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“Value strategies yield higher returns because these strategies exploit suboptimal behavior of the typical investor and not because these strategies are fundamentally riskier.”  

- Josef Lakonishok, Andrie Shleifer, and Robert Vishny,
"Contrarian Investment, Extrapolation, and Risk"

Read more of our favorite value-investing quotes.



APRIL 5, 2015



As many of our long-time subscribers are aware, we have spent the last several months working on revising our Deep Value (DV) Portfolio stock-selection system. The current system produced anemic performance (at least for us) in 2014 and the first quarter of 2015.

The following chart documents the results of our Deep Value Portfolio since it was launched in March 2009:

DV Results 09-14


As you can see from this chart, there is quite a bit of fluctuation in the annual returns. Excluding the incredible, once-in-a-generation value investing year of 2009, the portfolio produced return ranging from 30% in 2014 to 261% in 2013. However, the average return for the last-5-year span (excluding 2009) is 101%, which is pretty incredible. In fact, the returns of our Deep Value Portfolio are, on average and excluding 2009, eight times that of its benchmark index, the Russell 2000.


The takeaway from our DV Portfolio performance is that deep-value investing is exceptionally effective. However, it works best when there is a significant selection of deeply undervalued companies to purchase. Those deeply undervalued stocks are principally available following significant market downturns; i.e., when the vast majority of investors oversell stocks due to fear.  

The DV Portfolio demonstrates this fact clearly; following the crash of 2008, it was a veritable value investor's paradise, with great companies selling at bargain prices. When our Intelligent Market Risk Analysis identified the optimum time to re-enter stocks (March 9, 2009), we loaded up on the most undervalued companies with a discount-to-current assets approach that would have made 'ol Ben Graham proud.  The result was a return of 1600% for the remaining nine months of 2009. Following the bear market of 2011 (which few call a bear market, despite a decline of 20%), our DV Portfolio produced a return of 112% in 2012 and and 231% in 2013.

However, following those two bull-market years, 2012 and 2013, we did not see a typical correction, which would have enabled the purchase of a fresh set of deeply undervalued stocks from oversold conditions. Instead, the small-capitalization universe that we use for our Deep Value Portfolio entered into a volatile, sideways, year-long consolidation. The total return for the Russell 2000 (small-cap index) during 2014 was just 5%. Without a significant correction, it is been very difficult to find the deeply undervalued stocks upon which the DV portfolio preys.


The 'deep value' approach to identifying prospective stocks is something that is foreign to most. The vast majority of investors simply don't have the stomach for buying ownership in what appears to be a failing company. 

After all, when an investor is given the choice between a company with earnings that are growing, a high return on equity, and a stock price hitting 52-week highs – versus a company that is losing money with a share price that is collapsing, the choice is obvious, right?

Well, not so obvious. Companies that are in crisis with broken business models and futures that are unclear offer surprisingly favorable investment opportunity. The reason is a timeless force that is evident in all aspects of nature and human endeavor; reversion to the mean.

Mean reversion is an enduring phenomenon that we find in economies, stock markets, business performance, and individual stock prices. The returns of high-growth companies invariably plummet back to earth, and dying companies are resuscitated. The reason is well-established in microeconomic theory: capitalism just works. Companies and industries with high growth and high returns attract new entrants who compete away the excess profitability. Moribund businesses receive new life as competitors exit the industry, inept management is replaced, and assets redeployed.

Deep-value investing is the practical application of the principles established by Benjamin Graham in his seminal books, Security Analysis and The Intelligent Investor. Graham demonstrated what would be proven by researchers and savvy investors over the subsequent 80 years; the stocks that appear most attractive at the peak of their business cycle represent the worst risk/reward ratio. Those that are least attractive and at the bottom of their business cycle represent the best opportunity.

If you followed the simple maxim to purchase the least expensive stocks while avoiding the most expensive, your results would probably astound you. The chart below shows a comparison from 1963 to 2014 of the returns from purchasing the 25 cheapest large stocks (without regard to any qualitative criteria) vs. buying the 25 most expensive large stocks. Cheapest is in blue, most expensive in orange, and overall market in gray:


(Click to enlarge)
Comparison of 25 cheapest large stocks to 25 most expensive large stocks by EBITDA/EV, 1963-2014. Chart courtesy


As you can see from the chart, the results are vastly disparate. Consistently buying the cheapest stocks (without regard to quality) returned almost 90 times the return of buying the most expensive stocks. Even knowing these facts, very few investors are willing to sift through the detritus of broken-down publicly traded companies. Most are attracted to the Tesla's (unprofitable), the EBay's (PE of 1138), and the Amgen's (PE of 351) of the world. Few are attracted to companies that manufacture widget fasteners or other mundane enterprises.

The expensive companies are glamorous and exciting while the undervalued companies are boring, out-of-favor, and undesirable. However, it's those cheap, disdained, prosaic companies that produce the highest return. In the words of Tobias Carlyle, “deep value is investment triumph disguised as business disaster."


Since we created the DV Portfolio in 2009, we have sought companies selling at significant discounts to a variety of fundamental ratios that are deemed to be ‘deep value.’ These include Graham’s net current asset value (NCAV), price-to-book of 0.7 or less, or EV/EBITDA ratio of 3 to 5. However, for some time now, we have had very few stocks in the DV portfolio because there simply aren’t many from which to choose, as shown by this 1963-to-present chart:


Deep Value Stocks
Number of stocks selling at 'Deep Value' prices. Chart courtesy Click to enlarge.

There are only 3.2% of non-financial stocks with a market cap greater than $200M trading at a deep-value, EV/EBITDA multiple of less than 7. If we search for the deepest value stocks (multiple less than 5), there are only ten publicly traded companies that meet that criteria.


The market environment continually changes. The market in 2009, when there was a plethora of undervalued stocks and the DV Portfolio produced a return of 1,600%, is very different from the mature market environment of 2015. As a result, in the last year the performance of our Deep Value Portfolio has suffered. A glance at the 'Prior 12 Months' chart on the DV portfolio page makes that clear. Therefore, we have carefully reviewed the stock-selection approach of the DV portfolio to update it to fit the current environment.

We have spent hundreds of hours in the last three months working to identify an approach for 2015 that would meet the 'deep value' appellation while also producing robust outperformance. We finalized that exhaustive work in the last two weeks and, for the most part, are satisfied. We decided upon a trio of factors to identify deeply undervalued stocks which included Price/Book Value, Enterprise Value/Operating Income, and Price/Sales. Formerly we used the single ratio of Price/Book and required stocks to be priced less than 70% of their book value. Please see for details on these ratios.

When we use these three ratios to identify stocks that are selling at a discount to their intrinsic value, we get some very rousing backtest results, as shown in this table:


Deep Value Portfolio backtest October 2011 to present. Courtesy of


Using these settings, starting with our 'Market Up' signal on October 9, 2011 to present, the portfolio produces a return of 116% annualized, with 90% winners and a maximum drawdown of 18.48%. The average days held increases to 134 (6.7 months), and the average return per stock is 51.28%.

That 'Average Days Held' of more than half a year is a significant breakthrough.  Whenever possible, we should refrain from churning our positions to avoid the associated transaction costs and additional time, energy and effort. Our objective with this portfolio is to buy stocks when they are selling at a deep discount to their intrinsic value and give them time to recover to that intrinsic value. In this backtest, we see that we achieve these objectives, as evidenced by the 90% overall winner rate.

During the very difficult year of 2014, the backtest shows that while we were in cash for much of the year because of volatility in small-cap stocks, the portfolio would have taken advantage of the re-entries with outstanding outperformance each time.  This portfolio would have returned 65% compared the the benchmark's return of 5% (our live portfolio returned 30%):

Backtest of revised Deep Value Portfolio for 2014 would have resulted in a return of about 65%.


For the period of January 2013 to present, we were able to find factors and algorithms that would have mitigated the small-cap consolidation and produce significantly higher returns – more than double the gains we actually received in 2014. In addition, this method of selecting companies should continue to outperform in the future even if small-caps surge higher like 2013. Our tests provided equal returns to the 230% gain we achieved with our live recommendations in 2013. In summary, we were able to maintain the actual DV Portfolio performance during 2013 and substantially improve on the period when small-cap stocks consolidated in 2014.

We successfully revised our mid/large-cap RELATIVE VALUE Portfolio on February 22, and it is outperforming the market since we purchased a fresh set of stocks.  While many of the recently acquired DEEP VALUE Portfolio stocks are in negative territory, we anticipate holding them for months (assuming no market correction) and they should recover to make substantial profits. If the revision backtest is any indication, and we believe it is, 90% could turn out to be winners.

Because of the mature market environment and dearth of deep-value stocks, we are considering launching a new small-capitalization portfolio that is similar to the mid/large-capitalization RELATIVE VALUE Portfolio. These would be stocks of sound companies, with positive price momentum, yet still undervalued.

We would like to hear your feedback on whether or not you support the introduction of this second small-cap portfolio.

We hope that we have thoroughly discussed the issues in this Value Alert, and you can implement these ideas to your benefit.  Our objective is to give you the best value-oriented investment information possible, with ease of use, timely identification of the issues that affect our portfolio positions, and a full understanding of our approach.  If you have any questions or comments, please contact us with a support ticket.

Best Wishes for Another Week of Intelligent Value Investing,


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Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. Shareholders, employees, and writers associated with IntelligentValue, Inc. may hold positions in the securities that are discussed. If you are not sure if value investing or a particular investment is right for you, we urge you to consult with a Certified Financial Advisor. Neither, nor any of its employees or affiliates are responsible for losses you may incur.