The top 5 ways to find bargain stocks...
When it comes to buying anything, who isn't tempted or seduced by a bargain? Buying things for less than they are worth is a surefire strategy not only in life but also in the stock market. But bargains can be hard to find given that brokers, the press and tipsheets all tend to shower column inches over the most popular glamour stocks such as Apple or ASOS, and good bargains even harder to find as most "bargains" tend to be bargains for a reason!
Warren Buffett calls bargain hunting the ‘cigar butt’ approach to investing: “A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the ‘bargain purchase’ will make that puff all profit” . This kind of bargain investing is all about having a very conservative measure of a stock's value, for example its liquidation value, and the ability to buy it at a price that offers a big margin of safety.
Some of the world’s most legendary investors like Ben Graham and Walter Schloss have made a mint out of this investment approach - and our own bargain stock strategies have been handsomely outperforming the market in recent months. So how do you go about finding these kinds of deep value or bargain stocks, and how can we help?
1) Pay Less than Book Value
Perhaps the most common way to conservatively measure value is by using the so called price-to-book ratio. This involves comparing the current market value of a company's shares with the book (accounting) value of the equity in its balance sheet. True bargain investors would tend to be dismissive of any kind of intangible assets, given the inherent difficulties in valuing them and the scope for flexibility in accounting for them. Countless studies have shown that the lowest price-to-book stocks tend to outperform over time but, even after adjusting for intangible assets, hardened bargain investors may be sceptical that price-to-book is a sufficiently robust measure of value. It may not give enough margin of safety to their investment in the event of a severe downturn if fixed assets may have been overvalued. As a result, a number of other (more extreme) approaches are used by the deep value investors which are outlined below. But there are also ways to filter these cheap price to book stocks that help narrow the list to higher probability turnaround plays - such as with this simple accounting checklist approach which highlights 23 names.
2) Pay Less than Liquidation Value
Benjamin Graham is the guru of bargain investing and took price-to-book investing and gave it a serious twist. In essence he advocated buying stocks that, if they were to collapse tomorrow, should still produce a positive return because of the underlying asset backing. Graham suggested only valuing current assets (such as cash, stock and debtors) on the basis that these items could easily liquidated in the event of total failure, and then subtracting the total liabilities to arrive at the so called net-current-asset value (NCAV). The idea was that a market valuation below that indicated that the market had totally mispriced the company, or that the company should be sold or liquidated. To defend against the risk of individual failures, Graham also looked for a margin of safety of about 33% below that level and added the requirement to diversify the strategy to at least 30 stocks. In bull markets, NCAV stocks can be few and far between but in depressed conditions there are far more to look at – indeed there are currently 38 UK-listed stocks trading below 2/3rds of their net current asset value on the Stockopedia Benjamin Graham NCAV screen.
3) Pay even Less than Liquidation Value!
For investors that like the idea of liquidation value (NCAV) investing, it is worth noting that Graham pushed the formula a stage further. He reasoned that in a liquidation situation, cash due from debtors might not be collected and some stock may have to be discounted, so he made allowances for this. He called this even more conservative valuation as the Net Net Working Capital (NNWC) of the company - building in an even more extreme margin of safety.
Net Net Working Capital = cash and short-term investments + (75% * debtors) + (50% * inventory) – total liabilities.
4) Buy companies selling for less than Cash
A more modern version of the Net Nets and an alternative way of dealing with the “known unknown” of the true value of fixed assets in a liquidation situation is to deal simply with the cash in a business. Investors can look for companies whose cash is worth more than the total value of their shares plus their long-term debt ! This investment approach is known as buying stocks with a Negative Enterprise Value and waiting for them to be revalued.
A Negative Enterprise Value type approach is however not free from risks which may be because judging a company’s true current cash position, as opposed to its last reported cash position, is fraught with difficulty and there is also no guarantee that the company management will act in the best interest of shareholders in its use of these cash proceeds.
5) Buy when there's blood on the streets
A final strategy for bargain investors blends the all-important book value with stocks whose prices have fallen to new lows. This approach was taken by Walter Schloss, one of the most successful investors in history who studied under Graham and went on to refine his tutor’s theories into his own strategy. Over the 45 years from 1956 to 2000, his fund earned an astounding compound return of 15.7%, compared to the market’s return of 11.2% annually over the same period. In the words of Buffett, Schloss “ doesn’t worry about whether it’s January…whether it’s Monday…whether it’s an election year. He simply says if a business is worth a dollar and I can buy it for 40 cents, something good may happen”.
Despite not using a computer (he preferred hard copy Value Line research), Schloss was interested in the financials behind a stock. Without talking to the management (he was sceptical of his own ability to judge character) Schloss went on to assess the company based on certain key numbers. Most specifically, he was interested in stocks whose prices were at or near their 52-week lows. Schloss saw this metric as an indicator of a possible bargain stock, although he stressed the importance of distinguishing between temporary and permanent problems. Beyond that, he would look for companies trading at a price that was less than the book value per share. Even today this counter-intuitive strategy of buying the weakest stocks in the market can be found to pay dividends. There are currently 19 companies qualifying for our Walter Schloss New Lows strategy which has been outperforming the market over the previous 3 months.
Watch out - this ain't for the faint-hearted
Be warned: Deep value investing is not an approach for the faint-hearted. Warren Buffett argued against it as a strategy in his 1989 Chairman’s Letter to Shareholders, noting: “The original “bargain” price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces – never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns.” By definition, deep value investors do tend to get their hands dirty with some of the most unloved stocks in the market and that leaves a bargain strategy open to significant risk. While scrutinising the relationship between market price and underlying asset value (however you choose to do it) can prise open a basket of candidates that could offer substantial returns, investors should always back up their screening with detailed scrutiny as well.
So, how do deep value investors mitigate the risk of cockroaches? For the most part, this is done through the margin of safety... and of course diversification. This is a sledgehammer approach that recognises that some stock purchases will fail but with a big enough basket, the thinking goes, the successes should outweigh the catastrophes. For Graham, the diversification target was upwards of 30 stocks while for Schloss the number could be as heady as 100, not exactly a practical number for many investors!
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