Today Early Retirement Extreme presents a guest post by Saj Karsan from Barel Karsan that introduces the concept of hands-on value investing in the small cap universe. I use similar strategies and Barel Karsan is one of the few blogs I read daily. If you want to watch value investing in action, you should subscribe to their RSS feed.

On the road to early retirement, one of the most important things you must do is to ensure that your savings earn a decent rate of return(*). Achieving better returns is easy to say, but how are you supposed to achieve it? It won’t be by pouring your hard-earned savings into the day’s hottest investment (oil today, housing yesterday, tech stocks the day before). Participants in these “hot” markets overpay for these issues, and thereby incur downside risk. Better returns won’t come from mutual funds either, which are known to underperform the market thanks to their fees and short-term herd mentalities, as discussed here. Instead, you’re going to have to earn your returns just like you earn your salary from working and just like you earn your savings from cutting expenses.

To illustrate, let me use an example. If you knew of a company that was for sale for $25 million, but had inventory and accounts receivable worth over $80 million, and total liabilities of just $40 million, would you be interested? You would be buying $40 million of liquid assets for $25 million…but who has $25 million lying around? Fortunately, the stock market sells you much smaller chunks of these types of companies, but the ratio of what you’re going to own to what you have to pay is just the same!

In fact, the stock market contains a plethora of small cap companies that no analysts follow and that no institutions hold…these small stocks are just too tiny for paid analysts and large funds to pay attention to. As a result, for the prudent investor who is willing to look for the handful of gems among these issues (and finding these do take effort, for such blatant mispricings are few and far between), the promise of better investment returns along with downside risk protection holds true.

At Barel Karsan, we try to find companies worth $1 that sell for 50 cents (see here for one such example). We identify such companies, we discuss them, and we hold onto them until the market recognizes their true value. This investment strategy has been practiced by Warren Buffett, Ben Graham, and countless other value investors and has served them all well. It can do the same for you.

(*) A 1 percentage point move in your rate of return can have a monumental effect on your savings over a period of several years. For example, $100,000 becomes $760,000 after 30 years at 7%, but runs over $1 million at 8%.

Much thanks to JH for the donation.

Originally posted 2008-09-15 00:54:48.