As deep value investors, we seek out low-risk investments that have great upside potential. Such ideal investments do not exist in the eyes of the academics.
Since the advent of the financial market, it is clear the deep value investing produces phenomenal performance over the long run. If your time horizon is more than 3-5 years, deep value investing is definitely the way to go.
Warren Buffett, a legendary value investor, best years were when his fund was still budding. When his funds were smaller, he was able to utilize the deep value approach to generate such phenomenal performance with annualized returns north of 20%.
Why does deep value work?
The idea of buying stocks that are cheaper than their value is very intuitive, but most investors still end up generating disappointing results.
The philosophy behind value investing is very simple and straightforward. It is precisely about buying bargain stocks and selling when their values are realized. But how should we go about determining the value of the stock and in turn judge how expensive it is?
Many experts in the industry simplified this process even further by taking numbers and ratios off the book and create their own algorithms for trading. Whatever happened to understanding the business behind the numbers?
Many retail investors developed a certain form of heuristics where they associate low price-to-book and price-to-earnings as it being a value stock.
Such misconceptions prove to be dire for the typical investor.
In this article, we will be exploring 4 key tenets that forms the foundation of the deep value investing approach:
Deep value investor’s approach to risk
“Rule 1: Never lose money. Rule 2: Never forget rule 1” Warren Buffett
Deep value opportunities often reveal themselves when we look for places that are most depressed and unloved. However, such places are littered with hopeless companies that are doomed to fail too.
There may not even be a price that is justified for the company’s value. These are traps that deep value investors may land ourselves into if do not obey the first principle of deep value investing.
Risk is not defined as the volatility of stock prices as espoused by the academics. Risk, to us value investors, is the risk of permanent loss of capital. This isn’t just applicable in the event of bankruptcy; the value of a business may permanently dip as a result of a permanent change in economics too.
If you approach investing by taking care of the downside risk first, the upside will take care of itself.
Deep value investors adopt margin of safety
First introduced by the founder of deep value investing, Benjamin Graham, and later popularized by Seth Klarman, the margin of safety is a key concept that should follow us whenever we carry out our judgement. The entire operation of investing from screening, analyzing and reviewing should revolve around the margin of safety.
To deep value investors, risk stems from uncertainty. The more uncertain our judgement is, the greater the risk is.
There are two ways of dealing with uncertainty: eradicate the uncertainty by searching for the information or having a greater margin of safety.
In order to eradicate this uncertainty, you will end up wasting most of your precious time and resources trying to dig out all the information. In the sea of hundreds of companies to screen for, it isn’t wise to be spending the entire day on just 1 potential investment.
Instead, deep value investors account for a substantial margin of safety in our analysis. This broadens the scope of companies we can invest in. We do not have to be fully cognizant of everything about the business but we just need to know most of the business. If things turn awry, we know that our price-value gap has taken account of it.
Deep value investors only work with what they know
There are so many exciting opportunities in the market. Everyone around you is always talking about the next big thing but 99% of them do not know what they are talking about.
By investing in companies and industries we understand, we gain greater certainty by speculating less. These may be boring old companies that don’t create much drama but they certainly compound your wealth.
Deep value investors do not listen to Mr. Market
We know that the Mr. Market swings between extreme optimism and extreme pessimism. When he is feeling good, many investors are sucked into the vortex of buying.
Value investors are fully aware of such traps and resist the influence at all costs. Social proof doesn’t work in investing and there is no safety in numbers. Following the herd will just lead everyone off the cliff.
Instead, deep value investors exploit the emotional Mr. Market by sweeping up the market when he is depressed and offloading when he is exuberant.
Of course, there is more to it to deep value investing than these 4 points that we listed. Check out the rest of our blog or the following articles, where we have written articles dedicated to explaining the mindset of a deep value investor!