Quantitative Deep Value Investing iii

(Image: Zen Buddha Silence by Marilyn Barbone.)October 1, 2017Deep valueinvesting means investing in ugly stocks that have been doing terribly–with low- or no-growth–and that are trading at low multiples. Quantitative deep valueinvesting means that the portfolio ofdeep valuestocks is systematically constructed based solely onquantitativefactors including cheapness.There are many different ways to implement a deep value investment strategy. Traditionally, many deep value investors have looked for stocks at discounts to tangible book value. This tends to work over time if you have a basket of such stocks.In general, it's better to use several metrics for cheapness, such as low P/B, low P/E, low P/CF, and low EV/EBIT.Charlie Munger:

The model I like to sort of simplify the notion of what goes o­n in a market for common stocks is the pari-mutuel system at the racetrack. If you stop to think about it, a pari-mutuel system is a market. Everybody goes there and bets and the odds change based o­n what's bet. That's what happens in the stock market.

Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so o­n and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it's not clear which is statistically the best bet using the mathematics of Fermat and Pascal. The prices have changed in such a way that it's very hard to beat the system.

And then the track is taking 17% off the top. So not only do you have to outwit all the other betters, but you've got to outwit them by such a big margin that on average, you can afford to take 17% of your gross bets off the top and give it to the house before the rest of your money can be put to work.

Warren Buffett's October 1967 Letter to Partners:

The evaluation of securities and businesses for investment purposes has always involved a mixture of qualitative and quantitative factors. At the one extreme, the analyst exclusively oriented to qualitative factors would say. "Buy the right company (with the right prospects, inherent industry conditions, management, etc.) and the price will take care of itself." On the other hand, the quantitative spokesman would say, "Buy at the right price and the company (and stock) will take care of itself." As is so often the pleasant result in the securities world, money can be made with either approach. And, of course, any analyst combines the two to some extent–his classification in either school would depend on the relative weight he assigns to the various factors and not to his consideration of one group of factors to the exclusion of the other group.

Interestingly enough, although I consider myself to be primarily in the quantitative school (and as I write this no one has come back from recess–I may be the only one left in the class), the really sensational ideas I have had over the years have been heavily weighted toward the qualitative side where I have had a "high-probability insight". This is what causes the cash register to really sing. However, it is an infrequent occurrence, as insights usually are, and, of course, no insight is required on the quantitative side–the figures should hit you over the head with a baseball bat. So the really big money tends to be made by investors who are right on qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.

DEEP VALUE - CARLISLEValue investors are rewarded for mispricing... Munger quote: Any... can see horse with good win rate etc... but you have to look at the odds, and usually it's not very clear...Carlisle in the Preface:

The stock of high quality companies is driven so high that long-term returns are impaired even assuming the high rate of growth and profitability persist. The corollary is also true: A company with an apparently poor business will generate an excellent return even assuming the low growth or profitability persists. These findings reveal an axiomatic truth about investing: investors aren't rewarded for picking winners; they're rewarded for uncovering mispricings–divergences between the price of a security and its intrinsic value. It is mispricings that create market-beating opportunities. And the place to look for mispricings is in disaster, among the unloved, the ignored, the neglected, the shunned, and the feared - the losers.

Why? Mean reversion. Carlisle:

High growth and high returns invite new entrants who compete away profitability, leading to stagnation, while losses and poor returns cause competitors to exit, leading to a period of high growth and profitability for those businesses that remain.

Many investors, including value investors, have trouble appreciating the phenomenon of mean reversion. Carlisle explains:

We can show that a portfolio of deeply undervalued stocks will, on average, generate better returns, and suffer fewer down years, than the market. But rather than focus on the class of deeply undervalued stocks, we are distracted by the headlines. We overreact. We're focused on the short-term impact of the crisis. We fixate on the fact that any individual stock appears more likely to suffer a permanent loss of capital. The reason is that even those of us who identify as value investors suffer from cognitive biases, and make behavioral errors. They are easy to make because the incorrect decision–rejecting the undervalued stock–feels right, while the correct decision–buying stocks with anemic, declining earnings–feels wrong. The research shows that our untrained instinct is to naively extrapolate out a trend–whether it be in fundamentals like revenues, earnings, or cash flows, or in stock prices. And when we extrapolate the fundamental performance of stocks with declining earnings, we conclude that the intrinsic value must become less than the price paid. These biases–ignorance of the base case and, by extension, mean reversion–are key contributors to the ongoing returns to deep value investment.

Classic deep value according to Ben Graham: stocks below a conservative estimate of liquidation value. Even cheaper: net-net's. "Corporate gold dollars are now available in quantity at 50 cents and less - but they do have strings attached. Although they belong to the stockholder, he doesn't control them. He may have to sit back and watch them dwindle and disappear as operating losses take their toll. For that reason the public refuses to accept even the cash holdings of corporations at their face value."Graham explains that stocks trading at a discount to liquidation value did so because they "almost always have an unsatisfactory trend in earnings." Graham:

If the profits had been increasing steadily it is obvious that the shares would not sell at so low a price. The objection to buying these issues lies in the probability, or at least the possibility, that earnings will decline or losses continue, and that the resources will be dissipated and the intrinsic value ultimately become less than the price paid.

Graham answered that, while some individual cases did suffer such a loss of intrinsic value, there was a much wider range of potential developments that would result in a higher stock price. [See Graham's list...]But Seth Klarman warns:

As long as working capital is not overstated and operations are not rapidly consuming cash, a company could liquidate its assets, extinguish all liabilities, and still distribute proceeds in excess of the market price to investors. Ongoing business losses can, however, quickly erode net-net working capital. Investors must therefore always consider the state of a company's current operations before buying.

Warren Buffett on "cigar butt's"... "foolish unless you are a liquidator..." Carlisle then observes that, despite the reservations of Klarman, Buffett, and other value investors, net-net's as a group, in actual portfolios and also in backtests, have usually demonstrated outstanding performance.

• Henry Oppenheimer
• Oxman, Mohanty, Carlisle (1983 to 2008)
• London stock exchange (1981 to 2005)
• James Montier - all developed markets globally (1985 to 2007), but NOTE median market cap $21 million

Interesting note. Oppenheimer - and Oxman, Mohanty, Carlisle - also found that loss-making net-net's outperformed profitable net-net's, and non-dividend-payors outperformed net-net's that paid a dividend...Very few net-net's liquidated or merged... "That means that the most likely outcome is earnings generation commensurate with asserts."Graham observed that mean reversion was the typical outcome. Judging the quality of the business or management is subjective, according to Graham:

It is natural to assume that industries which have fared worse than the average are "unfavorably situated" and therefore to be avoided. The converse would be assumed, of course, for those with superior records. But this conclusion may often prove quite erroneous. Abnormally good or abnormally bad conditions do not last forever. This is true of general business but of particular industries as well. Corrective forces are usually set in motion which tend to restore profits where they have disappeared or to reduce them where they are excessive in relation to capital.

If the business had a good record, that indicated good management. (Graham says many counted good management twice...) Another mistake Graham warned against was assuming that a trend in earnings would continue...Munger noted:

Ben Graham had blind spots. He had too low an appreciation for the fact that some businesses are worth paying big premiums for.

Buffett resisted Munger's because Buffett had done so well following the teachings of his mentor and hero, Graham. The turning point for Buffett was American Express.salad-oil scandal. Buffett sent his broker, Henry Brandt, to conduct scuttlebutt research (Phil Fisher...) Brandt gave Buffett a foot-high pile of research. Buffett concluded that American Express was an "extraordinary business franchise with a localized excisable cancer".Carlisle writes that American Express was a significant departure from Graham's methods. But Buffett continued to use Graham's methods (to a large extent at that point in time)... he had two cigar butt's in his portfolio at that time - Texas Gulf Producing and Pure Oil - which made up another third of the Buffett partnership portfolio.The consumer franchise could compound value over time, while the cigar butt might only have one free puff...quote from Buffett on qualitative versus quantitative ideas....Buffett: "It took a powerful force to move me on from Graham's limiting view. It was the power of Charlie's mind."Final step in Buffett's evolution (at least in terms of business quality...) - says Carlisle - was the 1972 acquisition of See's Candies...Buffett summed up the lesson he had learned from Fisher, Munger, and See's:

It's far better to buy a wonderful company at a fair price than a fait company at a wonderful price.

Buffett hadn't rejected Graham's philosophy, but had rather extended it. Again, 1989:

Charlie understood this early; I was a slow learner. But now, when buying companies or common stocks, we look for first-class businesses accompanied by first-class managements.

Buffett realized that earnings alone do not determine intrinsic value. Return on capital detrmines intrinsic value. Two companies with the same earnings, but different returns on capital, could have dramatically different intrinsic values...[My note: It depends on capital intensity, or the capital expenditures required to generate the earnings.... owner earnings or free cash flow...]Buffett in 1992:The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase–irrespective of whether the business grows or doesn't, displays volatility or smoothness of earnings, or carries a high price or low in relation to its current earnings and book value.In other words: Earnings are only useful in the context of invested capital... Two companies with the same earnings... Growth only creates value when the return on invested capital is higher than the cost of capital... All else equal, the higher the ROIC, the more valuable the business... Carlisle gives example of two companies, one with 20 percent ROIC, the other with 5 percent, and assume cost of capital is 10 percent...And ROIC must be sustained. Buffett:

A truly great business must have an enduring "moat" that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business "castle" that is earning high returns. Therefore a formidable barrier such as a company's being the low-cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with "Roman candles," companies whose moats proved illusory and were soon crossed.

... "economic franchise"... "first-class management" (manage both the numerator and denominator in ROIC... and only make investments where the ROIC is higher than the cost of capital...)...MORE...The Acquirer's Multiple (Fair Companies at Wonderful Prices)Gray and Carlisle, 1964 to 2011... academic gold standard...Carlisle (page 63):

Greenblatt's earnings yield–known generally as the enterprise multiple, or, occasionally as the acquirer's multiple–is a highly predictive measure of relative valuation. In fact, various industry and academic studies have found it to be better at identifying undervalued stocks than any other "price-to-a-fundamental" ratio, including price-to-book, price-to-earnings, price-to-operating cash flow, or price-to-free cash flow.

LIST ALL INDUSTRY AND ACADEMIC STUDIES SUPPORTING ENTERPISE MULTIPLE...[Gray and Carlisle, 1964 to 2011, EBIT best....]The enterprise multiple prefers companies with high cash and low debt, although this also means that many small "cash boxes"–companies with large net cash holdings relative to their market caps–show up on the screen... "cash boxes" may have limited upside, but "happily" they also have limited downside...Mauboussin's very comprehensive studies... could not identify prospective factors that predict high ROIC...Mauboussin concludes by noting that you get paid for mispricings, not for identifying winners...IN SUM: Deep value is a better bet–recall Buffett's "more sure money" is made in obvious quantitative decisions (deep value including cigar butt's...)...The Clockwork MarketDe Bondt and Thaler, 1926 to 1982... extreme losers (35 stocks over 3 years) versus extreme winners...ALSO found that biggest stock price decline (extreme losers) had biggest EARNINGS growth...THIRD they looked at Undervalued portfolio - also saw biggest earnings increase subsequently...LSV: found naive extrapolation (there might be several possible reasons for this)... Expectations are too high for stocks that have done well in the past, while expectations are too low for stocks that have done poorly in the past...LSV on principal-agent problems...also biases... "neglect of the base rate" (ignoring mean reversion)... cogntive biases including representativeness, availability, and anchoring-adjustment... [Carlisle should also have noted overconfidence and hindsight bias...]LSV found that contrarian value–both poor recent performance and low valuation–outperformed simpy value strategies...NOTE: LSV also found that Contrarian Value outperformed High-Growth Value... in other words, both portfolios just as cheap on multiples, but High-Growth looked much better based on recent growth... but Contrarian Value outperformed High-Growth Value...Carlisle: "It seems that the uglier the stock, the better the return, even when the valuations are comparable."Carlisle: This counterintuitive behavior found in sub-liquidation stocks too.... recall loss-making and non-dividend paying net-net's...**... "it's clear that the ugliest of the ugly generate the best returns"Unexcellent companies... unadmired companies...Damodaran: an investment strategy that relies on buying well-run good companies and expecting them to continue growing "is dangerous" because the hoped-for growth is already in the stock price and it may not occur....What are all the research papers and reports that have concluded that EV/EBIT - the enterprise multiple - is the best metric for deep value?LSV (1995): past performance is measured by growth in sales, earnings, and cash flows, and expected performance is measured by multiples of earnings or cash flows (P/E or P/CF). "We find that a wide range of value strategies have produced higher returns, and that the pattern of past, expected, and actual future growth rates is consistent with the contrarian model."LSV note: for single variable, GS is sales growth (because sales is less volatile than either cash flow or earnings, particularly for extreme portfolios that we are most interested in). for 2-dimensional, GS is also sales growth...Low P/TB does not always work. If the business destroys value over time, and the asset value is not realized, then the strategy won't work. Buffett discovered this in some deep value (= cigar butt) investments including Dempster, Hoch, Berkshire... Berkshire worked because Buffett pulled cash out and purchased profitable businesses including National Indemnity...Sears - discount to real estate, but real estate never realized... business itself has been horrible...Deep value = "cigar butt's"** So often cigar butt's are horrible businesses trading at discount to net tangible asset value... net-net's work as a group because so extremely cheap. As Buffett says.. if super cheap, usually "some hiccup" (even if long-term terrible)...** Low EV/EBIT, low P/CF, low P/E - another way to implement a deep value investment strategy. These businesses have been doing terribly (low or no growth). And they are expected to do terribly (low multiples). But not as bad as pure cigar butt's.IMPORTANT NOTE: If you also screen for: current profits are positive, low or no debt, high insider ownership, and high Piotroski F-Score... then the businesses become even better. Even for bad businesses, if they're currently profitable, with low or no debt, and showing fundamental improvements, then on the whole INTRINSIC VALUE may be growing instead of being destroyed by losses (and at risk of high debt)....AGAIN: Still "Deep Value" for two reasons identified by LSV:

• Have low or no growth - have been doing terribly (GS)
• Low expected growth - low multiples. Expected to continue to do terribly...

Actual performance - mean reversion... most problems "temporary and not permanent," at least over subsequent 3 to 5 years...** Why deep value strategy continues to work (LSV Asset has used for past two decades successfully)... LSV paper: "naive" investors over-extrapolate past poor performance (or past good performance) too far into the future, ignoring mean reversion...** Deep value works: It's a statistical fact (based on over-extrapolation and then subsequent mean reversion) that, overall, the portfolio (basket) of deep value stocks–that deep value stocks do better in future (mean reversion to more "normal" levels) than is expected (predicted) based on their low stock prices (low multiples)...** common psychological error–intuitive statistics–ignoring the "base rate." behavioral errors (4 of them)

• over-extrapolating recent growth (low or high)
• assuming a trend in stock prices
• overreacting to news (bad or good)
• equating a good investment with a well-run company

"Regardless of the reason, some investors tend to get very excited about stocks that have done very well in the past... Similarly, they underreact to stocks that have done very badly, oversell them, and these out-of-favor "value" stocks become underpriced.""the pattern of past, expected, and actual future growth rates is consistent with the contrarian model""In the next section, we explore more sophisticated two-dimensional versions of these strategies that are designed to correct some of the misclassification of firms inherent in a one-variable approach."Best performance for two-dimensional...NOTE: Benefit to deep value–terrible recent growth plus low expected growth–low expectations, and that means in case of [profitable, low or no debt, high F_Score] low multiple / deep value stocks that generally (a) downside limited (b) upside large.22.1% vs 11.4% (and cum 100%) for P/CF and GS - avg annual over subsequent 5 years...22.1% vs 10.9% (and cumulative 104.2%) for P/E and GS - avg annual over subsequent 5 years...interesting: 18.3% vs 10.9% looking at high P/E / low GS vs high P/E / high GS... 16.2% vs 11.4% for high P/CF / low GS vs high P/CF / high GS...Poor past performance + low expected future performance -> leads to better results (actual future performance) than one-dimensional variable approach...LSV Section IV - "expectational" errors"While the market correctly anticipated high growth in the very short-term, the persistence of these higher growth rates seems to have been grossly overestimated."** even more dramatic for earnings growth** high growth in subsequent 1-2 years, but virtually nothing (or less) after that...** Conclusion: Superior postformation returns for value stocks "are explained by upward revisions in expectations about the relative growth rates of value versus glamour stocks"** only a very gradual realization of mistaken expectations, which is very different from Fama/French...** LSV say they've gone beyond customary evidence and shown relationship between past, expected, and future growth rates...LSV: systematic preference by individuals and institutional investors for glamour... "prudent" investments ... "agency problems"... "glamour stocks have done well in the past and are unlikely to become financially distressed in the near future, while value stocks have done poorly and are more likely to run into financial problems." "sponsors", also, mistakenly believe glamour "safer"... "career concerns" by institutional investors...* Both individual and institutional investors have much shorter time horizons than required for value strategies to work..** For many institutional investors, if they underperform the index even for a short time, their sponsors will withdraw funds** ultimately, value systematically underpriced and glamour systematically overpriced due to "judgment errors" but perhaps also because institutional investors tilt towards value "to make their lives easier."MOI Deep Value - "inelegant but profitable..."My Note (Again): Positive earnings (but low compared to probable "normal"), plus low/no debt, high insider, and especially high F_Score ("clearly improving, in general") -> generally low downside and substantial upside (generally low risk and high returns)...[Best example I know: ATW...]KEY Question: Are the problem(s) causing the low current fundamentals (revenues, earnings, and/or cash flows) temporary or permanent?Deep Value: few can do... requires "an unusual ability to stand alone, persevere, and look foolish..."SCHLOSS, Pzena, Graham, Cundill, Neff, Whitman... early Buffett, even Buffett in personal portfolio (South Korean net-net's)The Rewards of Psychological Discomfort"... acceptance of discomfort can be rewarding as equities that cause their owners discomfort frequently trade at exceptionally low valuations""most of us find it easier to accept a mistake if we can do so in good company""it makes sense that rewards await those willing to be miserable in solitude"Mauboussin quote... Montier quote: "People love extrapolation and forget that cycles exist. The good news is that you get paid for doing uncomfortable things..."Lambert looking for opportunities in areas of "currently depressed sentiment and hence probable low valuations"Graham-style portfolio: "quite uncomfortable" at times"mediocre business run by mediocre management... assets could be squandered"Deep value "requires faith in the law of large numbers"... "this conceptually sound view becomes seriously challenged in times of distress"..."by contrast...[high-Q, low debt, good m]"...Deep value [strong NAV + low earnings] - "In a stressed situation, investors may doubt their investment theses to such an extent that they disregard objectively appraised asset values. After all - the reasoning of a scared investor might go - what is an asset really worth if it produces no cash flow?""The people who tend to succeed seem to be able to match their strengths to the requirements of the opportunities they pursue."HOLDING PERIOD - 3 to 5 years... [not MOI]... and low P/B - can add to the thesis, but not central...Low P/B by itself can be a trap (Demster, Hoch, Berkshire... SHLD... relying on tangible assets can be a trap... or not ideal at least...KEY: Can flow (revenues. earnings, cash flows) return to normal?* Cyclical low (-> multi-bagger potential) vs. secular decline... "The question of whether a company has entered permanent decline is anything but easy to answer, as virtually all companies appear to be in permanent decline when they hit a rock-bottom market quotation. Even if a business has been cyclical in the past, analysts generally adopt a 'this time is different' attitude. As a pessimistic stock price inevitably influences the appraisal objectivity of most investors, it becomes exceedingly difficult to form a view strongly opposed to the prevailing consensus."[ex: ocean shipping, for-profit ed, financials, credit ratings agencies, refiners, natural gas producers, homebuilders...]Pabrai: predictable earnings (more important than absolute cheapness) because then stock gets cheaper over time and "gravity takes over"Robotti: cheap but IV grows... [cf positive earnings, low/no debt, high F_Score...]for "low-return business" limited business to "core competency" and "prioritizing return of cash to shareholders [instead of reinvestment in business]"... reinvestment if competitive position or market structure improves...Note on net-net's: These are super cheap stocks on average, as long as there are enough of them. Usually they are not liquidated, so it's mean reversion in future revenues, earnings, and/or cash flows.BUT: The essence of deep value is low growth in past 5 years plus low current multiple (low P/CF, low P/E, low EV/EBIT). (Low P/B is not as clean and doesn't work as well.)** MOI: Many (if not most) deep value investors focus on discount to "readily ascertainable tangible asset values."... Graham, Schloss, Cundill, Neff, Whitman...** Again: net-net's are usually SUPER cheap, so if you get a basket that usually works quite well. Buffett: net-net's in South Korea. Also: early Buffett (partnership)... again, net-net's: super cheap, often less than cash in the bank... but usually not liquidated, so it's still mean reversion in future revenues, earnings, and/or cash flows...THERE ARE DIFFERENT WAYS TO APPLY DEEP VALUE...Carlisle and Gray found that EV/EBIT - based on just one year - outperformed all other metrics, even composites...But O'Shaugnessy found (over a much longer period of time), that usually a composite approach worked best...low P/S, P/E, P/B, EV/EBITDA, P/FCFLSV: there are two components to DEEP VALUE:

• Low past growth - sales growth
• Expected low future growth - low P/CF, low P/E... low EV/EBIT may in fact be even better...

Mean Reversion: Future economic performance (revenues, earnings, and/or cash flows) BECAUSE most business problems are temporary and not permanent, at least when viewed over the subsequent 3 to 5 years...Low P/B, or low price "to tangible", or liquidation, or net-net's: a way to identify stock prices that, on average, are below intrinsic business value. Most of the time, the intrinsic business values are revealed by mean reversion in future revenues, earnings, and/or cash flows–the "hiccup"–rather than by actual liquidations...

• NOTE: For deep value defined by low earnings or cash flow multiple, "hiccup" less likely to be associated with bad business... if you add Piotroski F_Score, even more true... BUT "hiccup" for net-net that is losing money, yes more likely to be bad or mediocre business...

QUESTION: LSV quantitative deep value - the businesses may not be as bad, in general, as compared to net-net's or "discount to liquidation"... furthermore, Piotroski F_Score identifies cheap stocks with improving fundamentals, so this is another way (in addition to earnings-based screen like P/E, P/CF, EV/EBIT) to identify a STATISTICAL GROUP of stocks that "are not as bad" "BUT may not be quite as cheap as net-net's" (?). Performance of LSV: +1-2% per year (+2-3% gross perhaps). Not that much...SEE: LSV Notes including "Why Boole..."DEEP VALUE - nearly always some business problem or problems. But mean reversion in revenues, earnings, and/or cash flows over next 3 to 5 years = usually the problems are temporary and not permanent over next 3 to 5 years... when businesses are below intrinsic value - on average for deep value (low past growth + low multiples = low expected future growth) - usually something is done to improve the situation (and/or fix the problem(s)).... usually it's not activists [especially for micro caps because activists have much less incentive for micro caps - market caps below $300 million]...** Liquidation is usually not optimal, which means that - to some extent - the problem(s) is temporary, at least over next 3 to 5 years, i.e., revenues, earnings, and/or cash flows can be improvedback toward more normal levels [that's why liquidation usually not the best move, because usually the "normalized" or "more normal" economic performance of the business can be much better over next 3 to 5 years (i.e., much improved but also higher value than messy liquidation...)Deep value stocks have done poorly in the past, and are expected to do poorly in the future. Growth - or "glamour" - stocks have done well in the past and are expected to do well in the future.Deep value strategies bet against those who extrapolate past performance too far into the future. In other words, deep value investing bets on mean reversion.(In general, deep value stocks are underperforming their economic potential.) If you look at deep value stocks as a group, it's a statistical fact that many will experience better future economic performance–revenues, earnings, and/or cash flows–in the future than what is implied by their stock prices. This is due largely tomean reversion. The future economic performance of these deep value stocks will be closer to normal levels than their current economic performance.Moreover, the stock price increases of the good future performers will outweigh the languishing stock prices of the poor future performers. This causes deep value stocks, as a group, to outperform the market over time.LSV paper:While it's agreed that value strategies outperform the market, the interpretation of why they have done so is more controversial..."Value strategies might produce higher returns because they arecontrarian to "naive" strategies followed by other investors. These naive strategies might range from extrapolating past earnings growth too far into the future, to assuming a trend in stock prices, to overreacting to good or bad news, or to simply equating a good investment with a well-company regardless of price. Regardless of the reason, some investors tend to get very excited about stocks that have done very well in the past, and buy them up so that these "glamour" stocks become overpriced. Similarly, they underreact to stocks that have done very badly, oversell them, and these out-of-favor "value" stocks become underpriced. Contrarian investors bet against such naive investors..."Two components:

• Past performance is measured by growth in sales, earnings, and cash flows. Low growth in past...
• Expected future performance is measured by multiple of price to earnings or cash flow... Low multiples...

** Conclusion: A wide range of value strategies have produced higher returns and "the pattern of past, expected, and actual future growth rates is consistent with the contrarian model."

• past growth - low
• expected growth - low (based on low multiples)
• actual growth - better than expected (why quantitative [i.e., systematic] deep value works over time)

** LSV: Are value strategies riskier? No, outperform overall and outperform in bad states... (plus see my comments)** LSV: In general, they look at future performance up to 5 years...NOTE: How do we adjust these findings for cheap micro caps with improving fundamentals?... (1) Micro caps far outperform (2) Cheap micro caps do even better (3) Cheap micro caps with improving fundamentals do the best of all, on a net basis (after adjusting for transaction costs) - about 7% better (+/- 3%) than the S&P 500 index over time.... Also, cheap micro caps with improving fundamentals do better than Russell Microcap Index over time...Why Boole: Quantitative Deep Value Investing applied to cheap micro caps with improving fundamentals... Benefit: Outperform Russell Microcap Index, and in turn far outperform the S&P 500 Index over time...** LSV: P/CF and P/E are more direct measures of market's expectations of future growth. (P/B is not a very clean variable...) P/E probably includes (on the high end) some high-growth or high-Q companies that will continue that way (that may be why P/E not as effective as P/CF)** Past sales growth also works....LSV SUM UP: VERY LARGE RETURNS from SINGLE VARIABLE and BUYING AND HOLDING FOR 5 YEARS...** "In the next section, we explore more sophisticated two-dimensional versions of these strategies that are designed to correct some of the misclassification of firms inherent in a one-variable approach." For example, some high P/E firms are justifiably high P/E, so by including also high P/CF, you get better results w.r.t. the value hypothesis - in other words, you can more directly exploit - using 2-dimensional approach - the mistakes made by naive investors who ignore mean reversion...LSV Section III** LSV: Plenty of evidence that individuals ignore mean reversion– i.e., they ignore the "base rate," as Kahneman and Tverky found in 1982... To exploit this flaw, contrarian [deep value] investors should sells stocks with high past growth and high multiples (=high expected future growth) and buy stocks with low past growth and low multiples (=low expected future growth).** LSV: best performance for two-dimensional... P/CF and GS, and P/E and GS... low past growth, low P/CF... and low past growth, low P/E... (5-year average: 22.1% vs 11.4% average annual [cumulative 5-year difference is 100%], and 22.1% vs 10.9% average annual [cumulative 5-year difference is 104.2%])...INTERESTING: High P/CF but LOW growth (GS) 16.2% avg annual vs 11.4% for high P/CF but HIGH growth (GS). EXPLANATORY POWER OF 2-D MODEL...AND: High P/E but LOW growth (GS) 18.3% avg annual vs 10.9% for high P/E but HIGH growth (GS)....NOTE: High P/CF but low P/B... 18.6% vs 10.3% for high P/CF but high P/B... Here low P/B "proxies for low past growth"... in THIS CASE low P/B "adds information" (likely)...CONCLUSION: "the results suggest that value strategies based jointly on past performance and expected future performance produce higher returns than more ad hoc strategies..." (such as low P/B alone)Section IV: Evidence for "expectational errors"(1987) De Bondt and Thaler show some evidence..."too pessimistic" about value stocks (low past growth plus low expected future growth as shown by low multiples)... "too optimistic" about glamour stocks (high past growth plus high expected future growth as shown by high multiples)...

• Past growth - low or high
• Expected growth - low or high
• Actual growth - ...compared to expectations...

** Actual growth for value - relative to expectations - is way better than actual growth for glamour - relative to expectations...** A dollar in the value portfolio was getting 27.9 cents in current cash flow the value portfolio, but only 8 cents in current cash flow in the glamour portfolio... were these differences justified by subsequent performance? Not at all... over 5 years post formation, glamour cash flow grew at 11.2 percent annually versus 5.2 percent for the value portfolio. Also, biggest difference in first 2 years after formation - after that, annual growth for glamour vs value were 9.5 annual vs 8.8 annual... "While the market correctly anticipated high growth in the very short-term, the persistance of these higher growth rates seems to have been grossly overestimated." Even more dramatic for actual earnings growth...CONCLUSION: Superior postformation returns for value stocks "are explained by upward revisions in expectations about the relative growth rates of value versus glamour stocks." Very different from Fama and French - only a very gradual realization of mistaken expectations...SO: LSV say they've gone beyond customary evidence and have shown relationship between past, expected, and future growth rates. Investors are systematically too optimistic about glamour stocks and systematically too pessimistic about value stocks. Consistent with the "extrapolation" model. Subsequently, investors only correct themselves gradually over years.

My Note: Are value stocks riskier? "bad" markets, recessions... beta's, standard deviation's... if anything, LESS risky... ("while one can never reject the 'metaphysical' definition of risk - what performs better is 'by definition' riskier, according to some multifactor model where not all factors are even known....the weight of the evidence suggests a more straightforward model..." "in this model, value stocks are systematically underpriced while glamour stocks are systematically overpriced... systematic behavioral mistakes of investors...")

... similar results have been found for other countries...** LSV: systematic preference by both individuals and institutional investors for glamour strategies..."Individual investors might focus on glamour strategies for a variety of reasons..." extrapolate past growth rates of glamour stocks even though the "base rate" does not support this extrapolation... common psychological error (intuitive statistics), not just in stock market... also individual might equate good or well-run company with good stock...you might think institutional investors free from behavioral bias... but institutional investors might prefer glamour because they are "prudent" investments... agency problem.... glamour stocks have done well in the past and are unlikely to become financially distressed in the near future, while value stocks have done poorly and are more likely to run into financial problems... sponsors may mistakenly believe that glamour stocks are safer, even though value stocks are actually less risky over time... "career concerns of money managers..."Both individual and (even more) institutional investors have much shorter time horizons than required by value strategies... for many institutional investors, if they underperform index even for a short time, their sponsors will withdraw funds... ultimately, value systematically underpriced and glamour overpriced due to systematic judgment errors (biases, intuitive statistics) and "perhaps also" because institutional investors tilt toward glamour "to make their lives easier."NOTES:[April 1963 to April 1990...]DEEP VALUE"Which businesses are prone to inefficient value appraisal due to investors' focus on income? We find a category of businesses particularly interesting–companies that seek to offer a current yield to investors yet depend heavily on the hard assets on their balance sheet......"Consider also companies that offer products whose price is determined by the market. If the price series is reliably mean-reverting but investors become fearful at the bottom, they may undervalue assets of the companies involved." [see example: U.S. oil refiners]"On a more mundane level, the combination of a narrow-moat business and a lack of current profitability tends to sour the investment community on a company's stock, relegating a wide range of companies to Graham-style bargain status. Many of those businesses hide little value on their balance sheet, but the diligent investor will occasionally uncover gems that are ignored despite their strong net asset values...."[example of staffing businesses... low risk, high rewards if you can wait 3 to 5 years...]

Scott Barbee: 'We generally like to buy companies trading at a significant discount to their asset values and at mid to low single-digit multiples of normalized earnings two to three years out. This way, the assets provide downside protection while the earnings potential gives us upside.'

"Barbee's approach seems particularly applicable to money-losing businesses whose market value has declined to tangible book value or below. A key consideration seems to be whether the current money-losing period reflects a permanently damaged business or a cyclical or otherwise temporary decline in profitability."

NOTE: Whether problem is temporary or permanent... statistically, usually these problems are temporary, at least over the subsequent 3 to 5 years. Why a BASKET works EVEN MORE SO with Piotroski (fundamental improvements)...Few can do DEEP VALUE... "It turns out that Graham-style investing may be appropriate for a relatively small subset of the investment community, as it requires an unusual ability to stand alone, persevere, and look foolish. 'I have learned how to suffer,' reflects Jake Rosser... [cf Eveillard or Pzena...]"THE REWARDS OF PSYCHOLOGICAL DISCOMFORT** "The stock does look deeply undervalued, but I just can't get comfortable with it."...negative news flow, bad gut feeling, uncertainty of the situation..."Comfort can be expensive in investing. Put differently, acceptance of discomfort can be rewarding, as equities that cause their owners discomfort frequently trade at exceptionally low valuations..."** partly psychology "Most of us find it easier to accept a mistake if we can do so in good company..."** "... it makes sense that rewards await those willing to be miserable in solitude."Mauboussin: "Buffett's advice is so good but so hard. The point when there's a valuation extreme is precisely the point when the emotional pull–in the wrong direction–is strongest."James Montier: "People love extrapolation and forget that cycles exist. The good news is that you get paid for doing uncomfortable things, when stocks are at trough earnings and low multiples their implied return is high, in contrast you don't get paid for doing things that are comfortable."John Lambert: looks for ideas in "areas of currently depressed sentiment and hence probable low valuations."**... if portfolio of nothing but Graham-style bargains we might become "quite uncomfortable at times" ... "and conclude every that every investment could be worth zero"... "After all, we could have a mediocre business run by mediocre management, with assets that could be squandered. Investing in deep value equities therefore requires faith in the law of large numbers - that historical experience of market-beating returns in deep value stocks and the fact that we own a diversified portfolio will combine to yield a satisfactory result over time. This conceptually sound view becomes seriously challenged in times of distress. By contrast, an investor in high-quality businesses that are conservatively financed and run by shareholder-friendly managements may fall back on the well-founded belief that no matter how low the stock prices of those companies fall, the businesses will survive the downturn and recover value over time.""Playing into the psychological discomfort of Graham-style equities is the tendency of such investments to exhibit strong asset value but inferior earnings or cash flows. In a stressed situation, investors may doubt their investment theses to such an extent that they disregard the objectively appraised asset values. After all - the reasoning of a scared investor might go - what is an asset really worth if it produces no cash flow? ..."[we have to be honest about how much discomfort we can endure...] high-quality vs deep value... "The drivers of success merely shift - for example, away from a willingness to look foolish by going against the crowd toward an ability to analyze the durability of competitive advantage... [many analogies]... The people who tend to succeed seem able to match their strengths to the requirements of the opportunities they pursue."Buffett: CIGAR BUTT's... TRUE if discount to tangible book (Dempster, Hoch..., Berkshire Hathaway) / discount to liquidation... TRUE (usually) if net-net's (although net-net's are so extremely cheap...) ... BUT FALSE for many low P/E, P/CF, EV/EBIT ESPECIALLY IF IMPROVING FUNDAMENTALS....** A company at a cyclical low has multi-bagger potential... obviously we want a company at a cyclical low rather than one in secular decline..."The question of whether a company has entered permanent decline is anything but easy to answer, as virtually all companies appear to be in permanent decline when they hit a rock-bottom market quotation. Even if a business has been cyclical in the past, analysts generally adopt a 'this time is different' attitude. As a pessimistic stock price inevitably influences the appraisal objectivity of most investors, it becomes exceedingly difficult to form a view strongly opposed to the prevailing consensus." [examples: ocean shipping, for-profit educ, financials, credit ratings agencies, refiners, natural gas exploration and production, homebuilders...]** Scenario analysis - may be important for deep value... (at least high case, mid case, low case... not necessarily accompanied by subjective probabilities...) ... Is value growing, staying flat, or shrinking?...Pabrai - predictable earnings more important than absolute cheapness because then stock gets even cheap over time "and gravity takes over"Robert Robotti - deep value situations in which intrinsic value grows over time... this includes cyclicals with low debt... [see also Stolt-Nielsen shipping company example...]...NOTES: DEEP VALUECheap relative to some tangible metric... (?)discount to "readily ascertainable asset value" (Graham, Schloss, Neff, Cundill, Whitman...)Buffett at the beginning.... Buffett in his personal portfolio recently (South Korean net-net's)..."possible holy grail... asset protection on the balance sheet plus high returns on capital"Few shareholders think a net-net should be liquidated..."In many situations, the more appropriate objective may be to limit a business to its core competency while maximizing the return of cash to shareholders. Such a business may exist for a long time and may even retain an option to resume reinvestment of capital, should its competitive position or the market structure improve markedly. By prioritizing return of cash to shareholders, low-return businesses can assist investors in earning a strong investment return, assuming the equity purchase price was favorable."[example] "The dynamics described highlight the importance of returning cash to shareholders when the cash would otherwise be redeployed in a mediocre business. Sometimes the logical consequence is a push towards liquidation, but the latter is neither required nor optimal if a company has a cash-generative business segment with low capital reinvestment requirements."... "We find it quite fascinating that investors seem to appreciate assets in their personal lives but place greater emphasis on income when it comes to their portfolio holdings... Many of us are prone to taking on debt to buy the assets we desire today, regardless of whether those assets accrete value over time. We appreciate the present value of an asset we need or want. However, when it comes to public equity investments, many of us discount a company's balance sheet while placing a premium on periodic income. This is why faddish companies occasionally rise to incredible market valuations despite a relative absence of hard assets, and why asset-rich companies occasionally trade well below replacement value. Reflects Jeroen Bos, investment director of Church House Investments: 'Virtually all the companies I buy are loss-making, haven't paid a dividend... [but] they are at a discount to their working capital. They have losses, but their losses are containable for the next two or three years, and management is working.'""There is no question that income and cash flow deserve a place in a valuation exercise. They may even deserve primacy in most equity analysis. Consider companies like Coca-Cola, Johnson & Johnson, and Procter & Gamble, which have relatively few hard assets but whose income streams possess great value. As long as such franchise businesses have conservatively financed balance sheets that pose no risk to the equity, those balance sheets may be mostly disregarded for valuation purposes. Unfortunately, investors may have loosened their definition of a franchise business to such an extent that they ignore the balance sheet more often that is appropriate. In the long run, the income of most businesses does relate to the net assets a business has at its disposal. This is especially true for businesses that exhibit high capital intensity. They may earn abnormal returns on capital for awhile due to an imbalance of supply and demand or some other transient factor, but virtually all such businesses revert to the mean. Investors suffer mightily when they overestimate the duration of the abnormal earning period of a business."DEEP VALUE INVESTORS ARE RAREMost value investors prefer to invest in higher-quality companies rather than deep value stocks. The ideal high-quality company has a sustainable competitive advantage that allows it to earn a high return on invested capital for a long time. When you invest in such a company, assuming you've done your homework, you can simply hold the position for years as it compounds intrinsic value. Usually you don't have to worry much.Investing in deep value stocks, however, means that you've investing in many mediocre and even some bad businesses. These are companies that tend to have terrible recent performance and terrible fundamentals. Some of these businesses won't survive over the longer term, although even the non-survivors often survive many years longer than is commonly supposed.Deep value investing can work quite well, but it takes a certain temperament not to care about volatility, being isolated, and looking foolish. Many investors, including value investors, will look at a list of very cheap stocks and conclude that most of them would be terrible investments. But in practice, a basket of deep value stocks tends to outperform, given enough time. And typically some of the big winners include stocks that looked the worst prior to being included in the portfolio.Warren Buffett started out as a deep value investor. That was the method he learned from his teacher and mentor, Ben Graham, the father of value investing. When Buffett ran his partnership, he generated exceptional performance using a deep value strategy focused on microcap stocks.One reason Buffett transitioned from deep value to buying high-quality companies (and holding them forever) was simply that the assets he was managing became much too large for deep value. In his personal account, however, Buffett recently bought a basket of Korean deep value stocks and ended up doing very well.Buffett has made it clear that if your assets under management are relatively small, then deep value investing – especially when focused on microcap stocks – can do better than investing in higher-quality companies. Buffett has said he could make 50% a year primarily by investing in deep value microcap stocks. In the microcap world, since most professional investors don't look there, if you turn over enough rocks you can find some exceptionally cheap companies.Because deep value investing is still not popular at all – largely because it goes against our innate tendencies – quantitative deep value investing is likely to continue to produce better returns, net of costs, than an index fund over time.** SECTION ON SMALL/MICRO - SHOULD THIS BE ADDED HERE OR IN SEPARATE BLOG POST?BOOLE MICROCAP FUNDAn equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: https://boolefund.com/best-performers-microcap-stocks/This outperformance increases significantly by focusing on cheap micro caps. Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals. We rank microcap stocks based on these and similar criteria.There are 15-25 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 10-15% (at cost), while the average position is 5-7% (at cost). Positions are held for 3 to 5 years unless a stock approachesintrinsic value sooner or an error has been discovered.The goal of the Boole Microcap Fund is to outperform the Russell Microcap Index over time, net of fees. The Boole Fund has low fees. If you are interested in finding out more, please e-mail me or leave a comment.My e-mail: jb@boolefund.comDisclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.