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Deep value investing was the original investment style Warren Buffett used while he was learning under his mentor, Benjamin Graham, early in his investment journey.
Between 1957 to 1969, Warren Buffett enjoyed the best returns of his career and generated a compounded annual growth rate 29.5% applying the deep value method taught by Benjamin Graham. Since then, as Buffett’s investment capital has grown exponentially larger over the years, he has had to change his investment style and invest in large, high-quality business with a strong competitive advantage in order to continue growing Berkshire’s multibillion-dollar portfolio.
But make no mistake, deep value investing was where Buffett made his highest returns early in his career when his capital was smaller and he was able to invest in deep value stocks. As the Oracle of Omaha himself said:
“The highest rates of return I’ve ever achieved were in the 1950’s. I killed the Dow. You ought to see the numbers. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.” – Warren Buffett
So what is deep value investing?
In a nutshell, instead of chasing future growth and future stock returns, deep value investors look for undervalued stocks with a large margin of safety between value and price. So instead of predicting how well a company might (or might not) perform in the next year few years, deep value investors are more concerned about protecting their downside and getting a good price out of their investment today – and the upside naturally will take care of itself.
Here are 6 things you need to know about deep value investing:
Deep value investing focuses a lot on stock valuations because the price you pay determines how well you do. The rationale behind this is because when a company is so deeply undervalued even by long-term historical measures, your risk of losing money is lower and your odds of getting a sizable return is higher. There is a reversion to the mean.
Even better still, some companies trade below their net current asset value (NCAV), which means even if the business goes on to liquidate itself, you will still make money out of it. We call these net-net companies. To obtain NCAV, you take current assets (while discounting a few items) less total liabilities. If a company’s market capitalization is trading significantly below its NCAV, you have a good margin of safety to buffer for any possible unforeseen circumstances.
Many times, deep value companies have rather fair business models and that’s ok because as a deep value investor you’re less concerned about wide economic moats and sustainable future growth than stock valuations. This is NOT to say that you should invest in crappy companies. For example, photo film printing has been made obsolete by digital photography and you want to avoid this kind of companies even if they’re dirt-cheap because the value of the company is continually being eroded.
Similar to its business model, a company’s management team may not be an ‘A-team’ or the best in its industry simply because the most talented people usually run the best companies. But what’s more important in deep value is that the management must still be aligned with your interests as a minority shareholder, in order for you to unlock your value in the company.
Always look for a safety net when investing in deep value companies. You do not want to invest in a company that is heavily in debt. A company struggling with debt usually means its business is unprofitable and burning cash just to survive. Besides increasing your risk, the last thing you want is to have debt dig a sinking hole for a company even faster.
When using the deep value strategy, many of the companies you invest in will be facing tough times – which is why stock prices are depressed in the first place. Because of this, you don’t want to concentrate all your capital in just a few deep value stocks. Your portfolio allocation should be diversified into a good number of deep value stocks to spread your risk out. Hence, if any one of them went bust, you will not be drastically affected because it is just a small percentage of your overall portfolio.
“The stock market is a device for transferring money from the impatient to the patient.” – Warren Buffett
Being patient is the key to successful investing. When you invest in deep value stocks, don’t expect the company to recover immediately. Because a deep value stock is usually in a difficult situation, it may take time for the company to recover and eventually turn around. But when it does, stock prices will ultimately move up and earn you a nice return. You can then exit and move on to another deep value idea.