I really, really enjoyed this article on “hidden value”. For those of you too lazy to click through and read the article, the gist of it was the author found a stock that was being valued on a P/E basis despite high advertising costs in the growth stage. If the author normalized those advertising costs to “maintenance” level, he quickly realized the business was a steal.
This got me thinking a bit about my favorite area to invest in: deep value, controlled net nets (or stocks trading for a fraction of asset value). Often, the value you find in net-nets is pretty easily observable. For example, George Risk (RSKIA) had a pretty clear value proposition: at <$6 per share, the market was basically assigning no value to the company’s huge cash / investment balance.
But more times than not, the value comes in doing something similar to what the “hidden value” author does: backing out one time expenses, or expenses that a potential acquirer wouldn’t consider a normal piece of the business.
For example, it’s 100% normal to see some pretty crazy expenses flowing through in family controlled stocks. Airplane expenses, meal reimbursement, ridiculous retirement / profit sharing agreements…. the list goes on and on. These expenses are certainly red flags; however, I feel investors are often to quick to dismiss companies that have those red flags.
It’s easy to forget that the most normal exit for deep value and illiquid stocks is the company getting bought out. And the first thing any acquirer is going to do when they value a business is strip out all of those “personal” expenses and add them back to earnings.
Of course, this raises another problem: it’s true that the business will (eventually) be valued without those expenses, but until then those expenses are a real drain on cash that are keeping earnings from being reinvested into the business or dividend out to shareholders.
I think there’s a balance between those two solutions, and it’s pretty simple: in microcap stocks, don’t throw out a stock just because you find some red flags of egregious payments (though be willing to dismiss the stock if management is clearly intent on stealing the company for a song), but don’t have your out be completely dependent on the company removing those red flags.
For example, I’m currently invested in a deep value stock that’s trading for about 60% of NCAV and maybe five times earnings (sorry, too illiquid to mention the exact name on the blog right now!). The company earns a normal ROE and grows book value at a nice clip. But it also pays management a ridiculous salary and has one of the craziest / most generous executive retirement plans I’ve ever seen.
But I’m willing to invest in the company despite that. The company earns good returns on assets and represents a great value in spite of management siphoning of a ton of value. If they were to ever sell themselves (and the family has a history of deal making), the acquirer would strip out those costs and my 5x earnings purchase would represent something closer to 2x.
So, similar to the “hidden value” article, there’s upside to stripping out these excess costs. But even if the costs never got taken out, the investment should end up doing alright at these prices.
Would I have invested in the company if it was trading at say, 50x earnings, but would be trading at 1x once stripping out the excess costs? Absolutely not. In that (admittedly ridiculous) case, my out is 100% dependent on the cost catalyst (in addition, this would likely be a case of management being just too greedy to deal with!).
Just some food for thought for the next time you stumble upon a red flag- don’t immediately consider the company a pass. Think about if the red flag is actually an opportunity in disguise.
Disclosure: Long RSKIA
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