Deep Value: Profiting from Mean Reversion

(Zen Buddha Silence by Marilyn Barbone)

(Image:  Zen Buddha Silence by Marilyn Barbone.)

November 12, 2017

The essence of deep value investing is systematically buying stocks at low multiples in order to profit from future mean reversion.  Sometimes it seems that there are misconceptions about deep value investing.

  • First, deep value stocks have on occasion been called cheap relative to future growth.  But it’s often more accurate to say that deep value stocks are cheap relative to normalized earnings or cash flows.
  • Second, the cheapness of deep value stocks has often been said to be relative to “net tangible assets.”  However, in many cases, even including stocks at a discount to tangible assets, mean reversion relates to the future normalized earnings or cash flows that the assets can produce.
  • Third, typically more than half of deep value stocks underperform the market.  And deep value stocks are more likely to be distressed than average stocks.  Do these facts imply that a deep value investment strategy is riskier than average?  No…

Have you noticed these misconceptions?  I’m curious to hear your take.  Please let me know.

Here are the sections in this blog post:

  • Introduction
  • Mean Reversion as “Return to Normal” instead of “Growth”
  • Revenues, Earnings, Cash Flows, NOT Asset Values
  • Is Deep Value Riskier?
  • A Long Series of Favorable Bets
  • “Cigar Butt’s” vs. See’s Candies
  • Microcap Cigar Butt’s



Deep value stocks tend to fit two criteria:

  • Deep value stocks trade at depressed multiples.
  • Deep value stocks have depressed fundamentals – they have generally been doing terribly in terms of revenues, earnings, or cash flows, and often the entire industry is doing poorly.

The essence of deep value investing is systematically buying stocks at low multiples in order to profit from future mean reversion.

  • Low multiples include low P/E (price-to-earnings), low P/B (price-to-book), low P/CF (price-to-cash flow), and low EV/EBIT (enterprise value-to-earnings before interest and taxes).
  • Mean reversion implies that, in general, deep value stocks are underperforming their economic potential.  On the whole, deep value stocks will experience better future economic performance than is implied by their current stock prices.

If you look at deep value stocks as a group, it’s a statistical fact that many will experience better revenues, earnings, or cash flows in the future than what is implied by their stock prices.  This is due largely to mean reversion.  The future economic performance of these deep value stocks will be closer to normal levels than their current economic performance.

Moreover, the stock price increases of the good future performers will outweigh the languishing stock prices of the poor future performers.  This causes deep value stocks, as a group, to outperform the market over time.

Two important notes:

  1. Generally, for deep value stocks, mean reversion implies a return to more normal levels of revenues, earnings, or cash flows.  It does not often imply growth above and beyond normal levels.
  2. For most deep value stocks, mean reversion relates to future economic performance and not to tangible asset value per se.

(1) Mean Reversion as Return to More Normal Levels

One of the best papers on deep value investing is by Josef Lakonishok, Andrei Shleifer, and Robert Vishny (1994), “Contrarian Investment, Extrapolation, and Risk.”  Link:

LSV (Lakonishok, Schleifer, and Vishny) correctly point out that deep value stocks are better identified by using more than one multiple.  LSV Asset Management currently manages $105 billion using deep value strategies that rely simultaneously on several metrics for cheapness, including low P/E and low P/CF.

  • In Quantitative Value (Wiley, 2012), Tobias Carlisle and Wesley Gray find that low EV/EBIT outperformed every other measure of cheapness, including composite measures.
  • However, James O’Shaughnessy, in What Works on Wall Street (McGraw-Hill, 2011), demonstrates – with great thoroughness – that, since the mid-1920’s, composite approaches (low P/S, P/E, P/B, EV/EBITDA, P/FCF) have been the best performers.
  • Any single metric may be more easily arbitraged away by a powerful computerized approach.  Walter Schloss once commented that low P/B was working less well because many more investors were using it.  (In recent years, low P/B hasn’t worked.)

LSV explain why mean reversion is the essence of deep value investing.  Investors, on average, are overly pessimistic about stocks at low multiples.  Investors understimate the mean reversion in future economic performance for these out-of-favor stocks.

However, in my view, the paper would be clearer if it used (in some but not all places) “return to more normal levels of economic performance” in place of “growth.”  Often it’s a return to more normal levels of economic performance – rather than growth above and beyond normal levels – that defines mean reversion for deep value stocks.

(2) Revenues, Earnings, Cash Flows NOT Net Asset Values

Buying at a low price relative to tangible asset value is one way to implement a deep value investing strategy.  Many value investors have successfully used this approach.  Examples include Ben Graham, Walter Schloss, Peter Cundill, John Neff, and Marty Whitman.

Warren Buffett used this approach in the early part of his career.  Buffett learned this method from his teacher and mentor, Ben Graham.  Graham called this the “net-net” approach.  You take net working capital minus ALL liabilities.  If the stock price is below that level, and if you buy a basket of such “net-net’s,” you can’t help but do well over time.  These are extremely cheap stocks, on average.  (The only catch is that there must be enough net-net’s in existence to form a basket, which is not always the case.)

Buffett on “cigar butts”:

…I call it the cigar butt approach to investing.  You walk down the street and you look around for a cigar butt someplace.  Finally you see one and it is soggy and kind of repulsive, but there is one puff left in it.  So you pick it up and the puff is free – it is a cigar butt stock.  You get one free puff on it and then you throw it away and try another one.  It is not elegant.  But it works.  Those are low return businesses.


But most net-net’s are NOT liquidated.  Rather, there is mean reversion in their future economic performance – whether revenues, earnings, or cash flows.  That’s not to say there aren’t some bad businesses in this group.  For net-net’s, when economic performance returns to more normal levels, typically you sell the stock.  You don’t (usually) buy and hold net-net’s.

Sometimes net-net’s are acquired.  But in many of these cases, the acquirer is focused mainly on the earnings potential of the assets.  (Non-essential assets may be sold, though.)

In sum, the specific deep value method of buying at a discount to net tangible assets has worked well in general ever since Graham started doing it.  And net tangible assets do offer additional safety.  That said, when these particular cheap stocks experience mean reversion, often it’s because revenues, earnings, or cash flows return to “more normal” levels.  Actual liquidation is rare.



According to a study done by Joseph Piotroski from 1976 to 1996 – discussed below – although a basket of deep value stocks clearly beats the market over time, only 43% of deep value stocks outperform the market, while 57% underperform.  By comparison, an average stock has a 50% chance of outperforming the market and a 50% chance of underperforming.

Let’s assume that the average deep value stock has a 57% chance of underperforming the market, while an average stock has only a 50% chance of underperforming.  This is a realistic assumption not only because of Piotroski’s findings, but also because the average deep value stock is more likely to be distressed (or to have problems) than the average stock.

Does it follow that the reason deep value investing does better than the market over time is that deep value stocks are riskier than average stocks?

It is widely accepted that deep value investing does better than the market over time.  But there is still disagreement about how risky deep value investing is.  Strict believers in the EMH (Efficient Markets Hypothesis) – such as Eugene Fama and Kenneth French – argue that value investing must be unambiguously riskier than simply buying an S&P 500 Index fund.  On this view, the only way to do better than the market over time is by taking more risk.

Now, it is generally true that the average deep value stock is more likely to underperform the market than the average stock.  And the average deep value stock is more likely to be distressed than the average stock.

But LSV show that a deep value portfolio does better than an average portfolio, especially during down markets.  This means that a basket of deep value stocks is less risky than a basket of average stocks.

  • A “portfolio” or “basket” of stocks refers to a group of stocks.  Statistically speaking, there must be at least 30 stocks in the group.  In the case of LSV’s study – like most academic studies of value investing – there are hundreds of stocks in the deep value portfolio.  (The results are similar over time whether you have 30 stocks or hundreds.)

Moreover, a deep value portfolio only has slightly more volatility than an average portfolio, not nearly enough to explain the significant outperformance.  In fact, when looked at more closely, deep value stocks as a group have slightly more volatility mainly because of upside volatility – relative to the broad market – rather than because of downside volatility.  This is captured not only by the clear outperformance of deep value stocks as a group over time, but also by the fact that deep value stocks do much better than average stocks in down markets.

Deep value stocks, as a group, not only outperform the market, but are less risky.  Ben Graham, Warren Buffett, and other value investors have been saying this for a long time.  After all, the lower the stock price relative to the value of the business, the less risky the purchase, on average.  Less downside implies more upside.



Let’s continue to assume that the average deep value stock has a 57% chance of underperforming the market.  And the average deep value stock has a greater chance of being distressed than the average stock.  Does that mean that the average individual deep value stock is riskier than the average stock?

No, because the expected return on the average deep value stock is higher than the expected return on the average stock.  In other words, on average, a deep value stock has more upside than downside.

Put very crudely, in terms of expected value:

[(43% x upside) – (57% x downside)] > [avg. return]

43% times the upside, minus 57% times the downside, is greater than the return from the average stock (or from the S&P 500 Index).

The crucial issue relates to making a long series of favorable bets.  Since we’re talking about a long series of bets, let’s again consider a portfolio of stocks.

  • Recall that a “portfolio” or “basket” of stocks refers to a group of at least 30 stocks.

A portfolio of average stocks will simply match the market over time.  That’s an excellent result for most investors, which is why most investors should just invest in index funds:

A portfolio of deep value stocks will, over time, do noticeably better than the market.  Year in and year out, approximately 57% of the deep value stocks will underperform the market, while 43% will outperform.  But the overall outperformance of the 43% will outweigh the underperformance of the 57%, especially over longer periods of time.  (57% and 43% are used for illustrative purposes here.  The actual percentages vary.)

Say that you have an opportunity to make the same bet 1,000 times in a row, and that the bet is as follows:  You bet $1.  You have a 60% chance of losing $1, and a 40% chance of winning $2.  This is a favorable bet because the expected value is positive: 40% x $2 = $0.80, while 60% x $1 = $0.60.  If you made this bet repeatedly over time, you would average $0.20 profit on each bet, since $0.80 – $0.60 = $0.20.

If you make this bet 1,000 times in a row, then roughly speaking, you will lose 60% of them (600 bets) and win 40% of them (400 bets).  But your profit will be about $200.  That’s because 400 x $2 = $800, while 600 x $1 = $600.  $800 – $600 = $200.

Systematically investing in deep value stocks is similar to the bet just described.  You may lose 57% of the bets and win 43% of the bets.  But over time, you will almost certainly profit because the average upside is greater than the average downside.  Your expected return is also higher than the market return over the long term.



In his 1989 Letter to Shareholders, Buffett writes about his “Mistakes of the First Twenty-Five Years,” including a discussion of “cigar butt” (deep value) investing:

My first mistake, of course, was in buying control of Berkshire.  Though I knew its business – textile manufacturing – to be unpromising, I was enticed to buy because the price looked cheap.  Stock purchases of that kind had proved reasonably rewarding in my early years, though by the time Berkshire came along in 1965 I was becoming aware that the strategy was not ideal. 

If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible.  I call this the ‘cigar butt’ approach to investing.  A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the ‘bargain purchase’ will make that puff all profit. 


Buffett has made it clear that cigar butt (deep value) investing does work.  In fact, fairly recently, Buffett bought at basket of cigar butts in South Korea.  The results were excellent.  But he did this in his personal portfolio.

This highlights a major reason why Buffett evolved from investing in cigar butts to investing in higher quality businesses:  size of investable assets.  When Buffett was managing a few hundred million dollars or less, which includes when he managed an investment partnership, Buffett achieved outstanding results in part by investing in cigar butts.  But when investable assets swelled into the billions of dollars at Berkshire Hathaway, Buffett began investing in higher quality companies.

  • Cigar butt investing works best for micro caps.  But micro caps won’t move the needle if you’re investing many billions of dollars.

The idea of investing in higher quality companies is simple:  If you can find a business with a sustainably high ROE – based on a sustainable competitive advantage – and if you can hold that stock for a long time, then your returns as an investor will approximate the ROE (return on equity).  This assumes that the company can continue to reinvest all of its earnings at the same ROE, which is extremely rare when you look at multi-decade periods.

  • The quintessential high-quality business that Buffett and Munger purchased for Berkshire Hathaway is See’s Candies.  They paid $25 million for $8 million in tangible assets in 1972.  Since then, See’s Candies has produced over $2 billion in (pre-tax) earnings, while only requiring a bit over $40 million in reinvestment.
  • See’s turns out more than $80 million in profits each year.  That’s over 100% ROE (return on equity), which is extraordinary.  But that’s based mostly on assets in place.  The company has not been able to reinvest most of its earnings.  Instead, Buffett and Munger have invested the massive excess cash flows in other good opportunities – averaging over 20% annual returns on these other investments (for most of the period from 1972 to present).

Furthermore, buying and holding stock in a high-quality business brings enormous tax advantages over time because you never have to pay taxes until you sell.  Thus, as a high-quality business – with sustainably high ROE – compounds value over many years, a shareholder who never sells receives the maximum benefit of this compounding.

Yet it’s extraordinarily difficult to find a business that can sustain ROE at over 20% – including reinvested earnings – for decades.  Buffett has argued that cigar butt (deep value) investing produces more dependable results than investing exclusively in high-quality businesses.  Very often investors buy what they think is a higher-quality business, only to find out later that they overpaid because the future performance does not match the high expectations that were implicit in the purchase price.  Indeed, this is what LSV show in their famous paper (discussed above) in the case of “glamour” (or “growth”) stocks.



Buffett has said that you can do quite well as an investor, if you’re investing smaller amounts, by focusing on cheap micro caps.  In fact, Buffett has maintained that he could get 50% per year if he could invest only in cheap micro caps.

Investing systematically in cheap micro caps can often lead to higher long-term results than the majority of approaches that invest in high-quality stocks.

First, micro caps, as a group, far outperform every other category.  See the historical performance here:

Second, cheap micro caps do even better.  Systematically buying at low multiples works over the course of time, as clearly shown by LSV and many others.

Finally, if you apply the Piotroski F-Score to screen cheap micro caps for improving fundamentals, performance is further boosted:  The biggest improvements in performance are concentrated in cheap micro caps with no analyst coverage.  See:



An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.


If you are interested in finding out more, please e-mail me or leave a comment.

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Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.