When it comes to buying stocks, few investors would dispute that finding a bargain is a seductive prospect. But while most investors are looking for an attractive price, some bargain – or deep value – investors are prepared to great lengths to find one. Warren Buffett calls it the cigar-butt approach to investing:
“A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the "bargain purchase" will make that puff all profit”.
Bargain investing is all about having a very conservative measure of intrinsic value, essentially liquidation value, and a significant margin of safety, in order to trying to buy a pound for, say, 50p. In bull markets, true bargain investing can be an arduous (if not impossible task), but in depressed and volatile market conditions the basket of potential stock candidates tends to swell. Regardless of the conditions, some of the world’s most legendary investors like Benjamin Graham and Walter Schloss have made a mint out of this investment approach.
So how do you go about finding these kinds of deep value or bargain stocks?
1. Bargain Investing 101 – Low Price-to-Book Investing
Perhaps the most common way to measure liquidation value is by using the price-to-book ratio. This involves comparing the current market cap of the company with the book value of the equity in its balance sheet – this is the difference between the book value of assets (cash, accounts receivable, inventory, fixed assets) and the book value of liabilities (loans, accounts payable, mortgages, etc). Countless academic studies have shown that low price-to-book stocks tends to outperform over time.
Price-to-book can be calculated on a tangible and intangible basis. True bargain investors would tend to be dismissive of any kind of intangible assets, usually calculating price-to-book on a tangible assets only basis, given the inherent difficulties in valuing intangibles and the scope for flexibility in accounting for them. That's fine for manufacturing companies but, of course, this makes it unlikely that they would invest in most service businesses (as the value in, say, a consultancy company, lies with the knowledge of its workforce - which is an intangible which isn't even on the balance sheet).
However, even after adjusting for intangible assets, hardened bargain investors may be sceptical that price-to-book is a…
