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  1. Home
  2. / Investing

How to Identify Deep-Value Stocks

These stocks meet the criteria under the Melvin Grand Unified Theory of Investing.
By TIM MELVIN Oct 20, 2015 | 02:00 PM EDT
Stocks quotes in this article: SHOS, SENEA, ORN, AHT, BPY, BRT, PEO

Now that we have introduced the Melvin Grand Unified Theory of Investing, it's time to break down the components a little bit and talk about some of the stocks that might be a part of each segment -- so you can gain a better idea of how it might work, in practice. My career has been spent primarily as a deep value investor, and that will always be my core approach to the markets, so I will start with this bucket of the Grand Unified Investment Portfolio.

I have always done a lot of research and study about the markets in general, and value investing in particular, but the last couple of years has been an unusually productive period on the research front. A big part of that is thanks to new tools that allow me to overcome my technological and programming ignorance, and part is a result of being more organized about the whole thing. I have discovered several elements that I think will improve performance of this already very successful strategy.

I have always known that deep value investing was lumpy, in nature, and there are periods of outperformance. When I quantified the performance, I realized that it was far lumpier than I had ever imagined. In roughly the first third or so of a secular bull market, value blows the market away by a stunning percentage. In the second third, it pretty much matches the market, in the last third it underperforms and at the very tail end it lags the market badly. It does much better when the markets go boom and we enter a bear-market period. As we get into the late stages, however, it gets very difficult to be fully invested and cash drags on performance.

Research has also allowed me to redefine my approach -- from book-value-based to what I call a Rational Liquidation Value (RLV) basis. Rather than just use book value, I examine the assets and give them a haircut (or, in the case of some real estate and investment holdings marked at cost, an increase) to where they would be valued in a transaction between equally rational buyers and sellers. Then I insist on an adequate margin of safety and will only buy those companies that have an Altman Z-score and Piotroski F-score that indicate the company is financially strong and fundamentals are improving.

Right now, the list of stocks that meet these criteria is pretty short, but there are some interesting companies on the list. Had I used RVL instead of book value, I would have waited a bit longer to buy shares of Sears Hometown (SHOS) -- and got a much better price.  Seneca Foods (SENEA) is not in the most exciting business sector, but the fruit and vegetable processor and canner trades below my RVL estimate and has strong financials. Shipping and energy have been two of the worst businesses in the world in 2015, and Orion Marine Group (ORN) is affected by both.

The only problem with this approach is that it filters out all financial and real estate stocks. As I have made a pretty fair amount of money from insurance companies, banks and REITs over the years, we need to use a different approach to find stock in these areas. Here, I like to use price to book value and financial safety metrics like debt to equity, debt to assets, interest coverage and other criteria appropriate for these more-leveraged companies. Note that I include community banks of under $100 million of market cap in their own bucket.

There are not a lot of cheap stocks in these two sectors either, right now, but as I have mentioned in the past few weeks, I do see some real estate bargains that are worth buying. I think that Ashford Hospitality (AHT), Brookfield Property Partners (BPY), BRT Realty (BRT) and all the single-family REITs are bargains at current levels.

In the deep-value bucket I also include closed-end funds trading at a discount to net asset value. I have always liked this strategy, but the research I conducted on this approach earlier this year made me consider it a major tool for earning long-term profit. This is especially true when a market or sector gets crushed and the discount reaches extreme levels. I have been buying energy-related closed-end funds, like Adams Natural Resources (PEO), in the past few months and expect to be well rewarded when oil prices eventually rebound.

I have one final observation about my research findings this year. Who owns and is buying a bargain stock matters a lot more than I had originally thought. If smart-money value investors are buying a stock, your chances of success are improved. If some of the smart guys are selling, you need to go back and check your conclusions. Odds are you missed something. Having a known activist investor involved also further increases your chance of success with an out-of-favor, undervalued stock.

Deep-value investing works. It always has, and for a very long list of economic and psychological reasons, I am confident it always will. It is an integral part of the Melvin Grand Unified Investment Portfolio.

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At the time of publication, Melvin was long PEO, SHOS, BRT and BPY, although positions may change at any time.

TAGS: Investing | U.S. Equity | Stocks

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