What to Look for in Deep Value Investing

by Tim Melvin | August 14, 2013 9:21 am

Deep value investing has been practiced for decades very successfully by some of the most successful investors of all time, yet it’s a mystery to many people.

The simple fact is value investing isn’t as easy as reading the tea leaves or drawing lines on a chart. You have to have some basic knowledge of accounting and be willing to do a lot of reading of corporate reports. It takes a fair amount of time to do the research and homework, but the results are worth the effort.

When I look at the universe of stocks, the first question I always ask is “Is it cheap?” My universe of stocks is limited to those issues trading below book value — simply all of a company’s assets minus their liabilities, which is very similar to the net worth statement you might fill out as part of applying for a loan.

I am only interested in assets that can be converted to cash, so I subtract all intangible assets such as goodwill, brands, copyrights and anything else that is not a physical tangible asset. Some of these might in fact have value, but I have found it is almost impossible to determine in advance, so I remove them from my calculation. If the intangible assets turn out later to have a great deal of value, I instead just consider it a bonus.

I then divide the net tangible book value by the number of shares outstanding and come up with the tangible book value per share. This is my base number, and I only buy stocks trading at a discount to this value.

After that, I go back though the balance sheet and derive a net liquidation value for the company. I make adjustments to inventories, property value, machinery and equipment and everything else the company owns. Again, no value is given to intangible assets. Debts and liabilities are subtracted at 100 cents on the dollar. The result is divided by the number of shares, and that’s your liquidation value per share. Knowing this number gives me a worst-case scenario — and a price at which I would be willing to add more to my position.

The last number I derive is the ongoing concern intrinsic value of the company. This is the price the business is worth as an ongoing business based on cash flows, earnings and asset value. I also use buyout comps and private business transaction to come up with my estimate of this value. This usually is the value where I am willing to start selling my shares. This number can and usually does change every year based on the performance of the business. The best stocks are going to be those where the intrinsic value grows every year, and it takes the stock price years to catch up.

These numbers become the cornerstone of our value investing process. I like to buy shares at a discount to tangible book value, add shares if they at or below book value, and eventually sell shares at a premium to intrinsic value.

Of course, cheap is not enough. The company also has to pass my second line of questioning: “Is the company safe, and can it survive until it thrives again?”

We will look at those numbers and the process tomorrow.

Source URL: http://investorplace.com/2013/08/what-to-look-for-in-deep-value-investing/
Short URL: http://invstplc.com/1fr5Z8j