There are many different ways of building an investment portfolio; ultimately how you build your portfolio will depend on your investment objectives as well as appetite for risk.
Dividends or dividend stocks are usually the foundations of any portfolio no matter what your attitude on risk or investment objectives. Indeed, you can’t go wrong with a steady stream of dividends to improve your portfolio’s returns when times are good and generate a steady income when times are bad. Alongside dividend stocks, there’s one other class of equities that should have a place in every portfolio –Â deep value stocks.
First off I should say that deep value stocks are different than what many today would call value stocks. Deep value, by definition, means stocks that are trading at a deep discount to book value or intrinsic value – following the rules Benjamin Graham laid out decades ago. Today it seems that any stock can qualify as a value investment as long as investors believe it is cheap. But deep value stocks are harder to find. Companies that qualify must have a cash-rich balance sheet, be profitable, pay a dividend and be trading at a deep discount to net asset value (following Graham's rules).
Low risk, high reward
Deep value equities are, by their nature, low risk. Low risk, in this case, means a low probability of permanent capital impairment, which is the definition from value investors such as Warren Buffett (Trades, Portfolio) and Seth Klarman (Trades, Portfolio). Markets today generally interpret risk as beta, a measure of volatility that has no connection to a business’ financial profile or underlying business.
So, why should all portfolios contain a number of deep value stocks? Well, as mentioned above deep value opportunities tend to be low risk and high reward. Usually, higher risk portfolios will have a certain percentage of holdings devoted toward more speculative investments, hedge funds, private equity or fledgling companies that claim to be developing the next wonder drug or revolutionary technology. These investments are not suitable for all classes of investors due to the high probability that they will never generate any substantial return for investors and may go to zero. Of course, the upshot is that these investments could produce a return of multiples of the investors’ initial capital, but only the most risk-tolerant investors will be able to take advantage of these opportunities.
Deep value stocks offer the potential for lucrative returns (100% if bought at a 50% discount book) but unlike more speculative opportunities the risk of permanent capital impairment is greatly reduced. Many risk-averse investors would benefit from the added kick deep value opportunities would give to their portfolios thanks to the high returns coupled with limited risk.
(Assuming a portfolio designed to preserve capital while generating a relatively secure real return –Â in the current environment –Â would generate a real return of no more than around 5% per annum. Even if it took three years for a deep value stock to return 100%, this opportunity would still greatly outperform the rest of the slow and steady portfolio.)
Also, more risk-tolerant investors would benefit from the limited downside of deep value opportunities compared to speculative investments that often attract their attention.
Does value really outperform?
An enormous volume of academic research over the years has shown that deep value stocks outperform the wider market on a consistent basis. One of the most comprehensive studies was conducted by Eugene L. Fama and Kenneth R. French, who examined the effects of market capitalization and price as a percentage of book value on investment returns in “The Cross-Section of Expected Stock Returns,” Working Paper 333, Graduate School of Business, University of Chicago, January 1992. The study examined investment returns from July 1963 to December 1990. The results are presented in the table below, which is taken from Tweedy Browne’s booklet “What Has Worked In Investing.”
Another revealing study comes from Josef Lakonishok, Robert W. Vishny and Andrei Shleifer, who examined the effect of price as a percentage of book value on investment returns in “Contrarian Investment, Extrapolation and Risk,” Working Paper No. 4360, National Bureau of Economic Research, May 1993. In this study, the professors ranked companies according to stock price as a percentage of book value and sorted the companies into deciles. Portfolios were initially formed on April 30, 1968 and re-formed every year until the study period ended April 30, 1990. The decile portfolios were held for five years. The results are shown in the table below.
Conclusion
Overall, there’s a lot of evidence that shows value stocks outperform the wider market with limited risk for investors. By combining an element of deep value in your portfolio you will be able to improve your returns without putting capital at risk.
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