One of the first things we have to look at from the value investing perspective is the price/book value ratio(P/B Ratio). The book value is defined by total assets – total liabilities/divided by total number of shares outstanding or it could also be determined by dividing shareholder equity/total number of shares outstanding. There are other ways to calculate the book value, but that is the most basic form.

Now, without making this too complicated, book value per share basically means the value left over if you decide to liquidate the company, sell all inventory and assets,  pay off all liabilities and return all remaining capital to the shareholders.  For example, a P/B Ratio=1 means that if the company is liquidated at that time you will get $1 for every $1 invested.  The P/B ratio of 5 means that for every $5 dollars you have invested in the stock, if the company is liquidated now you will only get $1 back.  The P/B ratio of 0.5 means that for every $0.50 cents you have invested, you will get $1 back if the company is liquidated.

Value investors typically try to identify stocks with P/B ratio of 1 or less because it automatically gives them a margin of safety. As with the Radio Shack example above we can see that their P/B ratio stands at 0.67. This is a good start. Meaning that if you invest in Radio Shack today,  you are buying $1 in assets for just $0.67 cents. This gives you an automatic margin of safety to the tune of 33%. This also mean the company is undervalued, providing an investor with a possible gain of 33% or more. Not a bad start.

The next thing we try to do is determine the Intrinsic Value of the business. If you recall, the intrinsic value of the business is typically above book value. It includes its brand name, future growth projections and cash flow, interest rates, etc…. While figuring out Intrinsic Value could be a time consuming process I will show you how to do it fast in the next chapter.  No degree in finance is required.  We then look at the management team, business prospects, competition, products and a few other metrics to add into the calculation.

Once the Intrinsic Value number is estimated (it will never be 100%) we have a much better understanding of what the business is truly worth or we can see the true value of the company. Jumping ahead a little bit,  next chapters shows Intrinsic Value for Radio Shack at $10.  That means that the current stock price of $3.35 gives us a margin of safety of 66.5%.  This is indeed a significant margin of safety that allows us to protect our original capital.  In addition, the 66.5% margin of safety could be viewed as a potential profit margin which could be realized when the Radio Shack stock moves towards its intrinsic value.

Even thought it could be as simple as that, in the real world it is rarely so.  Depending on the future performance of the company both the book value and the intrinsic value calculated above can go up or down. Sometimes substantially so. That is why obtaining a significant margin of safety when purchasing any given investment is so important.  In the majority of the cases that lowers your risk profile and gives you an opportunity to get out without big losses if a mistake is made.

As such, value investors should always strive to minimize their risk by maximizing their margin of safety.

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Company Factors

The next primary factor of why certain companies or stocks sell at a significant discount to their intrinsic value have to do with the internal company causes. There could be a number of different issues here, but some of the primary ones include.

• Management Change or Internal Infighting
• Financial Failure, Financial Mismanagement or Fraud
• Competition Is Eating Their Lunch
• Product Failure or Market Failure
• Falling Growth Rates, Deteriorating Financials and No Clear Future/Catalyst
• New Technologies Are Entering The Market

Once again, there are many others, but these are the primary issues.  Any given corporation can have one or multiple factors working against it at the same time. Whatever the situation is, it can greatly impact the value of any given stock.  If investors are aware of any such negative developments there is a good chance the stock will be sold off.  So much so that you are likely to find it selling at a significant discount to its intrinsic value.

Let me give you an example.  I believe it was in 2003 when I was invested in a fast food concept out of San Diego called Pat & Oscars. It was a very well run company at the time, selling at a very reasonable valuation (that was well below its intrinsic value) and the company was planning to grow its chain nationwide.  So, value and growth all in one.  Yet, at some point in 2003 the company  had an E. Coli outbreak in its San Diego restaurants, poisoning a bunch of people in the process. The stock sold off the next day to the tune of 50%, giving investors a chance to buy a good company at a huge discount (assuming this E.Coli outbreak doesn’t kill the company).

This is what you would call a company factor.  It is company specific and depending on a situation it can provide investors with amazing buying opportunities. The trick here is to figure out if the issues is a permanent one or a temporary one as in the example above.  If it is a temporary one and if your research is proven to be correct a significant amount of money could be made while taking very little risk.

Industry Factors

Finally, various industry factors can push any stock into a significantly undervalued category. It could be because of cyclicality, it could be due to industry wide technological change, it could be due to pricing pressure and so forth. The trick here is to find the best performing company in the sector and make sure you buy it at a significant discount. When the industry eventually recovers,  the best performing companies should outperform the rest of the sector by appreciating the most.

For example, let’s assume that your research indicates that the price of gold should go through the roof over the next 5 years. Yet,  for some reason gold mining stocks are selling at an all time lows due to the price of gold being low today.  In fact, most of them selling well below their liquation value.  What you should do if you really believe in your investment thesis is identify 1 or 2 best companies in the sector and invest in them. If your research proves to be right, your stand to gain a substantial amount of money while keeping your risk at a minimum.

In summary,  while the are many other …. market, company and industry factors are the three primary forces responsible for driving stocks well below their intrinsic value.  When doing fundamental research you should clearly know which one of these forces is responsible for pushing the stock in question into the 50-90% discount category. Clearly understanding that could mean the difference between making a great investment and making a disastrous one. 

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As a side point, you do not really need that much money to start a hedge fund.  While most people believe you need millions to start one, it is possible to get away with spending as little as $200 to $500 on all of the above points. You do need to have capital to invest, but the overall structure of the hedge fund is fairly easy and inexpensive to setup. If you do have questions about setting one up, please don’t hesitate to contact me so I can point you in the right direction.

Now, with money sitting in my brokerage account and my fingers getting itchy I decided to concentrate on the following Value Investment Strategy.

1. Find substantially undervalued stocks (companies) selling at a significant discount to their intrinsic value.
2. Such companies must either be growing rapidly, about to grow rapidly or have some sort of a catalyst in the works to release value in point #1.
3. Concentration. These types of investments are hard to find.  As such, you should concentrate on having only 3-5 stocks in your portfolio. This is what Warren Buffett does as well. Diversification is a myth.  
4. Do an enormous amount of fundamental research to confirm points 1 through 3.
5. Watch your investments like a hawk in case of any change.

The first three years were amazing.  While the DOW remained basically flat in net terms during this time (2002-2004), my fund returned an astounding +149.75% net of fees.  I was on fire, I could do no wrong.  Most of the things I touched turned to gold.  

I was starting to get more clients, more money and making contacts in the industry.  I was now making fairly good money, but I was getting restless.  I was growing sick and tired of the strategy above. It was not exciting enough for me. There were only a few stocks/companies that matched my criteria and after a while I knew everything there is to know about them.  There is only so many times you can look at the balance sheet of any given company before getting bored out of your mind

Yet, I couldn’t sit still. I knew there had to be a better way to invest. A more advanced way. One of the major problems with value investing is timing. While you can identify a substantially undervalued asset, it might take years before its value is realized. You don’t know when it is going to happen.  It might be tomorrow it might be 2.7 years from today. In the meantime you have your investors calling you and questioning everything that you do.

The competition for capital in the investment industry is fierce.  While I am telling my clients about the balance sheet, fundamentals, valuations and why this company should appreciate significantly given enough time, their Lehman Brothers broker is screaming how NOW is a “Generational Buying Opportunity.”  I think they teach that phrase in the stock broker school.

I shouldn’t complain, I had great and understanding clients. Yet, I wasn’t naive, all they wanted from me is performance. If I couldn’t outperform this quarter or the next one, they would be gone.

At that time it was easy for me to figure out WHAT will happen, but next to impossible to try and figure out WHEN it will happen.  As such I shifted my research work on TIMING. I wanted to see if it was possible. I have studied everything I could put my hands on.  Technical analysis, cycle analysis, planetary movements, physics, mathematics, various other sciences and even witchcraft.  At the end of the day and after a tremendous amount of work I found what I was looking for.

Let me state this in no uncertain terms as the whole premise of this book relies on this statement.

Yes, it is absolutely possible to time the markets and/or individual stocks. I have proven that fact to my entire satisfaction.  Math doesn’t lie.  

To be continued tomorrow…….

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