Warren Buffett (Trades, Portfolio) built the foundations of his career using a deep value investment strategy. He followed in the footsteps of his mentor, Benjamin Graham, who designed a process of investing based on the idea that investors should look to buy stocks trading at a deep discount to the net value of their assets.
This wasn't the only investing strategy Graham devised, but it is the one he is best known for. And it worked for a long time; Buffett was not the only investor who made a substantial fortune following this approach. Other investors such as Walter Schloss, Rick Guerin and Charlie Munger (Trades, Portfolio) also built impressive track records following the ideas laid out in Graham's teachings.
Consigned to history
This old value investing style has almost been consigned to history over the past couple of decades. Very few, if any, high-profile investors still follow the approach Graham put forward for finding stocks trading at a significant discount to the value of their assets. Although he is still highly regarded by many investors who use some of his ideas, namely the principle of buying stocks trading at a significant discount to intrinsic value (commonly known as the margin of safety), it's undeniable that the deep value style isn't the cash cow it once was.
Many value investors have shifted away from looking for cheap stocks to searching for stocks that look cheap compared to their growth potential. This is the approach Buffett himself has popularized, replacing his mentor in the eyes of many investors. Now that market information is so readily available to investors and massive amounts of cheap debt are so readily available to companies, the rules of the game have changed.
That is not to say deep value investing no longer works. Deep value investing has become more challenging since Graham's time as the dissemination of information has vastly increased the number of value investors looking for opportunities around the world.
Online trading and interconnected global markets are two factors that have also reduced the number of opportunities as any investor around the world can buy a stock at the click of a button. Back in Graham's day, it was not uncommon for value investors to have to go hunting for stock certificates, knocking on doors to agree to deals to buy share certificates at a price both parties thought appropriate. This lack of efficiency only increased the opportunities for those who were able and willing to do the extra leg work.
This is just one reason why deep value investing has fallen out of favor. Another reason is the general shift away from using hard assets to produce returns. Intellectual and intangible assets are often far more valuable and productive to companies in the digital economy.
However, placing a value on these assets is usually far more difficult than it would be for hard assets such as ships and factories. Indeed, there is no correct answer to the question of how much intellectual property is worth. A second-hand ship is worth as much as someone else is willing to pay for it.
Another reason why Graham's strategy would not work in today's markets is that he often owned large numbers of preferred shares and bonds in his portfolio. These assets tended to have a more defined fixed payoff structure than common stocks.
Unfortunately, preferred shares have really fallen out of favor since the early 1900s. There is still an opportunity for profit in the bond market, however. Distressed debt hedge funds specialize in this area of the market, although this section of the market tends to be off-limits for individual investors as large amounts of capital are required.
Put simply, there is no one specific reason why deep value investing has fallen out of favor in recent decades. A number of factors have contributed to its decline.
The lack of opportunities is a real problem. Most successful value investors owned a well-diversified portfolio of stocks, up to 100 in some cases. According to my research, just 15 U.S. companies are trading below the value of their net assets today. That would make it very difficult to replicate the sort of diversified portfolio required to achieve attractive returns from deep value investing.
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