DCM seeks out investments where a disparity between value and price exists. Buying securities when this disparity is significant creates a dual benefit: significant appreciation potential and a “margin of safety” against adverse developments. These undervalued situations are not always plentiful or easy to identify.
Successful investing depends on finding opportunities that meet our value criteria. This requires patience. It is also highly dependent on where one looks. Here are some of the categories that regularly provide interesting opportunities:
Hidden Assets and Values
Many companies fail to attract the attention of Wall Street analysts or are simply misunderstood. Because of this, value is often hidden in plain sight. Complicated conglomerates do not fit into a clear industry category. Wall Street loves companies that are easily defined. Those that are not often get ignored.
Small firms have a similar problem. Because of their size, some companies do not generate enough interest from investors. Many simply fall through the cracks and go unnoticed. Whatever the reason, this benign neglect can lead to opportunity.
Hidden values and assets come in many forms. An example may be a company with real estate holdings that were acquired years ago at minimal cost. The company’s balance sheet lists the asset at the carrying value regardless of what it may be worth today. Another more common example is a gem of a company that no one has ever heard of. These represent a favorite area of investing for us and our portfolio reflects this.
Discount to Private Market Value (PMV)
Private market value (PMV) is the value a knowledgeable businessperson would pay to purchase a company or group of similar assets. Companies often consider the private market value of targets when evaluating a possible takeover. Schacht Value places particular emphasis on an analysis of the company’s normalized free cash flow, which is generally the most important consideration for a financial buyer. We also consider other recent acquisitions and the particulars of such acquisitions including the availability of financing, the type of buyer, and, of course, the acquisition’s value.
Spin-offs, liquidations, reorganizations, and broken acquisitions are special situations that many investors ignore. This lack of interest is completely unrelated to the company’s intrinsic value. Furthermore, most investment and research firms do not focus on these situations either. This creates greater inefficiencies. We analyze numerous special situations and invest in those where the discounts are most compelling.
Low Price-to-Earnings (P/E) Ratios
When looking for cheap stocks, it is helpful to identify companies that have a low price relative to normalized earnings or cash flow. When a company is selling for a P/E ratio of 10, an investor is buying $1 of annual, per-share earnings for every $10 in share price. A company with a P/E of 10 has an earnings yield of 10%, while one with a P/E of 5 has an earnings yield of 20%. Price to earnings ratios expand and contract for a variety of reasons and must be viewed within that context. In any case, the goal is the same: to buy a stream of future earnings at a bargain price.
Discount to Adjusted Book Value (B/V)
Securities that sell for less than the adjusted book value (net worth) on their balance sheet warrant further evaluation. This is often an indication that investors are paying very little for the assets of a company. Book value per share is calculated by subtracting total liabilities from total assets and dividing by the number of shares outstanding. Book value is often adjusted to add a measure of conservatism by excluding intangible assets and discounting assets like inventory.
Discounts to Net-Net Working Capital
The minimum liquidation value of a corporation, in most cases, is its net-net working capital. This net-net value is determined by subtracting total liabilities from adjusted current assets. If a stock sells for less than this value, it is referred to as a “net-net”. This usually constitutes an attractive price that warrants further research. While it is less frequent today, from time to time the market will price companies below this level. A “net-net” investor is trying to buy a company’s fixed assets at no cost, and pay little or nothing for the business as a going concern. This is even more conservative than the more common discount to B/V situation above.
The term “fallen angel” refers to a company that once was a darling on Wall Street, which has disappointed investors enough that its stock price has declined to irrationally low levels. If the company’s balance sheet is strong enough to withstand a difficult period and the long-term fundamentals of the business are sound, shares of a fallen angel can generate exceptional returns.
“Orphans” are companies that have lost popularity after an initial public offering (IPO). These companies typically have not lived up to the hype surrounding their IPO. The stock price has fallen and investors have moved on. The lack of interest and the correspondingly low prices allow value-oriented investors to find bargains among the orphans.