Hey friends. My book, “Choose Stocks Wisely,” addresses blending earnings with the balance sheet equity to derive a proxy for low price. In a nutshell, deep value plus an earnings catalyst often result in the most favorable outcomes.
While I have a mathematical approach to gain a proxy for low price, in my book I discuss that even though numerical analysis is a very critical part of risk assessment, it can only take one so far. An investment decision always comes down to making a judgment call. Since the future will drive things, that judgment call will evaluate investment candidates for catalysts or business drivers. Uncertainty will always exist with stock investments because the future is uncertain. Catalysts don’t always pan out, but it’s important to research a business for potential catalysts — a business that is otherwise an investment candidate by the numbers.
Deep value, as primarily defined by the balance sheet under my investment approach, is rarely found in large, well-known and long-established companies. These companies are priced almost completely on earnings, often without regard to how much equity exists on the balance sheet. As I’ve mentioned before in posts, it’s not unusual to find big companies sporting large market caps where the balance sheets reveal negative stockholders’ equity. That is, the stock price is very positive while the stockholders’ equity revealed on the balance sheet is negative. But in the world of small companies, it is not so unusual to find market caps below the tangible shareholders’ equity.
Even though a company’s market cap may be below, perhaps well below, its tangible equity, it may be justified. The equity may possess low quality. As described in my book, that equity has to be broken down in order to discern the quality of the balance sheet equity. My approach defines deep value as high quality equity. Equity is a summary term for the excess of assets over liabilities (net assets). Quality as a descriptive term for equity, in my book (pun intended), denotes strong liquidity of the net assets first and then strong tangibility of net assets.
Since equity belongs to stockholders, when a stock is being priced below the value of “quality” equity, it is arguably a deep value. Yet, that deep value can go unnoticed and unrewarded unless a catalyst draws the attention of the investment community. As stated in my book, earnings drive stock prices. So, when a company is assigned a meager valuation (deep value) by market participants for its existing equity, we ideally want to observe something about the company that suggests its business is likely to be improving in the foreseeable future. I mentioned in my book that a history of profitability is important since profits increase balance sheet equity. However, that history is important, not because the past drives stock prices (it does not), but because ideally we want a business that makes money. When we find deep value where management is commenting in its most recent earnings press releases or conference calls, as examples, that the outlook for its operations is pointing north, we may indeed be looking at a buy.
See you next time.
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