The goal of any young investor is to get rich. Make enough money in the markets to coast the rest of your life. Live off your assets and take orders from no one. Work when you want, where you want and on what you want.
Once you amass enough assets the math will take care of itself. It’s actually a pretty easy formula to calculate when you can stop working for the man and live off your assets. The key is to gather enough assets as quickly as you can, avoiding all of the pitfalls every young investor makes on the journey.
If you want to make money in the markets and become a real investor you have to think like a professional. If you want to become a professional investor, the first step is understanding how to value a business.
Before we learn how to value a business, first a word from our sponsor…
The Unexpected Way Millionaires Use Alternatives (And How You Can Too)
The Power Law dictates that 1% of the world’s population holds 46% of the wealth. And the rich are only getting richer.
In fact, the total net worth held by millionaires and billionaires grew by 61% during the pandemic—a staggering $3.9 trillion, according to Business Insider.
So what’s the one thing millionaires are doing that you and I aren’t? Allocating 30% of their entire portfolios to alternatives like Contemporary Art.
In today’s economy, it actually makes sense why.
The US faces a debt crisis. Inflation is at 5.4%, the highest rate since the Great Recession in 2008. And the pandemic is destroying global supply chains.
Ultra wealthy investors see uncorrelated alternatives like contemporary art as potentially the highest returning opportunity for the foreseeable future.
Here’s why Millionaires and I are betting big on art:
Contemporary Art outperformed the S&P 500 by 174% from 1995–2020.
Global value of art expected to grow by 53% by 2026
86% of wealth managers recommend art to clients
So how am I adding art to my portfolio? I use Masterworks.io—the only alternative investing platform valued at over $1B.
I love Masterworks because they make diversifying with this unexpected and potentially lucrative asset class easy. Once they do their DD, they securitize the painting so I can buy shares in it just like a company's stock.
Early investors already got a 32% annualized return in 2020 from a Banksy painting—2x better than the S&P 500 over that period.
Want in? You can join me on the hedge fund of art and get priority access with this Alpha Letter link*
*See important disclosures
How to value a business
There are four different methods I like to use when valuing a business.
Discounted cash flow methodology
Each valuation method has its own pros and cons. Using all four approaches on a single company provides the most accurate method of what a company could be worth. I broke down each approach below. Use these as a starting point. Feel free to reach out anytime if you ever want to dig deeper into valuations.
Discounted Cash Flow: I always start with a discounted cash flow valuation. This valuation method is the most time consuming. I build every model from scratch. Model from the segment level data and have it flow through into the consolidated statements. I go through earnings reports, transcripts and all of the financials to put together an accurate picture of past performance while trying to forecast future free cash flows. If you want to understand how a business works, build a discounted cash flow model on a company, then build 500 more. You will learn a significant amount on how professional investors value companies.
Relative Valuation: After the discounted cash flow is complete I compare this company with their peers. I like to buy companies that are trading at a discount to their competitors. I use all of the regular key metrics that any analyst would such as market cap, enterprise value, revenues, EBITDA, net income and any assets that a company owns. I don’t weight this valuation method as much as I do a discounted cash flow model, but it is still an important tool in my toolbox.
Liquation Value: I then focus heavily on the liquidation value. The goal for any investor is to not lose money. If you focus on the downside the upside will take care of itself. In a liquidation valuation analysis I focus on what a company could be worth in the event they have to liquidate all assets. The large part of this analysis is focused on the balance sheet and what all assets could be worth. I then discount the value of those assets for conservative purposes. All liabilities are kept constant.
Outright Sale: The final valuation technique I use is trying to figure out what a company could be worth in the event they are sold to a competitor, private equity or any third party. This valuation method takes into account any brand value and synergies (the removal of corporate costs) a third party could add if they bought the asset outright. This valuation method is typically the most aggressive as brand value is incorporated into the valuation and costs can be removed as the corporate team is typically gutted.
Once you understand how to value a business you need to put the tools to work and actually go out underwrite businesses. To underwrite a business, you need to first find the right business to start researching.
What kind of companies to underwrite?
Once you know how to value a business you need to find companies to value and invest in. If you want to outperform the market you will want to only focus on companies that no one else is looking at. Unless…
You are managing in excess of $250 million
You have a team of brilliant analysts working for you
You are a complete expert on the sector or company
Pretty much if you are not a huge hedge fund manager you should be researching and investing in the tiniest, most illiquid, most misunderstood and off the beaten path investments you can find.
Don’t become the next 10,000th Tesla analyst. You will never get an edge over the competition. No matter how many earning reports you read. No matter how elaborate your model is. No matter how many channel checks you do. It will be almost impossible to become the smartest investor on the street in Tesla. You will never have an edge investing in large cap stocks.
To get an edge in the investing world you got to start looking at companies no one else is looking at. The companies no one else is looking at are the smallest companies on Wall Street. I’m talking micro and nano-cap stocks. Companies with market capitalization rates below $300 million.
Microcap investing has been my sweet spot for years. I love the space. First, I am a contrarian at heart. I have never liked doing what the crowd does. The sheep. I’ve strayed off the beaten path my entire life. When I got into investing, I wanted to research original stocks. Stocks no one else was researching. That is how I found microcaps.
It dawned on me pretty quickly after discovering microcaps that very little institutional investors were playing in this space. It became clear almost immediately that I could become the smartest analyst on a handful of stocks. And if I purchased these stocks well below their intrinsic value, I had the potential to do really well.
There are a few things that make microcaps work:
Not many investors are looking at them and the ones who are typically are not institutional investors. You are competing with the average Joe, not some dude who graduated top of his class at Harvard.
Valuations are typically less aggressive. Compared to their large and even small-cap peers, microcaps on a relative basis have less aggressive valuations. Think two to three EBITDA turns lower.
You can find companies trading for less than their liquidation value. It is very rare to find a large cap stock trading for less than the liquidation value of all of its assets. In microcap land, not so rare. In fact, I was buying a stock earlier this month that was trading for less than the cash on its balance sheet. Find me something that cheap in large cap land!
You can talk with management teams. In the microcap space you have direct access to the management teams who are running these businesses. If you can pick up a phone, almost with an 80% hit rate you can establish a conversation with the team who is running a company and have an open dialogue. Try getting Elon Musk on the phone if you had a question about his financials, I dare you.
If you want to outperform the market you got to start looking at the most obscure stocks. Stocks that are so far off the beaten path it takes months to gather the amount of research needed to property underwrite the security. Stocks that no one else is looking at. Don’t know where to start?
Here are some examples
I was buying this company after COVID-19 hit. The stock got de-listed from the NASDAQ and was trading on the OTC boards. There were forced sellers as many asset managers have mandates that they cannot hold OTC stocks. The management team cut a massive amount of costs and was projecting things to get better. It was trading at a multi-decade low and the share price was a mere $0.25. I wrote it up for the newsletter when it was $1.70/share. The stock is now at $6.50/share.
I love buying stocks that people hate. This company fitted that description to the T. A dirty energy stock in the dumps. The Environmental, Social and Governance crowd hates this industry. They hate it so much the industry has a hard time getting financing. I started buying it when the price of their commodity started to move upwards. No one was watching the industry then. I felt like the only one despite the massive operating leverage that was about to happen. I was forecasting this company to generate almost half of their market cap in free cash flow in 2022. The stock has more than doubled now. I am currently invested in two of their competitors here and here.
Another great way to make money in the market is to screen for companies that have just emerged from bankruptcy. Typically when a company emerges from bankruptcy it is trading at a significant discount to its intrinsic value and most of the time is trading on the OTC boards. This company fit that situation. It might be one of the most undervalued securities out there. Peers are trading 2-3x the value, despite this company being the best operator in the industry. But given the ugly history and OTC status, almost no one even knows this company exists. And now with the new SEC laws, it is almost impossible to buy the stock, unless you are doing private transactions with a broker.
Mix international and microcaps and you get some cheap valuation discounts. This company, which I pegged “the cheapest stock I know”, is literally one of the cheapest stocks out there. The company recently announced an asset sale that will bring in almost their entire market cap in cash. In addition they have a couple other business segments that are worth just as much as the asset they sold. At the current valuation I expect significant upside and very little downside. This stock is the largest stock in my portfolio as I think the potential upside, significantly trumps the downside, which I think is very little.
Those are just a few examples of past stocks that I have owned, or own. In almost all cases the stock had a tiny market cap, there was very — if little — institutional coverage, and each equity was trading significantly below its intrinsic value.
If you would like to learn more about my investing strategy and what I invest in, consider joining Alpha Letter Pro. With Alpha Letter Pro subscribers get 1-2 high quality stock research reports per month that I am fully invested in. These research reports will be on companies no one else on Wall Street is talking about. They are the most off the beaten path investments out there.
If you want to see any example of a past research report, please reach out to me by replying to this email.