The Basics of Deep Value Investing

A few years ago I had a blog in which I used to post about the details of deep value investing and some of the methods by which an investor could go about exploiting market inefficiencies. Those posts weren't ever brought over to this site and it dawns on me that despite explaining some theoretical concepts, I've never explained much of anything about how I have been generating our performance over the past few years in basic, practical terms for anyone interested in hearing about it. 

I'm not sure how value investing originally started, but to my knowledge John Keynes is the first professional investor to document his thoughts on how he beat the market. He tried to capitalize on the emotions of the masses to buy companies when you could receive a high earnings yield (buy a company with very high annual earnings compared to the price you pay for the company) and when you could buy companies at prices less than the value of their assets. Benjamin Graham, who is Buffett's mentor, went further with this and used a mechanical, quantitative only method to purchasing cheap companies. Despite being the creator of deep value investing and someone who consistently beat the market, the records show that Graham had little interest or talent in analyzing the quality of companies and thinking about their future potential. He simply analyzed financial statements and bought companies at prices lower than their net worth and relative to the earnings they generated.

Beating the market using a deep value approach is quite difficult in practice, but the ideas behind it are extremely basic. In many cases when people ask about Comus and what I do to achieve our returns, it is difficult to say much more than "I buy cheap companies" and then add some detail on how I analyze them specifically. People within the field of investment in particular expect some complicated story or method where there is none and in many cases I believe are disappointed when that is the thrust of my answer. This is also the reason that quarterly commentary can be an issue for me and frankly useless in many cases. The happenings of the market and our investments on a quarterly basis are completely irrelevant to our long-term performance and methods and I usually don't have much more to add besides saying "this quarter we purchased more cheap companies and sold some others that aren't as cheap as they used to be". Frankly, such a simpleton approach to one's investment focus is how you properly beat the market in the long-run and I believe any other ego inflating topics or economic forecasting are going to distract from what a real investor is supposed to be doing.

Frankly if a portfolio manager is worried about anything other than the analysis of companies and exploiting differences between real value and current market value, it is my opinion they aren't real investors and won't generate any kind of decent long-run returns. This list of completely irrelevant topics include everything that the mainstream financial media and most large money managers speak to, such as interest rates, politics, misleading economic indicators, market sentiment, exchange rates, and recent stock price movements. Wall Street in particular has gained its reputation and profits focusing on such irrelevant topics and is one of the prime movers of corporate 'short-termism'. The current level of stock prices is only relevant in comparing price to value, and any price changes may or may not affect that relationship.

So on to the specifics. I'll use a quick analogy to better explain deep value investing because using financial terms might complicate things.

Imagine you have a rich friend with a net worth of $1 million. Her net worth includes $300,000 in cash and investments, a $700,000 house, and no debt. She also earns $70,000 in cash post-tax. Now let's say that somehow your rich friend is willing to sell both her current net worth and her stream of earnings to you for $500,000. So you would pay $500,000 and receive $1,000,000 in assets (30% of which are immediately liquid) as well as $70,000 in annual cash flows.

Does this seem like a good investment? If you answered yes you are correct. Assuming this person's earnings stay relatively constant and that the assessment value of her assets is fairly accurate, you are receiving a massive annuity for a low price, and are buying her assets at half off their real value.

This is the exact thing that deep value investors are doing, but with companies. They buy assets and earnings at very low prices in the expectation that others will eventually realize how much of a bargain the company currently is, pushing the stock price up (and if nobody else ever realizes, you can buy the entire company yourself). In the example above, even if you excluded earnings completely, you could get this person's assets at half price and immediately liquidate (sell) them for a massive profit- the earnings are simply a bonus and kind of irrelevant to the investment decision. Such decisions make life for deep value investors simple, as they do not have to attempt to predict the future of these bargain companies. This is why Graham never needed to be adept at analyzing competitive dynamics or the future of companies. 

If there were a world in which rich people like your hypothetical friend were out there selling their personal assets and earnings at ludicrous prices far below real value, wouldn't it be a good idea to take advantage of the situation? And if few cared to notice or take advantage of the situation because they believed it to be impossible and against the theoretical laws of market efficiency (which don't correlate with reality)? 

Such a deep value investment operation keeps in mind that the future is difficult and in some cases impossible to predict. Very talented and studied investors can in some cases properly analyze and predict the future of a company or industry, but there have been few that have shown to do this on a consistent basis over their careers and they generally stay within a very small circle of companies that they can understand. More than a few famous and previously successful investors (there are some great recent examples) have met their end overestimating their abilities in this regard, and have strayed too far from what they could properly understand and analyze. Like Icarus, their ego ruined their flight.

A deep value approach generally uses only current and past data to analyze firms rather than use predictions about the future. There are many styles within deep-value, but they all take advantage of discounts to real asset and earning value of companies, and generally purchase stable companies, assuming results will remain constant unless there are indications things will change or there has been some deterioration of results. I am personally comfortable holding a very focused portfolio because of the massive discount to real assets of some of the companies we own and the historical stability of their results (and my judgement of the industry) but there are others who like to on average own a 'cheap portfolio' but have fewer judgments about individual companies. All approaches are valid as long as one is comfortable with and capable of their approach and as long as focusing, as I do, doesn't detract from the returns one could have received from a more open and unbiased approach (sounds similar to the generally valid argument for indexing doesn't it?)

The stock market and the prices it gives to companies are only to be exploited, never taken as reality. Those of us who venture into individual company analysis and invest with the goal to beat the market understand we have some capacity to disagree with the market as to its pricing of companies. Stock prices are to be seen as temporary, ephemeral, ever changing, and almost always wrong. The idea is to analyze financials to get a general idea of a fair value of the company and then buy it when the market is giving that company a completely ridiculous price. It is a form of sentiment and time arbitrage- you buy now when people aren't interested and wait until they are.

Despite the general idea that technology, the proliferation of active managers, and indexing has created widespread market efficiency, I believe it has done the exact opposite to an extreme degree. The best managers manage large amounts which limit them to the components of the S&P 500 which they all trade amongst themselves. Indexing has no opinion as to value and indices generally hold the largest group of companies in a given economy which funnels most of the funds of the population into those few investments- mutual funds, index funds, and pension funds all collectively own the exact same companies (good luck getting decent returns when you all own the exact same companies and will pay any price for them). Frankly very few people care about company analysis and even fewer have the funds to look under the obscure rocks as Buffett once did- and this is why value investors such as myself will always exist. There will always be some form of market arbitrage in all types of asset classes which allow for exploitative returns relative to the general performance investors can receive from an index.