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Good morning,
We have 2 buy rules in the 5 Rules Of Deep Value Investing, both of which must be satisfied for a security to buy a buy:
- Buy stocks trading at or below their net current asset value.
- Buy stocks matching both of the following criteria:
+ Drawdowns of 90% plus from all-time high price
+ Trading at 10% or less from 52-week low price
This email looks at the 2nd Buy Rule from the 5 Rules Of Deep Value Investing.
The first item to note is the almost unbelievable returns from stocks that are trading for significant drawdowns:
Source: The Morgan Stanley Drawdowns & Recoveries research report by Michael Maboussin and Dan Callahan.
As the above image shows, stocks with 90%+ drawdowns go on to generate incredible 1-year returns of 200%+ percent at the median. No, that isn't a typo.
If you are like me, seeing the above number immediately raises suspicion. And the above number comes with caveats:
- The study is explicitly based on hindsight. We know what drawdowns and recoveries look like in the past. But if you own a stock in decline, you have no way of knowing the price at which it will trough.
- The study excludes companies that were delisted either for cause or bankruptcy, which typically results in drawdowns of 100 percent.
- The study excludes stocks that failed get to a market capitalization of $1 million (adjusted for inflation) by the end of any month, essentially a non-investable universe, as well as American Depositary Receipts (ADRs), which represent the securities of foreign companies.
We can know what level of drawdown a stock has currently. But we can't know where the drawdown will end ahead of time.
The study also excludes stocks that failed. Very high drawdowns end in failure, so results are skewed by this.
The ultimate takeaway from the study in my view is that investing in stocks with high drawdowns can result in excellent returns, but only when looking for stocks likely to persist.
Drawdown Math
When a stock with maximum drawdowns of 90% or more has any sort of partial recovery, returns can be explosive. Here's how the math works:
- High Price: $100
- 90% Drawdown Price: $10
- 70% Drawdown Price: $30
- Return from 90% to 70% drawdown: 300%
A stock does not need to achieve a full recovery when you purchase it at extreme drawdown levels to generate incredible returns.
The key to investing in stocks with large drawdowns is focusing on those most likely to continue on.
That's where detailed individual analysis and balance sheet protection come into play.
Net Current Asset Value + Deep Drawdowns
Every buy recommendation in the Deep Value Report is thoroughly vetted. Some stocks are very likely to go bankrupt.
Especially dangerous are those with weak balance sheets. A struggling, unprofitable business coupled with high levels of debt is very likely to be a disaster.
That's why we couple high drawdowns with a net current asset value (NCAV) approach.
We specifically look for stocks that are trading below their net current asset value. This means that current assets are greater than all liabilities. This means a clean balance sheet.
A clean balance sheet alone is no guarantee of success. But it does give a business time to recover.
And time is very valuable when perceptions are very negative. More time means a greater likelihood of recovery.
Drawdown & NCAV Synergy
Stocks trading below their NCAV compliment a deep drawdown strategy due to the balance sheet safety they afford.
And a deep drawdown compliments an NCAV strategy as well. That's because some NCAV stocks are seemingly perpetually stuck around NCAV value. They may have no catalysts and no reason to trade beyond NCAV. In essence, they are only worth their liquidation value and have found a way to survive.
As a thought experiment, if a bank account with $10 million were publicly traded, it would make sense for it to trade for $10 million, or a bit less due to not having actual control of it. This "cash box" stock should never trade above $10 million. It would pass a NCAV screen, but not a drawdown screen.
Stocks that are currently trading near 52-week lows and have large maximum drawdowns have extreme negative sentiment currently. They are beaten down.
The extreme price declines cause stocks with a healthy balance sheet to temporarily trade below NCAV.
Combining high drawdowns with stocks trading below NCAV gives you a unique opportunity set of stocks that are both safe from a balance sheet perspective, and also have extremely pessimistic views about their future.
The strong balance sheet gives the stock time to survive. This means time for market sentiment to change. Even a small bit of good news can send stocks with this level of negativity around them significantly higher.
And that's where the Deep Value Wealth shows its capital compounding power.
Deep Value Wealth
Deep Value Wealth exists to help investors find, buy, hold, and sell deep value stocks.
The Deep Value Wealth methodology is to buy stocks that:
- Are undeniably cheap from a fundamental perspective
- Have extremely negative market sentiment
These are stocks trading below net current asset value that are also down 90%+ from their all-time highs.
"If I were working with small sums, I certainly would be much more inclined to look among what you might call classic Graham stocks, very low PEs and maybe below working capital and all that. Although – and incidentally I would do far better percentage wise if I were working with small sums – there are just way more opportunities."
– Warren Buffett
Our full investment methodology is explained in the 5 Rules Of Deep Value Investing.
Each rule is supported by academic research and common sense principles from some of the world’s greatest investors.
Click here to download the 5 Rules Of Deep Value Investing PDF for free
You can put the 5 Rules Of Deep Value Investing to work for you with the Deep Value Report.
The Deep Value Report is our flagship service at Deep Value Wealth.
It has everything you need to start adding deep value stocks to your portfolio, including:
- One-off buy recommendations matching our buy rules in the 5 Rules Of Deep Value Investing.
- Actionable sell recommendations on past recommendations as needed matching our sell rules in the 5 Rules Of Deep Value Investing.
Each buy recommendation is thoroughly vetted and researched. This is not a quick screen or automated AI guesswork.
Note: We are focused on the U.S. market, not international stocks.
The stocks we recommend are often unprofitable businesses. But they tend to have catalysts that we believe are likely to unlock shareholder value.
And interestingly, unprofitable (and non-dividend paying) net current asset value stocks have generated better returns than those that are profitable.
Source: Deep Value by Tobias Carlisle, page 133. The above studies count net current asset value stocks as those trading for 2/3 or less of net current asset value.
You will instantly receive our 1st buy report when you join, and all future buy reports as long as you are a member.
- All reports are delivered by email from Ben@deepvaluewealth.com.
- We expect to deliver several more buy reports in the coming 1-2 weeks.
- The exact timing of buy reports going forward will fluctuate because our criteria are time-sensitive and highly selective.
We are targeting rare opportunities, which by definition aren't constantly available in large supply.
With that said, I expect at least a few new buy recommendations every month, with many more during times of market turmoil (when stock price declines make more opportunities available).
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Please email me at Ben@deepvaluewealth.com with any questions. I look forward to hearing from you!
To your compounding wealth,
Ben Reynolds
Founder, Sure Dividend & Deep Value Wealth
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