In Value investing skills #1, we highlighted the ‘informational edge’ to be had through a value approach to investing – that is, buying stocks that trade at a significant discount to their intrinsic value.
Rather than seeking investment ideas in, say, the media or broker reports, we explained, value investors focus their attention on the cheapest stocks in the marketplace – something, incidentally, that is easier said than done.
Having done the work to identify the investment pool you want to fish in, then, the next step is to assess the quality of what you find there.
#2 - Analytical edge
Once again, this is easier said than done because, at this company-analysis stage of the process, what value investors are trying to do is to separate those businesses that are cheap temporarily from those that are cheap permanently – and for a good reason.
If you can tell those so-called ‘value traps’ (companies that are cheap for good reason) from the real deal, you will have a significant edge over everyone else who are filtering companies by valuation. But how can you set about effectively differentiating between the two?
Lots of angles to consider
When you start analysing businesses, you will find there are all sorts of different angles to consider – balance sheets, company strategy, competitors and suppliers, to name just a few.
And with any cheap company, there will always be upsides and downsides to the investment case. For example, at the most basic level, the money you could make versus the money you could lose after buying in.
Human nature being what it is, investors will tend to focus on the more interesting ‘headline’ part of that equation – the potential reward – while skimming over the ‘small print’ – the associated risks.
As human beings themselves, value investors are well aware of the allure of a good headline but they also know reading the small print can make all the difference in the world.
In other walks of life, where the devil is in the detail, people build checklists into their process. For example, pilots like to make sure they have enough fuel to complete their journey, surgeons that they are operating on the right part of the body and so on.
As professional investors entrusted with other people’s money, we feel we should be similarly disciplined and so, here on The Value Perspective, we have built ourselves our own checklist.
This takes the form of seven questions we ask in relation to every single cheap company we analyse and which help us distinguish those likely to remain permanently cheap from those whose share prices have the potential to bounce back.
Addressing these questions helps flag up the companies to avoid. These relate to:
- The quality of a business
- The strength of its finances
- The degree of ‘structural change’ it is facing in the area in which it operates.
To take one highly topical example, over the last 18 months, Carillion (the failed facilities management and construction services company) kept on cropping up as one of the cheapest companies in the UK – and kept on falling foul of our checklist.
Carillion failed our questions in relation to its financial strength, the quality of its business and whether it turned its profits into cash and so, despite its undoubted cheapness, we did not own it in any of our portfolios, here on The Value Perspective.
And if you have a process that can – on a consistent basis – help you to weed out such companies that deserve to be cheap and only pick the ones that are temporarily so – that rebound – then, once again, you have an edge over your competition.