The heart and soul of this blog is deep value investing at the micro-cap level. It’s turning over rocks that no one else looks at to find stocks w/ high potential for appreciation w/ tons of downside protection. Why?
Quite simply: to beat the pants off the market in the long run. To generate significant amounts of alpha. If I’m not doing that, what’s the point of spending all this time researching stocks and writing this blog (trust me, it’s not for the google advertising fees. They don’t even cover the cost of hosting!)? And if you don’t think I can help you beat the market, why waste the time reading this blog???
All of that may seem obvious, though I think we sometimes overlook it when we’re putting together our RSS feed with our favorite blogs and getting stuck in the sometimes tedious task of researching stocks day to day. And I’ve mentioned all of this before, though perhaps not quite as succinctly.
But let’s drill down deeper- why do I think using a deep value approach when investing in stocks, or looking through micro-caps, will allow me to beat the market?
It’s because I think doing so will give me an edge. Again,this shouldn’t come as news to you if you’ve been following the blog for a while.
But here’s a question that I haven’t mentioned before, and I haven’t seen it discussed anywhere else. It’s a question I don’t have a good answer to.
When you’re searching for an edge, is it best to keep things simple, or should you go for complexity?
Let’s start with simple. Look at yesterday’s write up on MPAD. That’s as simple as it gets. The stock has a steady and consistently profitable operating history. It’s trading for under tangible book value, under net working capital levels, and about net cash levels. If they could buy the whole company for the price the stock market is offering today, any rational business person would leap at the opportunity.
Boom. Done. Simple.
But does that give you a real edge?
Honestly, anyone with basic accounting and finance skills could have told you all of those stats after a fifteen minute glance at the financials. You could do the same for most of my net-nets.
How can something be undervalued if the value is that clearly discernible?
I mean, how is this different then simply looking at a stock and saying “it’s P/E is under 8x, it’s a great buy!” or “it traditionally trades for 2x EV / Sales but it’s trading for 1.5x EV / Sales today. Discount!” They both require about the same level of effort and expertise. And in both cases, the investor could simply say they are taking a long term value approach to the stock!
Maybe you’ll argue that the net-net approach is based in harder values than sales or earnings, which mean different things for different companies. A dollar of sales of Microsoft is a lot more valuable than a dollar of sales for Wal-Mart! But you again come back to the fact that identifying net-nets takes no special skills and could easily be done by a computer.
Then there’s the other end of the spectrum. Look at the recent write ups for GKK, NCT, RAS, or ATPG (bonds or equity). All of them are super complex. They involve some degree of industry expertise, advanced knowledge of accounting, and tons of balance sheet adjustments. They involve extraordinary amounts of work to determine what the value is and where to find it.
Clearly, not everyone can do that. As a matter of fact, very few people can. Even a rather advanced investor would initially balk at GKK if they just did a quick look at the financials. Heck, it took me reading about them three or four times and then reading through their 10-K (which is hundreds of pages long) multiple times to even begin to figure it out. A computer certainly couldn’t find value in these.
So obviously, there’s an edge to be found here. But the chances for error greatly increase. So if the “complex” idea works out and you make money, how do you know you’re not just getting rewarded for taking on more risk? Consider that if you’re wrong on any of your assumptions, you’re in for a world of hurt- shouldn’t the reward for that sort of investment naturally be high?
Also consider this- What if (like me) you’re just starting out in the high yield space? How can you really know what is an effective covenant and what isn’t? For that matter, with all the preferreds I’m talking about, how do you know for sure all of those non-recourse liabilities can’t eat into any of the assets at the corporate level? I mean, management is the one who says that- do you just take their word for it?
Speaking of management, they’re the ones who should know their company and the value of it the best. If Wall Street is truly grossly mispricing their stock and there’s huge value to be found in it… why aren’t they buying up shares hand over fist??? Isn’t the lack of insider purchasing showing you’re misinterpreting a complex situation when you see huge value? Or that maybe there’s huge value, but, again, it’s only because the risk justifies the reward???
And let’s not forget that all of these complex situations are in existence because the company struck a deal with a Wall Street bank to raise publicly traded debt (in ATPG’s case) or preferreds (in the other three cases). If Wall Street was key in raising the deal, that means the “pros” know about the company. If they know about it, why are they letting it trade at such a huge “discount?” With the micro-cap net-nets, many of them are the size of a banker’s weekly paycheck. Not so here- Wall Street could put a significant amount of capital into any of these companies if they believed in them.
So what’s the right answer? Simple or complex?
I’m not sure.
Simple is easy. To some extent, it’s tough to make mistakes with simple. But it’s also tough to argue you have a true edge.
Complex is tough. You can certainly get an edge here. But it’s tough to know if you’re just being rewarded for taking on extra risk. And one small mistake can kill you.
So there’s upsides and downsides to both.
I wish I could give you a definitive answer with which to focus on, but I can’t. I hate to end an article with an “I don’t know”, but that’s investing for you. Sometimes, there just isn’t a definitive answer.
But I still think this post is important to keep in mind as you continue to develop as an investor. If there’s one take away from this post, it’s this: true edges are incredibly difficult to find as an investor, and if you have one and determine a situation is deeply undervalued, bet and bet big.
Disclosure- Long all securities mentioned in this article expect Microsoft and Walmart, and may be looking to buy more.
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