The basic tenets to value investing and margin of safety are the following:
- Every stock is a fractional share of an actual business.
- Every business or stock has an “intrinsic value.”
- The “intrinsic value” of a business generally changes at a much slower rate than the price of a publicly traded stock can change.
- Over time the “intrinsic value” of a business and the stock market value of a business converge.
- By buying the business at a substantial discount to “intrinsic value” you are thereby creating an adequate margin of safety.
In addition to buying stocks at discounts to intrinsic value, we also want the businesses themselves to create value. This can be done through a variety of different ways:
- New product development or technology.
- Business growth in excess of the cost of capital.
- Accretive mergers or acquisitions.
- Stock buybacks at a discount to intrinsic value.
- Financially attractive refinancings and/or dispositions.
- Improved efficiency.
Book Value= Assets-Liabilities
For our key financial stock investments, we have bought securities at deep discounts to intrinsic value and even discounts to a conservative estimate of liquidation value i.e. tangible book value. If you think about the assets and liabilities on the balance sheet of a bank or an insurance company, they are generally pretty straight forward, which is why book value is a much more relevant metric than for technology or biotech companies per se. These discounts have provided a strong margin of safety and incredible upside potential. For those of you that have been long-term clients, we have made a lot of money on these stocks.
Basically we are buying dollar bills for 60 cents and those dollar bills are accruing interest, which can be seen by growth and book value per share.
Over the last 6 months to a year, many financials stocks (in addition to other industries) have come under pressure as concerns over low interest rates and slow global growth have superseded the improving fundamentals in the underlying businesses. The disconnect between price and value is the greatest that we have seen since at least 2011 during the midst of the European Sovereign Debt Crisis. Any time prices have been this out of whack, we have seen our best returns in the ensuing multi-year rally and I fully expect that to happen once again.
We are finding some of the best investment opportunities that we have seen in the last 10 years.
While market participants tend to be much more reactive to short-term stock fluctuations, it is important to understand what is occurring in the underlying business. Below we take a look at the progress that our key financial stocks have made over the last 5 years and why we have so much confidence in a strong recovery.
BV/S= Book Value per Share
TB/S= Tangible Book per Share
MESP= Month End Stock Price
I believe our returns over the next three years should be exceptional EVEN IF the market is only average!
As you can see, all of these companies have seen very strong growth in both tangible book value per share and book value. For the big banks, this growth came despite tens of billions of dollars of litigation and fines from the Financial Crisis. These figures don’t even adjust for dividends so if you included them it would be even more impressive. Companies such as Assured Guaranty, MBIA and Goldman Sachs have seen greater growth in book value, due to their ability to implement stock buybacks more aggressively. An important catalyst for us, now that the big litigation is in the past.
All of these companies are in a position to increase buybacks and/or raise dividends.
Buybacks done at discounts to intrinsic value offer us the potential to see book value growth of 12-15% per year in most of these names. This means that even if the valuation multiples just says flat we could see returns of 12-15% a year, when the market is likely to do far worse. A more likely scenario in my opinion is that multiples increase so the corresponding stock gains could be 20% plus per annum. This would be a similar dynamic as to what occurred between 2000-2003 during the Tech bust when most market participants got killed, but value investors made a killing and financials were a major contributor to that.
Common Questions Answered:
- “If the stocks are so cheap, why have they sold off over the short-term?”
Stocks fluctuate all of the time and for a variety of reasons. Financials stocks often move in relation to market participants’ confidence, which has been very low especially after the global bear market to start 2016. It will not take much for these stocks to return to their highs as their businesses are growing in value. That alone would lead to very large gains for us.
- “What will be the catalyst for this?”
The potential catalysts are the CCAR process where stock buybacks and dividends will be approved in late June, continued strong earnings and value creation. It just takes a little time and moods shift. This is why Warren Buffett tells us to buy when people are fearful.
Now is a buying time for these value stocks and is certainly not a selling time.
When the same thing happened in 2011 during the European Crisis, we saw many of these stocks double over the next few years. This is just as good of an opportunity for those that keep their nerve and patience.
Thank you very much and as always please let me know if you need anything.