Deep value investing refers to a value investing strategy that focuses on extremely undervalued stocks that most investors tend to avoid. It involves thoroughly analyzing a company’s intrinsic value through financial ratios like low P/E, low P/B ratios and high dividend yields, and investing in stocks trading significantly below their intrinsic values. Deep value investors adopt a contrarian approach, buying distressed or overlooked stocks and holding them patiently for the long term. The key to deep value investing lies in the ability to estimate the intrinsic value of a business and determine if the current stock price presents a sufficient margin of safety. This article will explore the methodology, pros, cons and risks of deep value investing, as well as examine some successful deep value investors like Warren Buffett and David Einhorn.
Deep value investing relies on estimating the intrinsic value of a business
At its core, deep value investing is about analyzing a company’s fundamentals to estimate its intrinsic value independent of its current stock price. Valuation metrics like P/E, P/B and P/S ratios are used to identify companies trading at a steep discount to intrinsic value. Deep value investors compute the company’s intrinsic value using discounted cash flow models. Assumptions about future cash flows, growth rates and discount rates significantly impact intrinsic value estimates. Industry analysis is critical to determine realistic growth assumptions. Margin of safety, the difference between intrinsic value and market price, is a key consideration. The greater the margin of safety, the lower the risk.
Deep value investing involves buying distressed, overlooked stocks
Deep value investors search for underfollowed, unloved stocks that most other investors neglect or avoid. These are often distressed stocks trading at very low valuations due to temporary problems like lawsuits, management changes, product recalls or macroeconomic conditions. But the underlying business fundamentals remain strong. Deep value investors believe the problems are solvable if the business has durable competitive advantages. They wait patiently for the stock price to recover when the problems get resolved. Some deep value stocks even trade below liquidation value and book value, indicating extreme undervaluation.
Deep value investing requires a long term, contrarian mindset
The contrarian nature of deep value investing necessitates a long term mindset and strong temperament. These stocks appear cheap for good reason and tend to be more volatile. Holding periods of 3-5 years are typical to allow the stock price to converge towards intrinsic value. Patience is critical as turnarounds often take longer than anticipated. Being contrarian also means resisting the herd mentality and staying committed despite short term underperformance. David Einhorn held on to Green Mountain Coffee despite heavy losses before finally generating massive profits.
Risks include inaccurate intrinsic value estimates and value traps
The biggest risk in deep value investing stems from inaccurate intrinsic value estimates. Overly optimistic assumptions will overstate intrinsic value. Deteriorating fundamentals can also lead to continued underperformance. Deep value stocks also run the risk of being value traps – companies that appear undervalued but languish for years. Maintaining a diversified portfolio and focusing on high quality stocks with staying power mitigates some of these risks.
Deep value investing aims to profit from extreme inefficiencies in the market by buying solid companies at steep discounts to conservatively estimated intrinsic value. Success lies in accurately determining intrinsic value, resisting herd mentality and displaying strong patience to hold through volatility. While contrarian deep value strategies have proven rewarding for legendary investors like Warren Buffett, they also carry higher risks that warrant caution.