Deep value investing is a powerful way to beat the market, but deep value stocks are an endangered species in the U.S.
I was recently talking with Tobias Carlisle, author of Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations, about what constitutes a deep value stock. To find these stocks, Tobias prefers to use the “takeover” multiple. One version of the takeover multiple is the ratio of EBITDA (earnings before interest, taxes, depreciation and amortization) to enterprise value (market value of equity plus book value of debt minus cash).
This is a great multiple for stock selection. Like the price-to-earnings ratio, it helps you find unloved companies, but it also penalizes stocks for having too much debt (more debt = worse ratio, ceteris paribus). If all you did was buy the 10% of stocks with the cheapest EBITDA/EV ratios on an annual basis, you’d have outperformed the market by more than 5% annually over the past five decades.
I asked Tobias what he considers a very cheap multiple EV/EBITDA multiple, and we agreed that somewhere below 5x indicates a cheap stock, while a multiple of less than 3x indicates very deep value. So here is the problem: today, we face what is perhaps the most difficult environment for deep value investing in history. Just 3.2% of non-financial, U.S. companies with a market cap of at least $200MM trade at an EV/EBITDA multiple below 5x. That is just off June’s all-time low of 2.9%.
There are just 65 stocks today with deep value multiples. Most are small. While a few big energy stocks make the cut (COP, HES, MRO), the median market cap of these 65 stocks is just $1B. If we limit ourselves to EV/EBITDA multiples below 3x, then I see just 7 stocks available. The largest has a market cap less than $2B.
So what is a deep value investor to do? Two options are to go smaller (into the micro-cap market) and go international. I’ll explore these options in a future post. Going smaller isn’t feasible for big institutional asset managers, but is possible for the little guy. Going international is great, but hard to execute as a small individual investor.
As I’ve written before, this bull market has left us with a very homogenous market where valuations are clustered around the mean. The sad fact is that in 2014, it’s hard out there for a deep value investor.
For much more on the topic, go read Tobias’s book. You’ll notice that the book is expensive, but trust me—it is worth every penny.