“Deep Value” by Tobias Carlisle

deep

Deep Value” by Tobias Carlisle is one of my favorite books. I have a brief review in the books section of this website, but I think it is worthy of a more in depth review. The price of the book is expensive, but it is well worth it!

Mr. Market is Crazy

For years, I’ve believed that value investing works. It makes sense to me intuitively. It’s better to buy something cheap than something that’s expensive. I’ve read The Intelligent InvestorSecurity Analysis and all of Joel Greenblatt’s books and internalized the lessons. It just makes sense to me to buy earnings and assets for as little as possible.

It also makes sense to me that markets are fallible. I spent my high school years (I graduated high school in 2000) fascinated with a seemingly unstoppable market. I was only a teenager, but it seemed crazy to me that companies producing no earnings could command such high valuations. I remember thinking at the time: “It makes no sense, but these people know more than I do about the subject.” It turns out that they didn’t. An army of market prognosticators with extensive experience and impressive academic credentials were no smarter than me, a 17-year-old kid who hadn’t even gone to college yet.

I went through a similar experience during the real estate bubble. When I looked at charts of real estate prices, I once again instinctively thought that it was insane. Homes were increasing by 30% a year when incomes were stagnant and the raw materials to build the homes weren’t going up. It made no sense. Once again, I turned to the experts. Few were raising any alarms or taking the problem seriously. Surely, a financial bubble couldn’t form in an asset as illiquid and solid as real estate. I assumed that the experts must be right and I must be missing something. After all, they were more knowledgeable than I was. Then, along came 2008.

In 2008 during the crash, I kept thinking back to Benjamin Graham’s description of Mr. Market that I read about in The Intelligent Investor. Ben Graham was right. The stuff I learned in college about efficient markets couldn’t be true. Mr. Market is crazy and Ben Graham was right all along.

Why does it work?

While I believed that value investing works and this was confirmed by my observations, I never understood why it worked. It makes sense that buying dollar bills for 50 cents will work out in the long run, but how is this value realized?

Ben Graham was actually asked this question by Congress in the following exchange:

Chairman J. William Fulbright: What causes a cheap stock to find its value?

Benjamin Graham: That is one of the mysteries of our business, and it is a mystery to me as well as to everybody else.

This is the key question that “Deep Value” delves into, through an analysis of data and real world examples.

Mean Reversion

The most powerful force through which value is realized is mean reversion. I always thought of mean reversion in the sense of a stock chart, a price will revert to the mean.

What Tobias explains is that mean reversion applies less to stock charts and more to the actual performance of a business. Tobias explains, for instance, that the biggest earnings gainers of the next few years are typically the worst performing businesses. Other similar studies are brought up in the describing this tendency of businesses to change course.

Poorly performing businesses are trying to turn things around. They are not resting on their laurels. Meanwhile, changes are typically occurring in their industries that are improving things for the better.

I think it’s easiest to think of this phenomenon in terms of chemical companies and basic economics. Chemical companies can all produce the same thing. They all have the same resources. If a chemical runs up in price, all of the chemical companies are going to make more of it. At this point, all of the chemical companies are doing great and their stocks are likely to be bid up to high valuations. Eventually, the chemical will be over-produced and it will drop in price. All of the chemical companies will drop to low valuations. This situation sets the stage for the recovery. The chemical companies will inevitably scale back production. Some companies may go out of business, which will further reduce supply. The reduction in supply will eventually spur an increase in the price, which will ultimately lead to a recovery in the chemical business.

Meanwhile, news stories will be written about what a terrible business it is to produce this chemical, causing this wisdom to seep into the minds of investors. There then exists a situation where chemical companies can be purchased at a discount at a nadir in the business that is about to turn around.

The situation is doubly lucrative: a cheap stock at a point in the business cycle where it is about to turn around.

The lesson here is that human beings tend to think that the future will unfold like the past. Trends that are in place today will go on forever. This is rarely the case and it is one that Tobias demonstrates through a careful analysis of the data.

Mean reversion in business is the main force driving the realization of value.

The Illusion of “Quality”

Prior to reading deep value, I always assumed that the best course for the value investor was to combine “cheap” with “quality”. Yes, there are cheap ugly stocks out there, but many of them are dreaded “value traps”. Meanwhile, careful analysis can lead an astute investor to value investing gems: cheap companies that don’t have any real problems, companies that are growing and generating attractive returns on capital.

Tobias reveals that adding elements such as growth or high returns on capital to a value model actually underperforms cheap by itself. The ugliest value stocks are frequently the ones that lead to the highest future outperformance. This makes sense: if something is truly cheap, there must be a reason for it, and the scarier the reason then the better the bargain an investor will get. Moreover, the uglier the stock, the more likely its prospects for mean reversion.

This lesson is reinforced throughout the book with real world examples and massive quantities of data.

The Acquirer’s Multiple

Tobias’s preferred metric of “cheapness” is Operating Income/Enterprise Value (or other variants, such as EBIT/EV or EBITDA/EV). He provides data showing this metric’s historic outperformance. I found the same thing in my own backtesting, and O’Shaughnessy also verifies this in his most recent edition of What Works on Wall Street in which EBITDA/EV is given a prominent chapter.

The multiple works because it identifies stocks that are not only cheap but have healthy balance sheets. The balance sheet health allows them to survive whatever problems that the business (or industry) is enduring.

Another reason it works is that the metric is most often used by acquirers such as private equity firms.

What is Deep Value?

Another goal of this book is explaining how “deep value” is distinct from other types of value investing.

Most associate value investing with the investing style of Warren Buffett. Buffett began his career buying what he derisively called “cigar butts”, or simple cheap stocks. They were cigar butts in the sense that you could pick them up off the street for free because they were so cheap, and enjoy one last puff.

Buffett moved on from this style for a few reasons. The first was the influence of Charlie Munger, who was less influenced by Graham and was more interested in buying quality businesses.

The second was scale. Buffett became too big to nimbly buy a cheap low capitalization cigar butt, take his free puff, and move on. Frequently, Buffett had to buy up such large quantities of cigar butts where he became mired in the operational struggle.

The second was a handful of experiences that pushed Buffett in the direction of greater quality investments. In investments such as Dempster Mill (a struggling manufacturer of farm equipment) and Hochschild Kohn (a retailer forced to compete at razor thin margins in Baltimore), Buffett had to take controlling influence in each company to turn them around. In both situations, controlling a struggling company took its toll and consumed significant time from Buffett.

The experiences with Dempster and Hochschild stood in contrast to a different kind of investment that Buffett made in the 1970s: See’s Candy. See’s was a good business with a great brand. It generated high returns on capital and required little meddling. Once Buffett bought See’s and saw the benefits of high returns on capital, there was no turning back, and this became the basis for his future investment style. From then on, he bought large stakes in companies generating high returns on capital and held onto them for long periods of time to let them compound.

The 1970s and onward style of Buffett’s investing career is what most people think of when they hear “value investing”. Deep value, in contrast, is the style of investing that Warren Buffett used earlier in his career when he was managing smaller sums of capital and generated higher rates of return. Deep value is the style originally advocated by Benjamin Graham and later applied by investors such as Walter Schloss.

Deep value is buying cheap for the sake of being cheap and allowing mean reversion to return the stock to its intrinsic value.

The Buffett style of investing is certainly preferable because it generates higher compounded returns for longer periods of time, but it is extremely difficult to find businesses that generate high returns on capital that will not succumb to the forces of mean reversion. It is also a crowded trade, as all value investors are attempting to marry quality with cheapness.

Practical Application

Tobias maintains an excellent free stock screener keeping track of the best-ranking stocks according to the acquirer’s multiple, which you can use to systematically implement a value investing strategy. The large cap version is free, he also offers a paid version for the all-cap universe.

Recommendation

It’s rare that a book comes along that changes my mind and makes me see things from a different perspective. “Deep Value” was one of those books. I’ve read it three times so far and each time I gain a greater insight into the ideas that it conveys. I can’t give it a higher recommendation.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

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