The Ultimate Guide to Absolute Deep Value Investing

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For decades, deep value investing has been one of the most rewarding strategies for patient, disciplined investors willing to swim against the tide. The fundamental principle is simple: buy stocks trading at the absolute lowest decile of valuation metrics, such as Price-to-Tangible Book Value (P/TBV) and EV/EBIT, and hold them until they revert to fair value. The trick, of course, is avoiding the value traps—companies that are cheap for a reason and destined to stay that way or go bankrupt.

The goal of this article is to take an exhaustive look at the raw performance of deep value investing, how to enhance it using quality filters like the Piotroski F-Score, Joel Greenblatt's Magic Formula, and additional financial health metrics, and most importantly, how to manage risk. We will use historical backtests, risk-adjusted performance measures, and drawdown analysis to demonstrate why refining deep value investing leads to superior long-term gains.

Understanding the Core of Absolute Deep Value Investing

A traditional deep value investor buys stocks trading at fire-sale prices—the lowest 10% (bottom decile) of the market based on valuation ratios. The two most effective and widely researched metrics for this strategy are:

1. Price-to-Tangible Book Value (P/TBV) – Stocks trading at very low tangible book multiples indicate extreme pessimism, often unjustified.

2. EV/EBIT (Enterprise Value to Earnings Before Interest and Taxes) – This metric improves upon P/TBV by accounting for leverage and operating income.

Historically, research has demonstrated that stocks in the lowest decile of these metrics significantly outperform the broader market. However, the raw strategy carries risks—many of these companies are cheap for good reasons, including high debt, poor profitability, or structural decline.

The Performance of Buying the Cheapest Stocks

• Backtests confirm that the lowest-decile deep value stocks generate excess annual returns of 4-6% over benchmarks.

• However, these stocks suffer from severe drawdowns during recessions, often lagging the market for long stretches.

• Sectors like financials, industrials, and cyclicals dominate deep value screens, leading to industry concentration risk.

To improve the performance of deep value investing, we introduce three powerful filters: the Piotroski F-Score, the Magic Formula, and additional financial quality factors.

How to Improve Deep Value Investing: Quality Filters & Risk Management

1. The Piotroski F-Score: Filtering for Financial Strength

The Piotroski F-Score is a 9-point system developed by accounting professor Joseph Piotroski. It measures a company's profitability, liquidity, and operating efficiency to separate weak companies from strong ones.

A deep value stock with a Piotroski F-Score of 7-9 significantly outperforms those with a score below 5.

✅ Profitability Checks:

• Positive net income

• Positive cash flow from operations

• Improving return on assets

• Cash flow from operations exceeding net income (avoiding earnings manipulation)

✅ Leverage & Liquidity Checks:

• Lower debt levels year-over-year

• Higher current ratio (improving liquidity)

• No new share issuance (avoiding shareholder dilution)

✅ Operational Efficiency Checks:

• Higher gross margins

• Increased asset turnover

Result: Deep value stocks with high F-Scores increase annual returns by 3-5% while reducing drawdowns.

2. The Magic Formula: Balancing Cheapness with Profitability

Joel Greenblatt’s Magic Formula refines deep value investing by incorporating profitability (Return on Capital, ROC) alongside cheapness (EV/EBIT).

Formula:

• High Earnings Yield (EV/EBIT) – Identifies undervalued stocks.

• High Return on Capital (ROC = EBIT / (Net Fixed Assets + Working Capital)) – Ensures profitability and efficiency.

Why This Works:

• Filters out unprofitable businesses and serial capital destroyers.

• Avoids deep cyclicals that may remain depressed for years.

• Reduces industry concentration risk in financials and basic materials.

Result: Magic Formula stocks historically outperform standard deep value stocks by 2-5% annually with lower risk.

3. Adding Quality Factors: Margin, Leverage & Momentum Filters

Deep value investing can be further improved by integrating fundamental and price-based filters.

✅ Operating Margin > Industry Median: Avoids companies with poor cost control.

✅ Debt-to-Equity < 1.5x: Ensures financial stability and reduces bankruptcy risk.

✅ Positive Price Momentum (6-12 months): Prevents buying stocks in long-term decline.

Result: Combining deep value with quality factors increases Sharpe ratios, reduces drawdowns, and improves long-term performance.

Quantitative Backtest: How These Strategies Perform Over 20 Years

Annualized Returns & Risk Metrics

Key Takeaways:

• Quality-Filtered Deep Value had the highest Sharpe ratio, maximizing returns per unit of risk.

• Magic Formula and Piotroski-enhanced stocks reduced drawdowns significantly.

• Basic deep value stocks suffered the most volatility and worst drawdowns.

Final Thoughts: How to Apply This Strategy in the Real World

Deep value investing works, but pure valuation screens alone can be risky. Refining stock selection using the Piotroski F-Score, the Magic Formula, and additional financial health metrics significantly improves returns while reducing risk.

Practical Steps:

1. Screen for the bottom decile of stocks based on P/TBV and EV/EBIT.

2. Apply the Piotroski F-Score (7+) to filter for financially strong firms.

3. Use the Magic Formula to prioritize companies with high return on capital.

4. Add quality filters like operating margin, debt control, and price momentum.

5. Hold a diversified portfolio of at least 20-30 stocks to mitigate risk.

Final Word:

A disciplined deep value approach, enhanced with fundamental and quality filters, delivers superior long-term returns while reducing drawdowns. Stick to the rules, avoid emotional trading, and let value investing do its magic.

If this is something you’d be interested in hearing more about, let me know by replying to this email.