There are value stocks, and then there are deep-value stocks. The difference? The deep-value variety is very undervalued and offers a large margin of safety.
Deep-value stocks are examined in detail in chapter nine of "Strategic Value Investing: Practical Techniques of Leading Value Investors," the 2014 book by Stephen Horan, Robert R. Johnson and Thomas Robinson. It's part of a chapter dedicated to asset-based valuation models; earlier they examined book value and replacement value.
Net working capital
As with many ideas connected with value investing, Benjamin Graham makes an appearance. He talked about two classes in the "purchase of bargain issues":
- Companies currently in trouble of some kind, but are expected to bounce back. This is what the authors called "a more traditional, value investing approach."
- Special situations, referring to stocks available for less than a company's net working capital, after debt is deducted. The authors wrote that in such situations, investors may not pay anything for the fixed assets, such as buildings, machinery and land, and for goodwill items.
This is the equation for net working capital:
Current assets are those available to the company within one year and current liabilities are those that should be settled within 12 months.
It's hard to find deep-value deals, but they can be found. Expect to see more of them when the market is declining or feeling troubled. As the authors discussed, these are stocks that are seriously out of favor with the market--and often for good reason.
The management team may be ineffective, for example. Or the stock may have been neglected by the marketplace since it is not "sexy," nor does it have a compelling story that would attract investors.
Read more here:
- Strategic Value Investing: Replacement Value
- Strategic Value Investing: Book Value
- Strategic Value Investing: Free Cash Flow to Equity Model
Are they worth it?
Using data from the American Association of Individual Investors, the authors provided a list of nine stocks that were undervalued at that time:
Note that Paradise Inc. (PARF) has net working capital of $24.90, and its market price is $14.60. That's a $10.30 margin of safety on a $14.60 stock. Boss Holdings Inc. (BSHI) comes in second with a $2.30 margin of safety on an $8 stock.
How are those stocks doing seven and a half years later, at the end of August 2019? This is not something that could have been included in a book published in 2014, but I was curious to see how they had done. This table shows market prices then and now:
In retrospect, we see that Paradise, the company that had the biggest margin of safety among these stocks, has enjoyed the highest average annual capital gain: more than 21% per year (delisted Crexus was acquired by Annaly Capital (NYSE:NLY) in 2013; McRae Industries now trades on the pink sheets under the symbols (MCRAA) and (MCRAB)).
Deep-value stocks are those that are deeply discounted, and because of that discount have high margins of safety. Still, big margins among these stocks should not be lead to an immediate buy since the prices of these stocks may be depressed for a good reason.
One approach when shopping for the infrequently found deep-value stocks is to look for good companies that are suffering from what is likely to be a temporary setback. Warren Buffett (Trades, Portfolio), for example, made part of his fortune (and the fortunes of his investors) by picking up Wells Fargo (NYSE:WFC) and American Express (NYSE:AXP) when they were hit by bad news.
The second approach involves "special situations" and the relationship between net working capital and the market price. When we can find companies selling for less than their net working capital, we may find excellent opportunities, presuming their fundamentals are strong and their prospects are reasonable.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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This article first appeared on GuruFocus.
- Warning! GuruFocus has detected 5 Warning Signs with PARF. Click here to check it out.
- PARF 15-Year Financial Data
- The intrinsic value of PARF
- Peter Lynch Chart of PARF