Quantitative Deep Value Investing: The Best-Known Secret in Investing

This article on quantitative deep value investing was written by Jack Lyons. Jack has worked as an equity analyst and auditor in Dublin, Ireland. He focuses on applying a quantitative net net and Acquirer's Multiple strategy in his personal account. Article image (Creative Commons) by cafecredit, edited by Broken Leg Investing.

Are you missing the best known secret in investing?

The great theoretical physicist Richard Feynman once said:

“Mathematics is a language plus reasoning; it is like a language plus logic. Mathematics is a tool for reasoning.”

With this quote, Feynman captured the essence of quantitative deep value investing — one you really have to harness to invest well. Let me explain…

The Extremes of Quantitative Deep Value Investing

In practice, the investing spectrum can be measured by the level of subjectivity that is applied to such analyses. At one end is quantitative deep value investing (long term), which bases investment decisions purely upon a specific number/ratio/percentage or numbers/ratios/percentages. While not all value investors exactly fit this category, they all rely heavily on this quantitative deep value investing approach. At the other end of the spectrum is the purely subjective and speculative trader, who buys and sells securities based on their view on the short-term direction of the market.

While there is clear evidence that proves which end of the spectrum works best (which we will discuss in this article), in his book Margin Of Safety, Seth Klarman summarises this point best:

“Mark Twain said that there are two times in a man's life when he should not speculate: when he can't afford it and when he can. Because this is so, understanding the difference between investment and speculation is the first step in achieving investment success.”

“Speculation” is defined as “the forming of a theory or conjecture without firm evidence.” As such, speculation is typically not the best approach to a problem. Whatever the discussion, people have a very hard time believing something unless “firm evidence” is placed in front of them. However, for some reason, the minute we begin to talk about which stock to invest in, such quality assurance characteristics seem to dissipate.

Why One End of the Spectrum Works Better

Klarman explains the key differences between quantitative deep value investing and speculation quite well:

“To investors stocks represent fractional ownership of underlying businesses and bonds are loans to those businesses. Investors make buy and sell decisions on the basis of the current prices of securities compared with the perceived values of those securities. They transact when they think they know something that others don't know, don't care about, or prefer to ignore. They buy securities that appear to offer attractive return for the risk incurred and sell when the return no longer justifies the risk.”

Speculators follow a different path:

“Speculators, by contrast, buy and sell securities based on whether they believe those securities will next rise or fall in price. Their judgment regarding future price movements is based, not on fundamentals, but on a prediction of the behavior of others. They regard securities as pieces of paper to be swapped back and forth and are generally ignorant of or indifferent to investment fundamentals. They buy securities because they ‘act’ well and sell when they don't. Indeed, even if it were certain that the world would end tomorrow, it is likely that some speculators would continue to trade securities based on what they thought the market would do today.

Speculators are obsessed with predicting-guessing-the direction of stock prices. Every morning on cable television, every afternoon on the stock market report, every weekend in Barron's, every week in dozens of market newsletters, and whenever businesspeople get together, there is rampant conjecture on where the market is heading.”

The use of fundamental analysis allows quantitative deep value investing defenders to make objective decisions regarding their investment habits. In direct contrast, speculators decide instead to focus more on what they think the future holds, moving them far away from the realm of objectivity.

What’s perverse about speculators’ tendency to ignore firm evidence is that this ignorance is the exact reason that they underperform the market. As soon as investors begin to apply their own opinions to their investment decisions, their performance falls dramatically. In fact, Joel Greenblatt directly observed this phenomenon. He found that the more active an investor was and the greater the volume of subjectivity applied by retail investors to their investments, the worse their performance seemed to be; those who picked their stocks statistically and never looked at their accounts again did better than those who applied their own views.

This is amazing, and at least a little bit surprising. It is also the exact reason that this phenomenon is the best-known secret in investing!

The Grey Area of the Investing Spectrum

The investing spectrum becomes less black-and-white when observing the bit in the middle. This middle ground is typically the territory in which most Wall Street analysts reside. This cohort focuses on a mixture of both fundamental quantitative deep value investing (objective) and predictive (subjective) techniques in order to form investment decisions. One such technique — and a favourite amongst the analyst community — uses Net Present Value (NPV) and Discounted Cash Flow (DCF) calculations. This method analyzes company fundamentals to form predictions of future free cash flow growth within a business.

The trouble with this approach is that, although it involves and requires a deep knowledge of the company’s fundamental drivers, it also assumes that analysts can make accurate predictions regarding the growth that the company will enjoy well into the future. When put in such simple terms, anyone even attempting to make such forecasts would seem to be foolhardy. However, as I said before, these techniques are some of the most popular valuation methods on Wall Street.

As Klarman puts it:

“When future cash flows are reasonably predictable and an appropriate discount rate can be chosen, NPV analysis is one of the most accurate and precise methods of valuation. Unfortunately future cash flows are usually uncertain, often highly so. Moreover, the choice of a discount rate can be somewhat arbitrary. These factors together typically make present-value analysis an imprecise and difficult task.”

Klarman hammers this point home with this simple comparison:

“A perfect business in terms of the simplicity of valuation would be an annuity; an annuity generates an annual stream of cash that either remains constant or grows at a steady rate every year. Real businesses, even the best ones, are unfortunately not annuities. Few businesses occupy impenetrable market niches and generate consistently high returns, and most are subject to intense competition. Small changes in either revenues or expenses cause far greater percentage changes in profits. The number of things that can go wrong greatly exceeds the number that can go right. Responding to business uncertainty is the job of corporate management. However, controlling or preventing uncertainty is generally beyond management's ability and should not be expected by investors.”

Ultimately, if humans had the ability to predict the future with precision, the DCF and NPV valuation techniques would be the most accurate of all. However, because we cannot see the future, they are not the most useful techniques.

Invest at the Right End of the Spectrum

As soon as we investors can accept that humanity’s ability to predict the future is limited at best, we can begin down the road to becoming a successful investor. In fact, as far as Klarman is concerned, the successful quantitative deep value investing supporter will live by one simple rule: Capital preservation.

“Value investors, by contrast, have as a primary goal the preservation of their capital. It follows that value investors seek a margin of safety, allowing room for imprecision, bad luck, or analytical error in order to avoid sizable losses over time. A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes. It is adherence to the concept of a margin of safety that best distinguishes value investors from all others, who are not as concerned about loss.”

Speculation-driven decisions tend to lead to poorer outcomes than those that are evidence-based. We want to minimize the degree to which subjectivity and speculation impact our investment decisions. We instead want to maximize the degree to which we make these choices using quantitative deep value investing strategies and fundamental factors with a high margin of safety. Only by following these rules can we ensure that we are maximizing long-term returns while minimizing the risk of permanent capital loss.

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.