The first step to becoming a better investor, says Carlisle, is to recognise that all are naturally wired to jump off the cliff and follow the herd. So, deep value investing can be viewed as a sort of counter-intuitive survival guide to overcoming these self-destructive investment tendencies.
The next step involves giving counter-intuitive ideas a chance, as sometimes failing businesses, poor managements and unpredictability provide the most promising investment opportunities, says he.
He says deeply undervalued and out-of-favour stocks can offer asymmetric returns, with limited downside and greater upside.
Tobias Carlisle is the Chief Investment Officer at Acquirers Funds, and is best known as the author of the book
Deep Value: Why Activists Investors and Other Contrarians Battle for Control of Losing Corporations.
A graduate from the University of Queensland in Australia with degrees in Law and Business (Management), Carlisle has plenty of experience in investment management, business valuation, corporate governance and corporate law and has also worked as an analyst at an activist hedge fund.
Deep value investing
Returns to deep value investing can be realised in two ways:
- Through mean reversion, and
- When the discount to valuation narrows down either with the passage of time or through the intervention of activists and buyout firms
Carlisle says if one wants to beat the market, then she must do something different from the usual, like buying only undervalued stocks and waiting for the reversion to the mean. Mean reversion is a concept that works in favour of undervalued stocks and against overvalued stocks, as it leads to cheaper stocks becoming more expensive and expensive ones getting cheaper.
“The key to maximizing returns is to maximise our chances at mean reversion. That means maximising the margin of safety. We want the most undervalued stocks. And we want to make sure they survive to mean revert,” he said in a presentation at [email protected] Google.
Deep value investing takes advantage of mean reversion, where prices eventually move back towards normal, says he. “Mean reversion is the expected outcome. But we don’t expect mean reversion. Instead, our instinct is to find a trend and extrapolate it. We think it will always be winter for some stocks and summer for others. Instead, fall follows summer, and spring follows winter. Eventually,” he says.
Carlisle says one can also use the contrarian approach to beat the market, and do the opposite of what other investors do, which he believes is quite difficult because one is hardwired to follow the crowd, rather than run against it.
“Following the trend is instinctive. Mean reversion is not. But data show mean reversion is more likely,” says he.
Also, Carlisle believes low or no-growth stocks eventually beat high-growth stocks, as mean reversion affects growth as well as valuations.
Highly-profitable stocks beat the market only if they have moats that protect margins and profits. Otherwise, undervalued, low-profit stocks would outperform high-profit stocks in the long run.
Follow a simple strategy
Carlisle says it is very essential to keep things simple and follow a simple strategy while making an investment decision.
Many studies have concluded that investors who have followed simple rules have done better than those who follow complex strategies.
Carlisle advises value investors to stick to a couple of simple rules :
- Buy only when the price is well below a stock’s intrinsic value.
- Sell when the price is well above the stock’s intrinsic value
These rules are based on the assumption that an investor will use the same strategy every time. “It’s not easy for investors to stick to a single strategy every time, as they all want to be experts and bend the rules a bit,” says he.
Most investors hate strict rules. They think it’s better to use the output from the simple rule and then decide whether to follow it. “This isn’t a bad way to go. Experts make better decisions when they use simple rules. But they don’t do as well as the simple rule alone,” he says.
7 principles of deep value investing
Carlisle lists out 7 simple principles for deep-value investing that one can follow to ensure solid returns in the long run.
1. Zig when the crowd zags: Carlisle encourages investors to follow a contrarian approach towards investing, and advises them to avoid following the herd. But he warns that before taking a contrarian approach, one should know the crowd’s consensus, which can be found in the difference between a stock price and its value.
Attractive investment opportunities, says he, arise only when the crowd wants to sell. Further, companies available at attractive prices should be tilted to the benefit of the contrarian with a small downside and a big upside.
According to his, this tilting provides a margin of error and because of reversion to the mean, stocks that seem unattractive move from being undervalued to overvalued with time.
2. Find a margin of safety: Deep value stocks have a built-in margin of safety, and they are undervalued because the possibility of a worst-case scenario is already priced in. That gives it a high upside/low downside bet, says he.
“The worst-case scenario provides a low downside. So you can’t lose much if you’re wrong. But if you’re right, the high upside can bring exceptional returns. So even if you’re right as often as you’re wrong, you do okay. Be more right than wrong, you will do great,” he says.
Investors should buy stocks at deep discounts and that as margin of safety would allow room for investor error, he says. “The deeper the discount to fair value, the bigger is the margin of safety, and more the room for error, the better the potential return, and lower the risk,” he says.
3. Focus on cash flows: Carlisle feels a share of a company shouldn’t be considered a mere ticker symbol. When one invests in a stock, she becomes partial owner of that business. This, Carlisle believes, has two important implications. First, a shareholder has rights and can exercise those rights by voting at meetings; and secondly, an owner pays attention to all that a company owns and owes, especially its cash.
So, Carlisle encourages investors to focus on the amount of cash that a company has before making an investment decision. Many investors make the mistake of focusing on profits and ignoring the assets on the balance sheet. “The crowd ignores cash. They focus on the eggs rather than the golden goose. A seemingly poor business with a strong balance sheet could represent hidden value. The asset value offers a free call option on any business recovery,” he says.
4. Be cautious of fast growing companies: Carlisle says fast-growing and profitable companies attract competition, leading to erosion of margins and profits. Although moats do help, strong and sustainable moats are hard to find, and it is tough to gauge whether a moat will remain strong and sustainable in the future, he says. Also, due to reversion to mean, over time, high growth and profit companies eventually become just average companies.
So Carlisle advises investors to look at companies that are currently facing difficulties and have prices that reflect those challenges.
5. Follow simple, concrete rules to avoid errors: Investors should follow simple concrete rules that can be both back-tested and battle-tested to avoid major errors. Back-testing checks the rules for theoretical strength, especially when tested in different countries and different stock markets. A battle-test can ensure the rules work in the real world. “No strategy has ever failed in theory. Almost all have failed in reality,” says he.
6. Don’t have a concentrated portfolio: Carlisle believes a concentrated portfolio focuses only on a few high performing stocks for investment due to which it comes with two important trade-offs. First, a concentrated portfolio is more volatile than a diversified one, so a whole good year for the market can be a great year for the portfolio, but a bad year can turn out to be a terrible one.
Also, concentrated portfolios do not follow the broader market due to which a portfolio can go down even when the market is moving up, and vice versa. So, Carlisle cautions investors to not concentrate their portfolios too much, as it may lead to bad decisions when the market is not looking favourable.
7. Have patience for long-term success: Carlisle says investors often misprice stocks of companies that are facing tough times. This, he feels, can be an opportunity for patient investors willing to put up with below-average results in the short term. Carlisle believes investors who follow a buy-and-hold strategy and wait for a turnaround to happen have an enduring edge as they are focused on the long-term gains.
He says compounding may be powerful, but it takes time to build up steam and can get reduced or killed by taxes and fees. He feels interest and gains become significant for only those who are willing to wait for more than a year or two.
Carlisle says despite research showing that value investing is a very safe and sound approach to managing an investor’s portfolio, it is not very popular with most investors. He attributes it to investors’ reluctance to use this approach to self-preservation, as they have to defend their investments to clients who are usually emotional and impatient, especially if there’s prolonged period of underperformance.
(Disclaimer: This article is based on Tobias Carlisle’s book Deep Value: Why Activists Investors and Other Contrarians Battle for Control of Losing Corporations and his presentation at [email protected] Google)