Deep value refers to a strategy that has proven to be extremely valuable and uncontroversial—yet it demands patience, diligence, and hard work. For this reason, deep value is not incredibly popular with more impatient investors, yet it has produced above-par returns for those patient enough to do the legwork required to make deep value work.What is deep value? As its name suggests, this investing style relies on finding value that is underappreciated by the market, and allocating capital accordingly to undervalued stocks.
There are many ways to define undervalued stocks, but deep value investors predominately look for many things. For instance, they may seek stocks with stable or rising free cash flow with flat revenue. In many cases, companies that produce free cash flow at a stable rate will have a low P/E multiple that is slightly below the range of the broader market. For instance, the S&P 500 (SPY) is currently near a P/E ratio of 20, so most stocks with stable cash flow from operations will have a multiple in the mid to high teens.
Some stocks, however, will have P/E multiples substantially lower, in the low teens or even single digits. These stocks may be candidates for deep value investing.
But before a value investor can decide to invest in one of these companies, he or she will need to examine a few features of the company. Firstly, is its market share declining? A company that has produced a reliable flow of cash from revenues may see its cash flow decline if its revenues decline—and many stocks with low P/E multiples are often priced so cheaply because the market expects a loss of market share to cause revenues to fall, which in turn will negatively impact free cash flow.
This is not always a sell sign, however. In some cases, companies can counteract this process by developing new products or causing earnings per share to rise through stock buybacks. While growing revenues are always the best kind of growth, it is not the only kind of growth. Deep value investors will invest in companies that use financial engineering to increase shareholder value. So a deep value investor, suspecting a shrinking market share, may invest anyway.
Alternatively, companies that are priced cheaply because the market does not trust the accounting involved or because they expect a management change that will negatively impact the stock could be another deep value candidate. If an investor believes that a stock does not pose as much risk as the market suspects, and is still producing cash through positive margins from operations, they may decide to disregard the market-priced risk of the company and buy its stock. For instance, after the Enron scandal in 2001, many companies were sold off as investors feared the accounting scandal would spread. Deep value investors who knew the risks of the accounting practices in place, and who trusted the accounting of certain stocks, could buy at a discount and earn a hefty long-term profit.
Finally, there is the death-by-high-expectation stock that deep value investors crave the most. A good example of this phenomenon would be Apple (AAPL), who has maintained dominance of two markets the company single-handedly invented and expanded—smartphones and tablets—while maintaining a positive cash flow operation with its desktop and laptop businesses. Yet this stock has been priced at a discount many times in the past because its growth rate was lagging expectations. In many cases, this was merely a market misunderstanding; when AAPL began paying dividends, it messaged to the market that it was no longer a growth company, but an income producer. Many people who hold AAPL because of growth, not income, were irked and sold off over a period of many months. This is an ideal situation for deep value investors.
Deep value investing involves understanding market mispricing of securities when the market misunderstands the risk/reward profile of a company. It involves not only analyzing the finances of a company, but analyzing the market’s understanding of its finances to determine where greater value resides. This takes a mixture of industry and financial expertise, and has been mastered by many asset managers who have used this method to become multi-millionaires.