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Deep value investing is a strategy that requires patience and a long-term perspective. It involves buying undervalued companies with strong fundamentals that are likely to increase in value over time.
The key to deep value investing is to identify companies with a high margin of safety, which means their intrinsic value is significantly higher than their current market price. This is often achieved by looking for companies with a low price-to-book ratio.
A low price-to-book ratio indicates that a company's stock price is lower than the value of its assets, making it a potentially attractive investment opportunity. For example, a company with a price-to-book ratio of 0.5 is selling at half its book value, which could indicate undervaluation.
It's essential to conduct thorough research and due diligence before investing in any company, as deep value investing often involves holding onto stocks for extended periods.
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Investment Style
Benjamin Graham's investment philosophy is centered around a disciplined and rational approach to investing. He emphasizes the importance of analyzing a company's fundamental value rather than just looking at its current market price.
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Graham's approach focuses on buying stocks when they are cheap, which means finding undervalued companies with strong underlying fundamentals. He believed that rational investors should be able to identify opportunities where there's a significant difference between a stock's intrinsic value and its market price.
A key aspect of Graham's philosophy is his emphasis on margin of safety, which means only investing if there's a significant gap between the intrinsic value and the market price. This conservative approach allows investors to protect their capital and potentially profit from any discrepancies over time.
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Right Investment Style for You?
Deep Value investing is a game for the brave and contrarian individual investor. It's not for everyone, especially those who need quick access to their money or can't afford to lose.
The professional investor often struggles to play this game, as small caps are the typical cards dealt out. Liquidity in these stocks dries up when prices fall dramatically.
Individual investors can capitalize on the opportunities left by professional investors who can't play in the small and micro cap areas of the market. This is due to the pressure on fees from passive indexing.
Tight liquidity can be a double-edged sword, making it hard to buy or sell positions in illiquid stocks. It's a risk that must be carefully considered.
In spite of periods of underperformance, Deep Value investing is one of the most consistent return sources in markets. It's a long-term strategy that requires patience and a keen interest in financial statements.
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Characteristics
Deep value investors focus on intrinsic value, which considers a company's earnings potential, assets, management team, and competitive advantage. They understand that markets can be mispriced due to investor sentiment or market trends, but by digging deeper, they can spot opportunities others may overlook.
Benjamin Graham, the father of value investing, believed in a disciplined and rational approach to investing. He emphasized the importance of analyzing a company's fundamental value rather than just looking at its current market price.
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Contrarian investors also believe that markets are not always efficient or rational, and investors tend to be swayed by emotions such as fear and greed, leading to overreactions and mispricing in stocks. They capitalize on these mistakes by taking a contrarian approach.
Deep-value investors have a unique advantage in identifying undervalued stocks with significant growth potential by emphasizing intrinsic value rather than short-term gains or losses. They recognize that markets tend to overreact to news or events in the short term but ultimately revert back to reflecting a company's true worth.
A key aspect of deep value investing is the concept of margin of safety, which ensures enough room for potential mistakes or unforeseen circumstances. Benjamin Graham advocated for a significant gap between a stock's intrinsic value and its market price.
Contrarian investors are willing to question prevailing opinions and investigate fundamental factors, uncovering valuable insights that others have missed. By being contrarian, they can find opportunities others have overlooked.
Benjamin Graham's most compelling insight was that stocks occasionally trade for less than their actual liquidation value, presenting a golden opportunity for investors. He found that numerous stocks were trading below their net liquid assets during the Great Depression.
Additional reading: Benjamin Graham Value Investing
Bargain Hunting
Bargain hunting is an art that requires patience, discipline, and a keen eye for value. The opportunities are always there, but you need to know where to look.
Many people think that bargain stocks are a thing of the past, but that's not true. Even Warren Buffett, one of the most successful investors of all time, has moved on to other opportunities, but that doesn't mean the profits have dried up.
You can find bargains internationally when your own market gets pricey. Peter Cundill's Cundill Value Fund, which invested in global bargain stocks, generated 13.7% annualized returns between 1975 and 2010.
To find these bargains, you need to understand how acquirers think. They look for companies with low enterprise value relative to operating profits, which is known as the Acquirer's Multiple.
The Acquirer's Multiple is calculated as Enterprise Value / Operating Profits, and you want this number to be as low as possible. This is a better version of the P/E Ratio, which doesn't factor in net debt.
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By using the Acquirer's Multiple, you can identify companies that are more likely to be acquired and revalued. This approach has been backtested with impressive results, compounding at 18.6% annually over 44 years.
The market overreacts on the downside when companies have problems, leading to undervaluation and neglect. But what's remarkable is that valuations do not tend to stay cheap forever. Mr. Market eventually figures out the true valuation and reprices assets.
Mean reversion acts not only on the valuation of companies but also on their profitability. Cheap companies still have businesses and assets, and new management changes can often lead to profitability being revitalized.
The bargains are out there, and they can be found across the market cycle. In fact, our own market studies show that the number of "Ben Graham Bargains" changes through time, with more bargains appearing during difficult market periods.
At the time of writing, there are numerous bargain stocks available, with 171 sub-working capital bargains in Developed Europe, 41 in the UK, and 282 in the US.
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Stock Identification
To identify deep value stocks, we can use approaches like Ben Graham's "Net Net" stock evaluation, which focuses on a company's net current assets minus total liabilities. This method can help us find undervalued stocks.
One key principle in deep value investing is focusing on undervalued assets, which can come in various forms such as stocks, real estate properties, and commodities. By carefully analyzing financial statements, industry trends, and macroeconomic factors, we can uncover hidden gems trading at a discount to their intrinsic value.
Stocks like Meta, Apple, and Google are more likely to be affected by herd-mentality investing, whereas conglomerates like Proctor & Gamble or Johnson & Johnson are often overlooked. These undervalued assets can provide significant long-term gains for investors.
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Stock Identification
To identify undervalued stocks, focus on assets that are overlooked by the market due to negative sentiment or lack of media coverage. These assets can include stocks, real estate properties, and commodities.
Ben Graham's "Net Net" stock evaluation is a classic approach to identifying deep value stocks. It involves looking for companies with a low price-to-book value ratio, which indicates that the stock is trading at a significant discount to its intrinsic value.
You can also use the Acquirer's Multiple approach, popularized by Toby Carlisle, which involves looking for companies with a low acquirer's multiple, indicating that the stock is undervalued.
Don't get caught up in the hype of popular stocks like Meta, Apple, and Google. Instead, look for established companies like Proctor & Gamble or Johnson & Johnson that may be flying under the radar.
By focusing on undervalued assets and using fundamental analysis, you can uncover hidden gems trading at a discount to their intrinsic value. This requires careful analysis of financial statements, industry trends, and macroeconomic factors.
A low price-to-earnings (PE) ratio can be a sign that a stock is undervalued, making it a good candidate for value investing.
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Insider Activity
Insider Activity is a crucial factor to consider when identifying stocks. Insiders are the company's senior managers and directors, plus any shareholders who own at least 10% of the company's stock.
These individuals have unique knowledge about the company they run, so if they're purchasing its stock, it's reasonable to assume that the company's prospects look favorable. This is because insiders have a deep understanding of the company's inner workings and can make informed decisions about its future.
Investors who own at least 10% of a company's stock wouldn't have bought so much if they didn't see profit potential. They're essentially betting on the company's success and are willing to put their money where their mouth is.
A stock sale by an insider doesn't necessarily point to bad news about the company's anticipated performance. However, if mass sell-offs are occurring by insiders, it may warrant further in-depth analysis of the reason behind the sale.
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Risk Management
Risk Management is crucial for deep value investors, as it allows them to navigate the challenges of investing in undervalued companies. By understanding the potential risks, investors can make more informed decisions.
Identifying potential risks is a key part of risk management, and deep value investors should look for red flags such as high debt levels, declining sales, and poor management. This was the case with companies like Sears and General Motors, which were heavily indebted and struggling to stay afloat.
To mitigate these risks, investors can use techniques such as diversification, where they spread their investments across different asset classes and industries. This can help to reduce exposure to any one particular risk.
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Risks of
Value traps can occur when an investor believes they've found a deeply undervalued asset, but the investment fails to deliver expected returns.
Investors should be aware that undervalued assets might have low trading volumes, making it difficult to buy or sell positions without impacting the market price.
Limited market liquidity can lead to increased transaction costs and difficulties in exiting or adjusting positions in a timely manner.
Investing in companies with limited information available can create uncertainty and increase the risk of loss.
Without access to accurate and comprehensive information, investors may struggle to assess the true value or potential risks of their investment.
Losses can occur with value investing, despite it being a low-to-medium-risk strategy.
Investors should be prepared for visceral personal reactions when reviewing stocks on a Deep Value list.
Dealing with these challenges requires a thoughtful approach to risk management.
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Liquidity and Scalability
Liquidity and Scalability is a crucial aspect of risk management, particularly for deep value investors.
Deep value investing often involves undervalued stocks in niche markets, which can be a concern due to liquidity issues.
The acquirer's multiple strategy can be applied in large-cap universes like the S&P 500, maintaining robust performance.
This approach is scalable for institutional investors, making it a viable option for those with larger portfolios.
The S&P 500 is a large-cap universe that can provide a robust performance with the acquirer's multiple strategy.
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Portfolio Management
Concentrated portfolios can be effective, but they require extensive research and involvement with the management of the stocks.
Walter Schloss and John Templeton would buy 100 stocks or more, while Warren Buffett would put more than 25% of his portfolio in a single stock, but only after thorough research.
Owning a minimum of 16-20 deep value stocks is a more prudent approach for most investors.
Concentrate or Diversify?
Concentrate or diversify, that's the question. The answer depends on your mindset and level of research, just like Warren Buffett's approach.
Warren Buffett would put more than 25% of his portfolio in a single stock, but that's only after thorough research. He also regularly got heavily involved with the management of the stocks he bought.
If you're a full-time investor and genuinely know what you're doing, you may be able to run an effective concentrated portfolio with 8-10 stocks. For the rest of us, owning a minimum of 16-20 deep value stocks is a safer bet.
Joel Greenblatt, author of "How the Small Investor Can Beat the Market", advocated owning 20-30 stocks if you're buying stocks in groups.
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Running a Portfolio
A well-diversified portfolio typically has a mix of 10 to 20 holdings.
As a general rule, it's a good idea to rebalance your portfolio every three to six months to maintain your target asset allocation.
Rebalancing can help you avoid over- or under-investing in any particular asset class.
A portfolio with a high concentration of stocks in a single industry, such as technology, may be more vulnerable to market fluctuations.
Diversification can help reduce risk by spreading investments across different asset classes, such as stocks, bonds, and real estate.
Regularly reviewing your portfolio can help you identify areas where you may need to rebalance.
It's a good idea to set a regular schedule for reviewing your portfolio, such as quarterly or semi-annually.
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How Long to Hold Stocks?
Holding onto stocks for too long can actually decrease returns, with studies showing that the optimal holding period for net-nets is about a year.
Dealing costs do come into play, and some investors recommend selling on a 100% gain or after two years to avoid opportunity costs.
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Systematically buying and selling your whole portfolio on the same day is not recommended, as it's essential to use your judgement when managing a portfolio of illiquid stocks.
Beyond two years, the opportunity cost of holding onto a stock becomes too great, and it's often better to sell and move on to other investment opportunities.
Investment Strategies
Deep value investing is all about finding undervalued companies that have been overlooked or misunderstood by the market. Warren Buffett's approach is to hunt for these companies and focus on their intrinsic value rather than short-term price fluctuations.
To identify these companies, Buffett looks for businesses with strong competitive advantages or "moats" that allow them to maintain profitability despite changes in market conditions. He also emphasizes the importance of understanding a company's management team and its prospects for future growth.
Browne suggests researching a company's revenue potential by considering four key factors: raising prices, increasing sales, decreasing expenses, and selling off or closing unprofitable divisions.
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Here are some questions to ask when evaluating a company's potential for growth:
- Raising prices on products
- Increasing sales figures
- Decreasing expenses
- Selling off or closing down unprofitable divisions
By considering these factors and focusing on industries you're familiar with, you can make more informed investment decisions and increase your chances of success in deep value investing.
Strategies and Techniques
Warren Buffett's approach to deep value investing involves hunting for undervalued companies with strong competitive advantages or moats. He looks for businesses that can maintain profitability despite market changes or new competitors.
A key part of Buffett's strategy is to understand a company's management team and its prospects for future growth. He believes investing in competent and trustworthy people is just as crucial as finding undervalued assets.
To buy an undervalued stock, you need to thoroughly research the company and make common-sense decisions. Value investor Christopher H. Browne recommends asking if a company can increase revenue through price raises, increased sales, decreased expenses, or selling off unprofitable divisions.
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Studying a company's competitors can help evaluate its future growth prospects. However, the answers to these questions are often speculative and lack numerical data.
Investors can increase their chances of success by choosing stocks of companies that sell high-demand products and services. This approach is easier than predicting the success of innovative new products.
Here are some methods companies can use to increase revenue:
- Raising prices on products
- Increasing sales figures
- Decreasing expenses
- Selling off or closing down unprofitable divisions
Activism
Activism plays a crucial role in deep value investing by taking control of underperforming management and restructuring operations.
Activist investors often target undervalued companies to unlock shareholder value, providing a vital catalyst for mean reversion in the valuation of deep value stocks.
By helping to realize the intrinsic value of these companies, activists can be a powerful force in the investment world.
Activist investors can help unlock shareholder value by taking control of underperforming management and restructuring operations.
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Frequently Asked Questions
What is the book Deep Value Investing about?
Deep Value Investing" is about finding undervalued companies that can generate significant long-term returns, even if their assets were sold off immediately. This book reveals strategies for identifying genuine bargains in the stock market.
What is Warren Buffett value investing?
Warren Buffett's value investing focuses on a company's true worth, not just its stock price. It's about finding undervalued gems that offer long-term value and growth potential.
Sources
- https://www.stockopedia.com/academy/articles/deep-value
- https://www.phronimoscap.com/deep-value-investing
- https://gist.ly/youtube-summarizer/deep-value-investing-strategies-explained-by-toby-carlisle
- https://investordiary.com/what-is-deep-value-investing
- https://www.investopedia.com/terms/v/valueinvesting.asp
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