Guest Post by Jeroen Bos, Author of Deep Value Investing
Tweedy, Browne, the original broker to super star value investors, has given us mere mortals a great gift. Over many years it has established a unique archive that is accessible to all who are interested in value investing. One piece of research in particular stands out. Under the heading “What has worked in investing”, Tweedy, Browne collate the results of numerous studies conducted around the world which all come to the same conclusion: value investing is indeed the best way to invest in the long term.
Even better, they have broken these studies down into five categories, making it easy to look for those value strategies that have worked best over time.
The five main categories are:
- Low price in relation to asset value.
- Low price in relation to earnings.
- A significant pattern of purchases by one or more insiders (officers and directors).
- A significant decline in a stock’s price.
- Small market capitalisation.
Low price to asset value relation
In this first category – “dealing with a low price in relation to asset value” – there is a study that I have found particularly interesting. Conducted over the period 30 April 1970 through 30 April 30 1981, it is titled: “Price in relation to book value, and stocks priced at 66% or less of net current assets value”.
Concentrating on three-year holding periods, this study found that those stocks that were bought at less than 30% of book value (including those stocks which traded at 66% of net current asset value) gave on average a 87.6% return after three years, while the S&P 500 generated a 27.7% return. This same study also showed this group generated better returns over that same time period than any other group that was trading at either a smaller NCAV or even a premium to the book value.
These are eye-catching findings. As the study’s conclusion stated: “One million dollars invested on 30 April 1970 and rolled over at each subsequent 30 April into the stocks selling at less than 30% of book value would have increased to $23,298,000 on 30 April 1982. One million dollars invested in the S&P 500 on April 1970 would have been worth $ 2,662,000 on 30 April 1982”.
The kind of returns generated by this group caught my imagination many years ago when I read this study for the very first time. It seemed incredible that a group of stocks could boast such an outperformance while also being quite easy to identify.
After all, I always think that it is easier to establish the book value of a particular company than make accurate predictions about its particular future prospects, e.g earnings prospects etc. Book values tend to be more stable. Although they can erode over time they are usually more resilient than the earnings of most companies over similar periods. And buying stocks trading at big discounts to book value should give a certain margin of safety; less is paid for assets than what those assets are valued at on the balance sheet.
Group of stocks trading
Amongst this group of stocks in the Tweedy, Browne study was a sub-group of stocks trading at 66% or less of net current asset value, i.e. no value was ascribed to any fixed assets the companies might have had. To put this a different way, these companies could be bought at very low valuations and the fixed assets were free. They were not yet the “bargain stocks” or “net-nets” which could be even cheaper, but if we ever come across shares like this we know we are now dealing with stocks that are trading at the very margin of their book values.
So-called net-nets are at the most extreme of this sub-group. Net-nets are stocks where the net current assets after subtracting all liabilities (i.e. short and long-term liabilities), give us a “net-net” working capital which, divided by the number of shares outstanding, still has a higher value than the company’s share price in the equity market. When we find a stock at these valuations we have a situation where the liquid assets alone are worth more than we need to pay to the buy the total company. The company could be bought and put into liquidation and the investor should expect to get back more than what he had paid for it. The fixed assets come for free, potentially raising the total returns on his investment.
It always seems incredible that situations like this can exist in equity markets where the owners of these stocks are willing to sell their holdings for less than the liquidation value. There are many reasons why these situations arise; it usually involves a lengthy period of severe underperformance in the equity market, share prices that are now trading at a fraction of the highs they reached a few years ago. These stocks will come with a certain amount of “baggage” and the outlook for them may seem to be dubious at best.
As a group their performance clearly stands out and it would seem that this should be a very rewarding “hunting ground” for the value investor, which indeed it is.
If the results are so clearly in favour of this group why is not every equity investor involved in this particular approach?
A possible reason may be that in order to trade at these extreme valuations, this particular category of value stocks are typically “small caps” – their share prices (and market capitalisation) have shrunk, in many cases by 80% or more.
Another argument is that such extreme valuations – especially net-nets – are difficult to find in today’s equity markets. But in my experience there are usually over 200 individual stocks worldwide trading as net-nets at any one time. Besides, the studies that Tweedy, Browne have collected over the years show that the approach works equally well around the world, in all the main equity markets. In other words, there are always plenty of places to look.
They are out there and with a little bit of effort can be quite easily identified and made to work. The strategy continues to work as well as when it was first identified by Benjamin Graham in the 1930s. My new book, Deep Value Investing (www.harriman-house.com/deepvalueinvesting), deals exclusively with this sub-group and shows how to identify them and find the important numbers hidden in their balance sheets, making use of actual release statements and management commentary.
Value investing effective for investors
It covers ongoing investments and ones that didn’t go right, as well as recent successes – including a 270% profit with Barratt Developments, 182% gained with Spring Group and 196% with ArmorGroup – proof, if it were needed, that this form of value investing remains incredibly effective and relevant for all investors today.
Deep Value Investing by Jeroen Bos is published by Harriman House and available as an eBook and paperback. www.harriman-house.com/deepvalueinvesting
Dutch investor Jeroen Bos has lived in England since 1978. He has a diploma in Economics from Sussex University and has worked his entire career in the financial services industry, mainly in the City of London. He worked for many years at Panmure Gordon & Co, the stockbroker, and it was here that his interest in value investing developed. This process accelerated after the October 1987 stock market crash, during which time he took inspiration from The Intelligent Investor by Benjamin Graham. At the end of 2003 Jeroen joined Church House Investment Management to manage CH Deep Value (Bahamas), which in March 2012 became the CH Deep Value Investments Fund. He lives in Sussex, is married and has three sons.