Value Library

The following is an excerpt from the ABC Perspective - October 2010 - Pg. 16

Curiosity

Webster’s dictionary defines curiosity as a desire to investigate and learn. Moreover, curiosity as an integral element to successful investing forces us to constantly question the facts, to thoroughly investigate what is presented to us and, as a result, to devise well-thought out, rational investment decisions.

For instance, we may uncover a seemingly dirt-cheap common stock and in the process of satisfying our curiosity, we will dig up considerably more vital information as we put together the pieces of a puzzle. Quite often there is a very logical reason why a certain stock may appear too cheap. An example of this may be a common stock which may be trading at half of book value. In examining the corporation’s balance sheet we discover that the company is sitting on an incredible amount of questionable goodwill which will, in fact, substantially reduce its tangible book value. In one particular instance we discovered that the accumulated goodwill was so large it completely wiped out shareholders’ equity and, in effect, produced a negative tangible book value. Clearly, the market was aware of this fact and, as a result, had severely discounted the company’s share price. While at first blush the stock appeared to be a bargain, it most definitely was not cheap.

In a second illustration, a common stock was paying out an unusually high dividend yield, significantly higher than its comparable peers in its industry. Upon deeper analysis it was discovered that the company was paying out a dividend far greater than its actual earnings. In consequence, the company’s book value continuously declined each year due to their overly generous dividend payout. Not surprisingly, numerous investors had purchased this unsustainably high dividend-paying stock based upon its high yield. Evidently, the stock, also, was no fundamental bargain.

However, there may be certain instances where there is no fundamental reason for a company’s undervaluation other than a negative investment perception. Examples of such legitimate undervalued common shares include: micro and small capitalization stocks with no analytical following; complicated company financials; a company in an out-of-favoured and misunderstood industry; controversial or unknown management; etc. Frequently through an initial curiosity, rigorous analysis will separate the good from the bad companies to uncover the odd diamond in the rough. Examples of recent ABC Funds’ stock selections based upon our initial investment curiosity include: Argonaut Gold Inc., Cogeco Cable, Energold Drilling Corp., Equitable Group, Flint Energy Services, Fortress Paper and Genworth MI Canada Inc.

Overall, it is our view that curiosity is neither a waste of time nor a surefire path to success. Curiosity forces us to initiate a serious analytical process to verify a common stock’s valuation. It combines tedious analysis and steadfast patience to ascertain whether a seemingly dirt cheap stock is truly good value. At the end of the day satisfying our analytical curiosity is well worth the incremental effort.

Irwin A. Michael, CFA