My experiences with deep value investing

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

This mode ofanalysis is a quantitative, statistics driven method where in one holds a largenumber of such Cheap companies. A few positions work out, a few go down thedrain and rest just stagnate doing nothing. In spite of such a mix, the overallportfolio does quite well and one is able to earn decent returns at low riskThe keyelement in this investment operation is wide diversification and constantsearch for new ideas to replace the duds in the portfolio.

Initial forayinto high quality

My firstexposure to sensible investing (reading economictimes and watching CNBC doesnot count in that), was when I read the book The Warren Buffett way. I was completely mesmerized by this person and read allI could on him for the next few years.

I have alwayswondered why these stocks are called consumption stocks? are capital goods andreal estate un-consumption companies whose products no one wants to consume J ? Anyway I digress

I decided toterminate 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 longrun experiment.

Why did Iquit ?

I did notquit 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 inbuilding and maintaining a deep value portfolio , it is much lower than trying to identify ahigh quality and reasonably priced company .

If onecompares, the return on time invested (versus return on capital), the balance couldtilt towards the deep value style of investing.

Let me listthe reasons for moving away from this style of investing

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

Re-investment
risk- The other problem in this mode of investing is the constant need for newideas , to replace the duds in the portfolio. This exposes one to re-investmentrisk (replacing one bad stock with another bad idea), especially during bullmarkets.

Value traps
This part of the market (deep value) is filled with stocks which can be calledas value traps. These are companies which appear cheap on statistical basis,and remain so forever. The reasons vary from a bad cyclical industry to poorcorporate management. In all such cases, the loss is not so much as the actualloss of money, but the opportunity loss ofmissing better performing ideas.

The lessons

I know someof you, have never followed this mode of investing and have always invested inquality. 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 severalcompanies in the real estate sector in 2007-2008). Anyway, that is a topic foranother post.

As some hassaid 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 next10-20 years J.