Over the past few months, I have been studying various deep value investing strategies with the goal of trying to determine a set of rules or principles to follow when investing in deep value stocks to increase the likelihood of success.

I’ve seen at least a few posts on this subreddit on the topic of deep value investing which tells me people are interested in this topic. So here’s some of the key lessons I learned on how to identify both good and bad deep value stocks.

Essentially what I did was run backtests to generate lists of deep value stocks from 5 years ago and 2 years ago. I ran these lists multiple times over the past few months, which gave me a list of about 50 deep value stocks from the past to analyze/draw insights from. Then I looked at what their returns were from either 5 years ago or 2 years ago to the present to break out the winners from the losers.

After that, I looked into every deep value stock to understand the following:

1. Were they actually a deep value stock? (since we are primarily dealing with micro-caps, data errors in 3rd party websites is common, so always validate by looking at financial filings to ensure the company is actually a deep value stock)

2. Was this a company I can understand? As with any investing, it’s important to not invest in a company you can’t understand.

3. What is the makeup of NCAV? (I.e., the split between cash, receivables and inventory) This was a good check because some companies ended up in my backtests as net nets because of an accounting technicality. Like a company that reclassified a high value piece of real estate or equipment as “held for sale” which makes it a current asset instead of a non-current asset for a small period of time.

4. Does the company sell commoditized products? More on this later.

5. Why was it a deep value stock? The purpose of this was to understand what risk the company had that was scaring investors away and thus causing it to be a deep value stock.

6. How did the stock perform over the next 2-5 years and what catalyzed those returns? Whether they were positive or negative returns, and what the reason was behind it was. This helped me understand the common reasons for why deep value stocks did well or not so well.

My starting point for “deep value” stocks was to use Benjamin Graham’s net net method where NCAV must exceed market cap. (NCAV = net current asset value, which current assets less total liabilities). I also excluded certain industries that skewed the data such as biotech, real estate development companies, financial services businesses, and asset management firms. A lot of the time companies from these industries would appear as deep value stocks but aren’t really deep value once you understand them.

For example, biotechs would be burning cash extremely fast so the only reason they appear as net net stocks is because they haven’t reported their quarterly results yet, and investors are anticipating their current assets to be diminished (this is pretty common outside of biotechs too). Real estate developers would have 99% of their “current assets” in land inventory that may have lost value, asset managers were essentially holding companies and so the “holding company discount” was making them appear as net nets, etc.

NCAV is meant to be a conservative estimate of a company’s liquidation value. So we’re looking for companies worth less than liquidation value, which in theory provides us with a margin of safety.

Lesson #1: Avoid companies with a single shareholder that has majority control.
This is the kind of thing that can blow up an entire investment. Remember that the logic behind investing in companies below liquidation value is that even if they have to liquidate, you still won’t lose much (if any at all). However if a company is controlled by a single shareholder that refuses to change the board of directors, refuses to approve any dividends, or make changes to the business at all (let alone liquidate the business) then your margin of safety is ultimately useless.
An example of this is a company called Emerson Radio, which was a net net stock in 2018 and has gone down ~60% over the past 5 years. They have about 72% of their voting shares controlled by Nimble Holdings which is a Hong Kong-based holding company. Over the years there have been several attempts from activist value investors to get Emerson to pay a special dividend of $1/share since the cash is sitting idle on the balance sheet, which have ultimately failed.
Emerson Radio’s current assets were essentially entirely cash. And in 2018 they weren’t profitable, but were not losing very much money. NCAV was $40M and the market cap was about $33M, so plenty of margin of safety.
But over the years, sales gradually declined and the stock went down a lot as Nimble refused to do anything to change the business or liquidate it, all the while management was paying themselves excessive salaries. It’s not that uncommon for deep value stocks to have management teams that are actively screwing over shareholders.

Lesson #2: Avoid companies with shady management teams

This one may seem obvious, but remember there’s always a reason why a stock has become a deep value stock, and when you’re in the deep value investing mindset, it can be easy to ignore or discount the types of risks that are scaring away most investors.

An example of this is a company called Amira Nature Foods, a formerly NYSE-listed Indian basmati rice wholesaler. This company was hit by several short seller reports accusing the management team of overstating their revenue as well as misappropriation of assets, and while the claims were initially refuted, the company ended up going to zero and was delisted for failure to publish their financial filings (their last financial filing was over 3 years ago).

There’s a lot more to this story, but in short, if you have any doubts about management’s integrity, and you see related party transactions that don’t seem to make sense, I would avoid.

Lesson #3: Companies that sell commoditized products (oil, gold, etc.) can have stellar returns if their asset base has not been sold off/diminished

These two things together often made for deep value stocks having great returns (+20/30% annualized over 5 years), and I think it is logical when you break it down.

Companies that sell commoditized products, or products that can fluctuate in price very rapidly, can have a massive turnaround very quickly. There were numerous examples of this, such as oil companies that were priced for failure, but then had a turnaround when oil prices went up in early 2022. Or steel companies that had a turnaround when Steel prices went up in 2021.

Even if these rapid price increases are just temporary, one good year can be enough to make a deep value investment a success. Think of scenarios where a small oil company has a $60M market cap, is losing about $5M/year, then oil prices go up and they turn a $20M profit in one year. That simple turnaround could be 100-200% upside.

However, if a commodity-based company has sold off some of their income-producing assets (equipment, factories, land, etc.) then such a turnaround is not possible. Even if the prices of whatever commodity they sell increase very rapidly, if the company cannot produce/manufacture enough of that commodity because they sold their assets, then the upside is limited. Just a simple check of the balance sheet over the past couple of years can help you determine this.

The one caveat to this strategy is that it requires some catalyst to occur to induce commodity prices to go up, which is obviously extremely difficult to predict. However, this highlights the essence of deep value investing, which is that there’s the potential for massive upside (it’s not guaranteed), and the downside risk is limited since you are investing below liquidation value (heads I win, tails I don’t lose much). So even if you can’t predict a future turnaround, you’re not going to get kicked in the teeth if one doesn’t happen.

Lesson #4: Margin of safety is extremely important

Another one that may come across as obvious and not very insightful. But I will explain further with an example.

A company called O2Micro was a net net stock 5 years ago (NCAV of $54M vs market cap of about $45M). The margin of safety in this case would be the extent to which NCAV exceeds the market cap, which is $9M or 20% of the company’s market cap.

Current assets for O2Micro were about 2/3rds cash and short term investments, with the remaining third in receivables and inventory. The company sells integrated circuits used in LCD and LED products to OEMs (these get used in products like monitors, LCD and LED televisions, notebook and tablet computers, low/zero emission vehicles, mobile phones, power tools, etc.)

This stock is up about 170% over the past 5 years, which was mainly due to a turnaround in the business induced by the COVID lockdowns, which caused demand for electronics products to skyrocket, and so O2Micro benefitted massively. In 2018, they were doing about $15M in sales/quarter, and were consistently losing money. By 2021, they were doing about $25M in sales/quarter with 10%+ operating margins.

Again, you may be thinking it was impossible to predict such a turnaround in this business 5 years ago because no one would have predicted that pandemic-induced lockdowns would cause a spike in demand for electronics. Which is true, but the difference is in deep value investing you’re buying the company below liquidation value, so even if no turnaround ever happens, you’re downside is limited because the stock can only go so low before an activist investor starts buying up shares to force management to pay a special dividend to realize some of the value, or liquidate the business.

Lesson #5: All of the above lessons are just general rules and not absolute truths

There are very few absolute truths in the world of investing. The risk reward trade-off is one of them that is well documented and seldom refuted. But in general, these lessons serve as guiding principles that help investors make better informed decisions.

A perfect example of this is one company I looked at called VOXX International Corp. They had very little margin of safety ($138M NCAV vs. $131M market cap). Their NCAV was about 20% cash and investments, 30% receivables, and 50% inventory. The business was burning cash and revenue was declining throughout 2018. They didn’t sell commoditized products (they sold automotive and consumer electronics, and biometrics products). But despite all of that they still went on to deliver approximately 18% annualized returns for 5 years, which I think most people would be happy with. What’s even stranger is it seems that these returns just came from an expansion of valuation multiples and not an actual fundamental improvement in the business (their P/S ratio 5 years ago was about 0.3 and eventually went up to about 0.9).

Let me know what you guys think of these lessons, and if you have any you would like to add from your own personal experience.

I also published this YouTube video discussing my findings from this study with some more detail: https://www.youtube.com/watch?v=T_FqdqDY3Co&t=1058s

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