A book review by Richard Gill
One of the main flaws in the current investment world is the emphasis put upon predictions of the future by brokers, analysts, economists and their ilk. As the old joke goes, "six out of the past four recessions have been forecast by economists". Predictions of company earnings, commodity prices, interest rates and other factors which affect asset prices are frequently completely incorrect, often resulting in significant losses for those investors who base their investment decisions on these forecasts. Commentators who recently suggested that gold would hit $2,000 a ounce come to mind.
For those investors who recognise the inherent difficulties in attempting to predict the future, the investment approach laid out in Deep Value Investing by Jeroen Bos comes as a refreshing and informative change.
Jeroen Bos is a Dutch fund manager based in the UK. He learned his trade in the City of London, initially at stockbroker Panmure Gordon, taking significant inspiration from the classic tome The Intelligent Investor by Benjamin Graham. Bos is currently an investment director at Church House Investment Management and runs the Deep Value Investments fund, launched in its current form in February 2012. For the record, according to his latest September newsletter, the fund delivered a 24.9% gain over the previous 12 months, compared to an 18.9% gain in the FTSE All Share Total Return Index.
The main philosophy of "deep value investing" is quite simple and a strategy which can be implemented by any investor willing to put a reasonable amount of time into his research. Unlike traditional stock analysis, which focuses heavily on the profit & loss account and attempts to predict future earnings, Bos' strategy is almost entirely focused on analysing the balance sheet of a company. This is where the assets of a company are shown, and where the deep core value of a business can be found.
At its heart deep value investing is all about buying shares in companies which trade at a discount to their assets. The focus here is not on total net assets, which includes fixed assets, but on current assets. Bos' tends to ignore fixed assets, such as plant and machinery, as they can be illiquid and if they ever have to be sold the actual sale price could be much lower than their book value.
The main focus is on shares which are trading at a discount to working capital, or in other words liquid or current assets such as cash, debtors and stock which can quickly be realised for near their full balance sheet value. The most attractive companies, going back to Benjamin Graham's famous book, are referred to as "net-nets", or those companies which have current assets, minus total liabilities, which are more than their market value.
This approach allows investors a great margin of safety, where it is hard to lose money even if the worst case scenario develops. For example if company has £10 per share of net-net assets but is selling for £5 a share you are effectively buying a readily realisable £10 note for a fiver. If the worst happens and the company is wound up then arguably you would get your money back and potentially more from the sale of the assets. But then there are even greater potential rewards should the company have a turnaround in its fortunes. The fixed assets are also thrown in for free.
On the upside...
There are many advantages to the deep value investment approach. It helps to find stocks which are low risk but offer the potential for high returns - the ultimate goal for any investor. And unlike traditional "value investing" the deep value investing philosophy does not focus on whether a company is trading on a low multiple of earnings or has a high yield. Instead it is concerned with facts of value, not forward predictions from biased brokers or the opinions of ill-informed stock markets commentators which can often prove to be completely wrong. And the approach doesn't require detailed technical knowledge of a company, or its industry.
The book is refreshing in that only around 10% of the pages are dedicated to explaining the investment strategy itself. That's how simple it is. The rest of the book looks at how successful the strategy has been for Bos in practice by examining a number of situations in which it has been implemented. Seven shares are covered where the author has used the strategy very successfully in his funds, for example buying suit hirer Moss Bros at 27p in February 2011 before selling at 70p in March 2013 and oil services group Velosi for 82p in December 2009 before the company was bought out a year later for 165p per share.
Bos' favourite sectors are those which are light on fixed assets and heavy on current assets, in particular service companies such as recruiters, consultants and financial services firms. These tend to be cyclical, changing in value according to the boom and bust business cycle, which means they can be bought cheaply when they are unattractive to many investors. They also tend to have flexible business models, meaning they can react quickly to downturns and benefit from operational gearing when recoveries come.
On the downside...
Like all investment strategies there are disadvantages and downsides to deep value investing. For a start the method often focuses on distressed companies. This means that significant patience may be required before the market re-rates the stock. And of course there is always the possibility that companies do not recover and losses can be made. A stock may be trading on a net-net basis but if it continues to lose money its net assets will continue to be eroded. In that respect two chapters of the book are focused on investments which didn't go right for Bos - beleaguered hedge fund manager RAB Capital and classic value trap, the jewellery maker Abbeycrest.
In addition, the stock market rarely throws out opportunities to buy companies on the net-net basis described above, so opportunities may be few and far between. And used alone the method would ignore opportunities to invest in fast growing, asset light companies such as those in the technology industry. I would point out that the approach would have completely missed small cap stock market darlings such as Asos and Lo-Q, which have delivered four and five digit percentage returns.
Further Deep Value?...
To round off the book Bos includes an analysis of six potential deep value shares of tomorrow. Some of these look worthy of further investigation but given recent experience I have questions over one of Bos' candidates, the fashion retailer which used to be cool, French Connection.
At first look the company is a classic deep value candidate, trading on a net-net basis. The current market cap is just £37.8 million but current assets less total liabilities are 19% higher at £44.9 million. So in theory the company could shut down tomorrow and if all assets were realised at their balance sheet value shareholders would still make a profit.
However, recent interim results show a net cash outflow from operations of £5.2 million for the six months to July, showing a downward trend in asset value. In addition, the true value of £38.9 million worth of stock at the period end must also be questioned, especially given the short-term nature of the fashion industry.
During a shopping trip to Oxford Street last weekend I happened to look around one of French Connection's stores for 20 minutes or so. Noteworthy were the comments of my female companion, especially regarding a number of £200 dresses, which she "wouldn't be seen dead in". Don't be surprised to see these on sale for less than 50% of their current price in the January sales. Footfall in the store also seemed a lot less than nearby (and cheaper) competitors stores such as Primark, Next and Zara.
The lesson is that, as with all potential deep value candidates, management must turn around the company's fortunes if investors are to eventually make a profit. With French Connection the jury is still out.
Deep Value Investing is very well written, easy to understand and jargon free, although I suggest that a basic knowledge of how to read company accounts is needed in order to understand the book fully. It would also be an advantage if readers had previously read Benjamin Graham's classics Security Analysis and The Intelligent Investor. What I can say is that the book probably will help in making you a better investor, and on that basis it is definitely worth an addition to any serious investor's library.