This article on how to invest in value stocks was written by Luis C. Sánchez. Luis is a lawyer and private investor in Bogotá, Colombia who focuses on
Learning how to invest in value stocks, at its core, is about overcoming irrational fears.
Indeed, considered individually, deep value stocks seem like a terrible investment prospect. For any individual company to sell below its asset values, something about its business, industry, or management has to look scary.
However, if you zoom out and look at these companies from a group perspective, you’ll see that they are not scary at all.
As Philip Tetlock puts it, to make accurate predictions or forecasts, you have to select the right base rate.
Looking at deep value stocks from the perspective of the right base rate shows that their returns are actually quite spectacular. In fact, selecting deep value stocks with carefully crafted criteria can boost an investor’s expected returns nicely.
To illustrate my point, let me tell you a story about irrational fears and how gaining the right perspective allowed me to get past them.
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How to Invest in Value Stocks: Overcoming Irrational Fears
As a kid, I loved flying on airplanes. I enjoyed everything about flying: take-off, the view from 30,000 feet high, landing, and even turbulence. I dreamt about being a pilot one day.
Then one day in 2009, when I was a teenager, an Airbus A330 crashed in the Atlantic Ocean. Everyone died. The next day, I had to fly on an A330 across the Atlantic.
As I walked down the entrance ramp and rounded the corner to see the open door of the A330, my chest tightened and my pulse quickened. Stepping through the threshold, I couldn't help feeling that I was stepping into my own coffin.
That feeling just got worse over my next couple of flights. I panicked every time I boarded a plane. My childhood dreams were over — I didn’t enjoy flying anymore. I avoided traveling by plane altogether for at least two years.
But you can’t run away from your fears all your life. At least I couldn’t. As it turns out, I read a magazine one day and found some interesting facts: the odds of dying in an airplane accident are about one in 11 million, the odds of dying in a car accident are about one in 5 million, and the odds of dying in a shark attack are of about one in 3.1 million. Even if a plane does crash, the odds of actually dying are very low. In fact, 95.7 percent of people involved in airplane accidents survive.
What now? Driving my car every day to work down the highway was two times more dangerous than flying!
Still, my fear was very irrational, and I didn’t want to take a plane yet. That’s when learning about cognitive biases came in handy. One of these cognitive biases is the base rate bias, which states that when exposed to both base rate information and specific information, the mind tends to focus on the latter. So, if I constantly recalled airplane accidents — the specific information, which is permanently available on the news — I would perceive air travel as very risky even though the base rate (the general information) didn’t support that conclusion.
In short, I had to force my mind to focus on the correct base rate. Plus, I had to fly.
So I did, and it felt great! Although admittedly, it was only after four or six flights that I actually came to enjoy flying again.
How to Invest in Value Stocks: Selecting the Right Base Rate
How does this story relate to investing in deep value stocks? As I said, learning how to invest in value stocks, at its core, is about overcoming irrational fears.
Let’s say I offered you a bet where I tossed a coin and if it landed heads, you would give me $100, but if it landed tails, I’d give you $200. You’d probably decline my offer as there is a 50 percent chance you lose $100, given that the pain of loss is psychologically twice as powerful as the joy of winning.
However, if I offered you the same bet but repeated it 100 times, your chances of losing any money would be only 0.0004%. You’d probably take the bet.
If you find a company selling below its net asset value, you’ll probably see a dark picture. The stock is cheap for a reason. You decline that bet.
However, if you add similar bets on a portfolio of deep value stocks, you’ll see that the odds are actually on your side. By adding bets where the probability of permanent loss is smaller than the probability of gain, the overall risk substantially decreases.
That is the correct base rate from which to assess the risk of investing in deep value stocks.
How to Invest in Value Stocks: The 60% Rule
Yes, some of your bets in deep value stocks will fail. Even the superinvestors know that only about 60% of their bets work out.
In fact, it was Peter Lynch who said that he was right six out of ten times when he selected stocks, yet he achieved an annual compound rate of 29%. Seth Klarman, another great value investor, said only 64% of his stocks were winners, although he earned 20% a year.
When investing in the stock market, you can’t ever be 100% right. But a portfolio of deep value stocks consists of a group of bets with an asymmetric risk/reward spectrum, and so, even if some of them fail — and they will — you’ll end up winning.
How to Invest in Value Stocks: Boost Your Returns With Additional Criteria
Investing in a portfolio of deep value stocks, much like air travel, is actually quite safe. Your chances of losing money are statistically very low in the long run.
But what about the returns? As it turns out, by adequately selecting a base rate and adding some further criteria, you can expect fairly predictable — and quite substantial — returns on a portfolio of deep value stocks, as you’ll see.
I owe you some further explanations at this point. When deciding how to invest in value stocks, depending on how conservative your valuation of a company is, you get different groups of deep value stocks.
For example, the most conservative valuation method consists of taking the current assets of a company, then subtracting all the company’s liabilities, preferred stock, and off-balance sheet debt to get the liquidation value of the company. These are called net nets — Ben Graham’s favourites.
Now, if you take all tangible assets of a company — i.e., you exclude intangible assets such as goodwill and the like, but still include tangible fixed assets — minus all its liabilities, you get the net tangible asset value (NTA). While a less conservative valuation method than liquidation value, a portfolio of stocks at prices two-thirds below NTA still outperforms the market. These were Walter Schloss’s favourites after he couldn’t find enough net nets in the US stock market to stack up his portfolio.
Still, within any group of deep value stocks, you can find subgroups that perform even better. For example, by adding criteria such as share buybacks or the absence of debt, a market cap between US$1 and US$100 million, and a price less than 40% NTA to the group of stocks selling at prices below NTA, you get the subgroup of stocks called “Ultra,” a term coined by Broken Leg Investing.
By accurately selecting our base rate — i.e., stocks selling at prices below NTA — and adding criteria that statistically increase the chances of picking winners, we can boost our portfolio returns. To be clear, backtesting shows that a portfolio of stocks selling at two-thirds NTA offers average annual returns of about 15%, while a basket of Ultra stocks offers average annual returns of about 27%. Impressive, right?
To paraphrase the old maxim, don’t lose sight of the forest of deep value stocks for each individual stock in your portfolio. A single stock may look scary, but a portfolio full of them is actually quite safe — and if properly selected using carefully crafted criteria, has fairly predictable and spectacular annual returns.
I actually enjoy investing in deep value stocks, like I enjoy air travel now, but the effort needed to find these bargains would be unbearable if I didn’t have The Broken Leg Investing to shortlist them for me first.
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