underlying business may be fundamentally strong and the selling of income investors may bring the stock price well below intrinsic value. Points to look for: ● Reason for cutting the dividend- Look for companies that are cutting the dividend as a result of a temporary or cyclical setback, a change in business strategy, or to meet loan covenants and not as a result of fundamental weakness in the business. ● Companies with sound dividend policy- Corporations should be paying only a portion of cash flows out as dividends while retaining at least enough cash to reinvest and sustain operations. 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. 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. Smaller investors can ride their coattails by investing alongside them. You can track activists through 13D SEC filings, which are required to be filed when an entity purchases a five percent stake in a company. The investor is required to state whether he will be going “activist” to create change in the company, and many activists also enclose letters explaining their investment thesis and pushing management to take value enhancing action. Points to look for: ● An activist with a proven track record- This is not a must, but some activists who specialize in certain industries or in forcing certain corporate actions have built track records of success. 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. ● Management and directors with incentives for value enhancement- Aside from the rare cases where activists can acquire a majority share or win an extended proxy battle, company management and board of directors will still have the final say. Activists will face a protracted fight if management and the board are more interested in keeping their jobs than increasing shareholder value. Look for cases with significant insider ownership so that management and the board are incentivized to act on behalf of shareholders. On the other hand, if the insiders have a majority (or even just a very large) stake they are

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often resistant to activists attempting to force change as they fear losing control of the company. Generally avoid companies with anti-takeover defenses such as poison pills- Activists will have a harder time unlocking value in companies with built in defenses to keep the status quo.

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. The negative sentiment surrounding potential turnarounds is usually warranted and explains the low market valuation. 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. Most attempted turnarounds do not succeed and margin of safety can quickly dissipate as the company tries to recover. Choose turnarounds to invest in very judiciously. Points to look for: ● Coherent turnaround strategy- The company needs a strategy to restore profitability that is well defined and feasible. ● Strong executive leadership- Capable management that can execute the turnaround strategy is absolutely crucial. ● Downside protection- Try to find situations where a large part of the purchase price value will remain even if the company’s turnaround plan fails. Model #6: Buying on the Bad News Bad news for businesses can come in many forms such as a large lawsuit, government regulatory action, or the loss of a key customer. Behavorial finance has empirically proven what value investors already knew- stock market participants overreact to recent company news, whether good or bad. 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. The initial sharp reaction to bad news is often corrected over time as the market puts the event in perspective. Points to look for: ● A minor event in the long term perspective- The key to buying on bad news is to rationally measure the impact of the event on long term company value. 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. ● Extreme overreaction- Measuring event impact on company value is not typically easy, but often the market makes the buy decision easier by selling off the stock beyond any rational calculation. Model #7: The Ignored Micro Cap 5

Sometimes companies are cheap for a very technical reason- their market capitalization is simply too small. Small companies are often thinly traded and their shares do not have enough liquidity to attract institutional investors. 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. Individual investors without liquidity requirements can thrive on the more frequent mispricings in very small stocks. Points to look for: ● A legitimate enterprise- I would generally avoid pink sheet stocks (though there are some noteworthy exceptions). Pink sheet stocks do not typically issue audited financial statements. Audited statements are certainly no guarantee the company is legitimate, but they are a good starting point. Forensic due diligence on the company’s financials is always a good idea, but all the more so in smaller companies. ● Exit strategy- Unlike some of the other value templates, the ignored micro-cap doesn’t necessarily have a catalyst to unlock the value. Illiquid micro caps can be value traps. One way to avoid these value traps is to look for micro caps that have potential to become larger companies. Another good idea is to look for micro caps that would be strong acquisition candidates for a larger company in the industry. 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. Model #8: Cash Cows Out to Pasture Companies in decline can still be good investments in the right conditions. The market often associates a lack of growth with a company headed for zero in the very near future. Thus cash cows with declining cash flows can often trade below the present value of those cash flows. Points to look for: ● Broken but not too broken- Certain business models can go up in flames very quickly, especially in the hi-tech arena. 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. ● Management that will pull cash out of the company- Management often has incentive to keep the failing company alive by investing declining cash flows into new ventures that are likely to fail. If the company squanders the remaining cash flows through poor reinvestment then the cash flows are of no value to shareholders. Look for management that is committed to shrinking the company as cash flows decline by returning cash to shareholders through dividends or share buybacks. Model #9: Growth at a Reasonable Price (GARP) Warren Buffet tells us to reconsider the distinction between “growth” and “value” investing: 6

The two approaches are joined at the hip: Growth is always a component in the calculation of value, 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. 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. 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). Strong companies with good growth potential can be cheap even if they do not appear so upon glancing at simple valuation metrics. Points to look for: ● A “moat”- A company needs some level of competitive advantage to sustain growth in the face of competition for an extended period of time. ● A margin of safety- For value investors employing GARP the goal is to pay as little as possible (or ideally nothing!) for the “growth” portion of the valuation. Conversely, there should be a margin of safety such that current operations support the present share price in case the growth plans fizzle. 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, Ben Graham, labeled “cigar butts”. Businesses with significant problems still might have one last profitable “puff” in them. There are several valuation formulas one can employ to find cigar butts including: net current asset value (current assets-all liabilities), net/nets (current assets valued at liquidation prices-all liabilities), and net cash (cash on balance sheet-all liabilities). The idea behind cigar butts flows from Graham’s principle of margin of safety. If the company is trading at less than liquidation value then the odds of losing money have been minimized. 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 upside is usually unclear, but no good news is being priced into the stock and therefore any positive development will move it upward. Points to look for: ● Honest management- 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. ● Insider buying- Significant insider buying at the very least signals that insiders want to increase shareholder value and not run off with it themselves. It is one of the best signs that value will eventually be extracted from the cigar butt. ● A value unlocking catalyst- Most cigar butts do not have visible catalysts (that is why they are below net asset value), but you might be able to find a catalyst on the horizon with some research.

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Model #11: Inflection Point Inflection point companies are smaller companies that are at a crucial junction in their maturation. The most typical model here is a company that has reached break even. If the company can continue to grow revenues they will see their bottom line profitability soar. This is the concept of operating leverage in action. 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. 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. You can gain an edge over the market by following the company closely and honing in on when they have reached the inflection point. Points to look for: ● High operating leverage- In other words, a company that has mainly fixed costs and fewer variable costs. These are often companies in service or information related industries. Watch out for potential revenue declines- Operating leverage works to the downside as well. A company with substantial operating leverage will start bleeding cash quickly even if revenues drop slightly below covering their fixed costs.

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. (The parent company also tends to outperform the market as well post-spin.) Spinoffs often come under initial price pressure because the recipients of spinoff stock often do not want it for noneconomic reasons, providing an attractive entry price for value investors. Spinoff recipients might sell for a myriad of reasons. The spinoff company might not be in an “attractive” line of business or it might lack sufficient liquidity for a large investment fund. The corporate performance of the spinoff unit is also commonly boosted as a standalone company. Managers operate more efficiently with less bureaucracy and are held more directly accountable for performance. They also are often better financially incentivized. Points to look for: ● Institutional selling- Look for large recipients of spinoff stock sellling for reasons unrelated to the stock’s intrinsic value. ● Insider holdings- If insiders hold large portions of stock then odds are they believe in the future of the spinoff. ● Inherited liabilities- While spinoffs often free the spin from the corporate “weight” of the parent, sometimes the opposite occurs. The parent company may use the spinoff to load the spin with debt or other legacy liabilities to clean up their own balance sheet. Be careful with these situations. Even if the operating performance of the spinoff unit improves they might still be sunk by excess debt levels. 8

Model #13: Post-Bankruptcy Equity Post-bankruptcy equities can be structurally similar to spinoffs. The company will often have a cleaner balance sheet and better prospects after going through bankruptcy, yet the holders of the stock will be looking to sell. Typically pre-bankruptcy bondholders receive most of the equity value in the reorganized company. The ex-bondholders may not be interested in holding the equity for reasons similar to institutions selling post spinoff- the equity might not fit their investment profile or it might not be a big enough position for them. Additionally, there is typically no sell side coverage and thus little institutional interest in post-reorg equities. Points to look for: ● A good (or at least average) business- Viable businesses can go into bankruptcy for reasons other than a fundamentally broken business model. The company might have suffered from excess leverage or gross mismanagement. 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. ● Institutional selling pressure- Look for large bondholders who converted debt to equity and may be dumping the stock. Be forewarned that selling overhangs can take months to clear for stocks with limited liquidity. Model #14: Free Option Monish Pabrai describes these situations as “heads I win, tails I don’t lose that much”. These are situations where the current share price is supported by the current state of the business, and potential positive developments such as contract wins or a hit new product can be considered a free option. These may come about due to investors’ recency bias where the current downtrodden state of the company obscures their view of the upside option. Or we might attribute the mispricing to the conflation of risk and uncertainty. There is uncertainty as to whether the upside will be achieved, but there is little risk of permanent impairment of investment capital. Points to look for ● Coverage in downside scenario- The “option” is only free if the current earnings or asset base justifies the share price. Look for liquid assets on the balance sheet or good visibility into future locked in cash flows through mechanisms like long term contracts. ● A strong upside option or multiple upside options- 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. 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. Yet there is a market bias against liquidating companies, perhaps because a company that has failed as a 9

going concern is viewed as a risky investment even though shareholders will be recouping value as assets are sold off. Liquidating companies frequently trade below a conservative estimate of liquidation value. Points to look for: ● Alignment of incentives for management- 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. ● Residual liabilities- Make sure to consider all potential liabilities relating to unwinding the company (payouts to executives, operating lease cancellation etc.) when calculating liquidation value. Model #16: The Misunderstood No, this does not refer to you in high school. These are companies with unusual characteristics that cause analysts and investors to misunderstand and misprice them. These quirks can come in many forms, whether it be a business model undergoing change or different from others in the industry, an accounting oddity, or a complex corporate structure. These companies undergo a period of doubting by the market in which they are mispriced. Value investors who can see the value past the oddities can get in early before the market corrects the mispricing. Points to Look for: ● The point of misunderstanding- Have a clear take on what specific factor is causing the market to misread the company. ● The catalyst- Hone in on what will cause the Street to wake up to the value. 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?

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Reference List: 1. Depressed Cyclicals 2. Fallen Growth Angels 3. Dividend Cutters 4. Activist Coattails 5. Turnarounds 6. Buying on the Bad News 7. The Ignored Micro-Cap 8. Cash Cows Out to Pasture 9. Growth at a Reasonable Price 10. Ben Graham’s Cigar Butts 11. Inflection Point 12. Spinoffs 13. Post-Bankruptcy Equity 14. Free Option 15. Liquidation 16. The Misunderstood

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