Things to consider before investing in Deep Value stocks

Deep value stocks are often statistically cheap stocks that are unloved and unwanted by the market, they are companies with tons of problems both operational or managerial. These are stocks that nobody talks about, they are usually illiquid stocks that has zero coverage by equity analyst or little ownership by institutional investors. Deep value stocks can be so unpopular that some might be selling at huge discounts relative to intrinsic value.

Read: 20 Cheapest SGX Stocks with Low Debt – 2016

Having said that, not all deep stocks are great investments. If deep value investments are done without due diligence, it can easily lead to a permanent loss in capital.

So how do we identify a deep value stock for investment? What are the qualitative factors to look into? What kind of deep value stock should be avoided?

9 things to consider before buying deep value stocks

Avoid China based companies

Over the years, there has been a number of SGX listed Chinese companies that have defrauded investors with fraudulent accounting and misappropriation of funds. For obvious reasons, I would avoid China based companies as its accounting practices are unreliable.

Existing Business Operations

Avoid shell companies that owns no fixed assets, companies that owns only cash and other short-term assets in their balance sheet. Avoid companies that are selling obsolete products such as CDs manufacturing. Avoid companies that has just liquidate their operations and are returning cash to investors.

Strong financial health

Companies with strong balance sheets tend to be better survivors in tough economic environment. They have sufficient reserves to compensate any shortfalls, ideally we should also look for companies with low levels of debt.

Read: 5 Ratios to Determine Financial Health of a Business

Cash flows

Calculate the cash flows from the existing operations and identify if the cash flows are sufficient to sustain operations. If the business has negative cash flows, find out how long it will take to deplete cash reserves based on current conditions. A rough estimate is to take the average negative cash flows of the past 3 years and divide them over total cash. Avoid if the business is running on huge cash flow deficits.

Upcoming Catalyst

Finding catalyst for a turnaround will increase your probability of success, although this is not a must. Catalyst are not easy spots, you can start by looking into underlying problems of the business and identifying factors that could trigger a turnaround. Here’s a quick guide to help you identify catalyst: 6 Catalyst to look for in Undervalued Stocks

Insider Ownership

CEOs and Executive directors with high ownership of shares in the business is always a good sign that his/her interest with shareholders are aligned.

Increasing Insider Ownership

It is usually positive to see when a director or CEO increases his/her stock ownership as the stock trades at a discount. It shows believe in their own work and they foresee a brighter future ahead for the business.

However, if the insiders are decreasing ownership on stocks, find out why and keep a close eye on it. Do check on who they are selling their stake to.

Share buyback programs

A sign that the company is trying to reduce stock float and unlock shareholder value. However, there are a few things to consider. Is the share buyback done at attractive levels (cheap or rich valuations)? What is the source of funds used for share buyback (borrowed or cash reserves)?

Executive remuneration

Look into the compensation package for directors and CEO, ideally there should be a balance between salary and bonuses. Directors should be compensated based on performance and if the company is doing poorly, executive remuneration should be affected as well. Compare remuneration and revenue of the business, if the company spends too much of its earnings on salary and bonuses, investors should reconsider the investment.

Final note…

Deep value stocks are an unpleasant and unloved bunch, there stocks are often underestimated by the market.Deep value stocks are not great businesses with competitive moats, many are problem infested. However, with a strict selection criteria and a wide margin of safety, investing them as a diversified portfolio can be rewarding.

Next topic: Diversification vs Concentration: The Great Debate.

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