Deep Value Investing: Explained

A Brief History Of Deep Value Investing

Deep value investing was first introduced by Benjamin Graham, the British economist who authored Security Analysis and The Intelligent Investor, and was a teacher and employer of one of the wealthiest and most famed investors in history, Warren Buffett.

Graham put aside the idea that a company had to have the best business model or the strongest product or service, and decided that the value of the price you purchased the stock at was more important.

His logic: if you buy share of a company at a price that is significantly below the intrinsic value of the stock and simply wait, the odds are that the price will climb and you will profit.

While Graham was certainly an economic whiz and did not discount the important role of competitive advantages and excellent leadership and management, his unique value investing approach was distinctly absent of these factors.

For Graham, Buffett, and other value investors, the way to purchase a good stock is to get a discount on the dollar.

He believed that if he could buy a stock worth $10 for $6, he didn’t need any more information about the company—the discounted purchase was enough to make that company worth the investment.

Graham, who taught Buffett at Columbia University, shared his thoughts with Buffett, who has declared 85% of his investment style attributable to Graham.

During the 1950s and 1960s, Buffett used value investing formulas to generate eye-popping returns of nearly 30% compounded annually.

Today, deep value investing remains a popular method for investors around the world, and Buffett’s Berkshire Hathaway stock has outperformed the market for several decades.

It’s clear that deep value investing is responsible, at least in part, for many investors’ success, but how does this type of investing really work? What is it that makes deep value investing any different than ordinary stock picking?

Below, we’ll break down deep value investing, simplifying this investment strategy and giving you the tools you need to determine if deep value investing is something you’d like to get involved in.

Rather than poring over different deep value investing books, you’ll be able to get a brief, yet comprehensive guide to deep value investing right here. Keep reading to learn more about what deep value investing is, how it works, some of the popular tools used by deep value investors, and what to expect when you use this approach to investing.

Read More: Everything You Need To Know About Warren Buffett

What is Deep Value Investing?

Deep value investing is an investment strategy that emphasizes choosing stocks that are cheap and offer great value.

Traditional investment strategies typically examine a business’s future growth potential. Ordinarily, investors often want to park their money in stocks they think will skyrocket in the future, based on the fact that the company will perform well. Deep value investing, on the other hand, focuses on identifying stocks that are undervalued, and that have a reassuring gap between value and price that acts as a sort of safety net.

While most investors concern themselves with future prices, deep value investors are generally more interested in pinpointing which stocks are priced significantly lower than the value they offer. Sounds simple enough, right? Let’s take a closer look at what characteristics make a stock attractive to deep value investors.

How Can You Identify Which Investments Offer Deep Value?

Investing in deep value stocks isn’t as easy as just looking at a particular stock and guessing that it offers a great low price relative to its value. Deep value investing uses statistics in the form of valuation multiples to compare two similar companies and to, hopefully, conclude that the company being scrutinized is trading below their net current asset value (NCAV).

In plain English, the NCAV is the company’s assets less any liabilities. If the company is trading below the NCAV, that means that when you purchase its stock, the face value of its assets are already worth more than the price you’ve paid, so your chances of profiting in the future are quite bright. So, even if the company decides to liquidate its assets the same day you purchased the stock, you’ll still come out on top.

Understanding Valuation Multiples

One of the key components of deep value investing is what is known as valuation multiples.

Valuation multiples allow us to compare companies on a far more objective basis than some other metrics commonly used by investors. During the course of his research, Graham focused on the intrinsic value of a stock and learned that stocks with lower valuation multiples tended to beat out the market’s performance and yield higher returns.

There are several different valuation multiples that can be used to see how companies stack up against one another, and to determine which stock offers the greater value.

The objective of valuation multiples is to calculate what percent of the book value, or the value of the company’s assets, the price of the stock is trading at.

Data has shown that stocks whose price represented a lower percentage of a company’s book value were far more likely to yield greater returns and outperform the market on both over the short term and over a longer period of time.

There are several different ways to calculate a valuation multiple, all of which serve to measure the value of a stock by dividing its estimated value by a particular figure on the company’s financial statements. There are two main classes of valuation multiples: enterprise value multiples and equity multiples.

Let’s start with the commonly used price-to-earnings ratio, or P/E ratio. The P/E ratio is calculated by dividing the market value per share, or current stock price, by the earnings per share. Earnings per share, or EPS, is calculated by taking a company’s profit and dividing it by the number of outstanding shares of its common stock. Simply put, EPS is the sum of money that a company would pay to its shareholders per share if it gave all its profits to said shareholders. Investors prefer a higher EPS, which indicates a company’s strength and profitability.

Now let’s return to the P/E ratio. Since we want a lower price and a higher EPS, a low P/E ratio is a strong indicator of a company is undervalued, and that often aids deep value investors in determining which value stocks to buy.

In addition to the P/E ratio, there are several other types of value investing formulas you can use to help you select a deep value stock. Many deep value investors like to use the P/B ratio, or price-to-book ratio. The P/B ratio, like the P/E ratio, begins with the market price per share as the numerator. In the P/B ratio, the denominator is the book value per share (or BVPS), which is calculated by dividing the stockholder’s equities (assets minus liabilities) by the number of common shares. Like the P/E ratio, deep value investors look for a low P/B ratio as in indicator that a stock is undervalued.

What are the Risks of Deep Value Investing?

Every investment, regardless of how little, is subject to risks. Whether you’re investing in stocks, bonds, commodities, or any other securities products, there is always a chance that money can be lost.

Deep value investing is no different, and any time you invest in stocks there is a possibility that money can be lost, including loss of your principal investment. Though deep value comes with its own set of risks, they tend to be less dramatic on the whole compared with some other popular investment strategies.

Nothing Is Guaranteed

First, we have to acknowledge that even though deep value investing does its best to avoid risks, the reality is that anytime you are getting a good deal on a stock price, you’re taking a chance.

And, since deep value often disregards the telltale qualities of a strong company such as top leadership or a unique business model.

In deep value investing, there is a good chance that the company you’re investing in is a mediocre one that is struggling.

Overpaying

Another one of the risks of deep value investing is overpaying. Anyone can invest in a stock, and many people who are unfamiliar with the stock market are drawn toward the brand-name, blue-chip companies—the proven powerhouses.

Since these companies are so large and well-known, the chances that you’ll get a good, cheap price on their stock is very low.

Nevertheless, plenty of people will buy into them because they are considered a relative safe-haven, but there’s a reason they’ve gotten to be so profitable and that’s because they are great companies with the best management, powerful, proven models, and a long history of success.

When buying a blue-chip stock, the investment strategy varies from the deep value investing model.

Companies like Barclays, Unilever, AstraZeneca, BP, and HSBC aren’t going to be available for cheap prices because they don’t have to be. They’re widely acknowledged as some of the best in the business, and people expect them to continue on the path of profitability. Many deep value stocks carry the risk of investing in a company that is now well-known, doesn’t have a rich history, lacks the top management and models of the blue-chips, and is often struggling.

In short, deep value investing may necessitate you investing in a company that is, for lack of better words, not very good.

Volatility

The other main risk of deep value investing is uncertainty.

While no one can predict the future, buying cheap stocks can often mean wildly volatile price swings. Up, down, left, right, and sideways, deep value stocks can take you on a roller coaster ride of fluctuating price.

The Chance Of Human error

Finally, the last risk concerning the deep value investor is a simple error in calculations.

You may know how to identify deep value stocks, and those stocks may perform well, but if you don’t buy them then it doesn’t do you very much good. The deep value investor has to take pains to ensure that his or her calculations are accurate and that the numbers are double and triple checked for accuracy before purchasing the stock.

Read More: Here’s What Warren Buffett Looks For In A Company

The Importance of Diversification in Deep Value Investing

Investors are always harping on the need to diversify your portfolio. You’ve probably been told not to “put all your eggs in one basket,” and the same principle, however cliché, applies perfectly to deep value investing.

Let’s say you find a couple of great deep value stocks that you’d like to buy.

They all happen to be in the energy sector, and you’re sure you’ve looked over the valuation multiples and everything looks perfect.

Suddenly, a major change in government regulations shocks the entire industry, and values plummet in response.

Since you were banking almost entirely on energy companies to perform, your portfolio took a massive hit and lost a great deal of its value.

Had you diversified and only purchased one or two of the energy stocks, you still would have noticed the loss, but your portfolio would be largely kept intact.

What Kind of Returns Can Be Expected from Deep Value Investing?

Deep value investing is renowned for its impressive returns, and in part for Warren Buffett’s fame.

It’s impossible to say how a stock will perform, but when deep value investing is effective, returns can certainly be substantial. F

or Warren Buffett, a career of outperforming the market is a testament to the effectiveness of deep value investing as a strategy for success.

While the P/E ratio is one common measure deep value investors use to select stocks, it’s difficult to use a single valuation multiple to gauge what kind of returns deep value investing offers.

During an 18-year period between 1966 and 1984, the companies with the lowest P/E ratios yielded compounding annual returns of as much as 14.08%, while the companies with the highest P/E ratios yielded 5.58% annually.

No investment strategy is foolproof, but it seems that when using a deep value approach to investing, there may be an advantage when it comes to producing higher returns over time.

5 Tips for Successful Deep Value Investing

Stick to the Numbers

Don’t get caught up in the hype that lures many investors to buy certain stocks out of emotion and greed. Remember, the most important part of deep value investing is the price. Stay objective and stick to the numbers, and try to leave your emotions out of the equation. Don’t spend too much time concerning yourself with the conventional measures of success, since deep value investing has its own independent and largely unrelated set of value factors.

Acknowledge the Risks

Like any investment, it’s important that you acknowledge the risks associated with deep value investing. While the deep value investing approach and calculations are designed to help you find the best stocks to purchase to maximize your earnings, there are always things that are out of your control. Know these risks well and make your decisions accordingly.

Cheap Pricing is Paramount

We can’t say it enough—buying at the right price is the key to successful deep value investment. The whole idea behind deep value investing is that you create a sort of hedge against unnecessary risks through your initial purchase of the stock at a price that is well below its intrinsic value, hopefully giving you some equity right from the start.

Don’t Forget to Diversify

Another component of the deep value investing strategy involves diversifying your portfolio. In an effort to minimize risk exposure, deep value investing demands diversification, so that if one industry experiences a seismic shift, you should be able to weather the storm and come out on top through the aggregate success of your other investments across different industries and sectors.

Regardless of your investment strategy, and particularly when you are utilizing deep value investing, diversifying your investment portfolio is a best practice for minimizing heavy losses. While it’s still possible to sustain losses with a diversified portfolio, the odds are significantly reduced when your investment choices span a wider range of stocks.

Exercise Patience

Finally, keep in mind that deep value investing is not a gambit to “get rich quick.” Deep value investing requires patience and time. Most of the time, the reason you’re able to buy a company’s stock at a cheap price well below its actual value is because the company is struggling in one way or another. Be patient, believe in yourself, and give the company time to bounce back.