August 26, 2012

My experiences with deep value investing

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

This method of investing was introduced and popularized by the father of value investing – Benjamin graham in his classic security analysis (A must read for any serious investor). In this book, graham talks about companies selling below working capital, book value or in some extreme cases, even the cash held by the company.
This mode of analysis is a quantitative, statistics driven method where in one holds a large number of such ‘Cheap’ companies. A few positions work out, a few go down the drain and rest just stagnate doing nothing. In spite of such a mix, the overall portfolio does quite well and one is able to earn decent returns at low risk

The key element in this investment operation is wide diversification and constant search for new ideas to replace the duds in the portfolio.
Initial foray into high quality
My first exposure to sensible investing (reading economictimes and watching CNBC does not count in that), was when I read the book – The warren buffett way. I was completely mesmerized by this person and read all I could on him for the next few years.

After burning my finger a bit during the dotcom bust, my initial investments were in the warren buffett mold (high quality stocks with competitive advantages). My initial investments were in asian paints, pidilite, Marico etc - the so called consumption stocks except that they were not called by this label then.
I have always wondered why these stocks are called consumption stocks? are capital goods and real estate ‘un-consumption’ companies whose products no one wants to consume J ? Anyway I digress

An experiment in deep value
Around 2006-2007, i decided to run a small experiment of investing in deep value, statistically cheap stocks. I eventually invested around 10-15% of my portfolio in  names such as Denso, Cheviot company, Facor alloys and VST industries (see here), etc for a period of around 3-4 years.
I decided to terminate 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 long run experiment.

The results
The results from this portion of the portfolio (which was tracked separately) was actually quite 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 by 6-7% over the same time period. The difference may not appear to be big, but  adds up over time to a considerable difference due to the power of compounding.

I have not completely forsaken this mode of investing and once in while could buy something which is very cheap and has a near term catalyst to unlock the value.
Why did I quit ?
I did not quit 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 in building and maintaining a deep value portfolio ,  it is much lower than trying to identify a high quality and reasonably priced company .

If one compares, the return on time invested (versus return on capital), the balance could tilt towards the deep value style of investing.
Let me list the reasons for moving away from this style of investing

Temperament – The no.1 reason is temperament. I have realized that I do not have the temperament to invest in this fashion. I do not like to buy poorly  managed, weak companies which are extremely cheap and then wait for that one spike when I can sell it off and move on to the next idea. It makes my stomach churn everytime I read the annual report of such companies and see the horrible economics of the business and miserable performance of the management.
Life is too short such for such torture

Re-investment risk- The other problem in this mode of investing is the constant need for new ideas , to replace the duds in the portfolio. This exposes one to re-investment risk (replacing one bad stock with another bad idea), especially during bull markets.
Value traps – This part of the market (deep value) is filled with stocks which can be called as value traps. These are companies which appear cheap on statistical basis, and remain so forever. The reasons vary from a bad cyclical industry to poor corporate management. In all such cases, the loss is not so much as the actual loss of money, but  the opportunity loss of missing better performing ideas.

Higher trading – The final problem in this mode of investing is the constant churn in the portfolio resulting in higher transaction costs and higher taxes, both of which reduce the overall returns.
The lessons
I know some of you, have never followed this mode of investing and have always invested in quality. 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 several companies in the real estate sector in 2007-2008). Anyway, that is a topic for another post.

I am constantly 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 for me. It is one thing to read about it and another to put some money into to it and immerse oneself in it.
As some has said – 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 next 10-20 years J.


Ajay said...

Do you try backtesting your approaches? For example go thru annual reports of companies for year 2001, 2002, then make a guess about future earnings (say of year 2005) and check whether it worked out as expected by looking at annual report of 2005.

Shantanu said...

The approach you mentioned is quite risky. Also there could be an issue with the portfolio if profits from a couple of stocks gets averaged out due to losses in others.

I am still learning the basics of what Mr. Graham taught about picking stocks for the defensive investor in his book 'Intelligent Investor'. :)

Lucky said...

Looking for bargains requires looking wide; looking for quality requires looking deep. So it entirely depends upon the band'width' one has :-)

However, looking deep will automatically improve one's understanding of the company and, therefore, reduce the risk. So in the end, quality companies will tend to provide safer (and maybe better) returns with less time invested in the whole activity.

I initially thought that it would be possible to write statistical tools offering potential ideas. However, that has turned out to be too risky. Portfolio turnover is very high and sleep per night is quite low.

Back to basics, I guess.

vignesh said...

hi or hit, can pls hav a look at Lakshmi electrical control systems... it's promoted by the same group which promoted the LMW. market cap is equal to cash on books... it's looks interesting for me... pls do let me know ur views...

Dhwanil said...

Hi Rohit,

Very interesting analysis. I too lean towards your thought process after experimenting both the approaches of buying deep value stocks and buying great business at reasonable price. Even though, i still feel that "margin of safety" is more measurable and objective in "deep value" approach subject to not falling into a value trap! I think management integrity is of paramount importance if it is a cash bargain (typically arising out of sale of business/unit/asset). May be something like Piramal healthcare (management is both highly competent and honest) or JB chemicals (decent in its dealing with shareholders and reasonably competent) can be good deep value buys. However, can one generate compounding machine out of deep value stocks? my take would be "probably not" (Piramal is an exception in my opinion) because of the lack of "moat" in many of these deep value businesses. And then, as you so rightly pointed out, tax and transaction cost also lower the return of deep value stock.

Best Regards
Dhwanil Desai

Anonymous said...

Why do you not then follow this style of investing in high quality companies in your model portfolio.? Based on what I saw, it seems more of deep value.


Rohit Chauhan said...

Hi ajay
I generally dont try to get too precise on earnings ...try to work with a range and so i dont try to check if the actual earnings came as i predicted as i am not really trying to predict the earnings


Rohit Chauhan said...

Hi shantanu
no the approach is not too risky ..the downside is protected by the cheap valuations. also you may lose a bit in some cases, but it is covered by the gains made on others. overall deep value works out fine at low risk ...however you will rarely get a multi-bagger


Rohit Chauhan said...

Hi lucky
yes you have summarised it quite well ..the key is also to limit oneself to an area where one understands the industry. a focus portfolio with poor understanding of the business can get dangerous


Rohit Chauhan said...

Hi vignesh
lakshmi electrical is a proxy for LMW as LMW is one of its largest customer. it is cheap ...but i would prefer LMW over it


Rohit Chauhan said...

hi dhwanil
you are right is not easy to get multi-baggers from deep value investing

at the same time, this type of investing is profitable. it is not really speculative. also some people are more inclined towards deep value investing whereas some prefer to study a limited no. of companies in detail and invest in them. it comes down to temprament

piramal healthcase is a unique case is a high quality company available at deep value prices :)


Rohit Chauhan said...

we had some deep value ideas which we have exited since then. Some are high quality ideas available at deep value prices ...that is the best of both worlds as you are buying a high quality company at throway prices

i am not sure which ideas you are refering to in the comment. why dont you write to me on and i can clarify any questions


Aaditya said...

Dear rohit,
Warren buffet also stared with deep value investing and then migrated into investing. In quality businesses.According to him real money was made not on quantitative analysis but more on qualitative analysis I.e analysing a companies competive advantage,management abilities,growth prospects etc.So if one can properly identify these things in a company it's great but it's not a very easy thing to do,however quantitative analysis or finding value through numbers can done sitting at ur desk.So I believe the the best returns can be made when quality companies r available at cheap prices during depressing times.One should just have the patience to wait...