Deep Value stocks are cheap for a reason, these stocks are often plagued with operational problems. The common problems that these businesses faced are earnings and cash flow related. Hence, understanding the cost structure of a business is crucial in tracking earnings and cash flow. As a deep value investor, this gives you edge in understanding the breakdown from revenues to net profits. For deep value stocks that are suffering operational losses , you will be able to identify potential catalyst if net margins are improving.
Cost of Goods Sold (COGS)
This refers to the cost incurred to create the products or services that has been sold. The figure includes cost of raw materials and labour cost to create the products or services. Look for companies with decreasing COGS, this trend suggests a few things; company has found ways to substitute lower cost for materials, eliminate unnecessary and wasteful product features or the company has been able to negotiate better price for materials from suppliers.
Cost of Distribution and Sales
How much money is the business spending to bring its products or services from production to end users? The cost of marketing, advertising and sales can be a substantial amount and it varies due to nature of business. By comparing this figure to revenue, we will able to understand its weightage to net profits. This figure also gives you an idea if the company is allocating resources efficiently to marketing and sales efforts.
This refers to cost of salaries for management and staff, utility expenses and rent. Look for companies paying high salaries to directors and executive management, if the business is not making money, management don’t deserve such high salaries. I include this as part of my criteria for picking quality deep value stocks, I believe that management should be rewarded if the business is doing well but they should also be accountable if the business under-perform.
Cost of Research and Development (R&D)
Certain businesses needs to constantly innovate and improve its products to keep up in fast changing business environment. R&D expenses are usually high in technology, healthcare, industrial and pharmaceutical companies. These companies usually invest in R&D for many years before realizing any form of returns.
For businesses with long-term debt especially real estate developers and REITs, Deep value investors should take note of the amount of interest payments as a portion of revenue. If the business has high leverage, you want to know if rising interest rates would have an impact in the earnings.
Capital Expenditures (CAPEX)
CAPEX or capital expenditures refers to purchases of fixed assets such as land, buildings and large equipment. Heavy industries such as industrial, construction, manufacturing, oil exploration and production and real estate tend to have high CAPEX, though some of these expenses may not happen yearly, they present a significant portion of the balance sheet.