Deep value investing means different things to different people. Some deep value investors focus on cheapness relative to asset value. Other deep value investors may be attracted to so-called “cigar butts” where the long-term outlook for a business is terrible, but a bargain purchase can turn one last puff of earnings into a great investment. Yet another set of deep value investors is attracted to turnaround situations, where an investment appears attractive based on the company’s enterprise value being low relative to revenue, even if the company is currently losing money. And while there may well be other approaches, the purists of deep value investing will object to any approach other than the “net net” approach pioneered by Benjamin Graham, the father of value investing.
Net Nets: The Purest Form of Deep Value Investing
Ben Graham’s favorite approach to valuation was to emphasize the values evident on a company’s balance sheet. Unlike values derived from income statement and cash flow analysis, balance sheet values were deemed “safer” because they depended less on on the value of a business as a going concern. If Graham could buy companies for less than the carrying value of their current assets net of all liabilities, he reasoned it might be a good deal.
One of the most successful investors that practiced the deep value approach according to Ben Graham was the legendary Canadian superinvestor Peter Cundill. The Cundill Value Fund has one of the best long-term investment records — a track record of 15% per year compounded over more than thirty years. Peter Cundill’s success led to the fund’s assets increasing from less than $10 million in 1974 to nearly $20 billion in 2006 when Mackenzie Financial bought the management company. Among others, Peter Cundill popularized the concept of buying a dollar for 40 cents, which is so often associated with deep value investing.
In his wonderful book dedicated to the memory of the Peter Cundill investment approach, There’s Always Something to Do, Christopher Risso-Gill recounts the following quotes from Peter Cundill related to net net investing:
“Ninety to 95% of all my investing meets the Graham tests. The times I strayed from a rigorous application of this philosophy I got myself into trouble.”
“We do liquidation analysis and liquidation analysis only.”
“One of the dangers about net-net investing is that if you buy a net-net that begins to lose money, your net-net goes down and your capacity to be able to make a profit becomes less secure. So the trick is not necessarily to predict what the earnings are going to be but to have a clear conviction that the company isn’t going bust and that your margin of safety will remain intact over time.”
However, like other great investors, Peter Cundill was adept at both the science and art of investing, always remaining flexible. He fully recognized that there is no mechanical formula to investing. Rather, there is a balance between intellect and intuition, or “what your tummy tells you.” Peter Cundill referred to this as “osmosis”:
“I don’t just calculate value using net-net. Actually there are many different ways but you have to use what I call osmosis — you have got to feel your way. That is the art form, because you are never going to be right completely; there is no formula that will ever get you there on its own. Osmosis is about intuition and about discipline and about all the other things that are not quantifiable. So can you learn it? Yes, you can learn it, but it’s not a science, it’s an art form. The portfolio is a canvas to be painted and filled in.”
Jeroen Bos on Deep Value Investing
To learn more about the purest form of deep value investing — the net net approach — we had the pleasure of sitting down with Peter Cundill protégé Jeroen Bos in London. Jeroen, who has more than twenty years of investment experience, is one of the premier deep value investors in Europe and was an early scout for Peter Cundill in the London market. Jeroen Bos runs the Deep Value Investments Fund at Church House Investment Management. The fund holds a concentrated portfolio of equities that exhibit deep value characteristics according to the net net approach.
The following videos are excerpts from our conversation with Jeroen Bos. The full interview with Jeroen Bos is available in The Manual of Ideas Members Area, along with a full transcript. Jeroen Bos is also a ValueConferences instructor.
On the meaning of deep value investing:
“Deep value means I always start off with the balance sheet; that is the only thing that interests me. Lots of people try to argue that a stock is deep value when it has a low P/E or it has a high yield; that I don’t think is really value investing; that is something different. I really always start off with the balance sheet, and if that shows me it’s cheap, then I’m immediately interested. I’ve always worked on that basis.”
On what he learned from Peter Cundill:
“What I learned from him is that you never know when you start investing in each company if this is the one that is going to make fantastic returns or no returns. He always thought that if it was really cheap, then continue buying it until you have so much of it that it really starts to hurt and not to give up on them and to always keep your confidence in it. Check on how the company does; just go and talk to them. Go over your figures and if it still tells you the same story, stick with it and buy more.”
On idea generation:
“Every year Peter [Cundill] would make one big trip and that was always to the country that had the worst performing stock market. I thought that was the most obvious thing because that is where the bargains are, and that is what you have to do. Wherever there’s bad news, that is where you should be fishing, in whatever market it may be.”
“I look very much at companies that hit new lows on a 52-week basis, sectors that look very badly, because that is obviously where you’ll find them. It is generally where there’s bad news, where there has been a regulatory change…that is where you find them.”
On which net nets he favors:
“What I love are companies that are pretty simple, that have been around for a long time, and just are either called out by cyclicality or whatever is company-specific, and to see if they’ve been capable of actually generating money. Then it becomes a judgment: Are they ever able to get back to the level that they previously were?”
“What I like is to see a company that has huge volumes but is not making money out of it. I’d much rather have it with management that they can do whatever needs to be done to create the margins that they can make money again than a company where sales are just completely evaporated and it has to earn those back. I don’t know how much advertising or whatever it will take to get it going again. I really don’t feel comfortable with that at all.”
“There are certain sectors that I particularly favor. I love the service sector and the financial sector. I don’t really like big industrials. But companies that move bits of paper from one side of the table to the other, they are fantastic. Companies like recruitment companies are ones that I really, really like. Obviously, they are very cyclical, and you have to wait for the time in the market for them to appear. But when they do, they usually come as a whole sector being very cheap, and they have very nice balance sheet characteristics that I find easy to work with. It’s on the way down that cash tends to build up. They are laying off people as they are still receiving cash for work done. So it looks overly negative on the way down, but it also gives me a margin of safety. By just looking at what is happening in that sector, you can see where the turning points come, and obviously that is something that is very important because it is a finite game with them. If they go so deep that they burn through the cash and there is nothing left, that is when it starts to go wrong.”
“I have had stocks for five years; I have had stocks for three months…As long as the balance sheet doesn’t deteriorate, where my margin of safety continues to exist, I’ll stick with them. Obviously, I hope that management is working on shareholders’ behalf in rectifying the position, but I have patience for them.”
On the risk of net net investing:
“The risk—if that is the way that you want to approach it—with this type of investing is that you start off with a company that has a very strong balance sheet, but if it makes losses, then obviously that balance sheet is eroding. Your margin of safety is under pressure. You buy yourself a certain time period in order for management to turn that company around or for somebody else to step in there. If that doesn’t happen, then obviously you have a problem.”
Jeroen Bos on What He Learned from Peter Cundill
Watch our full interview with Jeroen Bos or download the transcript in The Manual of Ideas Members Area.
On a separate occasion, we recorded a conversation with Jeroen Bos on deep value investing in the UK, his focus market. The full interview is available to Premium members of The Manual of Ideas. An excerpt is available to Standard members.
For additional background on the deep value approach to investing, enjoy this article on the uses and misuses of Ben Graham–style investing.