Steak is worth more to beggars than vegans, and a company is worth more to some than others. The difference is investors value a company by its ability to resell. Resale potential is twofold, consisting of future value and present performance.
The future is subjective, but performance is factual. The principal behind value investing is that factual performance seeps into stock price over time. Deep value investing goes a step further.
Deep value investing is an approach that uses predefined discount thresholds to select heavily undervalued stocks, rather than relative discounts within a peer group or subjective metrics addressing a company’s competitive qualities.
Let’s unpack that with an example.
Imagine you purchase a house for $500,000. Soot from an upwind factory miles away colors the neighborhood black. Additionally, real estate agents discover corrosive piping in a local home. Someone makes you an offer for $250,000, and you sell.
Other homeowners sue the factory until it closes down, and it turns out the corrosive piping was a one-house issue. Now the home you sold is worth $500,000 again.
The buyer got your home for her target 50¢ on the dollar. She didn’t think twice about surrounding conditions because they tend to work themselves out, and a discount is a discount. This is deep value investing.
Deep Value vs. Value Investing
Value investing originated in the 1930s with legendary trader Benjamin Graham. He popularized the use of fundamental analysis to pick winners rather than following the herd and its ugly cousin, media hype. He ignored ideas about the “quality” of the underlying company and sought only extremely favorable prices.
His methodology used of a small number of financial ratios to compare companies within the same industry and identify cheap opportunities. This is value investing.
Deep value investing has one nuanced difference — absolute targets.
Value investing compares companies within an industry to contextualize discount ratios, whereas deep value investing establishes absolute thresholds and ignores peers.
Ratios as Discount Measurements
So how do investors calculate discounts? What does it mean to “buy $1 for 50¢”? They use valuation ratios.
Ratios Compare Share Price to Financial Performance
Ratios evaluate the relationship between a company’s share price (external in the markets) and its performance and holdings (internal to the company).
Strictly speaking, when the external valuation is lower than the internal valuation, the company is discounted. Value investors don’t require the discount be less than 1, but deep value investors do.
Not so Black and White
In practice, most asset managers have fluid strategies and don’t take such a hard stance on buying opportunities. Few practitioners today predefine absolute discounts and ONLY purchase stocks that beat them. Some of the old heavyweights like Walter Schloss did this, but it’s not common today.
Financial Ratio Examples & Targets
There are only a few valuation ratios. The most common are Price/Book, Price/Earning, EV/Sales, EV/EBITDA or Price/Cash Flow.
Price/Book value compares a firm’s market capitalization with its total assets. Another way to compute it is share price divided by assets/total shares outstanding.
Typical deep value P/B: <0.60
Price/Earnings (or P/E) compares a company’s market capitalization with its most recent yearly earnings.
Typical deep value P/E: <7.5
Price/Cash Flow compares a company’s market capitalization with its operating cash flow (before financing and investing activities).
Typical deep value P/CF: <6
Enterprise Value/Sales compares a company’s market [capitalization + total debt – cash] to its annual sales. The idea behind Enterprise Value is the total equity value (market cap) plus debt that a potential acquirer would need to pay during a purchase, less the cash he could use to pay down the debt ([total debt – cash] is also known as Net Debt).
Typical deep value EV/Sales: <1.5
Enterprise value to EBITDA compares a company’s EV to its earnings before interest, taxes, depreciation and amortization. The idea behind EBITDA is to determine a company’s earnings before considering long-term debt financing and capital expenditures such as the purchase of large machinery.
Typical deep value EV/EBITDA: <5
Altogether, typical deep investing ratios are:
- P/B: <0.60
- P/E: <7.5
- P/CF: <6
- EV/Sales: <1.5
- EV/EBITDA: <5
Strategy: Low Multiples & Quality Handles Itself
Because the only criteria for purchase is an extremely large discount, deep value companies often come with loads of issues. Operational inefficiencies, comfortable managers, declining industries, and operating losses are commonplace with deep value stocks. These companies often have bad analyst ratings and dismal press coverage.
So why buy them?
The intuition that companies with internal problems are bad buys is precisely what drives a wedge between value investors and quality investors. Any normal person would shy away from poor companies, but there are 4 reasons why you shouldn’t.
#1 Hot Hands Fallacy
First, the Hot Hands Fallacy says that it’s wrong to assume a current trend will continue into the future. In reality, trends are a question of chance and statistically will not last. The name “Hot Hands” comes from basketball, where spectators seem to believe a player who makes several shots in a row is “on fire” and can’t miss.
In reality, it’s more likely he will. If you roll a dice five times and get the number 2 each time, it’s not because you’re skilled at rolling 2s. It’s luck.
Company’s with loads of issues are outliers. Chances are, they will correct themselves on luck alone.
#2 Regression to the Mean & Base Rate
Regression to the Mean is similar to the hot hands fallacy. Imagine you see a beautiful woman dating an average-looking guy. You might ask, “how did she end up with him? She could do better!” The reality is she simply has fewer equivalents in the dating pool. Her choice is limited, and she “regresses” to the average.
Another way to think about outliers is base rate. Imagine you’re presented with the following scenario.
- Researchers know that 25% of Americans suffer from depression.
- They wanted to examine the phenomenon further and decided to survey students at two universities.
- The first one was a prestigious private college with low acceptance rates and high dropout rates.
- The second was a community college with nearly 100% graduation rates.
Which school do you think has higher rates of depression?“
Many people respond that the private college has higher depression rates, when in fact the rate at both school is ~25% — the base rate. Your mind makes you connect ideas like pressure and dropout rates with depression, but there’s no evidence to suggest that.
The same thing applies to companies. Even the most troubled companies regress to the mean over time. It also explains why the 10, 5, 3 rule works over long periods.
#3 Loss Aversion
Loss aversion is a well-documented phenomenon in which humans are more likely to avoid loss than accept the equivalent gain. For example, would you pay $50 today to avoid a 2% chance of paying $2,400 tomorrow? Many people say yes, but the reality is that 5% * $2,400 is $48. It’s definitely cheaper to take the 2% chance.
The same applies in companies. Companies with internal issues see the stock price dropping, and power structures activate to fix them. It’s loss aversion.
#4 Activism & Contrarians
Activist investors, in many cases hedge funds, purchase large portions of poor companies and improve how they are run.
Contrarian investors assume that stock optimism results from investors who are fully invested and have no more purchasing power, which will drive stock down. They likewise assume stock pessimism results from investors who have sold their positions and can only begin purchasing again, which will drive stock up.
Though smaller players in the market, activist and contrarians are the characters who do the bidding of hot hands, regressions, base rates, and loss aversion. They provide a means of reversing poor performance “in the field.”
Bankruptcy: The Only Reason to Fear Low Multiples
The only real reason to avoid a failing company is bankruptcy, and it’s not a great reason.
Because the deep value approach always purchases at a discount, liquidation resulting from bankruptcy will cover investors’ positions. For example, if you purchase a company with 0.90 P/BV, this means there are enough assets on the balance sheet to pay off debtors and investors, by exactly 11% (1 / 0.90).
The nuance is that asset value on the balance sheet does not always represent resale value. If asset resale is dramatically less than its paper value, or if you used a different valuation ratio than P/BV, you could sustain a loss. Then again, the assets could resale for more than their paper value and return a gain.
If you’re still not convinced, consider the likelihood of bankruptcy. Less than 0.006% of yearly bankruptcies come from public companies (only 22 in 2021). This means the base rate for it occuring is extremely low.
Combine low chance with low potential losses, and deep value investing seems like a surefire strategy.
Here are some example companies that could be considered deep value stocks based on P/E as of writing. Keep in mind that we provide this table for educational purposes only.
|Sum of P/E (ttm)
|Sum of Price/Book
|Leisure & Recreational Prdcts
|China Automotive Sys
|Auto – Truck Original Parts
|China Bat Group Inc
|Finance – Misc Services
|First US Bancshares Inc
|Banks – Southeast
|Banks – Southeast
|Tpg Re Finance Trust Inc
|Real Estate Operations
|Transportation – Ship
|Salem Media Grp Inc
|Broadcast – Radio & TV
|Banks – Major Regional
|Banks – Northeast
Tools for Deep Value Investing
Investors interested in deep value investing only need a two tools. Stock screeners remove huge amounts of manual work to find companies with target ratios. Investing apps and platforms handle remove oldschool brokers and handle the legwork to send order through stock exchanges.
Adapted Stock Screeners
We recommend a few screeners for deep value investing. The important thing is that these screeners can filter for relevant financial ratios, otherwise they’re not relevant.
Adapted Broker Apps & Platforms
We recommend a few investment apps for deep value investing. The important things are that they’re free and easy to use.
- SoFi Active Invest
- Ally Invest Self-Directed
(Optional) Adapted Portfolio Managers
If you’re an active trader with several portfolios, a good portfolio manager is useful to stay organized. Here are some options.
- Empower (Personal Capital) – Personal Dashboard
- Stock Rover
- Quicken – Simplifi
Deep value investing requires profound research and unwavering commitment to metrics. It’s not easy, but some of the greatest investors such as Ben Graham, Walter Schloss, and even Warren Buffet have used it with great success.
Based on facts, heavy discounts, and real-world performance, the deep value approach is perfect for investors with nerves of steal and belief that the underdog will prevail — as he so often does.