Financial luminaries and market wizards like Warren Buffet and Ben Graham have made millions by using deep value investing. This remarkable strategy has become quite popular these days but why? What is this strategy and how to buy bargains with insane potential using this strategy?
These are some important questions and knowing the answer to these questions may transform your investing experience. There are also some other relevant questions that might arise in your mind. Is deep value investing difficult? Can retail investors try it? Yes, you can give it a shot as we have a lot of shreds of evidence that testify to the effectiveness of deep value investing.
If you want to know all about deep value investing, then you are on the right platform. We are going to cover multiple aspects of this strategy. Therefore, keep reading and learn all about deep value investing.
Historical background of deep value investing
British economist Benjamin Graham first introduced the deep value investing concept. He is an expert economist as well as an author. Graham wrote popular books like The Intelligent Investor and Security Analysis. Moreover, he is also the teacher and mentor of one of the most successful investors of all time. Yes, you guessed it right. Graham is a teacher and mentor of Warren Buffet.
A company’s business model and its products or services were considered highly important factors. Investors used to consider these factors when analyzing the value of stocks. However, Benjamin Graham doesn’t agree with that idea. According to his philosophy, the value of a stock that you buy is more important than all other factors. Furthermore, he emphasizes buying stocks at a price substantially below the intrinsic value of that stock. Graham says that this is the way to make huge profits. The price will eventually rise when the market will realize the true potential of that company.
Furthermore, Graham considers a company worth investing in if he gets shares of that company at a discounted price. That means he doesn’t give much importance to other key factors like management, competitive advantage, etc. when valuing a company. Graham only considers buying price more important of all factors.
Warren Buffet, the veteran investor, also considers buying value of the stock the most important factor. He also thinks that if you are buying stocks of a company at a discounted price, you don’t need other information. The odds are in your favor as the price will eventually increase and you will make profits. Buffet himself used this strategy and accumulated his fortune. He made 30% returns on his investment during the 1950s and 1960s by using a deep value investing strategy.
What is deep value investing?
Deep value investing is an investment approach that involves buying stocks at a discounted price but have great value. It is significantly different from traditional investment strategies. Typical strategies direct investors to analyze the future growth potential of companies before investing in them. Investors analyze a lot of aspects of a company before making decisions.
On the other hand, deep value investing emphasizes buying stocks at a discounted price. In other words, deep-value investors find stocks with huge potential but available at a discounted price. Such stocks have the potential to skyrocket in the future because there is a considerable gap between the current price and the intrinsic value.
There is another aspect in which deep value investing differs from traditional investment strategies. Investors following traditional strategies think more about future prices. They invest in companies whose stock prices will rise in the future. Conversely, deep-value investors search for stocks available at prices significantly lower than the value they offer.
Passive vs. active value investing
There are two deep value investing approaches: active and passive. Passive strategies are simple as they involve buying cheap stocks and waiting for an increase in their prices. On the other hand, active strategies involve buying cheap stocks and then attempting to make the market recognize the true potential of those companies.
Passive value investing
Passive value investing involves searching for undervalued stocks based on certain criteria such as price/earnings ratio. These criteria were pretty simple during the time of Benjamin Graham. For example, Graham used to find a company that was valued lower than the net cash it had. Was that company worth investing in? Yes, it was because downside risk was negligible if the management was competent enough.
However, this isn’t simple enough these days. Now, there are more value screens to analyze the true value of a company. For example, the Fama-French Three Factor Model includes analyzing factors like whether the company is small-capped or large-capped. So, we can say that screening criteria have been changing from time to time. However, the philosophy to buy discounted stocks remains the same.
Furthermore, passive value investing strategy isn’t only limited to hedge funds, insurance companies, or pension funds. Almost anyone who knows how to find stocks at discounted prices may adopt this strategy. For example, if a person buys stocks of a company at price significantly lower than its intrinsic value and then starts waiting for the stock price to rise, he/she is using a passive value investing strategy.
Active value investing
Active value investing is an aggressive deep value investing strategy. It involves investing in stocks of companies whose management can make necessary decisions to boost the price. You can better understand the core concept through an example.
Let’s suppose that an active value investor identifies a conglomerate for value investing. The organization has multiple subsidiaries operating in sectors like healthcare, finance, staples, and retail. Now, the investor analyzes each subsidiary and finds out that one of the subsidiaries is underperforming and dragging down the stock price of the entire organization.
The investor will acquire a portion of the stocks of the conglomerate. What will the investor do now? He/she will meet the management to convince them to make important decisions. For example, the investor may try to convince the management to sell the subsidiary that is underperforming. However, the management of big public companies often doesn’t listen to such opinions.
So, what now? The investor will start lobbying the management to take action. He/she takes their case to the public and pressurizes the Board of Directors. If the management still doesn’t agree, the discord may cause a proxy war. Value investors also put their suggestions in front of other shareholders and convince them to join their side. In short, we can say that this strategy involves a conflict between value investors and the top management of the company.
You know about one of many factors active value investors consider as we discussed in the previous example. There are many other factors that may also lead to an increased value of stocks. For example, value investors may ask for changes in top management that will prove vital in the company’s growth. Similarly, changing the capital structure of the company may also lead to an increased value of the stock. Simply put, value investors analyze every aspect of a company before investing. You also need to find out at least one factor that may lead to an increased value of the stock.
Furthermore, it is also important to note that this strategy may take months if not years. Why so? Because leaders and management will always be reluctant to let status-quo go off. They defend their strategies at all costs. Therefore, patience and persistence are the keys here.
There is another key aspect and that is capital. As you know, you have to confront the leadership of the company when using an active deep value investing strategy. Therefore, it is imperative to buy a significant portion of stocks to get to a noticeable position. No one will notice you when you have just 1% or 2% of the total outstanding shares of the company. That means you need a huge capital to pursue this strategy.
Contrarian deep value investing
In between passive and active deep value investing is contrarian value investing. It is the most common and the most popular deep value investing strategy. Most of the big deep value investors like Warren Buffet and Marty Whitman are contrarian value investors. Contrarian value investing involves buying stocks of a company at cheap prices when all other parties consider the company finished. So, contrarian value investors are brave people who go against the entire market. Isn’t it?
Not exactly though, it is better to call them wise instead of brave. These shrewd investors know that sometimes investors overreact to a major news event. For example, common investors overreact to a drop in sales for a quarter and begin to sell the stocks of the company. As you know, high supply always leads to a decrease in prices. Therefore, stock prices begin to fall. These investors overreact to just one bad news but neglect several other positive aspects of the company.
However, contrarian deep value investors always stay ahead. They begin to buy stocks of such companies when all other investors are selling. Veteran investors like Warren Buffett have made billions using this strategy. Additionally, there are several academic studies that also support contrarian deep value investing. These studies have proven that a portfolio of underperforming stocks gives a better return on investment than a portfolio of stocks that gave better results than the previous year.
Just like active deep value investing, contrarian investors are also patient and they have to be. If you are impatient and cannot wait for a market correction, this strategy isn’t for you. It is better for you to day trade stocks. Conversely, if you have patience and can wait for months, even years, you can make significant gains.
It is common sense. Just because everyone else is selling an undervalued stock doesn’t mean that the price will rise immediately. Similarly, the price will not skyrocket just because you are buying stocks of that company. It is a long journey and correction eventually happens when such companies continue to perform better and better. As a result, the market will eventually recognize the true value of the company and its stock price will increase.
Risks associated with deep value investing
As you know, the trading and investing arena are risky. All trades and investments are subject to risk regardless of how little or how big they are. Similarly, the risk is always there regardless of which asset you choose and which strategy you follow. There is always the risk of losing money. Therefore, it is important to manage risk when trading or investing.
Deep value investing is not different from other strategies. It also carries a risk – the risk of losing money. However, the good news is that risks associated with deep value investing aren’t as dramatic as risks associated with other strategies.
1. There are no guarantees
Firstly, you need to acknowledge that there are no guarantees in investing and deep value investing is not an exception. Whenever you screen a company for value investing, you take a chance. Given the fact that deep value investors ignore certain other key aspects, they may invest in a company that turns out to be a mediocre one. So, you see, there are no guarantees.
2. You may overpay for stocks instead of buying at discounted prices
Secondly, there is also a possibility that you may overpay for stocks instead of buying at discounted prices. Yes, it is well and truly possible. Let me explain my point. As you know, deep value investing involves buying cheap stocks. However, stocks of big popular companies like Apple, Amazon, Unilever, etc. will never be there for value investing. Why so? Because these are highly popular companies and people all over the world know that these companies will remain profitable. So, deep value investing is a strategy for less popular struggling companies. You may not have enough information about the company and that may lead you to overpay.
3. Other risks
There are some other risks value investors may also face. For example, buying discounted stocks of a less-known company means facing high volatility. Furthermore, you may also commit a mistake when valuing a company. Human errors are a reality and can cause significant losses in the case of investing based on deep value investing.
Deep value investing and diversification
Diversification is one of the keys to investing and trading. Similarly, diversification is also the key when using a deep value investing strategy. You should not put all your eggs in one basket. This is the principle. Let’s suppose that you have the capital to buy stocks of two companies. You go on to buy stocks of companies operating in the energy sector. After a few days, the government changes its regulations and as a result, the stock prices of energy companies significantly decline. So, your portfolio gets significantly affected.
Contrarily, you choose to invest in companies operating in two sectors. Your portfolio won’t get hit in this case. Changes in regulations will affect half of your portfolio. So, this is the importance of diversification even when following deep value investing.
Tips for deep value investing
Deep value investing is a simple investing strategy. Yes, there are risks but returns are also insane. Therefore, follow the following tips for successful deep value investing.
- Careful analysis is the key to deep value investing. You need to listen to the numbers instead of hype. Moreover, you also need to keep your emotions at bay.
- Buying stocks at discounted prices is of paramount importance in value investing strategy. Therefore, conduct proper analysis to avoid overpaying for stocks.
- Understanding risks is also important. You need to understand all the risks associated with value investing and make decisions accordingly.
- Patience is a virtue. It is even a greater virtue when using a deep value investing strategy. You can achieve nothing if you don’t have the patience to wait for the market to recognize the true potential of the company.