Does deep value stocks makes you uncomfortable?
Does it give you that irk factor?
You’re not alone. Deep value investing sounds good on paper, buying a dollar for 50 cents. I mean, who wouldn’t want to? But the truth is, it is easier said than done.
You are probably concerned if the problems in the company would persist, what if we suffer a permanent loss? What are the signs that we should look at to avoid these losses?
Or are you in a situation where you’ve been burned too much from buying deep value stocks? Are you afraid of catching the falling knife?
These are valid concerns as deep value investing can be counter-intuitive and the fear of losing money can hinder you from making sound decisions. So hopefully I can help clarify these doubts, let’s begin with the first:
How do I know when to cut my position in a deep value stock?
Cutting losses seems to be the hardest part in investing, but most of us ignore this till its to late. I think the issue is that we do not have a proper exit plan when things go wrong. A deep value stock is no longer desirable if it continues to erode remaining value of the business. For example, if the intrinsic value of the company is the value to its net cash, you should look out for declining net cash value. In short, reassess key factors (Assets, Earnings, Cash flow, Catalyst) that influence your decision to invest and cut your position if they are no longer valid.
How do I avoid Value traps?
In general, I prefer to avoid investing in obsolete businesses, they are usually the most obvious value traps to me. Examples are companies with primary operations in manufacturing of CDs/VCRs/PDAs/MP3s/Phone book directories or companies with no existing operations. I would also avoid companies with no track record of earnings since public listing, 1 or 2 years of losses is fine.
Should I diversify? How much diversification is enough?
Most retail investors do not view investing as a portfolio, sadly, they are missing the whole point. There are many benefits to constructing a portfolio of deep value stocks, diversification ensures risk are distributed evenly and that the performance of a single stock does not dictate the returns of the portfolio. An investor with a well diversified portfolio tends to be less emotional as he/she is not concern of daily price fluctuations.
For a start, a portfolio of 20 deep value stocks would suffice while building the portfolio up to 30 is optimal.
How much capital should I allocate into each stock?
Another factor that is often overlooked by retail investors is capital allocation, which aims to balance risk and reward by distributing a portfolio’s capital according to an individual’s risk tolerance and investment horizon.
Imagine having 50% weightage on a deep value stock, do you think the overall performance of your portfolio will be correlated with that stock? It defeats the whole purpose of diversification, doesn’t it?
Personally, I set a limit of maximum 20% of my portfolio on a single stock. Risk tolerance is key, if you are conservative, aim for a lower limit of 10-15%.
Deep value investing seems to be under-performing now, maybe I should try something else?
KEEP FAITH in your strategy! Be discipline in sticking to your investment philosophy. I know some of you are prone to switching from strategy to strategy, but this habit is detrimental to your long-term returns. Regardless, of what is happening in macro economic environment, just stay discipline!
Start by setting your expectations right. Deep value investing does not guarantee that you’ll make money every year, there will be down years but in the long run it has proven to be a market beating strategy. Focus on performance of the portfolio and adopt a long-term view in portfolio management. Keep in mind that investing is building wealth through compounding returns over time.