Do you know that Warren Buffett’s best years as an investor was in his early years managing an investment partnership ?
Do you know that in his 12 year career as a fund manager, Buffett compounded capital at an average of 31% vs 9% CAGR against the Dow?
Since managing Berkshire Hathaway in 1965, Buffett has successfully grown its book value by CAGR of 19%. This is certainly an outstanding track record that many of us could only dream of. However, it is less impressive as his track record for Buffett partnerships.
So why did he performed much better as a fund manager than in Berkshire Hathaway?
Buffett confessed in a BusinessWeek report published in 1999:
“It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”
“Yes, I would still say the same thing today. In fact, we are still earning those types of returns on some of our smaller investments. The best decade was the 1950s; I was earning 50% plus returns with small amounts of capital. I could do the same thing today with smaller amounts.
It would perhaps even be easier to make that much money in today’s environment because information is easier to access. You have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map – way off the map. You may find local companies that have nothing wrong with them at all. A company that I found, Western Insurance Securities, was trading for $3 per share when it was earning $20 per share. I tried to buy up as much of it as possible. No one will tell you about these businesses. You have to find them.
No one will tell you about these ideas; you have to find them. The answer is still yes today that you can still earn extraordinary returns on smaller amounts of capital.”
In an annual meeting, he was recorded on video saying this:
“If I were working with small sums, I certainly would be much more inclined to look among what you might call classic Graham stocks, very low P/E and maybe below working capital and all that. Although…and incidentally I would do far better percentage wise if I were working with small sums…there are just way more opportunities. If you’re working with a small sum you have thousands and thousands of potential opportunities and when we work with large sums, we just…we have relatively few possibilities in the investment world which can make a real difference in our net worth. So, you have a huge advantage over me if you’re working with very little money.” Source: YouTube – Warren Buffett on investing small sums.
Buffett’s biggest problem at the moment is having too much money, not many of us would have that problem. I did a quick check on Berkshire’s balance sheet, it had over 70 billion in cash (record high).
So what was he referring to when he said “classic Graham stocks”?
50 cents on the dollar
Value investing nowadays has taken many forms, one of which is deep value investing: the act of buying a 1 dollar for 50 cents. It is one of the most conservative and contrarian investment frameworks in the value investing network.
Deep value investing approach considers a company’s stock price relative to its net asset value (NAV), this method focus on the value of assets on the company’s balance sheet while assigning appropriate discounts to certain assets. Assume company ABC has $100 million in assets and $30 million in liabilities, with that, ABC’s book value is worth $70 million. If the market capitalization of ABC is $50 million, theoretically we are buying ABC’s assets at discount of 28.5% or in other words ABC is trading at a price to book value of 0.7.
Define Deep Value investing
Deep value investments are statistically cheap stocks, they are valued solely based on current assets: Cash and cash equivalent, short-term investments, inventories and trade receivables.These items are taken at face value and to subtract all liabilities of the company, the difference is known as Net Current Asset Value (NCAV).
Source: S i2i Limited Annual Report 2015
Refer to Figure 1, this company owns approximately $77.6 million of current assets and $26.3 million in liabilities, hence, the Net Current Asset Value (NCAV) is 77.6 – 26.3 = $51.3 million. This figure will then be compared to its market capitalization, alternatively one can simply divide the NCAV by the outstanding shares. Example : NCAV / Outstanding shares = 51.3 mil/ 13.71 mil = $3.74 per share. If the stock price is trading at $1.7 per share, this also means that the stock is trading at 55% discount to its Net Current Asset Value.
Worth more dead than alive
As you can see, NCAV method is a proxy for liquidation value, this suggest that NCAV stocks are worth more upon liquidation and the market is obviously understating that fact. NCAV does not take into account the earnings power of the business nor the value of its fixed assets. Hence, buying a stock well below its NCAV gives the investor a wide margin of safety and it ensures downside protection for the investment. In the event that the business needs to be liquidated, there is a higher probability for the investor to recoup his capital.
The primary focus of this site is to search for deep value gems in Singapore stock market. There is tremendous potential in our market and the strategy itself as they are often overlooked and underappreciated by the investment community. Our Asian markets also tend be less efficient than developed markets in the West.
Deep value investing is proven to be an outstanding strategy that beats the market in the long run and so far has outperformed other forms of investing. It does not require fancy forms of cash flow projections or overly optimistic assumptions about the future. It is a consistently reliable form of valuation as it is simple and concrete. The key to outstanding returns is to exercise patience when needed and keeping composure when required.