Value stocks have often been favoured by those who are happy to go against the grain, and enjoy investing in stocks that are considerably disliked by the market. This is because value investors believe that if everyone hates a stock, then there is no optimism included in the price, which means there is a certain level of potential upside when the market sentiment eventually returns the stock to favour.
Value investing has been made famous by Benjamin Graham, often called the father of value investing, and the teacher of a certain Warren Buffett.
Benjamin Graham believed that a good stock to invest in should have a ‘margin of safety’ that would protect the investor from material downside. His idea requires buying a stock for less than the sum of its parts, or its book value. Value will always eventually be recognised, however, the investor must be prepared to wait for the catalysts that will unlock the value, or for market sentiment to turn in the stock’s favour. One problem of value investing is that it requires patience.
Buying a stock for below net asset value
To identify a stock that is trading below its net asset value we need to study the balance sheet and work out the total value of the assets, and the total value of the liabilities. This is often totalled already for us on the balance sheet and so it is a simple case of subtracting liabilities from assets. If the number is negative, then that means there is no net asset value and we have net liabilities instead. We want to avoid those stocks, because if we want to value invest there must be some value existing!
One thing to be careful of when looking at net asset value is that assets can both be tangible and intangible. Tangible assets are things such as cash, property, and machinery, whereas intangible assets can be the value of a brand or intellectual property. This, of course, is subject to management discretion.
Look for net tangible asset value
By stripping out intangible assets, we are left with a net tangible asset value, which is the sum of everything that exists and is real. This gives us an even bigger margin of safety, because ultimately something intangible is only worth what someone else is willing to pay for it. Of course, that is also true of tangible assets – but at least they have a generally agreed-upon intrinsic value.
Check the depreciation policy
When looking at tangible assets, it is important to check the company’s depreciation policy. For example, if we bought a new car, we would not expect to be able to sell it five years later for the same amount. Something must be deducted for the wear-and-tear on the vehicle. This change in value is accounted for on a company’s books by depreciating the asset over the course of its useful life. Make sure that the depreciation policy is realistic.
When investing in value stocks, we must always check the balance sheet carefully.
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Motley Fool UK 2020