Friday Edition-Rational Liquidation Value

Today I am going to share a method that one of the two best ways for individual investors to make money in stocks. I am talking big money, money that causes George Soros to blush with envy. If you put half your money into this strategy and half into small banks below book value, you would outperform pretty much every mutual fund and hedge fund that ever existed.

It is not easy to execute this strategy. You will own stocks no one has ever heard of before. You will own tiny companies in both parts of your portfolio. There will be many times you ask yourself, "WTF am I doing?" when you click the buy button in your brokerage account.

This is a variation of the technique that Ben Graham developed decades ago and his student Warren Buffett used to get rich. Buffett got so rich he could not use this strategy anymore.

Walter Schloss used a variation of it to compound his clients' money at more than 20% annually for almost 50 years.

The beauty of this strategy is that institutions cannot play the game. Most of the stocks are too small to move the needle for their portfolio.

This strategy and small banks stocks are why I laugh when people tell me value investing doesn't work.

It works.

It works as well as id did when Buffett used it to make millions in the 1950s and 60s.

It just doesn't scale.

You cannot use this strategy to run hundreds of millions or billions of dollars. It really cannot be used to run any outside money as subjecting these small companies to buying and selling based on the whims of passive outside investors would often be disastrous.

It can be used to manage your money. It is a hands-on DIY method for making tons of money in the stock market.

This is a variation of Ben Graham's original net current asset approach. Graham and then Buffett used this strategy to make enormous amounts of money. They subtracted all debt and obligations from the amount of current assets a company had on the balance sheet. That number was then divided by the number of shares outstanding. If they could buy the stock for a fraction of that number, they purchased shares.

Our approach is a little different, but just a little. Property, plant, and equipment are rarely worth zero. We are going to value PPE at 70% of book value. Then we add that number to the current assets. The result is divided by the number of shares outstanding.

If the stock price is less than what I like to call rational liquidation value, we have a candidate for the portfolio.

We need to make sure the stocks we buy are not headed for oblivion any time soon. When prices fall this, low there is often a valid reason.

We only want to own financially strong companies with improving fundamentals.

We will limit our purchases to companies with Piotroksi F-scores of 6 or higher Altman Z-scores of 2 or higher.

Companies that pass both filters are strong enough to survive until they can recover.

Once a month, check your stocks. If the F-score falls below five or the Z-score is below 2 for any of your companies, sell it.

If the stock trades above its rational liquidation value, sell it. This is a cigar butt strategy, not a buy and hold strategy.

Surprisingly it has a low beta with less volatility than the S&P 500. Over the past two decades, this strategy has returned a little over 4% on average per month during up months and lost a little over 1% in down markets.

On average, there will be about 21 stocks in the portfolio every month when the market sell-off and there are more than 25 limit your purchase to the 25 with the highest f-score.

Interestingly it also has some value as a market timing device. If there are more than 100 of these bargain stocks around, it's time to go all-in on stocks with every penny you can find. When there are over 100 stocks below rational liquidation value historically, it would have been a great idea to use as much leverage as you could get to invest in the stock market.

When there are less than ten qualifying stocks, it has been an excellent time to lessen your exposure to equity markets.

Before implementing the rational liquidation portfolio, you might want to consider that there are only five qualifying stocks today.

Buying stocks that trade below their liquidation value and selling them when they trade above that amount has made a lot of people ridiculously wealthy.

Why not you?

Posted to The Community Bank Investor… on Jan 22, 2021 — 12:01 PM
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