Deep Value
Deep Value

Deep Value

That stocks appear most attractive on a fundamental basis at the peak of their business cycle when they represent the worst risk-reward ratio, and least attractive at the bottom of the cycle when the opportunity is at its best. (Location 278)

These findings reveal an axiomatic truth about investing: investors aren’t rewarded for picking winners; they’re rewarded for uncovering mispricings—divergences between the price of a security and its intrinsic value. It is mispricings that create market-beating opportunities. And the place to look for mispricings is in disaster, among the unloved, the ignored, the neglected, the shunned, and the feared—the losers. This is the focus of the book. (Location 301)

As long as working capital is not overstated and operations are not rapidly consuming cash, a company could liquidate its assets, extinguish all liabilities, and still distribute proceeds in excess of the market price to investors. Ongoing business losses can, however, quickly erode net-net working capital. Investors must therefore always consider the state of a company’s current operations before buying. Investors should also consider any off-balance sheet or contingent liabilities that might be incurred (Location 971)

We do net nets based more on common sense. As, for example, you have an asset, a Class A office building, financed with recourse finance, fully tenanted by credit-worthy tenants, that, for accounting purposes, is classified as a fixed asset, but, given such a building, you pick up the telephone and sell it, and really it’s more current than K-Mart’s inventories, for example, which is classified as a current asset. (Location 979)

A corporate liquidation typically connotes business failure; but ironically, it may correspond with investment success. The reason is that the liquidation or breakup of a company is a catalyst for the realization of the underlying business value. Since value investors attempt to buy securities trading at a considerable discount from the value of a business’s underlying assets, a liquidation is one way for investors to realize profits. (Location 1093)

Are stocks pieces of paper to be endlessly traded back and forth, or are they proportional interests in underlying businesses? A liquidation settles this debate, distributing to owners of pieces of paper the actual cash proceeds resulting from the sale of corporate assets to the highest bidder. A liquidation thereby acts as a tether to reality for the stock market, forcing either undervalued or overvalued share prices to move into line with actual underlying value. (Location 1115)

home. Sitting in their living room, the young Buffett—he was 26 but looked 18 according to Eddie—laid out the ground rules for an investment in the partnership. For over an hour Buffett described his philosophy on managing money and the unusual terms of his proposed investment partnership—Buffett would have absolute control over the money and would not tell his partners how he was invested; (Location 1298)

So the really big money tends to be made by investors who are right on qualitative decisions, but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions. (Location 1443)

The lesson Buffett took from See’s is that a business’s intrinsic value is a function of the return it generates on the capital invested in it—the higher the return on invested capital, the greater the business’s intrinsic value. (Location 1513)

Despite his obvious regard for William’s theory, Buffett could show that two businesses with identical earnings could possess wildly different intrinsic values if different sums of invested capital generated those earnings. (Location 1547)

All else being equal, the higher the return on invested capital, the more valuable the business. (Location 1561)

An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company’s ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mismanagement. Inept managers may diminish a franchise’s profitability, but they cannot inflict mortal damage. (Location 1622)

In contrast, “a business” earns exceptional profits only if it is the low-cost operator or if supply of its product or service is tight. (Location 1626)

Good jockeys will do well on good horses, but not on broken-down nags. . . . The same managers employed in a business with good economic characteristics would have achieved fine records. But they were never going to make any progress while running in quicksand. I’ve said many times that when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact. (Location 1675)

A wonderful company owns a first-class business and is led by a first-class management. A first-class business earns sustainable high returns on invested capital because of its good economics and resistance to competition. (Location 1681)

The franchise is a special case with unusual economics that allow it to naturally resist competition and earn super-normal returns on capital. (Location 1683)

First-class managers will maintain and increase high returns on capital by regulating the amount of capital invested in the business and continually widening the business’s moat. (Location 1684)

The archetypal wonderful company—think See’s Candies—grows with minimal incremental reinvestment, compounding the intrinsic value at a high rate while paying out most earnings. (Location 1686)

pre-tax operating earnings (earnings before interest and taxes, or EBIT) to tangible capital employed in the business (Net Working Capital + Net Fixed Assets), defined as follows: (Location 1847)

Return on Capital = EBIT ÷ (Net Working Capital + Net Fixed Assets) (Location 1850)

Earnings Yield = EBIT ÷ EV (Location 1865)

Enterprise value is the cost an acquirer must pay to take over a company in its entirety. (Location 1868)

Mauboussin found that differentiated businesses with a consumer advantage—those that generated high returns via high NOPAT margins, rather than high invested capital turnover—were overrepresented in the businesses that sustained high return on capital over the period examined. (Location 2315)

It seems that they do. Solarz finds improved margins and returns on assets, increased payout ratios, reduced leverage, and reduced assets. Brav et al. also found that targeted firms generated moderately improved returns on assets (defined as EBITDA/Assets), and significantly improved returns on equity, which suggests that they took on debt to lever the balance sheet. (Location 5163)

The research shows that the typical company targeted by activists has poor recent stock performance, a low valuation, a large cash holding, and few opportunities for growth. (Location 5387)

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Warren Buffett has shown an extraordinary ability to find sustainable economic moats and sustainable high returns on capital, (Location 5947)

The data show, however, for those of us who don’t have Buffett’s talent, that the low- or no-growth value stocks are the more consistent bet. It seems that the uglier the fundamental business trend, the better the return, even when the valuations are comparable. This is deep value investing. (Location 5949)

Deep value stocks are often found in hairy situations—think of Buffett’s pursuit of American Express in his Buffett Partnership days—and some are mired in scandal. But scandal and crisis don’t connote distress. (Location 5951)

They have unfulfilled potential. This is why deep value investment and activism go hand in hand. (Location 5954)

The mandate is whales—deep undervaluation—not white whales—shareholder activism. (Location 5964)

As a portfolio, companies with the conditions in place for activism offer asymmetric, market-beating returns. (Location 5968)

The best returns are associated with an outright sale of the company, which delivers a full control premium. (Location 5973)

firm, has said of Icahn that he goes beyond betting against trends: (Location 5981)

He’ll buy at the worst possible moment, when there’s no reason to see a sunny side and no one agrees with him. (Location 5983)

The consensus thinking is generally wrong. If you go with a trend, the momentum always falls apart on you. So I buy companies that are not glamorous and usually out of favor. It’s even better if the whole industry is out of favor. (Location 5988)

My whole history if you look at it, is not to buy businesses that are great. I don’t pay retail. I go in when people say they’re terrible. It’s really the old Graham-and-Dodd philosophy. You go in when nobody likes it, but it’s still ok. . . . A lot of analysts miss this stuff. (Location 5998)