Do you believe that big institutional investors, brainy retailers, and smart algorithms create an unbeatable market? We don’t. Here’s to the world of deep value investing—the foundation of our investment philosophy where everything is possible.
The Context
You’ve probably encountered the concept known as “Value Investing”, maybe through wisdom shared by investing legends like Warren Buffett or discussions on social media. If you’re new, picture Value Investing as seeking promising investment opportunities in stocks and sectors priced lower than they should be.
But, have you ever wondered why stocks still sell below their true worth in a market where everyone is constantly trying to beat the others?
It’s because stock markets are inefficient, influenced by numerous chefs trying to cook the same broth with fear and greed as key ingredients of their recipes.
Now, Deep Value Investing takes it a step further, hunting for even cheaper stocks, often in companies facing challenges or overlooked by mainstream analysts. It’s like picking a lovable puppy from a rescue center – not the cutest, but with a good pedigree.
Benjamin Graham called “Mr. Market” bipolar, causing trouble for overly optimistic investors. Deep value investing aims to exploit this bipolar behavior of the market uncovering hidden gems for a deeper margin of safety.
If you are interested to read on, this guide will help start your journey as a deep-value investor.
The Origins of Deep Value Investing
Deep value investing finds its roots in the work of Benjamin Graham, often called the “father of value investing.” Graham, a well-known economist and investor, established this approach in his 1934 book “Security Analysis.” Further insights were shared in “The Intelligent Investor,” co-authored with David Dodd.
Graham promoted a cautious investment style, stressing the importance of a margin of safety and thorough analysis of financial statements.
From there, deep value investing further developed as some investors, much like ourselves today, sought to identify stocks with significant undervaluation, exploiting the market inefficiencies. With time, Graham’s principles influenced successful investors, such as Warren Buffett, who incorporated, refined, and adapted these concepts into their own strategies.
Who Can Dabble in Deep Value Investing
Although the deep value investing strategy may seem intriguing, it’s not suitable for everyone.
It’s one of the trickier approaches, demanding patience, a solid market understanding, and a rare instinct, not everyone has in today’s distracted world.
So, if you already have a successful investment strategy that seems to be working well for you, it’s advisable to stick with it. However, for those adventurous types who enjoy customizing their approach, combining this strategy with your existing one could yield impressive results.
How to Approach Deep Value Stocks
The research for deep-value stocks typically follows a basic approach as used in value investing where you seek companies with low P/E ratios, substantial assets, or strong cash flows through fundamental analysis. But as the conventional value investing strategies find stocks below their true worth, deep value requires more.
You see, many investing strategies depend on freely available online financial data, eliminating any chance of a competitive advantage. In contrast, deep value investing leans on instincts and experience which is a unique variable. The success here lies in spotting stocks overlooked by mainstream analysts or dealing with temporary difficulties.
Understanding why a stock is under an “out of favor flag” is hence crucial. You gotta be extra careful as this territory has potential value traps that may look like deep value but are falling knives. Deep value investing demands time in the market and thorough independent research to navigate these challenges.
The Fertile Hunting Grounds
Ideal spots for deep value investing lie in sectors or stocks meeting value criteria but facing challenges, temporary distress, or being overlooked by mainstream analysts. Commonly found patterns in these deep value trenches include:
1. Cyclical Sectors
Cyclical sectors are like the heartbeat of the economy, rising and falling with economic cycles. These encompass industries such as manufacturing, construction, and consumer goods, thriving in economic highs but struggling in lows. Every deep Value hunter must monitor sectors facing challenges. In 2019, we applied this approach to the Auto sector, seizing opportunities when it was near the end of its downturn. We didn’t predict the sector’s rebound as no one can; instead, it was a commitment to consistently lower our buying average as the downturn persisted. Explore our case study on why we opted for Tata Motors.
2. Turnaround Stocks
Turnaround stocks are those punished victims who faced a slump but are now showing potential for positive change, making them perfect for deep value investing. It’s crucial to investigate the reasons behind their poor performance—is it a market shift, changing consumer preferences, bad publicity, or an industry no longer economically viable?
Take the State Bank of India (SBI) as an example—they faced challenges with non-performing assets (NPAs). SBI implemented strategic measures, showing improvement over time, marking a successful turnaround. Similarly, Hindustan Unilever Ltd. (HUL) experienced a setback when news in November 2022 revealed high levels of a cancer-causing ingredient, Benzene, in HUL shampoos. Although HUL recalled some lots in the US and Canada, they denied selling the specific product in the Indian market, creating another turnaround scenario.
3. Out-of-Favor Sectors
Out-of-favor sectors are momentarily less popular with investors, often due to economic trends, regulations, or changing consumer behavior. For example, the COVID-19 pandemic hit sectors like hotels, airlines, and tourism hard, casting doubt on a quick rebound. Lockdowns and remote work also caused a sharp decline in commercial real estate stocks, making them potential turnaround candidates.
4. Unsung Hero’s
While many mid-cap companies attract attention from institutional and retail investors, there are lesser-known ones crucial to the larger picture. These often escape professional analysts’ coverage, remaining hidden from view. Some are overlooked by mutual funds due to concerns about holding substantial stakes, creating a hunting ground for deep value seekers.
Consider the case of Tasty Bite, an Indian-American preserved food manufacturer. In 2017, it was priced at around Rs. 5,000, with strong fundamentals, no mutual fund holdings, and minimal analyst coverage—a green flag for deep value. The current price has risen to close to Rs. 14,000. In the mid and small-cap segments, numerous untold stories are rapidly unfolding if you pay close attention.
Great Power, Great Responsibility
Now that you’re aware of ideal places for practicing deep value investing, it’s important to acknowledge the cautionary side of this magical wisdom.
Seemingly attractive deep-value stocks can sometimes be value traps, where the stock appears cheap based on certain ratios but fails to recover. Try talking to someone who invested in companies like DHFL or WeWork during their majestic declines and you can get a better perspective on what we are talking about.
Deep-value investors often face this scenario, resulting in significant losses. However, there are measures to deploy to minimize the likelihood of such discomfort.
1. Structural Declines is a Big No
Deep value traps often involve industries facing long-term decline due to irreparable structural issues. Deep value plays are better sought in companies with short-term problems rather than those in stagnant industries. For instance, the tobacco industry, despite cheap stock metrics, lacks growth prospects, making it a less favorable choice for deep-value investing.
2. High Valuations is a Big No
A stock qualifies for deep value investing when it trades well below its fair value. To assess this, compile key valuation multiples such as PE Ratio, PB Ratio, price-to-sales ratio, and price-to-free cash flow ratio over several years. Validate your observations with standard valuation models like discounted cash flow, Comparative Valuation, or Growth Valuation analysis. Our courses extensively cover these models for your understanding. If, after analysis, you’re convinced, you might have discovered a deep-value stock.
3. Insecure Management is a Big No
Successful deep value investing requires companies led by experienced management with a keen focus on revitalizing the company. Watch for indicators like significant offloading by company insiders or institutions; if this offloading appears excessive, it could signal a potential deep value trap.
4. High Capital Exposure is a Big No
Discovering a perfect deep-value opportunity is manageable, but handling greed is crucial. Invest only what you’re willing to lose, ideally within 5% of your total capital. Ensure a justifiable risk-reward ratio, and if you’re new to this concept, explore our dedicated piece on it.
When buying a deep-value stock, avoid going all in at once. Systematically average over days and weeks, not months, to position yourself for a potential rebound. Set stop losses at 20% to trigger your panic point and exit once you reach your realistic target without remorse.
Conclusion
Deep value investing involves finding opportunities where the market undervalues a stock’s true worth. When trading deep-value stocks, patience is crucial as it may take months or even years for the position to realize its potential. Be cautious, as some stocks are cheap for valid reasons!
We trust you found this guide enjoyable. It’s time to set out on your journey to become a deep-value investor.
Frequently Asked Questions (FAQs)
1. Is deep value investing suitable for everyone?
No, deep value investing demands patience, market understanding, and a unique instinct. It’s not for everyone, but adventurous investors willing to filter out market noise can explore this strategy.
2. How can one approach deep-value stocks?
To research deep-value stocks, focus on low P/E ratios, substantial assets, or strong cash flows through fundamental analysis. Deep value investing relies on instincts and experience, requiring thorough independent research to navigate challenges.
3. What are the ideal hunting grounds for deep value investing?
Ideal spots include cyclical sectors, turnaround stocks, out-of-favor sectors, and lesser-known companies (unsung heroes). These areas often harbor undervalued stocks facing challenges or being overlooked by mainstream analysts.
4. What precautions should one take in deep value investing?
Avoid stocks with structural declines, high valuations, insecure management, or excessive exposure. Practice caution, invest only what you’re willing to lose, and set stop losses to manage risk. Averaging systematically over time can also minimize potential losses.
5. How long does it take for deep-value investments to realize their potential?
Patience is crucial in deep value investing. It may take months or even years for a deep-value position to realize its potential. Investors should be prepared for a longer investment horizon when engaging in deep-value strategies.
