Deep Value or Buffett’s Moats: Which Should You Buy?

This guest article assessing whether you should buy deep value or Buffett's moats was written by Net Net Hunter member Kevin Pumphrey. The opinions expressed here may or may not reflect those of anyone else at Broken Leg Investing. Article image (creative commons) by Dean Hochman, edited by the Broken Leg Investing.

Should you invest in deep value or Buffett’s moats? Maybe Deep Purple can help…

For those of you, like me, who learned how to play guitar listening to Classic American Rock n’ Roll – You just can’t tell me that the first riff you ever learned wasn’t “Smoke on the Water” by Deep Purple because it was. You know it…I know it…we ALL know it…  I mean, it’s practically a rite of passage. I can still hear that simple, catchy riff droning away right now as if it was the first time I ever heard it. All four notes of those sludgy power chords just bring me back to my youth. You can hear it right now, can’t you? Yeah - You’re welcome.

Deep Value or Buffett's Moats: Making the Shift is a Rite of Passage

Today I’m here to offer you a bit of consolation on the deep value or Buffett's moats question. I want to let you know that we’ve all been through it, and you’re not alone. Warren Buffett is arguably the greatest investor that’s ever lived. He’s a living legend… It’s only logical to think that we can just copy his strategy, right?! Well, I hate to dash your dreams so early on in this article, but because we’re friends I want to be candid with you.  Don’t bother.

Just like my early days of wailing on a $100 guitar with 6-month old, rusty strings, this Warren Buffett wide-moat notion, too, is a rite of passage. Now, undoubtedly some of you may go on to pursue Buffett’s compounder strategy and a few of you may even be successful. But to be curt, most of you won’t.

As small investors, the odds of success are significantly in our favor as compared to the professionals. While the big boys compete over who can prophesy the ‘winners’ of just a few hundred over-analyzed businesses, we have access to thousands upon thousands of potential investment candidates. This article will seek to establish that for smaller investors, deep value investment strategies are far superior to high-quality, durable competitive advantage (moat) pursuits, while also providing examples and stimulating further discussion on the topic.

Deep Value or Buffett's Moats: Size Really Does Matter

Value investors generally operate under the assumption that markets are not always efficient. In fact, in certain circumstances markets are outright ludicrous!  Tell me – in what universe is the opportunity to buy $1 worth of liquid assets for 50 cents not a good deal?! The micro-cap and nano-cap universe of stocks lend themselves quite well to this type of market inefficiency and ultimately, mispricing. Analysts have no interest in covering these tiny, unknown companies. These businesses have essentially been left for dead with no one willing to put their reputation on the line to even throw up an SOS. Further, institutional ownership is practically non-existent. We must bear in mind that these are highly illiquid stocks. The large institutions and high net-worth individuals just have far too much capital to deploy to take a position that will have any meaningful effect on their portfolios. Ultimately, the major players tend to stay away from these opportunities.

I have always advocated investing only when you have an edge. One significant edge available to investors managing small sums is the inefficiency created in markets where no one is looking. Said edge is augmented by a relative absence of competition with large investors, of whom have access to significant resources not typically available to smaller operations. Such pervasive, systemic neglect leaves a reliably profitable, if not guerilla-warfare-esque, field of operation available to the small, enterprising investor.

Deep Value or Buffett's Moats: Where's the Evidence??

Buffett’s wide-moat strategy is well understood, well documented, but generally not well executed. In fact, aside from the track records of a very select few superstar managers, there is not a significant depth of research to back claims that buying high-quality businesses with durable competitive advantages and holding for long periods will necessarily result in outperformance. Perhaps due to the subjectivity of a “high-quality business,” conceivably with many facets of selection being inherently qualitative, the pursuit of accurate and dependable data is, indeed, quite difficult to quantify.

On the other hand, deep value strategies’ results have been well documented over many decades. For instance, let’s explore Tweedy, Browne LLC’s infamous “What Has Worked in Investing – Studies of Investment Approaches and Characteristics Associated with Exceptional Returns.” Tweedy, Browne concluded that their research had “empirically confirmed that the fundamental approach to security analysis developed by Benjamin Graham, and long practiced by Tweedy, Browne, produces attractive long-term rates of return.” In their research, they explored several different approaches to selection including: Low Price in Relation to Asset Value, Low Price in Relation to Earnings, A Significant Pattern of Purchases by One or More Insiders, A Significant Decline in a Stock’s Price and Small Market Capitalization. To stay within scope of choosing between deep value or Buffett's moats, in this article I will confine myself to references to balance sheet e.g. (Low Price in Relation to Asset Value) analysis. Tweedy, Brown examined the historical returns on stocks with minimum market capitalization of $1 million ranging from 66% or less of Net Current Asset Value (NCAV) through up to 140% of book value. Not surprisingly, the most deeply discounted stocks made up a disproportionate amount of the total returns.

Tweedy, Browne white paper "What Has Worked In Investing" does a fantastic job highlighting the performance of deep value. Here, the firm showcases the performance of various price to book valuations and net net stocks. This is strong evidence when choosing between deep value or Buffett's moats.

Ultimately, this is just one example of many others that provide concrete and verifiable evidence of the long-term statistical return of deep value stocks as a group. As you can see, a diversified basket of deep value stocks (without applying any filters for quality) can produce outstanding returns over long periods of time. Such results should also acclaim the prospect of broad portfolio framing as critically essential. While it is certainly within the realm of possibility for some to earn similar (or perhaps even greater) returns using Buffett’s wide-moat strategy, the margin of error is markedly smaller.  

Deep Value or Buffett's Moats: Are You a Business Genius?

While seemingly elusive, significantly superior rates of return do not require an MBA from Harvard or a genius IQ. As a means to achieve such returns, one must be willing to faithfully adopt a contrarian disposition. He would do well to disregard Mr. Market’s manic-prone mood swings and the talking heads in the financial news.  

Deep value investors and moat investors represent two sides of the same spectrum. On one side is Mr. Buffett himself who once said, “Diversification is a protection against ignorance. It makes little sense if you know what you are doing.” For those who can accurately predict price movements and long-term prospects of businesses, he is irrefutably correct.

On the other hand, the research and statistics prove that even if a deep value investor is incorrect some of the time, he should end up crushing the performance of the major indexes in the long-run. It’s important to learn from those who have come before us and succeeded in ways that we, too, wish to succeed. I am no Warren Buffett, and no offence intended, but you probably aren’t either. And you know what? That’s ok! After all, there is NOTHING wrong with being more like Walter Schloss who once said,

“The thing about my companies is that they are all depressed, they all have problems and there’s no guarantee that any one will be a winner. But if you buy 15 or 20 of them…”

Enter your email address below because we’ll send you inside info on the best performing deep value investing strategies today PLUS a free copy of The Broken Leg Investment Letter.

This entry was posted in Uncategorized. Bookmark the permalink.