How to Find 'Extreme Value' in Any Market
Extreme value is always out there... Three pillars of great value investments... What our top picks of 2019 have in common... Our 'North Star'... And our No. 1 recommendation right now...
Editor's note: You've heard from Extreme Value editor Dan Ferris a few times over the last week in Digest. Today, Dan's teammate, Extreme Value lead analyst Mike Barrett, takes the helm to explain the best way to identify a great "value investment."
Shortly after I became the analyst for Extreme Value, editor Dan Ferris told me (Mike Barrett) something I've never forgotten...
"Extreme value is always out there. Our job is to find it whatever the market is doing."
Eight years later, I've come to fully appreciate this nugget of wisdom.
We've found "extreme value" when stocks are near 52-week lows and other investors have given up looking...
Like in June 2013, when we recommended Apple (AAPL)... At the time, most investors thought the company's growth story was dead. The market's consensus was that Apple's flagship product – the iPhone – had run its course.
But the stock had gotten so cheap, you weren't paying a dime for growth... We figured readers could make 50% to 100% within two to four years. We ultimately closed the position in December 2018 for a 190% gain.
We've also found extreme value when stocks are near all-time highs...
In January 2017, we recommended Ametek (AME), a leading manufacturer of precision parts and tools. At the time, the stock was trading within 10% of its all-time high. Over the next 18 months, it pushed upward to new all-time highs and we booked a 34% gain.
And, we've found extreme value even after a stock has done nothing for years...
For the better part of three years, shares of Starbucks (SBUX) bounced between $50 and $60. We recommended this "World Dominator" of coffee shops near the end of this stretch, in August 2018. Today, almost a year later, the stock is around $90 and we're up 77% on the position.
Extreme value really is always out there.
The question is, how do we consistently find it?
Well, it turns out Extreme Value ideas often have three things in common...
These attributes, or pillars of great value, give us great conviction to recommend stocks whatever the market is doing: hitting all-time highs, plumbing new lows, or moving sideways.
In today's Digest, I'd like to share them with you... and explain how we use these principles to identify great value investments, including our favorite buy recommendation right now.
In short, great value companies have...
- Quality assets with "optionality," meaning ones that can adapt to market conditions
- Managers with a contrarian streak
- Challenges creating wide but temporary discounts to "intrinsic value"
I'll use our top ideas so far in 2019 to illustrate...
These are stocks we expect to perform well for long-term investors and are comfortable recommending without the use of protective stops.
Why we want to buy companies that own quality assets with "optionality"...
Every company owns assets... Typically they include tangible things like real estate or manufacturing plants.
Less often, companies own valuable intangible assets. I'm talking about things like patents and royalties that give their owners special rights and privileges.
In the mining world – when we talk about getting things like gold and silver out of the ground – royalties are universally recognized as the most desirable assets.
Historically, royalties in the mining industry started when prospectors discovered that they couldn't necessarily afford to do the proper exploration of a property. So they sold the property to a larger company that could, and took back a royalty in exchange.
Today, companies purchase the rights to these royalties, and you can invest in the portfolios of these "royalty owners."
That's what we did in April when we recommended that Extreme Value subscribers buy shares of a company that owns what could be the world's best gold royalty. We wrote that the company...
... is an ideal way to gain exposure to the leveraged upside potential in gold exploration and a rising gold price, while limiting downside through cash-flowing royalties.
The valuation is right. The current time in the mining cycle is right. It's time to invest.
Royalties are prized because the royalty owner gets a cut of a mine's revenue but incurs none of its expenses.
If production rises, the royalty generates more revenue. And if the price of whatever commodity is being mined also rises, royalty payments do as well.
The gold royalty business we recently added is one of the best for a couple of reasons.
First, the royalty rate is double what's typical across the industry. That means it generates twice as much revenue as the usual gold royalty.
Second, the mine it's attached to operates at some of the lowest costs in the industry. That means unless gold prices move dramatically lower – something we deem unlikely – the mine is likely to produce more than half a million ounces per year into the 2030s.
In short, this company's top asset is the very definition of high quality: limited downside, and huge upside if the price of gold rises meaningfully from here.
Another royalty in the company's portfolio provides something even more exciting: huge exploration "optionality."
In other words, it provides great value for additional investment opportunities.
You see, the royalty on this second world-class mine also covers a vast area that the mine operator has just begun exploring.
Here's how Dan and I described the situation to subscribers in our April issue:
It's a good bet that such an expansive area in one of the richest gold regions in the world contains more than one big gold deposit. When [the mine operator] makes another discovery on the property, it'll likely build a mine there. And when that mine begins producing, [our recommended company] will continue to earn a royalty at an increasing percentage of the mining revenues.
There's still time to get in on this trade, as the stock remains below our buy-up-to price.
Our strategy doesn't only work for mining...
Asset optionality is also a bedrock of value investing across industries, like retail. A decade ago, e-commerce was in its infancy. Most products could still only be purchased by getting in your car and driving to the store.
That, of course, is no longer true.
Today, consumers want options when it comes to how an order is fulfilled and what it will cost.
Some want to buy online and take delivery at their nearest store within two days to avoid shipping costs. Others want to buy online and are willing to pay more for it to be delivered directly to them.
The important takeaway is that retailers must now offer customers multiple fulfillment options.
But building the distribution infrastructure to provide these new fulfillment options at competitive prices and delivery times doesn't happen overnight...
It takes years to acquire real estate in the right locations and construct high-tech distribution facilities... You also better have the clout to compete with Amazon (AMZN), Google/Alphabet (GOOGL), and Facebook (FB) for the best technology talent, and provide them with abundant resources to build and integrate state-of-the-art IT systems.
Many retailers haven't had the scale, expertise, or capital to successfully pull this off – an opportunity Amazon has gladly exploited.
But this "World Dominator" in its industry that we added in July – and I can tell you it's not Walmart (WMT) – has been continually upgrading its supply chain over the past decade. And its latest effort will provide fulfillment optionality on par with Amazon.
The company we recommended in June is also the established leader of its retail category. It got there by quickly growing its store fleet in a unique way that minimizes development costs.
Now, it's expanding the reach of those stores to a broader customer base through the addition of key convenience items.
In short, the presence of high-quality assets, the kind that can evolve over time as market realities change, are a common feature of extreme value stocks.
Why we want managers who dare to be different...
The management team of our June recommendation employs a unique retail-store development concept that limits costs.
As a result, the company earns superior returns on the capital it does invest... and it's able to be the dominant retailer in many locations where others can't, simply because the economics don't make sense for the competition.
Our July pick also earns superior returns on invested capital, largely by gradually removing excess inventory.
The company is able to shed its extra inventory primarily because it doesn't use a traditional retail supply chain, but rather one with a unique second layer of distribution facilities.
Both of these companies use strategies that are... different. But somebody has to make the decision to use them.
In short, it's not enough for a company to have high-quality assets with optionality.
Those assets must be managed by people who also have the expertise and vision to maximize their productivity.
That's no truer than in the mining industry, where high costs and cyclical commodity prices can quickly destroy capital.
But our latest royalty recommendation is in good hands, something Dan confirmed through his many contacts across the industry. We wrote in April:
Most times in mining, you need to read between the lines so you don't get screwed by a mercenary, amoral management team. That's not the case [here]. You can take their word to the bank.
Specifically, this team has discovered more than 80 million ounces of gold, and created roughly $8 billion of shareholder value across a number of public companies since 2003.
A lot of that value was created by this company seeing potential in certain mining jurisdictions that its peers overlooked.
Now, let's move on to the final attribute commonly found in extreme value ideas...
How temporary challenges create value opportunities...
Many investors equate "value investing" with buying moribund businesses selling at low multiples of earnings.
For Dan and me, value investing is about something far more important: It's about maximizing what you get for what you pay.
The best way to do this is to first estimate what the business is worth, something we refer to as "intrinsic value."
Essentially, this is the present value of all of the free cash the owners are likely to extract from it in the future. Intrinsic value establishes an important benchmark for evaluating investment opportunities.
We consider it our "North Star."
Once we've estimated intrinsic value, we compare it with the current share price. The variance between the two provides a measure of the investment opportunity at hand.
Ideally, we're looking for situations where the current price is at least 30% to 40% lower than what we think the business is worth.
Why would an exceptionally managed business owning high-quality assets ever be priced well below its intrinsic value?
Most often, the answer is a business or market challenge that's temporary in nature – something expected to last between several months and a couple of years.
This challenge is causing investors to question the likelihood of the future cash flows embedded in that intrinsic value estimate.
For instance, precious metals prices have moved sideways for years, so it's hard for most investors to imagine a future that's any different, contrary to our belief.
As Dan wrote in last Friday's Digest, despite any short-term moves in gold prices...
I still think a bet on higher gold prices over the next few years – maybe longer – is a prudent one.
If gold and silver prices break out and gradually return to the highs last seen in 2011 (something that doesn't have to happen for this recommendation to work out well), we think our latest royalty stock's intrinsic value will soar.
That's because its costs won't change much, no matter how high the price of gold goes.
Remember, royalty owners pay zero mining costs, so most of the rise in prices falls directly to their bottom line.
As precious metals prices rise, investor expectations will too, making it likely the company's share price will follow intrinsic value much higher.
The substantial discount to intrinsic value for our latest two picks stems from something else: Both companies have initiated large strategic investments to upgrade their businesses.
This will make them stronger companies (and competitors) in a year or two. And their valuations are likely to rise as they spend less.
But right now, the changes are pressuring margins and profitability, something investors with a short-term focus don't like.
We think both ideas will work out well for anyone with a three- to five-year investment horizon.
In sum, extreme value really is always out there – even when the broader market is at or near all-time highs, like it is now...
To help us find it, we constantly look for high quality assets possessing optionality... in the hands of exceptional managers who dare to be different... but facing temporary challenges that create wide discounts to intrinsic value.
And as much as we like the three ideas I've highlighted for you today – all of them selling below our maximum buy-up-to prices – our No. 1 recommendation for this year is even better.
The company has a royalty-like core asset, limited downside, and enormous upside. Insiders own substantial shares and have thrived in tough market conditions when others did not.
Now, they're making key investments that could revolutionize the way one of the world's most important commodities is bought and sold.
And the stock has been on a roll recently. Last month we raised our maximum buy-up-to price on it by 10%, and shares have already jumped 18% since then.
But that's likely due to an influx of new readers, and the momentum traders who pile in when they buy. We anticipate the share price to calm down.
To learn more about this company and to get more information on a subscription to our Extreme Value service, click here right now.
New 52-week highs (as of 7/22/19): First Majestic Silver (AG), Blackstone (BX), Enterprise Products Partners (EPD), Franco-Nevada (FNV), Barrick Gold (GOLD), Lundin Gold (TSX: LUG), Match Group (MTCH), Royal Gold (RGLD), Sprott (TSX: SII), and Wheaton Precious Metals (WPM).
In today's mailbag, a pair of readers share their joy about Dan's essay yesterday on our "debt addiction"... As always, we love to hear your comments, questions, or concerns. Send your notes to feedback@stansberryresearch.com.
"'Then the Fed pulls away the punch bowl, the lights come on, and suddenly investors realize corporate America has been wearing beer goggles for 10 years.' Thanks Dan. The soda I just drank shot out my nose on that one." – Paid-up Stansberry Alliance member Jerrald C.
"Excellent, eye-opening facts regarding debt of every sort and the questionable workmanship of rating agencies. I read each word attentively. Thanks." – Paid-up subscriber Louanne H.
Ferris comment: Thanks for the kudos, and for reading "every word attentively." That's humbling.
With any luck, the outcome for investors will be better than I expect, but I still gotta call 'em like I see 'em!
As for ratings agencies, somebody has to do the job of figuring out how likely a particular debt issue is to default... but the sausage factory Wall Street has set up doesn't do that job. It's like everything else on Wall Street: sales material posing as research. It's dangerous.
Regards,
Mike Barrett
Orlando, Florida
July 23, 2019