Four Rules for Finding Undervalued Stocks

During their recent episode, Taylor, Carlisle, and David Samra discussed Four Rules for Finding Undervalued Stocks. Here’s an excerpt from the episode:

[David] Sure. We are value investors, and I think your audience is pretty sophisticated to know what it means, so I’m going to insult them a little bit by giving our insight as to what that means, but if we find a business that trades at $20 a share and we do our homework, and we’re growing by 10%, we buy it at $20, a year goes by, if we do everything right, it revalues up to $33, right, because it’s growing 10% a year, so we make most of our money on the unwind of that discount to intrinsic value, and then we pick up a little bit as the underlying value of the business grows, and why do we do that? Because it’s a two-for-one deal.

You are able to generate an excess return from the unwind of that discount, and because life is not linear, and the world doesn’t operate in a straight line, things go wrong, and government changes the rules, management makes a bad deal, you know, all sorts of things can go wrong with businesses, and if it ends up being worth $25 a share, you make a mistake, you’ve avoided a permanent loss of capital, and a lot of value investors have forgotten over time that there are two components to value investing, which is why I’m sort of going through the basics all over again, is that managing risk is a huge, huge part of being an effective value investor over time, so when we started this way back in 2002, we not only thought about this dynamic between what we pay and what the estimate of intrinsic value is, but we added on what we call additional insurance policies, so for example, we like strong balance sheets. We like companies that have, you know, what we would deem to be very strong balance sheets, what others would call excess capital, and why do we want that?

Well, it helps us, you know, if you’re going to get a company at a discounted price, usually there’s something wrong with the business, right? You’re not getting it because everything’s peachy, and there are all sorts of things that go wrong with businesses, and the company having enough capital to properly reinvest back in the business, right, or if you’re just in an economic downturn, the company can use that capital to keep investing in the business, right, where some of their competitors may not have a strong enough balance sheet, won’t be able to do that, but we looked at it as a risk management tool, right, and then what we also like on top of that is a good business, meaning, you know, we talked about that stock that was worth 30 but growing 10 percent.

Well, that growth, that underlying growth is really important to avoid value traps, right? Inflation is ever-present, and it erodes away your purchasing power, so you want the underlying value of the business to keep growing as you own the stock, and that helps you retain your purchasing power, and the fourth thing that we look for is a good management team, and, you know, if everybody had a choice, they would prefer to have a management team that’s going to add value rather than one that doesn’t, right?

So, you know, we haven’t had anyone on the show who said we’re looking for terrible management, crappy businesses, and, you know, it’s funny because we see a lot of investments made in companies, and we know the executives, and we know that they do a lot of damage, and yet, you know, the register, somebody’s on the register, right? There’s always somebody on the register, so it’s, you know, it’s interesting to watch over time, and so those are the four things we look for in a business, and, you know, it’s kind of needle in the haystack. It’s kind of hard to find those things in combination, which is, you know, getting back to my original description of who we are and what we do.

That’s why we have most of the money in 25 securities.