Matt Franz : Zealous For Knowledge

Exceptions To The Rule

The other day I wrote about a simple investment checklist. Investors would do well to only buy stocks that meet the four criteria on the checklist. Stocks that pass are rare, so following it results in a long-term, concentrated, low-turnover portfolio, which is ideal.

But some readers contacted me to point out that there are a lot of ways to make money in stocks besides this. My simple investment checklist is really a checklist for finding compounders. But I also invest in asset-based bargains.

There are three way’s stock prices change. A compounder’s return is driven by growth in the underlying business and changes in its capital structure (i.e. EPS). An asset-based bargain’s return is driven by a re-rating of the stock’s multiple (i.e. P/B). Compounding can go on for decades, while a change in multiple is a one-time event. That’s why I favor compounders over asset-based bargains.

The downside to compounders is that they require you to make a subjective judgement about their competitive position and pricing power. And you won’t know if your judgement was correct for many years.  Asset-based bargains, by contrast, tend to rely on a quantitative investment thesis.

Below is my checklist for asset-based bargains:

  1. A business which I understand.
  2. A stable to growing intrinsic value (such as tangible book value per share).
  3. Honest and able management with skin in the game.
  4. A price which is at least 50% below intrinsic value.

Here’s a little color on each:

1. A business which I understand.

When you’re investing based on asset values, you should be able to independently verify what the assets are worth. Don’t take the balance sheet’s word for it. How many investors really understood the components of AIG’s book value in 2008? If it’s too complicated, skip it.

2. A stable to growing intrinsic value (such as tangible book value per share).

You do not want to invest in melting ice cubes: businesses which are slowly but steadily decaying. If you invest in these, book value may converge to the stock’s market price, rather than the reverse.

For example check out Outerwall, which owned Redbox. The company was cash-flow positive, but DVD rentals peaked in 2013 and have declined annually since. The stock offered an enticing free cash flow yield but free cash flow shrunk every year. The company was eventually taken private, forcing many public investors, including Allan Mecham, to lock in a loss.

3. Honest and able management with skin in the game.

This is exactly the same as in the compounder’s checklist. Incentives are the most important thing to understand.

4. A price which is at least 50% below it’s fair value.

Joel Greenblatt teaches that if your assessment of intrinsic value is correct, the stock will converge to it inside of five years. A stock which closes a 50% valuation gap in five years will produce a 15% IRR, which is my personal hurdle rate. If the gap closes quicker or the business grows, the IRRs only go up.


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