Deep Value: From Ben Graham To A Young Carl Icahn

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.

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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.

Quibbles

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.

Summary

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.”

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

 

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.