As value investors we sometimes find ourselves in the most obscure parts of the market. We end up there by design, because we are constantly seeking to limit downside risk by investing in securities that are the most undervalued. After many years of experience we have become accustomed to tuning out much of the rhetoric that accompanies low valuations: controversy, fear, and doubt about near term prospects. Such sentiment should be expected and is often a necessary prerequisite for how these securities came to be undervalued in the first place. But how do we discern a compelling opportunity from just another broken story? Valuation is our trusted guide. Our valuation work helps us drive our own proprietary view of what a security is worth. This week’s Trends and Tail Risks outlines how valuation gives us confidence to see opportunity where others do not.

The first step in our valuation process typically begins with a replacement cost analysis to breakdown a company into its constituent parts such as raw material production, factories, stakes in other companies, and any other hidden assets. We focus first on the unit of production. What exactly does the company produce? It may be a ton of steel, a megawatt of electricity, or a loaf of bread. We want to see rising units of production per outstanding share. This is pivotal evidence that the management team is growing its earnings power over time. If management is growing capacity per share inexpensively, such as through buying competitors at a fraction of replacement cost, then we know we have found a team with whom we want to invest. Earnings drive stocks but remember that earnings are a multiplicative function of two things: 1.) production per share times 2.) profit margin per unit of production. Management’s capital allocation drives production per share, but it’s the cycle that drives profit margins.

Once we have the capacity numbers for each business line we value the company as a whole. We ask ourselves a few important questions such as ‘what would it cost to replace the company’s entire asset base?’ and ‘would it be rational to do so?’ We analyze the company and its sector globally to differentiate the low cost producers from the high cost producers.

We look at a company that is down on its luck and ask ourselves how it came to be in that position. We tend to get very excited when we find through our research that the company’s setback is a temporary, cyclical downturn. In many cases a company is simply suffering from an adverse environment. One example might find a company struggling with excess capacity from a supply glut that has driven down the profitability of a sector below sustainable levels. Another example would find the economics of a sector temporarily depressed as excess inventories get worked down, bringing supply and demand into balance once again and restoring the sector’s economics. Experience has taught us that the return of a more normal operating environment can lead to dramatic earnings acceleration if management has dramatically increased capacity per share. This is why we disaggregate capacity per share from margin per unit of production.

The bottom line for us is that it’s our own valuation analysis that drives our interest in downtrodden sectors off the beaten path. We are prepared to look through temporary difficulty for undervalued stocks which are low cost producers – especially when these companies have grown production per share through trying times. Experience has taught us that sometimes we may find these securities in the strangest nooks and crannies of the market. But at all times we try to let the numbers be our guide, remembering as Ben Graham said that ‘Price is what you pay, value is what you get.’ •