Do you know that Warren Buffett’s best years as an investor was in his early years as a fund manager ?
Do you know that in his 12 year career as a fund manager, Buffett consistently outperformed the market by an average of 22% CAGR against the Dow?
Since managing Berkshire Hathaway in 1965, Buffett has successfully grown its book value by CAGR of 19%. This is certainly an outstanding track record that many of us could only dream of. However, it is less impressive when compared to his track record with Buffett partnerships.
So why did he performed much better as a fund manager than in Berkshire Hathaway?
Buffett confessed in a BusinessWeek report published in 1999:
“It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”
“Yes, I would still say the same thing today. In fact, we are still earning those types of returns on some of our smaller investments. The best decade was the 1950s; I was earning 50% plus returns with small amounts of capital. I could do the same thing today with smaller amounts.
It would perhaps even be easier to make that much money in today’s environment because information is easier to access. You have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map – way off the map. You may find local companies that have nothing wrong with them at all. A company that I found, Western Insurance Securities, was trading for $3 per share when it was earning $20 per share. I tried to buy up as much of it as possible. No one will tell you about these businesses. You have to find them.
No one will tell you about these ideas; you have to find them. The answer is still yes today that you can still earn extraordinary returns on smaller amounts of capital.”
In an annual meeting, he was recorded on video saying this:
“If I were working with small sums, I certainly would be much more inclined to look among what you might call classic Graham stocks, very low P/E and maybe below working capital and all that. Although…and incidentally I would do far better percentage wise if I were working with small sums…there are just way more opportunities. If you’re working with a small sum you have thousands and thousands of potential opportunities and when we work with large sums, we just…we have relatively few possibilities in the investment world which can make a real difference in our net worth. So, you have a huge advantage over me if you’re working with very little money.” Source: YouTube – Warren Buffett on investing small sums.
Buffett’s biggest problem at the moment is having too much money, not many of us would have that problem. I did a quick check on Berkshire’s balance sheet, it had over 70 billion in cash (record high).
So what was he referring to when he said “classic Graham stocks“?
Value investing nowadays has taken many forms, one of which is deep value investing: the act of buying a 1 dollar for 50 cents. It is one of the most conservative and contrarian investment frameworks in the value investing network.
Unlike Buffett type of stocks which considers competitive advantage and economic moats of a business, Deep value is a quantitative-value strategy, the focus is on the net returns of the portfolio, not individual picks. When you invest in a portfolio of deep value stocks, some stocks will out-perform better than the rest, and some will disappoint.
In a Deep Value portfolio, you will have stocks generating 100% return while some losing -50%. Your long-term track record depends on the yearly net returns of the entire portfolio. Hence to execute this strategy perfectly, you need to diversify adequately and restrict a position limit to each stock so that if one stock fails, it doesn’t drag the entire portfolio down. This is why investors like Ben Graham and Walter Schloss advocate diversification while Warren Buffett concentrates his capital in a few high-quality stocks.
Deep value investing approach considers a company’s stock price relative to its net asset value (NAV), this method focus on the value of assets on the company’s balance sheet while assigning appropriate discounts to certain assets. Assume company ABC has $100 million in assets and $30 million in liabilities, with that, ABC’s book value is worth $70 million. If the market capitalization of ABC is $50 million, theoretically we are buying ABC’s assets at discount of 28.5% or in other words ABC is trading at a price to book value of 0.7.
Defining Deep Value investing
Deep value investments are statistically cheap stocks, they are valued solely based on current assets: Cash and cash equivalent, short-term investments, inventories and trade receivables.These items are taken at face value and to subtract all liabilities of the company, the difference is known as Net Current Asset Value (NCAV).
Source: S i2i Limited Annual Report 2015
Refer to Figure 1, this company owns approximately $77.6 million of current assets and $26.3 million in liabilities, hence, the Net Current Asset Value (NCAV) is 77.6 – 26.3 = $51.3 million. This figure will then be compared to its market capitalization, alternatively one can simply divide the NCAV by the outstanding shares. Example : NCAV / Outstanding shares = 51.3 mil/ 13.71 mil = $3.74 per share. If the stock price is trading at $1.7 per share, this also means that the stock is trading at 55% discount to its Net Current Asset Value.
As you can see, NCAV method is a proxy for liquidation value, this suggests that NCAV stocks are worth more upon liquidation and the market is obviously understating that fact. NCAV does not take into account the earnings power of the business nor the value of its fixed assets. Hence, buying a stock well below its NCAV gives the investor a wide margin of safety and it ensures downside protection for the investment. In the event that the business needs to be liquidated, there is a higher probability for the investor to recoup his capital.
Why you should buy deep value stocks
Deep value investing is counter-intuitive and contrarian. Most are thought to buy “wonderful companies at wonderful prices” logically, that is common sense. Therefore, buying “poor companies at cheap prices” seems counter-intuitive. Contrary to popular belief, studies have shown that buying deep value stocks have proven to provide market-beating returns in the long run.
A case study conducted by Causeway Analytics titled “The compelling case of value” illustrates the long-term performance of two indices, the MSCI World Value Index and MSCI World Growth Index. The study showed the MSCI World Value Index outperformed the MSCI World Growth Index by 2.1% annually since 1975 (the inception of these indices). Remarkably, this superior value return has exhibited lower volatility (14.4% annualized) than the growth return (15.3% annualized volatility).
Another research done by The Tweedy, Browne Company in “What has worked in investing” uncovered that stocks with the following characteristics significantly outperformed the market over the long-term:
- Stocks bought at less than book value or even more conservatively, at less than Net Current Assets (cash, receivables, inventory minus liabilities)
- Stocks bought at low Price / Earnings offer high earnings yield when considering their potential dividend payment to prevailing stock price
- Insider buying: Inside information on likely improvements, not a tough one to imagine
- Significant price decline as a result of poor recent performance resulting in lowered expectations
- Small market capitalisation – small companies with higher growth rates and therefore more price appreciation
An excerpt from Financial Times article “Value investing – you’d be crazy not to”
“The original investment guru Benjamin Graham told us this was so back in The Intelligent Investor in 1949. Some stocks, he said, traded below their intrinsic value thanks to “neglect or prejudice”. They might continue to do so for an “inconveniently long time”, but those with a longish time-frame could and should just buy these cheap stocks with a low price/earnings (P/E) ratio and wait. His studies showed that this worked perfectly well. From 1937 to 1969, $10,000 invested in the expensive stocks in the Dow Jones would have ended up worth $25,300. But $10,000 in the cheap stocks would have risen to $66,900.”
Economist Eugene Fama and Kenneth French have extensively studied the relationship between stock performance and price to book ratios. Their research covered periods from 1963 – 1990 and included nearly all stocks on the NYSE, Amex and Nasdaq. The stocks were divided into deciles based on price to book and were re-ranked annually. The lowest price to book stocks outperformed the highest price to book stocks by 21 to 8 percent, on average, with each descending decile performing worse than the previous. Fama and French also examined the beta of each decile and found that value stocks had lower risk, while growth stocks had the highest.
To add-on, James O’Shaughnessy has proven some fascinating statistics in “What Works on Wall Street”. If you had invested $10,000 into high P/E stocks at the beginning of the 52 years leading up to 2003 it would have grown to $793,558. But had you invested the money into low P/E stocks your returns would have been better – $8,189,182.
Excerpt from “What Works on Wall Street, 4th Edition”
“An analysis of the past behaviour of stocks grouped by defining factors such as PE ratio, price-to-sales ratio and EBITDA/EV shows that rather than careening about like a drunken monkey, the stock market methodically rewards certain types of stocks while punishing others. What’s more, had you simply read and followed the advice in the last edition of this book you could have avoided the carnage that investors in the highest valued stocks suffered between 2000 and 2003. The severe bear market of 2007 through 2009 was more difficult in that much of it was caused by panic selling that affected all stocks, regardless of their valuations, but would nevertheless leave you better positioned to take advantage of the resurgence of stock prices in the last three quarters of 2009. And even though this book has been in the public domain since 1996, nothing has really changed regarding the longer term performance of overpriced companies: They do horribly over the long term.”
Recent publications such as the book “Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations” by Tobias Carlisle, documents the different forms of deep value from the “cigar-butt” days of Ben Graham to the corporate raiding era of Carl Icahn to the magic formula of Joel Greenblatt. The book combines engaging stories with industry research to illustrate the principles and methods of deep value. It provides perspective on shareholder activist strategies in a format accessible to both professional investors and laypeople.
Why deep value works?
One of the key reasons that prove deep value works is the concept of “Mean reversion”. Mean reversion suggests that asset prices and returns eventually return back to the long-run mean or average of the entire data-set. Investors such as David Dreman and behavioral economists such as Richard Thaler and Werner De Bondt have uncovered strong evidence that mean-reversion occurs on financial markets.
Benjamin Graham on the concept of mean reversion:
“Investment values can be related only to demonstrated performance so that neither unexpected increases nor even past results under conditions of abnormal business activity may be taken as a basis“
Economically, there are fundamental truths behind the concept of mean reversion:
- A highly profitable business or industry attracts competition and that naturally erodes away at high returns over time. In most cases, competition and other corrective forces work on the highly profitable business to push its return back to the mean.
- Similarly, an under-performing business or industry repels away the competition as loss-making companies exit the industry. Therefore, low returns will more often than not, revert toward the mean. Stocks with big market price losses and historically declining earnings tend to see their earnings grow faster, and outperform the market.
Deep Value Investing Singapore
In recent years activist investors, having targeted companies in Japan and South Korea have discovered a new hunting ground in Asia. Institutional investors are on the prowl for deep value stocks in Singapore.
Shareholder activism is on the rise as investors seek to unlock value in companies that are poorly managed. Investors are challenging a clubby, consensus-driven corporate culture where shareholder interests have traditionally taken a back seat. In doing so, they’re shining the light on small companies that are undervalued, cash-rich and often ignored by analysts.
In 2016, Quarz Capital Management urged retailer Metro Holdings Ltd to return excess cash to investors and Dektos Investment Corp pushed Geo Energy Resources Ltd to change its debt structure, saying the coal miner’s shares are undervalued by as much as 60 percent.
This is no surprise as the Singapore stock market remains one of the cheapest markets in the region, it is certainly fertile ground for value hunters.
The primary focus of this site is to search for deep value gems in the Singapore stock market. There is tremendous potential in our market and the strategy itself as they are often overlooked and underappreciated by the investment community. Our Asian markets also tend to be less efficient than developed markets in the West.
Failing businesses, poor management, and unpredictability often provide the most promising investment opportunities. Deep value offers the best risk/reward ratio for investors willing to go against intuition and what is normally accepted by the investment crowd.
Deep value investing is proven to be an outstanding strategy that beats the market in the long run and so far has outperformed other forms of investing. It does not require fancy forms of cash flow projections or overly optimistic assumptions about the future. It is a consistently reliable form of valuation as it is simple and concrete. The key to outstanding returns is to exercise patience when needed and keeping composure when required.