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.

Like most investors, I studied a number of different approaches for investing in the stock market. The number of different strategies is virtually limitless, but I’ve always been drawn to a more fundamental value-based approach.

However, there are subtle differences within the value discipline itself and with how those principles apply to various investment types or methodologies.

Warren Buffett learned the basic investing methods from Benjamin Graham – but today, Graham would probably disagree with some of Buffett’s latest decisions.

Buffett’s approach has evolved over the years.

With several years of experience under my belt, I wanted to look back at my own evolution as an investor.

Dividend Increases = Income

A large portion of the historical return in equities is due to dividends, and this was one of the first places I looked when I started investing.

I paged through the Dividend Aristocrat and Champion lists, looking for companies that had regularly increased dividends, often for decades in a row.

There was something attractive about receiving that steady, quarterly deposit into my brokerage account, and then re-investing it back into more shares of the business.

As long as a dividend stock was purchased at a reasonable price, those dividend increases could provide a sizable return, especially over the long run.

However, I quickly realized that my investment goals did not match up to those of an income investor. While dividends are still core to my analysis, I no longer focus exclusively on them.

I am young and extremely driven.

I wanted to beat the market and was willing to take on more risk to get there.

(I made a living playing poker – market swings are tame by comparison!)

FCF is King

I quickly learned that analyzing the cash flow of the business is one of the most important indicators for long-term investing success. It is usually much better than the often-manipulated earnings numbers loved by the Street.

The best businesses – with the largest competitive moats – are able to grow FCF at a steady pace through the ups and downs of the business cycle.

These businesses are often large-cap stocks, having stocked up on brand reputation built to withstand minor fluctuations in the market.

When running stock screens, I looked for businesses that not only had positive FCF for the past 10 years, but were able to grow that cash flow every single year.

Then, by forecasting out future FCF increases and discounting back to the present, an investor tries to pick up shares at a discount to their intrinsic value.

Despite a solid method, finding quality businesses was difficult as many in this category (never having a down year) trade at a significant premium.

Sales are rare.

However, the financial meltdown in 2008-2009 touched even the most well-regarded businesses, and I managed to purchase many leading names at rock-bottom prices.

As the market rebounded, the discounts disappeared, and I continued searching for value in other market areas.

CROIC as a Key Metric

Largely influenced by the writings at FWallstreet (I cannot recommend Joe’s book and blog posts enough), I began to search for businesses with high CROIC. According to Joe, CROIC

“tells us how much cash our company can generate based on each dollar it invests into its operations.”

It is a great metric for evaluating companies, and it was possible to build a screen using Stockscreen123 to search for stocks with CROIC as the primary input.

Both ADVC and NOOF were found using the metric.

This number also became the basis for the growth rate in most DCF models.

OSV even provides a screen showing that businesses with improving CROIC substantially beat the market in the long run.

Over time, I kept running into the same companies over and over again, so it was time to look for opportunities using new methods.

Continued – Part II

Disclosure

Long NOOF, ADVC