Book Review: Deep Value by David Merkel, CFA of The Aleph Blog
Deep Value is a book that starts with a simple premise: buy stocks at a fraction of the per share intrinsic value of the company, conservatively calculated. Neat idea, huh, and it is called value investing.
The author starts by giving a preview of where he will end — with Carl Icahn when he was much younger, where he was buying closed-end funds at large discounts, and pressuring managers to liquidate the fund. Eventually he started doing the same with overcapitalized companies trading a discount to the net worth of the company.
Then the author takes us on a trip through history, starting with Ben Graham buying the shares of companies at prices lower than the net liquid assets of the company, net of the debt. It was easy money while it lasted, but eventually many of those companies were bought up and liquidated, and many of the rest had the stock price bid up until the value was no longer compelling.
Then we get to travel along with Warren Buffett and Charlie Munger, who note that the easy pickings are gone, and begin investing in companies that are inexpensive relative to their growth prospects. This is more complicated, because these companies must have an advantage that will sustain their effort versus their competition.
Then we visit Joel Greenblatt, where he analyzes buying good companies at cheap prices, analyzing them the way an acquirer might do, but also looking for high returns on invested capital. Lo, but it works, and furthers the efforts of those trying to obtain excess returns.
Then Deep Value gets gritty, and looks at mean reversion of companies that have done poorly over the last four years. Surprise! The worst tend to do quite well on average. Also, raw application of simple valuation ratios tend to work on average in stock selection. People undervalue the boring crud of the market, and overvalue the glamorous stocks, leaving an investment opportunity.
Then it tells a story that is personal to me, that of Litton Industries. Litton Industries was one of two stocks I owned as a boy — gifts from relatives. Litton Industries was a company that in the ’50s and ’60s used its highly valued stock to buy up companies that were not highly valued, and made Litton look like its earnings were growing rapidly, which propelled the value of Litton stock still higher. So long as Litton could keep acquiring cheap-ish companies, the idea kept working, but eventually that ended, and the stock price crashed. When did my relatives buy me shares of Litton? Near the end, natch, when everyone know how wonderful it was.
Quite a lesson for an eight year old to see the stock price down by 80% in a year. The other stock, Magnavox, did that also, so it is a testimony to my mother’s own clever investing that I ended up in this business… my story aside, the point of the Litton chapter was to point out that not all earnings growth is real, and that it is far better to focus on boring companies than what seems glamorous and successful. Untempered optimism tends not to be rewarded.
The book then moves onto investors large enough to effect change outright, buying enough of a company to force change in a management team that is lazy, incompetent, or overly conservative. The book goes through the experiences of Ronald Brierly, T. Boone Pickens, and Carl Icahn. The art of spotting an undervalued company, and gaining enough influence to buy the company and fix it, or see the company sold to another company that will fix it, can lead to great gains.
Here the trail ends. It started with Ben Graham buying companies that would be good investments regardless, moves to companies that will be good investments if you analyze them more closely, and ends with companies that good be good investments if you could influence a change in corporate behavior. The same principles are being applied, but with much more analysis and potentially threat of a takeover.
In closing, Deep Value talks about what can be a way of measuring moats, which is gross profits as percentage of assets. It also reviews what factors activist investors look for when they invest, which may give the clever a guide into what stocks to pursue.
I liked Deep Value, and I recommend it, but in one sense the book is a statement of how tough the value investing game has become. Ben Graham could sit back and do simple analyses, pursuing artistic endeavors and the good life in his spare time. We have to analyze far more closely, and be aware of whether what companies larger activist players may consider. Value investing still has punch for amateurs, but there is a lot more work and analysis to do.
This book would be good for investors looking to understand value investing better, and how it has changed over the years. It would not likely be good for novices. If you still want to buy it, you can buy it here: Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations (Wiley Finance).
Full disclosure: The PR flack asked me if I would like a copy and I said “yes.”
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