It would be an odd sort of investor who bought assets they felt were expensive. As such, by the very loosest of definitions – that buying what you view as ‘cheap’ stocks makes you a value investor – we are part of a much wider club than we believe is actually the case, here on The Value Perspective. To underline the distinction, we describe ourselves as ‘deep value’ investors – as does our latest guest on The Value Perspective podcast.
After working in hedge funds and private equity – and along the way finding time to write a best-selling book, American Uprising – The Untold Story of America’s Largest Slave Revolt – Dan Rasmussen founded asset management business Verdad in 2014. Rather than put words in his mouth, though, how would he characterise his style of investing?
“At its heart, I believe in the academic approach to deep value,” Rasmussen replies. “And I would describe that as starting from simple ranking – you rank stocks by valuation multiple and choose the cheapest ones. Apparently ‘value’ now means buying things you think are cheap – well, everybody buys things they think are cheap. So I guess ‘deep value’ qualifies as buying things that are ‘actually cheap’ and that’s the camp I’m in.”
Financial health
Onto that, Rasmussen layers an extra “philosophical insight”, which he draws from one of his professors at Stanford Graduate School of Business, Joseph Piotroski. “There is an intersection between quality and value,” he explains. “Pure statistical value is a big part of the story but it is not the whole part – you don’t just want to buy cheap things, you want to buy cheap things that are healthy, not ones that are on the road to bankruptcy.”
In an ideal world, Rasmussen continues, a promising cheap business identified by a deep value investor will not only be fundamentally in good financial health, it will actually be improving. As a result of his time spent in private equity, he adds, Rasmussen and his colleagues have a particular focus on ‘levered’ companies – that is to say, businesses with significant amounts of debt on their balance sheets.
“Levered companies are interesting for two reasons – the first being that people worry a lot about them so they tend to trade really cheaply,” says Rasmussen. “As a result, you end up looking at a lot of levered companies in the deep value universe – almost by default. And second, if we acknowledge value stocks do not always grow as much as growth stocks, then where do the returns come from?
“Well, they come from market pessimism and the mood changing – that pessimism turning to optimism – and then the multiple changing as a result. And, when a business is levered, you will see a multiplier effect on that multiple change. It is a volatile place to invest – if you think value is a wild ride, try deep value and then go to levered deep value – but it is a fun and bizarre little niche to play in.”
Red or green?
We need no persuading about the fun bit – however, as we have observed in pieces such as The ‘seven deadly sins’ of company debt, as investors we generally view leverage more as a red flag than a green light. After all, cheap companies tend to be cheap for a reason – an issue at the corporate level, say, their sector coming under pressure or the country where they operate going through a hard time.
If, on top of that, you add leverage into the mix, then a company might find it does not have the time it needs to turn its fortunes around. It would, of course, depend on the sort of debt involved but, for example, a bank might not allow the company to implement a strategy if it starts breaking covenants that had previously been agreed. How then does Rasmussen incorporate such considerations into his analysis?
“With these companies, there is not just the normal pessimism about value stocks, there is this added wrinkle that a lot of people just avoid levered businesses – and for a lot of reasons,” he replies. “Leverage is going to reduce the amount of time the company has to turn around. Leverage brings extra bankruptcy risk. Leverage puts financial strain on the company. All of these things are true.
Benefits of leverage
“But leverage also has some benefits, right? The first is that it is a financial discipline – the company is going to be oriented around cashflow generation and margin expansion. And these are generally the things that lead to the growth turnaround stories in value – the business starts cutting costs, it starts paying off debt and then, ideally, you see some revenue and/or market change that takes things in a good direction.
“What you can see then is this ‘baby thrown out with the bathwater’ phenomenon among levered companies and then this sort of ‘crucible’ moment, where it could go really badly or it could go really well – and that is, in my mind, what you want. You want a sort of forced catalysing effect of that leverage pressure to drive the outcome – but, yes, it does mean your analysis is doubly important.
“You have to understand the predictors of bankruptcy. You have to understand how the banks and the bond market are going to look at the company. And you have to be able to see some evidence of a turnaround already. So what we look for is de-levering – we look for very strong cashflow statements, where the cashflow is going to the debt paydown and where we think it is going to continue to go into debt paydown.
“Even if the operational turnaround does not happen, if the company is generating, say, a 14%, 15%, 16% free cashflow yield and that de-levering alone will reduce interest payments, it will reduce the burden on the firm. Then, once the debt is gone, other value investors may conclude the business will turn around the next year, so we will see multiple expansion even before the turnaround happens. That is how we think about levering.”
Listen to the full podcast HERE.
