Deep Value Investing And Unexplained Returns


To be a successful deep value investor, you need to patient and disciplined. Over the long-term, the returns can be better than the market average but only if you’re willing to fully commit to the cause.

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Why deep value strategies outperform the market is a question that’s been asked and studied many times. A study by Jeffrey Oxman and Sunil Mohanty of the University of St. Thomas (Minnesota), along with Tobias Eric Carlisle of Eyquem Investment Management LLC attempts to give an explanation as to why these strategies outperform.

The paper source can be found here.

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Deep Value Investing and Unexplained Returns

The paper, entitled, Deep Value Investing and Unexplained Returns looks at the strategy of holding “net-nets” and how this affects returns over the long-term. The study looks at the returns of holding a portfolio of net-nets over the period 1975 to 2010 and attempts to explain the excess risk adjusted returns generated by the strategy.

All in all, it was found that the average monthly return from this strategy is 2.55%, and excess returns adjust for risk using a simple market model amount to 1.66%. Not only does the strategy look at the performance of the net-nets strategy, it also looks at the affect a firm’s size, degree of analyst coverage, stock price (in terms of low/high stock price, not based on valuation or company size. For this the study include a $3 and $5 filter. ) and liquidity.

The study is detailed and revealing but I’m only going to be able to scratch the surface of the results here. I strongly recommend that you check out the study in full, which can be found at the link above.

Driving outperformance

Unsurprisingly, the study found that the only firm characteristics that drive excess returns among net-net firms are the analyst coverage, price per share, and turnover. The results show that controlling for firm size and market-related risk factors, excess returns are higher among net-net stocks with low analyst coverage, low stock price per share and lower trading volume.

There’s plenty of evidence to support this conclusion. Stock with little to no analyst coverage and low trading volumes have been shown to outperform numerous times in the past. That being said, the unexplained returns paper also found that in order to realize gains, investors must have a fairly lengthy investment horizon. As I’ve mentioned above, the study found that the average monthly return from this strategy is 2.55%, and excess returns using a simple market, risk adjusted model amount to 1.66%.

However, the unadjusted mean monthly return, for net-nets situations was in fact much higher over the period, as shown the in table below, extracted from the study. The table shows the number (N) of net-nets firms purchased during the year beginning in March, along with the average and median monthly returns (Mean, Median), and the standard deviation of returns (Std. Dev). Results have been separated for the $3 and $5 filters:

Deep Value Investing unexplained returns

Revealing results

Of course, with the market currently trading at near all-time highs, the number of net-nets available is an all-time low. Nevertheless, this is interesting food for thought to keep in mind for the next time the market presents opportunity.

See full study here.

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