This guest post on Value Investing vs Deep Value was written by Net Net Hunter member Jonas Åström. Jonas is a private investor from Stockholm, Sweden. Article image (creative commons) by qimono, edited by The Broken Leg.
Value investing vs deep value: what’s the difference? Does it really matter if you choose the former or the latter as your investing strategy?
One of the most common mistakes made by investors is to not consciously decide on an investment strategy. Following the crowd leads to underperformance, maybe by a few percentage points per year. Doesn’t sounds too bad, no? WRONG! With compounding, we’re talking about leaving potentially millions of dollars on the table over a lifetime of investing. The choice you make between value investing and deep value investing is crucial — and could make the difference between good and great returns.
Over and over again, research has proven that deep value strategies outperform “normal” value investing strategies based on such metrics as low PE, low P/B, and P/FCF. There is quite a lot of research available on the subject, and I strongly recommend you to read it — or even better, read what Tobias Carlisle has summarized in his great books, The Acquirer’s Multiple” and Deep Value. Value strategies outperform the market by a lot and deep value strategies even more. Tobias focuses on his “Acquirer’s Multiple” strategy, but other deep value strategies (such as net net) also have proven to show similar outperformance.
Deep value — an ignored approach
If you want the same results as the rest of the investment community, do exactly like they do and follow what is popular right now. That is a great strategy to not look like a fool; no one will ever blame you, and you will not feel lonely — but you will not reach your investment goal as quickly.
If you want to significantly outperform the market, you can’t do index funds, MA200 investing, or even Buffett-style investing (honestly, you’re not Buffett). You need to find your own contrarian strategy. The choice when comparing value investing vs deep value will make a big difference just because of the fact the everyone knows about “Buffett style” investing. Being different gives you a head start.
It is very unlikely that popular strategies such as index, MA200, or great company Buffett-style will point you to the type of stocks that a deep value strategy singles out. That means fewer people, and fewer people also means larger price movements and larger ask-bid spreads. Small deep value investors can, and should, exploit this. It is not uncommon to see a deep value stock trade down or up 10-15% in a few trading days. All it takes is for someone to sell a large chunk of the outstanding stocks, and that has a pretty large price impact. This gives you an opportunity to capture an extra 10-15% when you buy and sell shares.
Full- or part-time investor
Be honest: are you really a full-time investor? Can you spend 50 hours a week analysing stocks? It is an important question to ask oneself, and it is very important to be honest. There is a big difference in how you want things to be and how things really are. I’ve made this mistake myself, and it is very counterproductive for your investment returns. Comparing the investment mechanics behind value investing vs deep value investing shows that it is easier to follow a deep value investing strategy. The reason is simple — a deep value strategy is easier to implement as you rely on the company’s current balance sheet, and you don’t need to add your own guesses about the company’s future profitability as you would for a value stock.
Analyzing a value stock requires you to look at the past and then make a forward projection of the company’s future cash flow so you can justify the current stock price. That requires a lot of segment- and company-specific knowledge, and to get diversification you might need to learn about several segments such as retail, automotive, banking, and technology. It is not an easy task and takes lots of time.
Analyzing a deep value stock is quicker. You can follow some well-defined metrics, with the most important one being existing assets minus debt vs. current market capitalization. There are, of course, many more parameters you want to check, but that is relatively easy compared to making estimates of future cash flow.
Mean reversion — ugly becomes beautiful
Capitalism creates a phenomenon called mean reversion, which basically means that profits gravitate toward the average over time. This applies to most companies and is caused by a few factors. If a company dominates its segment and has big profit margins, that attracts more competitors that want a part of the pie. The contrary also applies — if a company has been losing money for a long time, there is huge pressure to reform and restructure the company to become profitable again. People fight for their jobs and will not give up easily. That is why a highly successful company suddenly runs into problems, and it is also why bad and ugly businesses recover.
Companies showing up on a deep value screener are normally bad businesses, completely ignored and hated by the investment community. This is why they become so cheap in the first place. An improved product offering, new management, an activist investor, or even a competitor’s mistakes all could trigger the mean reversion needed to unlock the company’s inherent value.
Deep value stocks are ugly but eventually revert to the mean, and that is a good thing for you and your wallet.
Value investing vs Deep value – deep value outperforms
Now, it is pretty clear that a small investor should opt for a deep value strategy instead of a generic value investing strategy. The advantages can lead to outperformance by several percentage points or more. Even a “small” 3% outperformance over an investment life of 20 years — remember to not switch strategy as others might — will give you a whopping 80% compounded outperformance. That’s why squeezing that last 2-3% of return matters!
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