Note to Readers: This article is an excerpt from the November 4, 2022 issue of the Weekly Digest newsletter published on Rational Reflections. Readers can subscribe to Rational Reflections for free to receive Weekly Digest and there are paid options that provide access to the business profile series.
“If we assume that it is the habit of the market to overvalue common stocks which have been showing excellent growth or are glamorous for some other reason, it is logical to expect that it will undervalue — relatively, at least — companies that are out of favor because of unsatisfactory developments of a temporary nature. This may be set down as a fundamental law of the stock market, and it suggests an investment approach that should prove both conservative and promising.”
— Benjamin Graham, The Intelligent Investor
Two months ago, I wrote about the perennial debate over whether growth or value investing represents the best way to achieve market-beating returns. Whenever the question of growth and value comes up, Benjamin Graham is usually mentioned as a proponent of “deep value” strategies. Most investors associate Graham’s style with “cigar butt” investing — that is, searching for businesses that might be dying but are trading at such cheap levels that a buyer might still get a few puffs out of it.
The reality is that Graham’s investing style was never one dimensional. Many investors either do not know or have forgotten that he advocated a passive approach for most people. Only enterprising investors, those who are willing to do the hard work involved in security selection, should deviate from a passive strategy.
For those who take an active approach, Graham suggested three distinct strategies:
- The Relatively Unpopular Large Company
- Purchase of Bargain Issues
- Special Situations or Workouts
Looking for bargain issues is what we would refer to as “cigar butt” investing which often means looking for stocks selling under net current asset value. In most market environments, such opportunities are relatively rare. Special situation investing might involve taking a position in an overcapitalized business such as Dempster Mill Manufacturing Company in the 1960s or George Risk Industries in the early 2010s. Special situations also include merger arbitrage and related ideas.
For some reason, investors rarely discuss Graham’s recommendation to look at unpopular large companies. I first wrote about this approach in 2010 after one of my periodic re-reads of The Intelligent Investor. There are many reasons to look at unpopular large companies. The most important benefit is that there are almost always plenty of unpopular large companies in any market environment. Favoring large companies might also involve a larger margin of safety, as Graham describes:
“The key requirement here is that the enterprising investor concentrate on the larger companies that are going through a period of unpopularity. While small companies may also be undervalued for similar reasons, and in many cases may later increase their earnings and share price, they entail the risk of a definitive loss of profitability and also of protracted neglect by the market in spite of better earnings. The large companies thus have a double advantage over the others. First, they have the resources in capital and brain power to carry them through adversity and back to a satisfactory earnings base. Second, the market is likely to respond with reasonable speed to any improvement shown.”
Of course, if a well-known large company is out of favor, there are usually very good reasons for the unpopularity. In the October 14 Weekly Digest, I linked to an article that compared the sentiment surrounding Meta Platforms with the negative consensus outlook for Microsoft in the early 2010s. Since mid-October, Meta shares have collapsed another 30% and are trading under $90 as I am typing these words.
Meta’s third quarter financial results were greeted negatively by investors concerned about the health of the company’s core advertising business and the ongoing operating losses at the Reality Labs segment charged with the company’s metaverse initiatives. There is no doubt that Meta is a large company, with a market capitalization of $238 billion, and there is no doubt that it is unpopular with a stock price that has collapsed nearly 75% from its 52 week high.
But just because a large company is unpopular and trading at a modest multiple of trailing earnings does not mean that it qualifies as an intelligent investment by Graham’s standards. The key caveat in Graham’s approach is that the problems facing the company must be temporary. In the case of Meta, CEO Mark Zuckerberg is determined to continue plowing cash into the Reality Labs segment and he has provided no real insight into when these investments might pay off. There is no prospect of outside investors forcing a change in strategy. Mark Zuckerberg has an unassailable controlling interest due to his ownership of super-voting shares.
Meta is a widely held stock that appears in many of the super-investor portfolios tracked by dataroma.com. As we approach the deadline for large institutional investors to file 13-F reports with the Securities and Exchange Commission for their portfolios as of September 30, it will be interesting to see how many value-oriented managers took positions in Meta during the third quarter.
Disclosure: No position in Meta.
The purpose of a business profile is to provide background information about how a business works rather than to serve as an investment recommendation. Profiles are not stock picks, although they should help investors save time as part of a complete due diligence process. For more information regarding how companies are chosen for this series, please read Selecting Companies to Research.
All business profiles include an Excel file containing financial statements going back at least a decade along with other important data, statistics, and charts. The Costco, Union Pacific, and George Risk profiles also include formatted PDF downloads.
The following profile is available for all readers:
George Risk Industries, September 8, 2022
The following profiles are available for paid subscribers:
Costco Wholesale Corporation, October 25, 2022
Union Pacific Corporation, September 26, 2022
Burlington Northern Santa Fe, August 25, 2022
CarMax, August 16, 2022
Tractor Supply Company, July 13, 2022
Investors Title Company, June 30, 2022
America’s Car-Mart, June 8, 2022
DaVita, May 20, 2022
This week, I started working on a profile of Fastenal which will be published later this month. To gain access to the entire archive of profiles listed above as well as this month’s profile, please consider purchasing a subscription. The cost to subscribe is $12 per month or $120 per year. A fifty percent discount is available for students.
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