Failing businesses, poor management, and unpredictability often provide the most promising investment opportunities. Tobias Carlisle’s Deep Value offers insight into finding the best risk-to-reward ratio for investors willing to go against intuition and what is normally accepted by the investment crowd.
Tobias Carlisle is the popular blogger on value investing, contrarian thinking, and activist investing. He blogs at Greenbackd (Deep value, contrarian, and Grahamite investment)
“Deep value is investment triumph disguised as business disaster. It is a simple, but counterintuitive idea: Under the right conditions, losing stocks – those in crisis, with apparently failing businesses, and uncertain futures – offer unusually favorable investment prospects,” explains Carlisle. “This book is an investigation of the evidence, and the conditions under which losing stocks become asymmetric opportunities, with limited downside and enormous upside.”
Deep Value provides plenty of research that the ‘cheapest’ shares based upon simple value formulae consistently outperform.
What distinguishes a first-class business from an ordinary business?
In a cruel irony, most good businesses earning high returns on invested capital can’t absorb much incremental capital without reducing those high returns, while most bad businesses earning low returns on invested capital require all earnings be reinvested simply to keep up with inflation. Bad businesses that can only earn sub-par returns destroy capital until they are liquidated. The sooner the business is liquidated, the more value that can be salvaged. The longer the good business can maintain a high return on invested capital, the more valuable the business. What then distinguishes the first-class business from the ordinary business? The differentiator is not simply high returns on capital, which, as Graham pointed out, even an ordinary business will earn at some point in the business cycle, but sustainable high returns on capital throughout successive business cycles. The sustainability of high returns depends on the business possessing good economics protected by an enduring competitive advantage, or what Buffett describes as “economic castles protected by unbreachable ‘moats.'”
On Ben Graham and activism
Graham was a forceful and eloquent advocate for the use of shareholder activism to foment change in deeply undervalued companies. The very first edition of his magnum opus, Security Analysis, published in 1934, devoted an entire chapter to the relationship between shareholders and management, which Graham described as “one of the strangest phenomena of American finance.” “Why is it,” he wondered, “that no matter how poor a corporation’s prospects may seem, its owners permit it to remain in business until its resources are exhausted?” In answering his question, Graham wrote that it was a “notorious fact … that the typical American stockholder is the most docile and apathetic animal in captivity:”
“He does what the board of directors tell him to do and rarely thinks of asserting his individual rights as owner of the business and employer of its paid officers. The result is that the effective control of many, perhaps most, large American corporations is exercised not by those who together own a majority of the stock but by a small group known as ‘the management.'”
He saw deep undervaluation as a prod impelling shareholders to “raise the question whether it is in their interest to continue the business,” and “management to take all proper steps to correct the obvious disparity between market quotation and intrinsic value, including a reconsideration of its own policies and a frank justification to the stockholders of its decision to continue the business.”
Characterizing Price and A Wonderful Company
We know that a wonderful company will earn an average return if the market price reflects its fair value. To outperform, the price must be discounted—the wider the discount, or margin of safety, the better the return—or the business must be more wonderful than the market believes. Wonderful company investors must therefore determine both whether a superior business can sustain its unusual profitability, and the extent to which the stock price already anticipates its ability to do so. This is a difficult undertaking because, as we’ll see, it is the rare company that does so.