The past can be a terrific teacher.
One reason to keep historical records is to avoid mistakes made by those before us. Yet in the financial world, it takes a long time to learn anything. And sometimes we repeat the same mistakes over and over again.
Had we learnt from tulip mania in 1636, we might not have had the dotcom bubble in the late 1990s. Had we learnt from past credit crises and problems with overleveraging, we might have avoided the credit meltdown in 2008.
There’s a bright side to all this though. If other investors are irrational, it gives you an opportunity to profit. Like in early 2009, when you could buy stocks at an extreme discount. And it’s simply because investors aren’t learning from the past. But more on that later.
Lessons from an 85-year-old article
In 1932, Forbes published an article titled ‘Inflated Treasuries and Deflated Stockholders’.
The author was none other than Benjamin Graham, the father of value investing. He described situations where companies sold for less than their liquidation value.
If you’re unfamiliar with what that means, Graham posed a simple scenario to readers:
‘Suppose you were the owner of a large manufacturing business. Like many others, you lost money in 1931; the immediate prospects are not encouraging; you feel pessimistic and willing to sell out–cheap. A prospective purchaser asks you for your statement. You show him a very healthy balance sheet, indeed. It shapes up something like this:
‘The purchaser looks it over casually, and then makes you a bid of $5,000,000 for your business-the cash, Liberty Bonds and everything else included. Would you sell?’
You don’t need to be a stock market genius to know the answer. You obviously wouldn’t sell. Why sell for $5 million when the company has $8.5 million in cash alone?
‘…But preposterous as such a transaction sounds, the many owners of White Motors stock who sold out between $7 and $8 per share did that very thing–or as close to it as they could come.’
But surely this is a one-off occurrence, right? How often do companies sell for less than the value of their assets?
According to a Columbia Business School study covering 600 industrial companies, Graham found 200, or one-third, sold for less than this. Over 50 of them sold for less than their cash and marketable securities alone.
Why would such a thing happen? There are two possible reasons.
First, earnings power is generally more important than balance sheet items. Yet, some investors take this to an extreme and neglect balance sheet items entirely.
As Graham put it:
‘…since value has come to be associated exclusively with earning power, the stockholder no longer pays any attention to what his company owns–not even its money in bank.’
Second, in the bear market of 1931, investors preferred to stay out. Just two years before, Wall Street had its most infamous stock market crash. Investors burnt by the bust were fearful to jump back into the market. And many had little left to invest.
Both this overemphasis on earnings and lingering fear made it possible for a third of companies in Graham’s study to trade below the value of their assets. It was a great time for investors. And these opportunities still exist today. You just have get out there and find them.
As at 19 May, 2017, there were 63 stocks on the ASX trading below the current net value of their assets. It’s far fewer than the 119 similar stocks trading on the same date in 2009. But it shows there are still absolute bargains to buy.
But before you run out and buy all the stocks with this apparently deep-value quality, there are a few things you need to know. (There’s always a catch, isn’t there?)
It’s no secret why these stocks are cheap. They are cheap because they have declining earnings, terrible management and/or some other frightful quality. As Graham put it, shareholders believe the company is worth more dead than alive.
The key is to buy those businesses that are temporarily cheap. Then, when negative sentiment wears off and operations pick up, your dirt-cheap stock should rocket up.
I’ve probably made it sound too easy. But it’s a viable approach for any retail investor. All you need to do is think about the following…
Need to know
Like I said before, some businesses are just terrible. Earnings are eroding, and management cannibalises assets to keep the business afloat. This is value-destroying and exactly the kind of stock you don’t want to hold. That’s why you always want to reassess what’s happening to assets and liabilities.
Another thing you need to be aware of is the reliability of a company’s net current assets on the balance sheet. Some businesses may have an inflated figure for current assets. Think of a food producer or a manufacturer. If it has inventory that depreciates or spoils, its current assets could be a lot different from quarter to quarter.
You also want to avoid value traps. Easier said than done. But this is usually when you find companies that look cheap but have problems that won’t disappear.
For example, the business could be obsolete due to new technology. That’s why you want to be sure that the business can continue operating for the long term.
Lastly, while I’m not big on diversification, it is key when investing in ultra-cheap stocks. The reason why is to reduce losing all your money. No matter how good of an analyst you are, you’re bound to be wrong sometimes. That’s why it’s best to hold a portfolio of around 20 deep-valued companies to reduce the risk of losing all your money.
With that said, using this deep-value approach can significantly boost potential returns. It’s how Graham beat the market throughout his investment career. And it’s how Buffett averaged an annual return of 29.5% from 1957-69.
If you like digging for bargain-basement sales, deep-value investing might be for you. But if you don’t have the time or energy to find undervalued stocks on your own, why not let Greg Canavan help you out?
In his advisory service, Crisis and Opportunity, Greg takes advantage of temporary crisis situations driving down a stock’s share price. Through his analysis, Greg is often able to find stocks that can return 30-40%, regardless of what the market is doing.
To learn more, click here.
Contributing Editor, Money Morning