Andrew Williamson, who runs the Hawkwood Deep Value fund at Hawkwood Capital, lays out the case as he sees it for deep value investing.

The following article is by Andrew Williamson, who runs the Hawkwood Deep Value fund at Hawkwood Capital, based in London, referred to in the subsequent article. The editors of this website are pleased to share these insights with readers but as ever stress that they don’t necessarily endorse all the views here and invite readers to respond.

Warren Buffett, the legendary US investor, once wrote that value investing is like an inoculation - it either takes or it doesn’t - and when you explain to somebody what it is and how it works and why it works and show them the returns, either they get it immediately or they never will. This is very much our experience at Hawkwood Capital.

Value investing takes a number of forms but invariably the aim is to buy a dollar of value for 60 cents (or even lower). The key difference between the different value methods is how you calculate that dollar. Our method, which we call deep value investing, is conceptually very simple. We calculate the liquidation value of the business. In other words we assess what the value of the company’s liquid assets would be in an orderly liquidation and take away all its liabilities. That is our dollar of value and we try to buy a share at a substantial discount to that dollar.

There are two important characteristics such deep value investments have.  Firstly, in common with most other well executed value strategies, there is a margin of safety between what you pay for the stock and what you think it is worth.  A lot of bad things should be able to happen to the economy and to your company before you start worrying about permanently losing the money you have invested. Secondly, we believe our investments are doubly resilient because we “count” only the liquid assets such as cash, trade receivables and the like. These assets are generally much less likely to decline in value due to the economic environment than say a piece of equipment or a factory.

There is another famous quote, by John Templeton, which is relevant here.  He said that “If you want to have a better performance than the crowd, you must do things differently from the crowd”. The vast majority of investors, both professional and amateur, look almost exclusively at company profits or cash flow. We do look at cash flow, particularly the risks of negative cash flow and its impact on our liquidation value but our primary focus, and the thing that gets our pulses racing is a cheap balance sheet. A quick case study illustrates the point.

Our fund, Hawkwood Deep Value, purchased shares in US broker dealer FBR Capital in the third quarter of 2011, beginning our purchases around $10 per share and then buying more at $8. At that time the business was very modestly profitable and was of little interest to an investor looking solely at the income or cash flow statement. But to the tiny minority of investors who really care about balance sheets it was screaming value.

At that date, the business had $5 per share of cash and a liquidation value (which essentially valued only the cash and the liquid equities and bonds on the balance sheet) of at least $16 per share. This investment proposition satisfied all our requirements for a value share. Firstly, hardly anyone was looking at it. Prospects for substantial profits or cash flow were opaque at best. Secondly, we were buying liquid assets which were highly resilient to economic distress. Most of the value was cash and publically traded bonds passing through FBR’s balance sheet from and to its customers. And finally, but most importantly, we were buying the company at a very sizable 40 per cent discount to liquidation value.  Just over two years later the stock is trading at $26 per share but most importantly even if equity markets had been weak over this period we would still have had very solid protection for our invested capital.

If Buffett is to be believed this short article should be enough to whet your appetite. If you think it makes profound sense, you should look at deep value investing. If it doesn’t grab you now it probably never will.