Deep Value Special Situations

Investment Philosophy

Carbon Beach’s holdings fall into two broad categories:

  1. Special situations; and
  2. Deeply undervalued or out-of-favor securities

Special Situations

Special situations are corporate event-driven opportunities. They have three defining characteristics:

  1. The return on investment depends on a corporate act—board-level action like a merger, takeover, liquidation, spin-off, or similar—rather than an improvement in the underlying business.
  2. The return on investment can be calculated with something approaching mathematical certainty. When combined with a known timeline, this calculation can be converted into an annualized figure.
  3. The security must be undervalued. This reduces the risk and produces the opportunity type most highly prized by investors—asymmetric returns, meaning low or no downside, and a higher, surer upside.

The main attraction to special situations is that the return doesn’t depend on the direction of the stock market. Returns depend on the execution of the corporate event, not on whether the stock market goes up or down. It is only incidentally “stock market” investing.

Generally undervalued or out-of-favor securities

We prefer those that can first survive and then recover fundamentally. We want companies with cash-rich balance sheets and businesses with strong operating earnings. We hope to eventually enjoy both improved business performance and a narrowing of the price-to-intrinsic value discount.

Concentrated

We invest with conviction, holding only our best ideas. Our portfolios hold sufficient positions to reduce the risk of loss from any individual stock, but few enough to capture outperformance. As a result, our performance will be highly idiosyncratic

Engaged

We seek a dialogue with the managers of our portfolio holdings, pushing for the highest standards of corporate governance, and recognition of shareholders’ rights.

Evidence-based, research-intensive process

We conduct research into security valuation and portfolio management, and invest on the basis of those findings–not on conventional wisdom.

Investment Process

Carbon Beach builds our portfolio by following an investment model developed following extensive research detailed in the books Concentrated Investing (2016), Deep Value (2014) and Quantitative Value (2012).

We examine each position to determine the best security to create the best opportunity: We use equity, options, LEAPS, and warrants; held long or short.

We size holdings by discount to value first, and then time and likelihood of catalyst second. The cheaper the stock and the closer and more likely the catalyst, the larger the holding, and vice versa. We refer to our highest conviction positions, those possessing both deep undervaluation and near-term, sure catalysts as “oaks.” We may commit up to 10 percent of the portfolio to an oak. We refer to stocks that are closer to value, or possessing no obvious near-term catalyst as “acorns.” Acorns command between 1 and 5 percent of the firm’s capital.

Our process is as follows:

  1. Universe: Carbon Beach starts with a universe of approximately 3,000 U.S. stocks and ADRs with a market capitalization between approximately US$250 million and US$3 billion.
  2. Forensic credit and accounting analysis: We eliminate stocks at highest risk of financial distress, earnings manipulation, fraud and short raids because they offer no margin of safety
  3. Valuation: We identify stocks trading at the greatest discount from intrinsic value using an ensemble of value metrics, but primarily the Acquirer’s Multiple® (introduced in Deep Value and Quantitative Value). We seek real businesses with strong operating earnings and balance sheet protection. We examine the best security to express a position, either option or equity
  4. Legal and corporate diligence: To identify near-term catalysts, we conduct a diligence process, examining capital structure issues including off-balance sheet and contingent liabilities, historical income statement write-downs; corporate issues including management and board history and attitude towards shareholder value; and activist 13D filings
  5. Portfolio formation and rebalancing: We form a portfolio of stocks possessing the best combination of value and potentiality for a near-term catalyst, rebalancing towards the best opportunities

Shareholder Engagement

Carbon Beach is an engaged shareholder, seeking from the managers of portfolio holdings the highest standards of corporate governance, and recognition of shareholder rights. We believe that engagement is the best method of enhancing and accelerating value creation for all shareholders.

Portfolio

A highly concentrated portfolio of fifteen (15) to twenty (20) deep value U.S. equities and ADRs with a catalyst in the tradition of Graham and Buffett. We use a market-timing model to determine when to fully hedge the long portfolio by selling the index. The strategy is highly idiosyncratic and not managed with the objective of achieving a particular return relative to a benchmark index. However, to compare the performance of the strategy with a measure of performance, reference may be made to the HFRI EH: Fundamental Value Index over a over a three-to-five year horizon.

 

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Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations (Wiley Finance)

Cover of Deep Value

From the Inside Flap:

Deep Value offers investors an authoritative exploration of the philosophy of deep value investment. Written by Tobias Carlisle—an active value investor and the well-known blogger at greenbackd.com—this important resource describes the evolution of the various theories of intrinsic value and activist investment from Benjamin Graham to Warren Buffett to Carl Icahn and beyond. Filled with engaging anecdotes and meticulous research, the book illustrates the principles and strategies of deep value investing and examines the counterintuitive idea behind its extraordinary performance. Deep Value is a practical guide that reveals little-known valuation metrics that activist investors and other contrarians use to identify attractive, asymmetric investment opportunities with limited downside and enormous upside.

Tobias Carlisle presents an insider’s perspective on valuation and activism in a format that is accessible to both professional and general investors. The value investment philosophy as first described by Benjamin Graham initially identified targets by their discount to liquidation value. This approach has proven extremely effective; however, those opportunities have all but disappeared from the modern stock market. To succeed, today’s deep value investors have adapted Graham’s philosophy, embracing its spirit while pushing beyond its confines. In Deep Value, Carlisle examines Graham’s 80-year-old intellectual legacy using modern statistical techniques to offer a penetrating and highly original perspective: that losing stocks—those in crisis with apparently failing businesses and uncertain futures—offer unusually favorable investment prospects. As the author demonstrates, the evidence reveals an axiomatic truth about investing: investors aren’t rewarded for picking winners; they’re rewarded for uncovering mispricings.

Deep Value shows the place to look for mispricings—in calamity, among the unloved, the ignored, the neglected, the shunned, and the feared.

Buy the book at Amazon.