I just finished my first read of the new book Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations by Tobias Carlisle. I say first read because this excellent book covers value investing from Ben Graham to Carl Icahn. Carlisle uses statistical data to back up statements on net-net stocks, activist situations and what has worked in the market for decades.
In a chapter entitled the "The Acquirer's Multiple" he does a deep drill-down on the enterprise value to earnings before interest, taxes, depreciation and amortization (EV/EBITDA) measure of corporate value. He points out that this is the ratio used by private equity and leveraged buyout firms when evaluating purchase candidates.
Carlisle finds that focusing your investing efforts on those stocks in the bottom 10% of all stocks ranked by this measure delivered market-beating returns between 1951 and 2013. Digging deeper, if you were equal weight in a portfolio instead of capitalization weighting, the returns soar, and they actually compound at more than 21% annually for the 62-year period. Since very few of us weight our individual portfolios by capitalization, this is probably a more accurate reflection of the potential returns from the deep value portfolio based on the EV/EBITDA multiple.
A quick check shows that the cutoff for the lowest decile of stocks ranked by this multiple is about 7. In the book, Carlisle shows that those in the bottom half of the bottom decile outperform those at the top half. This brings us down to an EV/EBITDA multiple of about 5 as our cutoff. (Interestingly, that lines up perfectly with what I was told by a private equity manager years ago while sipping cocktails at Red Eye's Dock Bar in Maryland.)
It is a relatively simple matter to run a screen for stocks trading below that valuation level. The resulting list turns up interesting names worth consideration by long-term investors. The St. Joe Co. (JOE) makes the grade. The Florida-based real estate company was the subject of a very public battle between the shorts and the longs a few years ago when David Einhorn's Greenlight Capital made a very public short sale recommendation. While he was touting the flaws, Bruce Berkowitz of the very successful Fairholme Funds was aggressively buying the shares. While we cannot declare a winner yet as the shares have very much gone sideways since, the current valuation seems to favor Berkowitz. The stock currently trades with an EV/EBITDA ratio of just 3.
Another stock on the list makes my Peter Lynch-like "Buy What You Use" list. My wife, son and I like target shooting, and we frequent the local range. We all shoot Smith & Wesson (SWHC) pistols and love the company's products. It is a little dangerous to suggest this stock today as it reports earnings after the close, but the current EV/EBITDA ratio is just 4.4. Demands for handguns and ammunition are off the charts for the past few years. Demand is probably going to slow from the frenetic pace, but Smith & Wesson is an industry leader and it should continue to prosper.
Oil States International (OIS) has an interesting range of natural-resource-related businesses. It makes subsea equipment and offshore vessel and rig equipment, and it provides well-site services to the oil and gas industry. It also has land-drilling services for shallow to medium-depth wells. The company recently spun off its accommodations business to focus on core activities. It is doing very well in a slack drilling market, but the stock is still cheap as measured by Carlisle's acquirer's ratio. The current EV/EITDA ratio is just 4.4 and Oil Sates has been taking advantage of the low valuation to buy back its stock.
It is no secret that my favorite metric is and always will be the price-to-book-value multiple (which tests well in Carlisle's book for long-term performance, as well). I have found, however, that EV/EBITDA is a very useful metric used either in conjunction with P/B or as a standalone measure of value. It should be in every long-term value investor's toolbox.
