All Deep Value Funds Are Not Created Equal

This article on deep value funds not being created equal was written by Net Net Hunter member Bryan Shealy. Bryan worked in the inventory business for 5 years which gives him an edge in net net investing. Article image (creative commons) by DEZALB, edited by Broken Leg Investing.

I was avidly following a very interesting contributor on a well-known stock investing site. It was fascinating and amazing to see his insights and thoughts on these well-known large cap stocks. Then one day, he let slip how large his overall portfolio was. I was stunned. It was smaller than mine! Why was he investing in such large companies, and why should I take his advice? He was obviously an amateur who was giving up the single largest advantage he had.

His tale mirrors the story of when I first started actively investing. I mainly dabbled in a few large cap stocks that I expected to hold forever. That just was not cutting it. I was young and needed higher gains, so I decided to invest smaller. You see, unlike mutual funds, ETFs, hedge funds and deep value fund portfolios, I had an advantage. This advantage was my small portfolio size.

With deep value funds, size matters

By targeting much smaller companies, I was able to uncover a large number of deep value companies. You may ask, why couldn’t I just invest in a deep value fund and be done with it? They invest in companies that are deeply undervalued and much smaller than the large cap companies I had been purchasing. This should have been enough.

This, I soon found, was incorrect, since many deep value funds actually are forced to invest in larger companies for fear of purchasing too large a share of any single company. If they were to invest in truly great deep value companies, it would account for such a small portion of their portfolio, it would be insignificant — not to mention that they would be forced into lower quality stocks and bring down their overall return.

“In 2011 the average mutual fund had just shy of $1 billion under management. Most mutual funds don’t want to own more than 10% of the outstanding shares of any one company because of the regulatory issues and the possibility of spooking management who might fear a hostile takeover. On top of that, the fund manager can run into serious problems trying to find the market liquidity to buy or sell large chunks of a company.” (source)

You see, large deep value funds just can’t compete. Their portfolio size usually ends up being so large, they can’t even touch companies that have the greatest deep value potential. They also can’t buy in and out of a single stock over the course of a week. For a company worth less than $50 million, it would take the fund months to purchase enough in order to make a dent in its portfolio. There is also the possibility of pushing up the stock price, even with purchases spread over those long months.

But are all deep value funds created equally?

You see, not all deep value funds have the same amount of capital — some have more and some have less. The ones that have less can actually have better returns than the larger deep value funds, but this is not always the case.

The smallest deep value funds will likely have a much larger expense ratio, essentially negating some of your gains. Since there is so little capital, they will need a larger expense ratio to pay the bills. This extra cost and extra research may not even be beneficial for a small investor. You are essentially giving up knowledge for lower returns — which may be fine, but wouldn't you want to find the best performing deep value fund?

It takes nearly the same skills to distinguish a good fund from a bad one as it does to create your own deep value portfolio. For the skills that you don’t have, you can essentially purchase them on the cheap, compared to what you would lose in returns over time.

With this extra investment knowledge, you might also notice that many of the stocks in the deep value fund are not even that cheap anymore. These stocks could have risen so dramatically before you invested that you are essentially buying an overpriced stock. Rebalancing a deep value fund typically does not occur until it has owned the stock for at least a year. I don’t know about you, but if I’m going to invest in value, I want to make sure it actually has value.

What is a hedge fund? And why is it even worse to invest in deep value hedge funds?

A hedge fund is essentially a fund that not only can go long on stocks, but can also short stocks if the opportunity presents itself. If this sounds like a terrible combination with a deep value investor’s goals, you’re absolutely correct.

When investing in deep value, we generally want to reduce risk. Hedging sounds like a great way to reduce risk by shorting areas that are overvalued or going long on areas that are undervalued. However, instead of reducing risk, you are engaging in market timing and decreasing your overall chances of outperformance. This leads to a mediocre return with the best deep value hedge funds — and even negative returns on poor performing ones.

Hedge funds can invest in basically anything — land, real estate, derivatives, currencies and alternative assets. While a hedge fund can be designated as a deep value hedge fund, it may still have some of the assets listed above. This could be potentially destructive for value investors, since currencies or alternative assets are essentially a zero sum game. If you win or lose, you are still paying hedge fund fees and losing value.

Oftentimes, deep value hedge funds will underperform, but even the best managers will increase fund size and begin producing returns closer to the overall return of all hedge funds. Again, they will run into the size problem that plagues most deep value funds.

If you thought the problems with deep value hedge funds were not worse than deep value funds already, then consider that oftentimes they are only open to accredited investors with a net worth requirement over $1 million.

Take your advantage seriously

I hope this has helped investors like you understand the importance of your advantage as a small deep value investor. If you still believe investing on your own is too much work, at least leave with the knowledge that not all deep value funds are the same.

If you are interested in achieving the best stock returns of your life, do yourself a favor and take advantage of your small investor advantage. The Broken Leg investment letter will help by teaching you what is needed to invest in small deep value companies.

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