It has been a difficult three months for value investors. Since the mid-July stock market peak and the subsequent decline precipitated by the U.S. subprime mortgage and Canadian asset-backed commercial paper problem, value stocks have mostly declined. The hot technology sector, as represented by such stocks as Research In Motion, Apple, Microsoft and Google have performed extraordinarily well and have largely powered the market upward.
For the record, as a deep-value manager I have encountered extremely challenging periods like this at least half a dozen times over the past 30 years. In all candour, during these times your patience and conviction are severely tested. You are bombarded with conflicting analyst comments, plummeting stock prices and numerous disgruntled client calls. It is my view as both a client and portfolio manager of the ABC Funds that the rewards are well worth the wait.
Interestingly, I looked back exactly seven years ago when we were last severely tested. At that time, Nortel and all the high tech stocks had been spectacular investments. Nonetheless, we did not believe the valuations and refused to join the crowd. We stuck to our serious disciplines and basic fundamental analysis. Some clients disagreed and regularly questioned our management style. In response to the criticisms at that time I decided to respond to client concerns by writing a full page commentary entitled "Running The Gauntlet" in our October 2000 ABC Perspective. Incidentally, this piece along with all previous ABC Perspectives are archived on our ABCFUNDS.COM web site for everyone to peruse.
At that time, I wrote:
"...we believe that a certain class of stocks will outperform, namely out-of–favor equities that are extremely undervalued and are ripe for merger, restructuring, privatization, or takeover. However, the equity market is dichotic, as the undervalued, unloved value stocks are the polar opposite of the power-charged and grossly overvalued high technology, new economy stocks.
These seemingly turbo-powered high tech equities have been trading at astronomical valuations, high price to book and sales multiples and triple digit price to earnings multiples. In many cases they have gargantuan cash burn rates and the only way they survive is through perpetual equity financings. But this hasn’t, up until recently, bothered investors. There remains considerable investor optimism that these technology stocks will recover and that sky-high valuations will charge upward once again. Maybe so, but the risks are increasing and these stocks are now running the gauntlet.
As a value investor, I must admit that it has not been an easy time. Basic “Investment 101” tenets are disregarded and snubbed by the marketplace. Underpriced old economy stocks are trading at inexplicably low prices. Clients incessantly ask, why? All I can reply is that it is very difficult to explain. However, I do believe that the incomprehensible overvaluations are vulnerable and that value investing will triumph in the end.
We suspect, however, that the end result will be a continued shift back to the relative safety of balance sheet, cash flow, and price to earnings analysis. This rotation, we believe, will be the ultimate catalyst toward value stock success and exceptional performance."
In summary, our thoughts, disciplines, analysis and resolve, today, are no different than what they were seven years ago. Admittedly, during the late 2000 period we suffered through poor short-term relative performance. At that time, however, we were positioning our ABC Funds portfolios toward superior performance for the next 3-5 years. Today, much like October 2000, we are planting the seeds for 2008 and beyond. Strangely enough, the extreme cyclicality of the securities market presents a certain sense of deja-vu to a market veteran such as myself.
On a final note, as a frame of reference relating to our style and discipline we have attached our ABC Ten Commandments of Deep-Value Investing.
ABC Funds’ 10 Commandments of Deep Value Investing
- Low Price to Earnings Multiples
We search out stocks trading at low price to earnings multiples (typically under ten times). This reduces the risk of overpaying for a security.
- Low Cash Flow Multiples
We look for companies trading at under five times price to cash flow. This also reduces the risk of overpaying and uncovers many "dirt cheap" equities.
- Discount to Book/Net Asset Value
We like to buy stocks trading at a discount to book/net asset value. In many cases, this not only uncovers significantly undervalued stocks but also prime takeover candidates.
- Hidden Assets
Some examples of hidden assets that can be uncovered after thorough research and analysis are tax-loss carry forwards, over-funded pension funds, undervalued inventory, real estate, potential spin-offs, Initial Public Offerings (IPOs), and favourable litigation.
- Management
Two types of management could be key in the search for a turnaround candidate: a) Solid, proactive management and b) Poor management, which leaves the company ripe for a proactive acquisition or merger.
- Products/Services in Tune with Present Times and Beyond
This includes expandable, growing markets with good margins. We tend to avoid companies with outdated, shrinking, or obsolete products/markets.
- Value Catalyst
In order to push up the value of a stock, we look for a significant value creator, or catalyst. Some examples of possible value creators are fresh management with new direction, an important sale or purchase of a meaningful asset, an unsolicited takeover bid, or disgruntled and impatient proactive shareholders who may put pressure on management to make changes or sell.
- Discounted Valuations Compared to Peers
Comparative valuation measures such as price to earnings and cash flow could indicate a take-over by relatively expensive Canadian or foreign competitors looking to expand market presence.
- Contrary Opinion and Under-followed by Investment Analysts
With little investor exposure, undervalued stocks are 'pregnant with possibilities', providing very little buying competition when attempting to accumulate the security. Generally an undervalued and under-followed security will offer terrific capital gains opportunities.
- Discipline
Stay on track and adhere to strict value discipline of low P/Es, strong cash flows and price targets. Do not get sucked into buying the flavour of the day! Combine patience and persistence to attain superior performance. Patience! Patience! Patience!
Irwin A. Michael, CFA
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