What is a Deep Value Investor?

Interview with Tobias Carlisle

What is value investing? Why do some value investing companies underperform? What’s the difference between deep value investors and franchise investors? Tobias Carlisle, Founder and Managing Partner of Carbon Beach Asset Management, shares his insights.

Douglas Goldstein: I’m very excited to have on, The Goldstein on Gelt Show, Tobias Carlisle, who is the Founder and Managing Partner of Carbon Beach Asset Management.

He wrote a fascinating book called Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations.

Tobias, you are the kind of guy who looks for value, and it’s even in the title of your book. I think a lot of people who listen to this say, “Of course I’m a value investor. Why wouldn’t I buy something that’s good value?”

What is value investing all about?

What Is Value Investing All About?

Tobias Carlisle: In its very simplest format, it means trying to buy book value, or earnings, or cash flows at a lower multiple. That’s the idea that Benjamin Graham promulgated in his book Security Analysis.

The idea has been extended by Warren Buffet, who says that you can do this calculation where you value a company like a bond, and you look at the cash flows from here until kingdom come.

You discount them back to today. If you find that the stock is trading at a wide enough discount, which value investors call “a margin of safety”, then you can purchase that stock.

It’s an assets and income cash flow test and it’s worked fairly well.

Douglas Goldstein: Those are a lot of terms that you use. We won’t be able to break all of them down. Let’s talk about this future cash flow, because the only cash flow an investor gets when he holds a stock is the dividend.

Unless you sell it, there’s no profit. There are only two ways to make money on a stock: you buy it and you sell it for capital gain, or you get a dividend.

Does that mean that if you’re valuing for cash flow, that a real value investor would never buy a stock unless it pays a dividend?

What Does “Value for Cash Flow” Mean?

Tobias Carlisle: No, not at all. Because you have a book value there and you have an asset value that’s offset by some liabilities.

You are seeking to buy as much asset value as you can, but the cash flows that come into the company are redeployed in a sensible way and the company grows over time.

That sort of compounding of the cash flows that come in, added to the existing assets that grow the underlying business.

In one sense, you have to think about it in two different ways. You think about a stock as a share in a company and that company owns some assets.

A business generates some cash flows. You’re trying to buy at a discount and then hopefully you get some growth as well, so that you don’t necessarily need the dividend.

In many instances, you might not want the dividend for tax purposes or because it’s better in the hands of the management because they’re growing at such a high rate.

Douglas Goldstein: If you’re not necessarily looking for a dividend, what about revenues? Would the company have to have revenues?

The Difference between Deep Value Investors and Franchise Investors

Tobias Carlisle: No. This is one of the things that makes a distinction between deep value investors and franchise investors, or investors who are more like Warren Buffet.

Buffet is looking for a very good business. He wants a management that can grow that business over time.

The way he describes a very good business is one that has a high return on invested capital. That means it makes lots of money for the amount of money that management has or the original founders of the company have invested in the company.

Guys like me are deep value investors, and this is more towards the Benjamin Graham, more classic, traditional style of value investing.

You are looking more for an asset value. Sometimes you can find a substantial asset value with either a business that’s not worth anything at all or it could be worth less than nothing, if it’s losing money.

In those instances, if it had no revenue then it’s worth a little bit more because that would mean that the business was no longer being conducted.

You buy it at a discounted value. Then you hope that either management liquidates the company or it attracts an activist who gets on the board and causes the company to be liquidated.

Douglas Goldstein: Yeah. I can’t say that I’ve seen a lot of companies liquidated in my career. This is not a common thing, right?

Tobias Carlisle: It’s not uncommon. When you are looking for these companies, they are always going to be very small companies.

In a market like this, there are fewer of them because the market is very strong. It’s easy to raise money. It’s easy for businesses to lose money and then raise it on the public markets or even from venture capitalists.

A lot of that pressure is taken off them, but in a 2007, 2008, or 2009-type market where it’s very difficult to raise money, it’s difficult to raise debt as well. You’ll see a lot of liquidations.

You’ll see companies trade at a big discount to that liquidating value. You can make fairly good returns investing in those.

Douglas Goldstein: We’re talking with value investor Tobias Carlisle, who’s been explaining to us a couple of interesting points, which is that a value investor is not necessarily going to require a company to pay a dividend before he buys the stock.

He’s not even going to necessarily require a company to have revenues before he would buy the stock.

Tobias, if you can buy an asset, if you can buy a dollar for cheaper than a dollar, it’s a good deal. Can a normal investor just go to YAHOO! Finance and look up the book value of a stock?

Then if the book value is higher than the price that is actually created on the stock market, go ahead and buy that and wait till the contrarian comes along and takes part of the company to get that value out?

Can a Normal Investor Just Go to YAHOO! Finance and Look up the Book Value of a Stock?

Tobias Carlisle: Yes, they could. The better metric, and this is one that Benjamin Graham identified, is the net current asset value.

What he was looking for there was cash. That’s the most liquid asset that a company can have. That’s the one that is the best to have.

It also means its receivables or its inventory, and those are discounted a little bit more than cash.

Cash is worth 100 cents on the dollar. Receivables are worth slightly less, maybe 85 cents on the dollar.

Then inventory, depends on the inventory, but maybe 50 cents, maybe 30 cents. You conduct this valuation where you work out what those things are worth. Then you find all of the liabilities, all of the debt and you deduct it from that net current asset; from the current asset amount to get the net current asset amount.

If you can then buy the company for two thirds of that net current asset value, then that’s something Benjamin Graham would recommend doing.

There are very few of those companies around, but the historical returns to them are excellent.

Douglas Goldstein: When you say very few, does that mean there are like four or there are maybe hundreds but you have to know how to find them?

Tobias Carlisle: It depends on where you are looking. Globally, there have been between one to 300 pretty consistently over the last seven years - though there are fewer now than there were in the last year or the year before.

In 2009, at the very bottom of the last crash, there were a thousand or something like that available. They had a very good return when the market did finally recover.

They also did fairly well through that period, because there are activists and people who are running those companies who are liquidating. The money is coming up. That’s a catalyst. You can generate a little bit of a return even though the stock market is falling.

Douglas Goldstein: There are a lot of people are out there calling themselves value investors. They have some dog-and-pony show that they’ll do to say why they are looking for value, but they do poorly.

When you follow one of these companies or these managers, they don’t do well. What are the mistakes you think they are making that are causing them to underperform?

Why Do Some Value Investing Companies Underperform?

Tobias Carlisle: I’m always very careful criticizing other value investors, because it means that you are just about to go into a period like that yourself. It has been a very difficult period for value over the last seven years.

The last period of underperformance like this was the late 1990s. Then that led to a very good period in the early 2000s. Through this period, value has done okay. It’s just that the market has been so strong that the relative performance isn’t great.

One big mistake that I see - and that I’ve shown quantitatively to be an issue - is overpaying for return on invested capital; overpaying for growth.

Businesses don’t exist in a vacuum. They’ve got competition that desperately wants that very high return on invested capital.

It means you grow very quickly without putting too much into the business.

These businesses are assaulted all the time by their competitors, or companies, in adjacent industries or startups that are very well financed.

That return on invested capital tends to revert. It also happens on the other side, with poorly performing companies.

Lots of the competition leave the industry or they just fold because it’s so tough to survive. They tend to do better.

That’s why deep value investors do quite well looking for those companies that look like they are in a bit of trouble, but they can survive because they’ve got the balance sheet value there.

You get that improvement in the business and the narrowing of the gap between the discount to value. You get these two ways to win, which is why I prefer deep value.

Douglas Goldstein: Tobias, I have so many questions for you. I’m wondering how diversified someone who does this should be?

What are the tax consequences of being a deep value investor? What sort of portfolio should someone try to buy in and when?

We are just about out of time, so in the last few seconds tell me, how can people follow you and follow your work?

Tobias Carlisle: I’m on Twitter @Greenbackd. The website is acquirersmultiple.com. That has some of the stock picks. It’s a screener. In the top thousand, it chooses the best 30 in the U.S. on this metric.

My books are available through Amazon: Deep Value, Concentrated Investing, andQuantitative Value.

Douglas Goldstein: Tobias Carlisle, thanks so much for taking the time.

Tobias Carlisle: It was a pleasure. Thanks, Doug.