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One question we always get asked is, how to we hand-pick the 90 best Deep Value Stocks for our screens?
Hand-picking the 90 best Deep Value opportunities from 1000’s of stocks is like trying to find a needle in a haystack but, we know that historically once they’re found, these stocks provide investors with great opportunities for out-performance.
We use a valuation ratio called The Acquirer’s Multiple® to find attractive takeover candidates.
This ratio examines several financial statement items that other multiples like the price-to-earnings ratio do not, including debt, preferred stock, and minority interests; and interest, tax, depreciation, amortization.
The Acquirer’s Multiple® is calculated as follows:
Enterprise Value / Operating Earnings*
* The screener uses the CRSP/Compustat merged database “OIADP” line item defined as “Operating Income After Depreciation.
It ‘s based on the investment strategy described in the book Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations, written by the Founder of this site, Tobias Carlisle.
Lets take a look at how we do it…
The Acquirer’s Multiple screeners examine the universe of US-listed stocks and ADRs to find the cheapest on the acquirer’s multiple, the name for the metric used by activists, private equity firms and corporate raiders to find deeply undervalued targets.
How are the universes defined?
At January 1, 2015, there were 9,254 stocks traded in the US. We exclude stocks traded over-the-counter (OTC stocks), and closed-end funds, shrinking the universe of listed stocks to 4,939. We also exclude two sectors, utilities and financials, from the screeners. This reduces the universe to 3,800 stocks. We exclude utilities and financials because their financial statements are unusual, and don’t readily bend to an analysis using the acquirer’s multiple.
We divide the remaining universe of US-listed stocks into three universes: Large Cap 1000, All Investable, and Small and Micro Cap.
The Large Cap 1000 screener is drawn from a universe comparable to the Russell 1000. We define the universe as the largest 20 percent of listed companies. This means that the Large Cap 1000 draws the 30 best stocks from a universe of the largest 1,046 stocks. As at January 1, 2015, the smallest of stock in the Large Cap 1000 had a market cap of $2,940 million.
The All Investable screener is drawn from a universe comparable to the Russell 3000. We define the universe as the largest half of all listed companies. It includes stocks in the Large Cap 1000 universe. As at January 1, 2015, it contained 2,954 stocks with a median market capitalization of $1.43 billion, the smallest of which had a market cap of $131 million. This universe gives the best balance of returns and ease of investability.
The Small and Micro Cap screener is drawn from the universe of stocks that fall outside the All Investable universe. We define the universe as the smallest half of all listed companies. This means that the Small and Micro Cap screener draws the 30 best stocks from a universe of the smallest 846 stocks. As at January 1, 2015, the largest company in the universe had a market capitalization of $131 million, and the smallest of which had a market cap of $0.9 million.
Why use the 50th percentile as the demarcation point between the All Investable and Small and Micro Cap universes?
Why not use say the 66th or 33rd percentile? It’s an arbitrary cut-off, but it’s chosen for practical reasons. As at January 1, 2015, the smallest company in the All Investable universe had a market capitalization of $131 million.
In the 2009 edition of his wonderful book What Works on Wall Street (Fourth Edition), quantitative investing pioneer Jim O’Shaughnessy used a minimum market capitalization of about $205 million for his All Stocks universe. O’Shaughnessy arrived at $205 million by adjusting for inflation the $150 million figure he recommended in the first edition of the book (published in 1995), which he determined by consulting traders at several large Wall Street brokerages.
O’Shaughnessy’s objective in constructing his All Stocks universe was to focus only on stocks that a professional investor could buy without running into liquidity problems, which, in 1995, was $150 million. Our objective is to find stocks that an activist might target. Activists tend to look for companies that are no smaller than approximately their assets under management (AUM).
Activism
The rationale is straightforward: Activism is by definition hands on, active investing. It’s difficult to manage more than 10 positions in the ordinary course, and 20 positions would be considered the maximum number of holdings.
To influence management, a fund needs to buy 5 percent or more, at which point it is obliged to disclose its holding and intentions in a Schedule 13D filing. If a fund holds 20 positions, and invests 5 percent of its AUM in a target company to buy 5 percent of the target’s stock, the funds will be targeting companies no smaller than the fund’s AUM.
A fund may target bigger companies, but, for foregoing trading liquidity and portfolio concentration reasons, funds tend not to target smaller companies. The minimum for SEC registration is $100 million in AUM, and the nearest round-number percentile is the 50th, so we’ve used that as the minimum for the All Investable universe. For most investors, this universe will provide the best balance of returns and ease of investability.
If you think the 50th percentile cut-off is too high for the All Investable universe, consider this: On March 6, 2009–at the stock market trough in the 2007-2009 financial crisis–the smallest company in the largest half of the market (what we now define as the All Investable universe) had a market capitalization of just $27 million. (By way of comparison, the market capitalization of the smallest company in the Russell 3000 was $2.7 million!).
Why use a percentile cut-off for the universes, rather than a fixed market capitalization?
We use a percentile cut-off for the universes: the 20th percentile and larger for the Large Cap 1000, and the 50th percentile to demarcate the line between the All Investable and Small and Micro Cap universes.
Why don’t we use a fixed market capitalization cut-off–say $1 billion for the large capitalization stocks, and $200 million to distinguish between investable stocks and small and micro cap stocks–as many investors do?
If we use a fixed market capitalization cut-off, the universes vary in size depending on the direction of the market. If the market goes up, more stocks move will into the Large Cap 1000 and All Investable universes and those universes will grow in number. If the market goes down, more stocks will move into the Small and Micro Cap universes, and the Large Cap 1000 and All Investable universes shrink in number.
This is a perverse outcome. As value investors, all else being equal, we would prefer that our investment universes do the opposite: Shrink as the market gets more expensive and grow as the market gets cheaper. As the screeners are already focused on the cheapest 1 percent of stocks, we are satisfied if the universes stay approximately the same size in number as the market goes up and down. That’s why we use the percentile cut-off.
Why are there 2,954 stocks in the All Investable universe–above the 50th percentile–and only 846 stocks in the Small and Micro Cap universe–below the 50th percentile?
Why aren’t there equal numbers in each? The 50th percentile cut-off is calculated on the entire universe of US-listed stocks, but the vast majority of OTC stocks, which are removed from the potential universe, fall in the Small and Micro Cap universe. The removal of OTC stocks disproportionately reduces the number of stocks in the Small and Micro Cap universe.
Click here to see a backtested comparison of the performance of each screener.
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