What is the difference between value investing and deep value investing?
Traditional value investing focuses on businesses that are trading at a great price to book ratio, have a low price to earnings multiple, and can go up when the existing value of the company is realized or unlocked through new management or selling assets.
Deep value investing looks to buy a stock that is so oversold it hasn’t got much lower to go. Deep value stocks tend to be companies in the low single digits in price that were once market leaders. These companies also tend to have some of the highest short interest of any stocks as short sellers start betting on zero as a price level.
What is a deep value investment?
A deep value investment is a stock bought that is at a deep discount versus the value of the company as a brand, business, and has the potential to double or triple in price on any good news or even the attempt of a turnaround. New management, new products, or a pivot in strategy can lead to at least a short term rally.
These are not long term investments, they are simply a position taken and held until a catalyst causes a short-term run up in price based on hope and a forced short covering rally. This is a strategy that Michael Burry and Roaring Kitty both used to find Gamestop in 2020.
How do you pick a deep value stock?
The formula for finding and picking a deep value stock has five key filters to look for:
- Clustered insider buying
- Credit default risk
- Business operations
- High short interest
1. Clustered Insider Buying
“Insiders might sell their shares for any number of reasons, but they buy them for only one: they think the price will rise.” – Peter Lynch
Look for recent insiders buying the shares. This is an indicator that management of the company is putting their money where their job is and betting on the stock price going up. Who better to know the future of the company than the people running it.
This doesn’t guarantee that the price will rise but it shows that there is still hope in the company of not just survival but a turnaround attempt of some form. Clusters of multiple inside buyers between three to five people buying six figures or more worth of shares shows the highest potential that someone may know something.
2. Credit Default Risk
You want to choose a deep value stock that is going to survive and not go bankrupt. The bond yield, debt rating, and prices on credit default swaps can show you quickly the odds the market is putting on a company not making it. When bond yield goes up the bond price goes down, when the bond yield goes down the bond price goes up.
The higher the yield on the bonds of the company the greater the risk of default. If the bonds are paying double digit returns in yield it’s very risky. Over 20% yield on a bond is priced that way due to the high risk of default.
For a company to continue to operate it must have access to new credit and be able to refinance its debt. A company goes bankrupt when all its lines of credit dries up and it must file for bankruptcy protection from creditors. Make sure your deep value pick has enough time left to stage a comeback.
3. Business Operations
A deep value stock can only buy time and stage a turn around if its business operations is functional and they have positive cash flow or a plan to achieve profits in the near future. If the company is operating at a loss with no plans to close locations, lay off employees, or change its business model then it can be doomed.
However, if a company has a plan to turn itself around that can be all it takes to move a stock price higher over weeks and months. You want your deep value stock pick to still give the market hope for its future. It needs to be a real business with a history of real operations for distribution of products and services.
A stock price can get so low it acts like an option without the complexity of the pricing model for option contracts. Optionality is when you can buy shares of a stock at prices similar to option contracts so you have the asymmetric risk/reward ratio in your favor.
A stock that trades similar to option contract prices can create capped risk if it goes to zero but can give the trader the potential to make triple digit returns if it goes up in price. This is the opportunity and the danger as single digit prices are naturally attractive to new traders as they dream of it going up to double and triple digits in price.
The key to manage the risk is in the position sizing, only risk a percentage of you capital on these bets, 10% of 5% of your speculative capital is a good range for most people. The percentage they can go down can also be high.
5. High Short Interest
A list of the current highest short interest stocks can be a great place to look for potential deep value buys. The higher the short interest percentage rises in ranking on the list the greater the probability of a short squeeze higher on any positive news. Most of the highest short interest stocks will have at least one short covering rally even if it’s only temporary.
The high short interest list can give you stocks to analyze fundamentally to see if they are ones that fit the above criteria of a good deep value buy.
The deep value investing formula is: Low price versus business value + insider buying + high short interest – high default credit risk = good asymmetric bet on price increase.
Image created by Holly Burns