We are firm believers in the non-efficient market hypothesis.
Human emotions – fear, greed, disgust, apathy, neglect etc. – sometimes cause significant dislocations in the price at which securities trade in various markets. We see these as opportunities and rich potential sources of returns.
In our Deep Value strategy, we seek out shares or debt instruments that are trading at such depressed valuations that the potential return is multiple times larger than the purchase price. This occurs when investors have given up on the future of the business; in essence they have fallen out of love with the company, its management, industry or geography.
By definition, these opportunities involve ugly optics. The reasons for the deterioration in sentiment can range from concerns over the business model or industry through to uncomfortably high debt levels or even pending legal or regulatory action. Sometimes, the cause of disgust is a long period of poor or even mediocre returns, leading to long-standing disappointment for investors.
The nature of Deep Value investments is that they involve high levels of uncertainty of future outcomes. These uncertainties are “obvious” to all market participants, which is why the price is trading at such cheap levels. Our approach is to assess the potential return based on a mean-reversion strategy. In other words, we buy these investments when a good return can be achieved if things just return to approximately an average position over time.
If heroic assumptions are needed about future outcomes to justify an investment, then it isn’t a Deep Value opportunity.
The companies that suit this strategy have resilient cash flows and high shareholder pay-out yields (buybacks and dividends), combined with improving fundamentals despite a potentially low growth rate. The depressed entry price means that a high return on invested capital for the company is not a prerequisite. The focus is on buying solid cash flows and/or valuable assets at an extremely favourable price.
Through following this approach, we aim to avoid the most common risk in this strategy: the opportunity cost related to a “value trap” – a cheap company that justifiably stays cheap for an extended period. Thorough analysis of the underlying company is required to avoid these traps.
A feature of Deep Value investments is that returns are lumpy and unpredictable. They can take an uncomfortably long time to materialise. The size of the allocation in our portfolio is important, along with the spread of the “vintage” or starting date of these investments. As our mandate doesn’t compel us to do anything, we have the flexibility and luxury of only including these opportunities when we consider them to be extremely attractive. Where there are no such opportunities available, we deploy capital in other strategies or simply wait it out in cash.
Having said all of that, a few practical examples should help to clarify.
“Net-nets” is a term coined by Ben Graham in the 1930’s that refers to companies where the share price trades at a level that is lower than the company’s liquidation value. This means that if we buy the entire company at the prevailing share price, we can put the business into liquidation immediately and after having closed all operations and sold off all of its assets (including the stock and debtors’ book), and paying all liabilities, we would receive back our capital plus a profit from the liquidation process – in cash.
When one reads it like that, it is almost unfathomable that situations like this could exist in a time of abundant information and efficient markets. Yet, sometimes investors become so disgusted with an asset’s history (or its prospects) that they are literally willing to give it away for free.
Since the inception of our fund, we have been able to buy shares in this category virtually all the time. We employ a very straightforward way of searching for net-nets – we look for companies where the share price trades at a level lower than an even more conservative measure: current assets minus ALL liabilities. This means we only count those assets on the balance sheet that can be converted to cash in the next six months (and in so doing ignoring all other assets – property, brands, machinery, patents, or investments in other subsidiaries), while deducting all liabilities – debt, outstanding taxes, creditors, and pensions liabilities.
In most cases, when companies trade this cheap, “the market” finds a way to unlock the value. Our very selfish act of buying these shares is part of that process.
An example of one such investment is Lewis Group Ltd, a retailer of household furniture and electrical appliances. We have been owners of Lewis since November 2017 and are still shareholders at time of writing[1]. Over that period, we have experienced a compound return of 21.8% per annum, of which 12.1% was in the form of share price appreciation and the remaining 9.6% in the form of dividends (see graph below). Despite this, Lewis still trades below its liquidation value (which we estimate to be around R54/share) because the liquidation value has increased by 8% per share over the period, despite the company having returned heaps of cash to its shareholders in the form of dividends and by buying back 30% of its own shares – in stark contrast to the market’s initial expectations!
Graph 1: Lewis share price and total returns
Source: Refinitiv Eikon, 31 March 2022
Spin-offs occur where the board of a company decides to split a group into two separately listed companies – often by unbundling a subsidiary or a division into a new, independent, listed company. This is frequently a direct result of pressure from shareholders.
Invariably, one of the two is favoured more by the receiving shareholder as it has a better ‘story’ or prospects, or sometimes it is just less offensive, almost like ‘Cinderella’ while the other is seen as ‘The Ugly Duckling’ with no prospects or it’s seen as outright toxic. (Pardon the mixing of the fairy tales, but you get the point.)
It is therefore no surprise that shareholders are more inclined to hold on to their Cinderellas while they are much more inclined to get rid of their ugly ducklings as soon and as quietly as possible – especially if those are small companies or if those do not fit an investor’s mandate or fall outside of an index and there is a quarter-end portfolio discussion looming. This process normally creates a situation where the ugly ducklings become Deep Value opportunities.
The skill thus lies in identifying the duckling.
Since the inception of our fund, we have been able to capitalise on a number such opportunities. In the case of the PSG/Capitec spin-off, investors benefited from owning both stocks, but it was clear to us that the parent, being the PSG-without-Capitec part of the spin-off was the ugly duckling in this story. It was the smaller of the two, illiquid, not included in any indices, and given the arbitrage transactions available before the actual spin-off, investors would be clear sellers of PSG after the transaction. No surprise then that we bought PSG as a top-10 position in our fund.
Another example is Thungela Resources, a South-African focused coal miner that was unbundled from mining giant Anglo American after pressure from their shareholders to become more ESG compliant – in other words: “Don’t touch coal!”
Anglo American, in their wisdom, opted to hand these same pressure-bearing shareholders a piece of a small coal mining company. Ducklings don’t come uglier than this and the share was sold indiscriminately and relentlessly on unbundling. The subsequent result of this Deep Value situation is clear from the total return graph below.
Graph 2: Thungela Vs Anglo American since spin-off
Source: Refinitiv Eikon, 20 March 2022
There are many more examples of Deep Value situations – many of them opportunistic. We will continue to seek out these opportunities as part of our long equity strategy.
[1] (31 March 2022)
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