Deep Value (Wiley Finance)

1. Deep value investing targets undervalued, out-of-favor stocks

Deep value is investment triumph disguised as business disaster.

Essence of deep value. Deep value investing focuses on buying stocks trading at significant discounts to intrinsic value, often due to temporary problems or market pessimism. These stocks are typically:

• Out of favor with investors
• Facing short-term challenges or setbacks
• Trading below liquidation or net asset value
• In industries experiencing cyclical downturns

The strategy aims to profit from the gap between price and value closing over time as the company's fortunes improve or the market recognizes the stock's true worth. Deep value investors like Benjamin Graham viewed this as providing a "margin of safety" to protect against permanent loss of capital.

2. Mean reversion drives returns in deep value investing

Abnormally good or abnormally bad conditions do not last forever.

Power of mean reversion. The core premise of deep value investing is that business performance and stock valuations tend to revert to historical averages or industry norms over time. This manifests in several ways:

• Poor performing companies improving operations
• Overvalued stocks declining in price
• Undervalued stocks appreciating
• Industry conditions normalizing after booms/busts

Research shows stocks with the worst recent performance tend to outperform going forward, while previous top performers lag. This counterintuitive dynamic creates opportunities for deep value investors to profit by betting against the prevailing trend and market sentiment.

3. Activism can accelerate value realization in undervalued companies

We know from experience that eventually the market catches up with value. It realizes it in one way or another.

Catalyst for change. Activist investors like Carl Icahn aim to unlock value in underperforming companies through board representation, management changes, operational improvements, strategic shifts, or capital allocation changes. Key activist tactics include:

• Proxy contests to gain board seats
• Public pressure campaigns
• Pushing for spin-offs or asset sales
• Advocating for increased dividends/buybacks

While not all deep value investors engage in activism, the threat of activism can motivate management to make value-enhancing changes. Studies show activist interventions tend to generate above-market returns, particularly when pursuing well-defined objectives.

4. Quantitative metrics help identify deep value opportunities

We found that the enterprise multiple, and Greenblatt's EBIT variation in particular, does the best job of identifying undervalued stocks.

Screening for value. Quantitative metrics and screening tools can help identify potential deep value opportunities, including:

• Price-to-book value ratio
• Enterprise value-to-EBIT multiple
• Net current asset value
• Earnings yield

Research shows the enterprise value-to-EBIT multiple has been particularly effective at identifying undervalued stocks across different time periods and markets. Combining multiple value metrics can further improve results. However, quantitative screens are just a starting point and should be complemented with qualitative analysis.

5. Behavioral biases create deep value opportunities

We tend to reward others when they do well, and punish them when they do badly, and because there is regression to the mean, it is part of the human condition that we are statistically punished for rewarding others and rewarded for punishing them.

Exploiting market inefficiency. Deep value opportunities often arise due to behavioral biases and cognitive errors that cause investors to overreact to negative news and extrapolate recent trends too far into the future. Common biases include:

• Recency bias
• Loss aversion
• Herding behavior
• Overconfidence

By maintaining emotional discipline and taking a contrarian stance, deep value investors can profit from these widespread psychological tendencies. Understanding behavioral finance principles helps explain why deeply undervalued stocks persist and eventually rebound.

6. Deep value investing requires patience and contrarian thinking

Our native intuition is wrong, and our reasoning apparatus poor under conditions of uncertainty.

Psychological challenges. Successful deep value investing often requires:

• Buying stocks others are actively selling
• Holding positions for extended periods
• Tolerating paper losses and volatility
• Resisting the urge to sell at the first sign of a rebound

This approach runs counter to human instincts and can be psychologically challenging. Deep value investors must cultivate emotional discipline, independent thinking, and a long-term perspective to overcome these natural tendencies and stay the course.

7. Corporate governance and capital allocation are key focus areas

Management is one of the most important factors in the evaluation of a leading company and it has a great effect upon the market price of secondary companies.

Importance of governance. Deep value investors scrutinize corporate governance and capital allocation decisions, as these factors significantly impact long-term shareholder value. Key areas of focus include:

• Board composition and independence
• Executive compensation structures
• Capital expenditure and acquisition track record
• Dividend and share repurchase policies

Poor governance and misaligned incentives can destroy value and prevent undervalued stocks from rebounding. Activist investors often target these areas to drive improvements and unlock shareholder value.

8. Deep value stocks offer asymmetric risk-reward profiles

Stocks with big market price gains and historically high rates of earnings growth tend to grow earnings more slowly in the future, and underperform the market. Stocks with big market price losses and historically declining earnings tend to see their earnings grow faster, and outperform the market.

Favorable odds. Deep value stocks often offer asymmetric upside potential relative to downside risk due to:

• Low expectations priced into the stock
• Potential for multiple expansion as sentiment improves
• Room for operational and financial improvement
• Limited downside if trading below net asset value

While individual deep value stocks can be risky, a diversified portfolio tends to outperform with lower volatility than the overall market. This dynamic creates a favorable risk-reward proposition for patient investors.

9. Industry structure and competitive dynamics impact deep value

High returns invite new entrants who compete away profitability, while losses and poor returns cause competitors to exit, leading to a period of high growth and profitability for those business that remain.

Contextual analysis. Deep value investors must understand industry dynamics and competitive positioning to assess whether a company's struggles are temporary or structural. Factors to consider include:

• Barriers to entry and competitive advantages
• Industry capacity and supply-demand balance
• Technological disruption and obsolescence risk
• Regulatory environment and policy shifts

Companies in secularly declining industries may be value traps, while temporary industry downturns can create compelling deep value opportunities as weaker players exit.

10. Successful deep value investors combine quantitative and qualitative analysis

The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information.

Holistic approach. While quantitative screens can identify potential deep value candidates, thorough qualitative analysis is crucial for separating genuine opportunities from value traps. Key qualitative factors include:

• Management quality and incentives
• Competitive positioning and industry trends
• Balance sheet strength and liquidity
• Potential catalysts for value realization

Successful deep value investors like Seth Klarman emphasize the importance of understanding the business model, industry dynamics, and potential risks. However, they also warn against analysis paralysis and the pursuit of perfect information, which can cause investors to miss attractive opportunities.

Last updated: July 31, 2024