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Tim Melvin

Tim Melvin is a value investor, money manager and writer. He has spent the last 27 years as in the financial services and investment industry as a broker, advisor and portfolio manager. He has also...

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Why Deep Value? Because It Works

Most investors avoid the idea of buying stocks below book value.

Investors consider it to be an outdated, old-fashioned approach to picking stocks that no longer works. But, this method does not capture all the really exciting stocks that friends and co-workers are talking about, like Tesla (NASDAQ: TSLA), Netflix (NASDAQ: NFLX) and Amazon (NASDAQ: AMZN).

There are rarely discussions about stocks trading below book value on the financial networks, and the deep value approach does not gather many headlines in the print media, either.

It is just not a very exciting or sexy approach to picking stocks.

What it is, however, is a highly profitable method of investing that has stood the test of time.

Related: 5 Keys To Spotting Value Stocks

Tobias Carlisle of Greenbackd.com has done a study of buying stocks that trade below book value across several time frames. He looked at all available data from 1926 to today, as well as 1951 to today to track other recent academic papers, and the last 15 years to bring the strategy into more recent market conditions.

He found the price to book value approach handily beats the overall market and the more exciting glamorous stocks that trade at the highest multiples of book value. The capitalization weighted portfolio of low price to book value stocks earns 12.6 percent annually from 1926 to 2013, versus 8.6 percent for the glamor stocks.

From 1951 to 2013 value leads by 15 percent to 9.6 percent compounded. Over the last 15 years value earns 13.2 percent compared to glamor's 6.8 percent and the overall market return of about 2.4 percent.

That is for capitalization weighted portfolios as is the habit of many academics. Since most individual investors are far more likely to equally weight portfolios, Mr. Carlisle took a look at how that performance stacks up. Since many of the best low price to book value stocks are small caps, it will come as no surprise that the performance ramps up substantially.

When equally weighting the portfolio and rebalancing annually, all three time frames show a compounded rate of return that is 20 percent or higher.

In the past 15 years, when the overall market has generated returns of less than three percent and the glamor stocks have earned 6.4 percent, the deep value approach has a compound rate of return of 20.6 percent.

Related: 3 Stocks To Profit Like Bank Stock Activists

The outperformance persists in recent years, with the deep value approach beating the glamor stocks and the overall market in four of the past five years.

Most investors still avoid the deep value approach of buying the cheapest price to book value stocks no matter how much evidence is presented. It is not very exciting to buy cheap stocks and hold them for a year or longer. It is completely out of step with most of the rest of the investing.

Noted deep value investor Donald Smith says less than one-tenth of one percent of professional money managers practice a deep value approach. One could grow very old sitting in front of the TV waiting for the talking heads to mention deep value investing.

It is against traders' nature to buy stocks that have been going down in value, and most of the stocks that trade below their book value have declined and are out of favor with Wall Street.

Many investors today are worried about the short-term performance of stocks, and obsessively check their prices against moving averages and other technical patterns in search of buy and sell signals. Quarterly earnings reports are analyzed and reviewed as if they are the definitive answer to finding profits in the markets.

This type of short-term thinking leads to overtrading, and chasing overvalued stocks and crushes the performance of many individual investors. Wall Street encourages this type of activity -- as it keeps the lights on and pays for all those beautiful big buildings in New York and other financial centers.

The simple truth is that most investors would earn much higher returns if they would simply switch to that old fashioned, unpopular approach to investing and buying stocks that trade at a discount to book value. They should, but history tells us that they probably won't.

Deep value investing either makes sense to a trader right away, or it probably never does. Fortunately for those who practice this approach, it will never appeal to most investors as much as chasing the high-profile, exciting stocks.

Tags: Deep Value Investing Donald Smith Greenbackd.com Tobias Carlisle

Posted in: Education Small Cap Analysis Trading Ideas General