My experiences with deep value investing

Deep valueinvesting or cigar butt investing, is buying stocks whose price is way belowthe various statistical measures of value of the company. Now, value can bemeasured by various means such as PE ratios, discounted cash flow analysis orasset values. In case of deep value investing, one is investing in stocks whichare selling at a very low PE, below book value or in some cases even below cashheld by the company.

This methodof investing was introduced and popularized by the father of value investing Benjamin Graham in hisclassic security analysis(A must read for any serious investor). In this book, graham talksabout companies selling below working capital, book value or in some extremecases, even the cash held by the company.

This mode ofanalysis is a quantitative, statistics driven method where in one holds a largenumber of such Cheap companies. A few positions work out, a few go down thedrain and rest just stagnate doing nothing. In spite of such a mix, the overallportfolio does quite well and one is able to earn decent returns at low riskThe keyelement in this investment operation is wide diversification and constantsearch for new ideas to replace the duds in the portfolio.

Initial forayinto high quality

My firstexposure to sensible investing (reading economictimes and watching CNBC doesnot count in that), was when I read the book The Warren Buffett way. I was completely mesmerized by this person and read allI could on him for the next few years.

After burningmy finger a bit during the dotcom bust, my initial investments were in thewarren buffett mold (high quality stocks with competitive advantages). Myinitial investments were in Asian Paints,Pidilite, Maricoetc - the so called consumption stocks except that they were not called by thislabel then.

I have alwayswondered why these stocks are called consumption stocks? are capital goods andreal estate un-consumption companies whose products no one wants to consume J ? Anyway I digress

An experimentin deep value
Around 2006-2007,i decided to run a small experiment of investing in deep value, statistically cheap stocks. I eventually invested around10-15% of my portfolio in names such asDenso, Cheviot company, Facor alloys and VST industries etc for a period of around 3-4 years.

I decided toterminate this approach in 2011 and have been exiting the positions since then.In the rest of the post I will cover my experience and learnings from this longrun experiment.

The results
The resultsfrom this portion of the portfolio (which was tracked separately) was actuallyquite decent. I was able to beat the market by 5-6% points during this period.At the same time, this part of the portfolio lagged the high quality portion by6-7% over the same time period. The difference may not appear to be big, but adds up over time to a considerable differencedue to the power of compounding.I have notcompletely forsaken this mode of investing and once in while could buysomething which is very cheap and has a near term catalyst to unlock the value.

Why did Iquit ?

I did notquit for the obvious reason of lower returns than the rest of the portfolio.The lower return played a part, but if I compare the effort invested inbuilding and maintaining a deep value portfolio , it is much lower than trying to identify ahigh quality and reasonably priced company .

If onecompares, the return on time invested (versus return on capital), the balance couldtilt towards the deep value style of investing.

Let me listthe reasons for moving away from this style of investing

Temperament
The no.1 reason is temperament. I have realized that I do not have thetemperament to invest in this fashion. I do not like to buy poorly managed, weak companies which are extremelycheap and then wait for that one spike when I can sell it off and move on tothe next idea. It makes my stomach churn everytime I read the annual report ofsuch companies and see the horrible economics of the business and miserableperformance of the management.

Life is too shortfor such torture

Re-investment
risk- The other problem in this mode of investing is the constant need for newideas , to replace the duds in the portfolio. This exposes one to re-investmentrisk (replacing one bad stock with another bad idea), especially during bullmarkets.

Value traps
This part of the market (deep value) is filled with stocks which can be calledas value traps. These are companies which appear cheap on statistical basis,and remain so forever. The reasons vary from a bad cyclical industry to poorcorporate management. In all such cases, the loss is not so much as the actualloss of money, but the opportunity loss ofmissing better performing ideas.

Higher
trading The final problem in this mode of investing is the constant churn inthe portfolio resulting in higher transaction costs and higher taxes, both ofwhich reduce the overall returns.

The lessons

I know someof you, have never followed this mode of investing and have always invested inquality. The problem with investing in quality is the risk of over payment,especially if the quality is just an illusion (faked as in the case of severalcompanies in the real estate sector in 2007-2008). Anyway, that is a topic foranother post.

I amconstantly experimenting , with a small amount , with new approaches and ideas.If there is a valid approach, which matches my overall value investing approach(momentum and technical trading is out), I will try it and see if it works forme. It is one thing to read about it and another to put some money into to itand immerse oneself in it.

As some hassaid an expert is someone who has made the most mistakes and survived. Well,at the current rate of making mistakes, I hope to become an expert in the next10-20 years J.

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