Historically, value investing has been the most financially rewarding investment strategy. Warren Buffett offered anecdotal evidence of this during a speech he gave, famously summarized in the article “The Superinvestors of Graham-and-Doddsville.” Academia later confirmed the merits of Buffett’s speech when Eugene Fama and Kenneth French completed a 20-year empirical study which showed value investments outperformed other strategies by 7.68% per annum. However, despite this wonderful track record, value investing is still widely misunderstood.
I suspect the confusion is due to misconceptions about where risks and returns are derived from, coupled with the seemingly endless iterations this strategy has undergone – diluting its very name. It’s why we need to distinguish the purist form of value investing, what we deem as deep (or absolute) value investing, which was established by Benjamin Graham and popularized by his famous protégé Warren Buffett, from the misleading “relative value investing” strategies being promoted today.
At its core, deep value investing stresses conservatism and focuses on relentless fundamental research in the pursuit of uncovering; great companies, in great industries, run by exceptional management teams. Upon finding one of these opportunities, it’s only deemed attractive if it’s priced significantly below (30% or more), its already conservatively calculated intrinsic value. This naturally creates a substantial margin of safety. This margin of safety also represents the first of many layers of protection against a permanent loss of capital, while simultaneously offering attractive return potential. In other words, this strategy can reduce risk while achieving attractive long-term returns.
Deep value investing practitioners pride themselves on avoiding common misconceptions about where returns and risks are derived from. Some investing fallacies investors commonly fall victim to are; revenue growth assures profits, dividend-paying companies are better than non-dividend paying companies, and stocks (and now bonds) with low historical volatility are safe. Those who invested in high-growth technology companies in the late 1990’s, and more recently in oil companies, for their seemingly safe monthly distributions, are painfully aware of the pitfalls associated with this way of thinking.
In contrast to deep value investing, relative value investing does not consider how expensive a security is relative to its long-term historical valuations. Instead, it only focuses on a security’s value relative to other similar investments at a specific moment in time. Removing historically conservative valuations weakens the most important line of defence against losses, the margin of safety, leaving an investor susceptible to the risks associated with frothy markets.
Finding needles in a hay stack
We practice the purist form of value investing, exploring qualitative and quantitative business factors, not financially superficial ones, to ensure quality exists. For instance, we look for consistent and strong cash flow generation and sound return on tangible assets throughout the business cycle – indicating a great business model exists. These quantitative characteristics, which can differ dramatically between companies, are usually found in less capital-intensive industries that enjoy high barriers to entry and a high degree of predictability. Management teams are also critical, but extremely difficult to assess. A long track record of successful capital allocation, alignment of interest with shareholders, and business acumen is imperative. Uncovering these traits requires meeting management and touring factories, which isn’t practical for a portfolio of hundreds of securities. Therefore, we focus our efforts on holding a portfolio of 10 to 20 meticulously-vetted investments for long periods of time, ensuring tax efficiency and diversification.
Our investment in Exco Technologies, an auto parts tooling manufacturer, is a classic example of deep value investing. This lesser-known company long had growing revenues, a sticky customer base, high operating margins, no debt, and an asset-light business model. In 2013, when we identified Exco, the automotive industry was out of favour and valuations were extremely depressed, despite its rapid recovery at the time and valuations were extremely depressed. The industry was also adapting to tighter emission regulations by using lighter materials, like aluminum — a core competency at Exco.
Importantly, management had an outstanding operational track record. Their reputation across the industry was exceptional, something we determined when speaking with their customers, suppliers, industry experts, and competitors. The executives were also aligned with shareholders, with their CEO Brian Robbins owning 23.4% of the company. The culmination of our extended research process, which included multiple site tours, also uncovered considerable organic and acquisitive growth potential. It was also attractively priced, at 60% below our conservative calculation of its intrinsic value. We invested when the stock price was at $6.10, and we sold two years later at $15.10 as the company neared our projected intrinsic value of $15.30.
Working shoulder to shoulder
With deep value investing, portfolio managers and their investors must be in sync. For an investor, understanding the manager’s thought process and comparing it to unfolding events is critical, as is a deep understanding of the manager’s approach to risk and how he or she mitigates it.
Deep value investing, if used and communicated to clients properly, is suitable for many investors. Often, deep value managers will make investments during periods of extreme price mismatches in the markets and wait, sometimes for years, before their investments realize their full potential. Portfolio managers must prepare investors so they have the temperament and financial ability to withstand market whims and reap the benefits of the investment. To successfully adopt deep value investing, younger investors should focus on using it for the funds that they intend to retire. Older investors should look to this strategy for funds they plan to leave to loved ones.
Talbot Babineau is president and CEO of investment management firm IBV Capital.