In Part I, I detailed my entry into the value investing discipline with a focus on dividends, free cash flow generators, and CROIC.

Here is the next (although likely not the final) chapter in my investment philosophy.

Special Situations or Workouts

Influenced again by Fwallstreet, along with Joel Greenblatt’s book You Can Be A Stock Market Genius (one of the best investing books out there), I began looking for workouts and special situation investments.

These are event-driven events, such as merger arbitrage, going private transactions, self-tender offers, spin-offs, and liquidations that are often overlooked by the broader market because of their unique characteristics.

They are a nice supplement to a traditional value investing portfolio, and can provide nice returns, especially on an annualized basis.

I completed my first successful merger transaction, picked up free money as an odd-lot investor in several tender offers, and saw through a microcap going private transaction.

I continue to keep an eye out for new transactions in this space, but have gradually put less emphasis on these plays.

In many cases, upside is limited due to the nature of the event (such as a fixed price for a tender offer), and the downside can be extremely painful.

Also, when the stock market is on a big upswing, I’d rather put workouts on the back burner and try to find undervalued stocks with much higher upside on an absolute basis.

NNWC – Getting the Business for Free

In addition to DCF, EPV, and other valuation methodologies, one of the simplest involves finding businesses that are trading at a discount to their Net Current Asset Value (NCAV).

This is an investing philosophy that goes directly back to Benjamin Graham’s teachings.

According to Graham, picking up businesses that are selling at a significant discount to their net current assets (once all liabilities have been subtracted out), will provide a basis for solid returns.

Even better, some stocks even trade for less than their Net-Net Working Capital (NNWC), an even more conservative estimate of liquidation value.

In the depths of the recession, many solid if unspectacular businesses were trading for less than the net cash on their balance sheet – basically, you were able to buy the cash at a discount and get an entire business for free!

My most successful investment on ValueUncovered, CHBU, was a microcap that was trading at a large discount to net cash.

This is one of my favorite investing methods, but suffers from a lack of qualifying companies during a booming market.

Venturing into the OTCBB and PinkSheets

My new favorite!

As the market continues to heat up, fewer and fewer businesses in the broader market have a large enough margin of safety to satisfy my requirements. I’ve started delving into the world of nanocap stocks trading off the major exchanges, the tiny of the tiny.

One of the core tenants of value investing is finding situations that are being missed by the rest of the market.

Logically, the tiniest stocks – the ones that are too small for Wall Street and the major fund managers – are often the ones trading at the largest mispricings.

While there are many scams, other stocks in this category are hard-working family-owned businesses that have been around for generations. Many of them moved off the major exchanges due to the high costs of compliance, and yet continue to published audited financial statements and communicate with shareholders.

Along with this transition, I’ve also found that I’ve greatly simplified my valuation methodology.

Rather than get caught up in analyzing growth projections or worrying about discount rates, I look for businesses trading at a low multiple of free cash flow or operating income. A solid (and simple!) balance sheet certainly helps to provide downside protection.

More importantly, I search for catalysts – an event, announcement, or influence that catapults these small unknown stocks towards reaching their true intrinsic value.

The importance of catalysts cannot be understated in the microcap world. Otherwise, many can languish for years, still trading at a discount but slowly eroding any margin of safety.

In my view, the thrill of finding a situation that is being missed by the rest of the world is unparalleled!

Conclusion

The good news is that many of these investing principles are not mutually exclusive.

• I still calculate CROIC for the microcap .PK stock I’m doing due diligence on
• I still stumble on liquidations and small workouts with substantial margins of safety on the OTCBB
• I still keep an eye out for chances to invest in profitable net-net’s
• I still find stocks that are one catalyst away from multi-bagger territory

Traditionally, I used stock screeners to find stocks that matched my criteria.

However, I haven’t found an accurate screener for stocks trading on the Pink Sheets (if you do, please let me know!).

So investing in this space requires more legwork and discipline, but I believe it has the potential for the most rewards – there is a reason that Buffett guaranteed he could make 50% per year with a small portfolio.

With that in mind

I’m going through every Pink Sheets stock one-by-one.

I’m through several thousand so far with a few hundred left to go.

Gotta be some value in there right? 🙂

Disclosure

No positions.