Cigars, Diapers and Investments

We are Back!  Baby Herman and I are here!

It has been a long time since the last post.  This blog is a hobby and it is hard to find time to write as much as I would like to.  But here we are.  Yes, we are.  I decided to do something a little bit different this time.  Instead of having a detailed post about the Brazilian deep value results, I’m going to write two posts.  The serious one is the Everyday Deep Value in Brazil.  But before going there you may consider a lighter approach to finance.  An interview with my alter ego, Baby Herman.

I was very fortunate that some friends actually read this blog! I thank you all!  It is nice to have an audience.  And it is even nicer when your friends ask you clever questions! Since the beginning the idea of this blog was to interact with the outside world.  I have been reading about investing and investing for a long time, but I missed someone to discuss the topic with.  This blog and Twitter solved the problem.

Now it is time to address the comments and questions I received.  I was wondering how to do this.  Just writing about them would be the obvious answer, but finance is a dull topic.  I thought there might be a better way to convey my message and I found the answer.  I will not address the comments or respond the questions.  Baby Herman will.  They are to be addressed in an interview with Baby Herman!  Let’s put my alter ego to work!

I was a kid in the 80`s and when I saw Who Framed Roger Rabbit, one character caught my attention: Baby Herman.  You may not remember him, but take a look at this video:  As I said in the About section of this blog, this 50 year old baby epitomizes the autodidact.  A grown-up in some fields and a child in other ones.  The video takes less than two minutes.

Now that you know who Baby Herman is, let’s go to his interview.

The Interview


 We are all here.  It is a sunny Saturday and we meet in a park.  I arrived a little bit earlier and waited for Baby Herman.  He arrived in a nice baby carriage, smoking a Cuban cigar, together with his hot babysitter.  She was carrying a large cooler. I could not understand why.  After some chatting, we started the interview.

Me: Baby Herman, thank you very much for this interview.

Baby Herman (BH): It’s my pleasure; I thank you for this opportunity. I managed to have some interested readers and I felt I had the obligation to answer their clever questions.  They read my stuff!

Me: I know the cigar is a kind of trademark of yours, and in view of your paradoxical age (50 years old, but a 3 year old dink), I can fully understand the baby carriage and the presence of your babysitter, but how about that big cooler?

BH (looking angry): First of all, I have to address my statement in the video.  That movie was for kids! Kids in the 80`s, but kids!  I can deal with this 3-year-old dink very well! Don’t you agree? [BH takes a look at his babysitter]

Baby Herman’s Babysitter (BB): Yes, you do!

BH (with a smile on his face): But let’s go back to your question about the big cooler.  Well, it has some baby bottles prepared for this interview!  I got some specially for you!  They have to do with investing, believe me! They’ll help to explain what I’ve been doing.

Me: Investments and baby bottles?

BH: I’ll get there in time, just wait.

Me: I have here some questions I received from your readers, can we go over them?

BH: Of course, we can!  But before answering specific questions, I’d like to make some comments about what I heard.  It’s interesting to see the reaction of people and how some ideas about finance just persist out there.  As a M&A lawyer, several of my friends are lawyers or from the M&A world.  In all of them I could see some persistent issues.  There is a really broad range of subjects covered in the comments and questions.  Some assumed that the performance of the deep value strategy is derived from small cap investing, others took rule-based investing as technical analysis.  There is also a belief that there is a right moment to invest.  And you know what? Some people take finance as an exoteric subject.  Some friends thought that I became some sort of financial wizard! Can you imagine?  Gee!! A baby wearing diapers and smoking a cigar a financial wizard?  It’s just crazy how people react!  But among all comments, there is one thing that is always present. People only see either the chances of gain or the chances of loss.  They don’t see a middle ground.  I fully agree that greed is good.  Gordon Gekko was correct[1], but I think it has to be combined with the possibility to survive.  To continue in Hollywood, I think that Gordon Gekko has to be combined with Rocky Balboa[2].   Rocky is right about survival: it’s not how hard you hit, it’s how hard you can get hit!  Investments have to do with savings.  Savings are the result of work and a form of safety.  Dealing with the product of work and also with safety involves deep psychological issues.  Can you imagine years of work being lost in a couple of hours? People go crazy!

Me: You’re right, we’re dealing with a very sensitive topic.

BH: Can I tell you something in off?

Me: Of course, you can!  Don´t worry, what you tell me, I won´t post it on the internet.

BH (looking incredulous): You know, among my readers there is a couple of fellows that are really, really crazy! Those guys take me seriously! They are longtime friends of mine. They made some really interesting questions about timing and small caps investing.  Can you imagine if some day they let me manage some of their money? They got to be totally crazy!! That’s what I’d like to tell you in off.

Me: Understood.  What you said about your crazy friends I won’t post.  Off is off.  Trust me.

BH: You have the questions, right?  Let’s go over them. But, can I light a cigar first?  Darling, can you help me? [BB lights a cigar for Baby Herman.]

Me: Is it a Cuban cigar?

BH: Of course!  Communists know how to make money from a franchise!  Cuban cigars are the best!

Me: The first question I have here is about small cap investing.  Are the results of your deep value research in Brazil the result of the investment in small caps?

BH (with a smile on his face): Well, the answer is no. It’s hard to have a final separation among small, mid and large caps in Brazil and also to have a reasonable sample of companies in all slots.  It appears that portfolios with small caps had a better performance when compared to the ones that had only large caps.  But in any case, all portfolios had good results.  In some cases, portfolios with small caps lost to the ones that had no small caps in their composition.  In my opinion, the cause for these results is the cheap price of the acquired stocks.

Me: Is deep value a form of technical analysis? Because you don’t look at the specifics of the financial statements, right?  It’s a numbers game, right?  You define EY (earnings yield) and invest, right?

BH (shaking his head): No, it’s not a form of technical analysis! It’s not because you have rules to invest that it is technical analysis.  In fact, it’s fair to say that deep value, as Carlisle defined, is a form of XXI century hard core Graham investing style.  Just for your reference, Benjamin Graham was the father of value investing.  I need to differentiate what is technical x fundamental analysis.  On one hand, technical analysis believes that the price is the only source of useful information.  Price reflects supply and demand and that is what matters.  To a technical analyst all fundamentals are reflected in the price and it makes no sense to waste your time analyzing any fundamental information.  On the other hand, fundamental analysis believes that a proper analysis of an investment is based on its fundamentals, broadly meaning characteristics of the business besides the price.  In most cases, the financial statements are the main source of fundamental information.  The fundamental investor is always comparing a theoretical price, derived from a valuation based on the fundamentals of the company to its market price.  Price isn’t the king, it’s only a reference.

Me: Let me see if I got it right, an analyst that focus solely on price movements is technical and an analyst that makes a valuation of the company is fundamental, right?  If this is the distinction, where is the valuation in the deep value?

BH: You’re almost right.  It’s correct to say that an analysist that focuses solely on price movements is technical and it’s also correct to say that an analysist who bases his investment decision on the valuation of the company is fundamental.  But you can also be a fundamental investor, if you do not carry out a full valuation of the companies you invest in.

Me: I haven’t understood.  How do you know the value of the companies you invest in?

BH: People asked me this question a lot.  The problem is that they first think about investing in a stock and only later think about forming a portfolio.  Deep value isn’t a strategy to invest in this or that stock.  It’s a strategy to form portfolios.

Me: Gosh! That is the difference!  People think that you pick stocks and form portfolios, but here it’s the opposite.  You form portfolios and pick stocks, right?

BH: I think it oversimplifies things, but you got the idea.

Me: Is this formation of portfolios approach related to rule-based investing?

BH: Yes!  Totally!  We can say that the investing process can be ruled-based or discretionary.  If the investor has a pre-defined set of rules that define the actual investments, it’s rule-based.  If the investor can make discretionary investment decisions, it’s discretionary.   But you’ve have to pay attention here, all investors have their analysis process.  Even discretionary investors have their investment rules.  But in the discretionary approach, the last word is given by the investor.  In the rule-based world, the last word on any investment is given by the rule.

Me: I see.  It means that the rule (the model) is the key.  In fact, you form the model and it picks the stocks.

BH (smiling): You’re pretty clever for a lawyer!

Me: Thanks! You’re my alter ego!  Why do you say it’s rule-based instead of quantitative investing, or quant as people say?

BH: Gee!  Quant is for math geeks!  I’m a lawyer and a baby!  I think investing is much more art than science.  That’s why I prefer to say rule-based.  Making a model is much more art than science, mainly if it follows a classic value investment approach, based on Graham.  I my case, I see the rule as a form of common sense: buying stocks of companies that have assets that generate good results.  The quant stereotype is someone that processed zillions of numbers before investing, I’m far from that.

Me: You have a point.  But in the end, you got a rule to invest, as quants do.  Tell me one thing, if you’re only forming portfolios, how can you be sure that you’re not buying trash?

BH: Very good question.  It goes to the heart of the rationale behind deep value.  BB, can you give me another cigar?

[BB lights another cigar and Baby Herman inhales deeply.  He looks very concentrated.]

Me: Are you worried? Is everything ok?

[BH continues very concentrated and exhales deeply.]

BH: Yes, everything is fine.  I was thinking about the answer and my diapers.  No need to change them yet.  I think now it’s time to go to the baby bottles.  I got some baby bottles filled with pét-nat sparkling wine!  They’ll help me to explain what I’ve been doing.  BB, take the cooler please! Give one baby bottle to our friend here, one to me and serve yourself!

[BB gives me a baby bottle with pét-nat sparkling wine, another one to Baby Herman and starts drinking.  She has a proper glass for her.]

BH: Do you know what pét-nat means?  Also, do you know that there are two ways of making sparkling wine?

Me: No, I don’t. Please tell me more about it.

BH: I knew one day I would have to explain the rule-based investment process, we live in a world of stock pickers.  It’s hard to be a baby in this world! [Baby Herman shakes his head, takes a deep breath, but he seems resigned.]  Basically, there are two methods to make sparkling wine, the charmat method and the champenoise one.  The first one is a one-stage method.  The wine gets ready in a single process, that takes place in the barrel.  What interests me here, is the champenoise method.  This is a two-stage process, that takes place in the bottle.  The wine spends some time in the bottle and the yeasts will do their job.  Once the bottle fermentation is ready, the bottle is opened, yeasts removed and the bottle is closed.  You see? Two stages!  That is the traditional champenoise method.  The pét-nat method does not remove the yeasts.   It’s half of the champenoise method.  You drink the yeasts.  Can you see that the sparkling wine is cloudy?  If they had removed the yeasts the wine would have been much clearer.

Me: I didn’t get you.

BH: No?  I’ll explain again.  Can you do me a favor?  Have you seen how fast she drinks?  Can you spare some baby bottles for us?  Otherwise BB will drink all of them!  She cannot handle bubbles very well.

[I take some baby bottles from the cooler. BB has already drunk a lot and looks very happy!]

BH: When you invest in stocks you need to have some form of screening.  Even in a small market like Brazil, it would be impossible to analyze hundreds of stocks without some screening.  You can take the deep value criteria to screen stocks and then further analyze some.  That would be the complete champenoise method.  Active management is a two-stage process: screening plus stock picking.  But you have a pét-nat approach as well.  You stop your work after one stage.  The result will be cloudy, but still very good!

Me: Okay, I got you.  You rely on a good screening.  But, how do you deal with the trash you may be choosing?  Let’s say that there may be some bad yeasts in the screening.  How can you make sure they’re not poisonous?

BH: I’m not feeling very well.  This sparkling wine is delicious, but side effects suck!  Darling can you help me?

[BB takes Baby Herman from the baby carriage, puts him against her generous chest and pats on his back few times.  Baby Herman burps noisily!!]

[BB puts Baby Herman back in the baby carriage.]

BH:  Gee! I needed this burp!  Now I can continue! Thanks darling!  You have a very good question.  The mechanics of my research and my actual investments will help me to explain it to you.

Me: Let’s do the following, can you please tell me what the deep value approach is?  After that, we can go back to its mechanics (screening, hygiene, etc.).

BH (nodding his head): Very good idea.  You have to read Deep Value, written by Tobias Carlisle.  The book is wonderful!  All rationale of deep value investing is explained there in detail.  First of all, you have to know that it’s a form of value investing.  The basics go back to the father of value investing, Benjamin Graham.  We can summarize the foundation of the deep value strategy in five topics.  As a baby, I like this five topcis approach.   I can use my fingers to memorize things!  One topic to each of my fingers in my right hand.  [Baby Herman shows his right hand opened and starts his explanation.] The pillars are (1) buy cheap, price paid drives returns; (2) people perpetuate the present into the future; (3) mean reversion is everywhere; (4) market will find its ways to unlock value; and (5) the metric or sweet numbers, like cotton candy, you know?  Can you see, one topic to each of my fingers?

Me: Good, I see that you like to keep things simple.

BH: Thanks.  Have you read The Intelligent Investor, written by Benjamin Graham? The roots of pillar 1 are there.

Me: Yes.  This is another must read book.

BH: I agree with you.  The principles in The Intelligent Investor are timeless.  Buy cheap (pillar 1) is another way of saying that what matters is the margin of safety.   There is an entire book called Margin of Safety, written by Seth Klarman.  He takes margin of safety so seriously that he says that you should sell if another investment offers a better margin of safety!  But let me return to buy cheap.  If a stock is cheap maybe something went wrong.  Maybe there is a crisis in the economy or in the sector of that company.  Maybe the company didn’t meet the market expectations for that quarter.  Or even worse, a factory exploded.  Many things may have happened.  It doesn’t matter, but in moments like these, people sell.  If people sell, prices drop.  Guess what?  The margin of safety increases!  Counterintuitive, don’t you think?

Me: Yes, totally counterintuitive.  It’s like if someone shouts fire and you run into the fire instead of running away from the fire.

BH (nodding his head and speaking in a very emphatic tone): I’m a baby!  I’ve no sense of danger!  Let me taste the fire!  I’ve mentioned the buying cheap, but there is the flip side of the coin, that is buying expensive.  When everything is well, the economy is booming, revenues and profits are raising and price gets expensive.  It means that you won’t have margin of safety in your investment or that it’ll be too thin.

Me: Why do you think people ignore the margin of safety if it’s so important?

BH: The reason for that is exactly what is covered in the second pillars of deep value.  Let’s begin with some human characteristics.  Sometimes, people tend to be very optimistic about the future or very pessimistic about the present.  Think about a soccer fan after his team wins a championship.  He will say that his team is the best, is going to win the next championship and bla, bla, bla.  Everything is easy and the future of his team is rosy.  Now, think about the fan of a soccer team that was downgraded to a lower league.  He will see no future for his team.   It’s the end of the world and the future is dark.  Both fans are projecting the present into the future.

Me: Can you be more specific?

BH: Sure.  People tend to think that good companies will always be good and bad companies will always be bad.  It makes them pay too much for the good ones and dump the bad ones, depressing their prices.  But if you think about a competitive market, it’s of its essence to equalize things.  If a business is very good, it’ll attract competition.  Think about Cielo (the payment means company).  It has lived a long honeymoon with the market and paid juice dividends for a long time.  Now it has several competitors and is having a hard time in the market.  If people perpetuate the present in the future, they’ll pay too much for some growth that may never exist or drive down the price of stocks that are facing hard times, assuming that the problems will never be solved.  Then, a mispricing opportunity appears, the buy cheap chance.

Me: I see, you just connected pillars 1 and 2.  How about mean reversion?

BH:  I don’t want to sound too profound, but things are cyclical, you know?  Day and night, four seasons of the year and many other cycles.  We can say that among the many cycles of life there is the return to the mean.  This expression has not only a statistical meaning, but also a non-technical meaning that can be summarized by the famous sentence: “This too shall pass”.

Me: I’m trying to follow you; you’re saying that people exaggerate and this makes some companies too expensive and others too cheap. Is there a sort of mysterious force that makes things revert to the mean?  How can it be possible?

BH (laughing very loudly):  My friend, are you asking me this question?  I’m just a baby! Not even Benjamin Graham had an answer to that when he was testifying before the US Congress!  How can a baby in diapers smoking a cigar know it?  I don’t think we’ll ever know the “why”. But we can focus on the “how”.  Some market participants will trigger the adjustments. Here is the fourth pillar of deep value.  There is good and detailed literature on that in the Deep Value book.  When a mismatch between value and price occurs, the sharks can smell the blood.  Several situations may unlock value, such as the acquisition of the undervalued company by a competitor, the action of activist investors or the attraction of value investors, for example.  There is the example of Unipar (chemical company), when the shareholders refused an offer of the controlling shareholder to make the company private.  The offer was virtually ignored by the market.  Initially, the controlling shareholders offered R$4.40 per share (UNIP6), the offer was refused by the minority shareholders, and the share reached R$43.50.  Another example is the offer of Cosan to acquire the control of Comgas (the gas company of São Paulo), paying a premium of 23,31% on the preferred share class A.

[I can see some tears in the eyes of Baby Herman.]

Me: Are you okay?

BH (holding the tears): Yes, I’m.  But I miss Comgas.  I loved its dividends!  It was like a kind of favorite toy, you know?

Me: You know that Carlisle has tested the strategy in the U.S. market.  Do you really think its rationale is applicable to Brazil, mainly with respect to pillar 4? There isn’t much activism in Brazil, for example.

BH: I believe the rationale is universal.  It’s buying cheap! If you find a package of Cuban cigars or diapers for half the price, won’t you buy them?  I’d buy them all!  In the case of financial markets, I believe the discretionary value investors are also part of the sharks that smell blood.  I don’t have any research to say that, I speculate that the active managers are doing the job. I can’t understand these guys that say that active management is useless. They find the stock, start buying and the process is initiated. The overall market may be efficient for almost all the time.  But such overall efficiency only exists because active management eliminates inefficiency.  That’s my opinion at least.

Me: Don’t you know the debate about beta and alpha, and that it’s very hard to generate alpha?  How can you believe in active management?

BH: Gee!  I’m illiterated!  I have no idea of English or Portuguese!  Do you want me to know Greek?

Me: You’ve described the four pillars of the deep value strategy.  They are: buy cheap (pillar 1), what is made possible because people project the present into the future (pillar 2), ignoring mean reversion (pillar 3).  At the same time, the sharks in the market will unlock value (pillar 4).  How about the metric or sweet numbers, as you call it?

BH (looking sad): Is there any baby bottles with sparkling wine left in the cooler?  I got to drink one more to forget Comgas!  Gosh, I loved that toy!

Me: Yes, there is a couple.  Let’s drink together! Take one.

BH (drinking almost all content in a single gulp): Thanks.  The metric.  This is the numerical heart of deep value.  Carlisle tested several metrics and covered academic research on many metrics as well. In the end the chosen metric was the earnings yield (EY).  EY takes in its calculation EBIT and Enterprise Value (EV) (detailed explanation in the post Everyday Deep Value in Brazil).  EY=EBIT/EV.  I don’t want to get too technical here, but the beauty of these numbers is that they show the performance of the company in relation to the value of the entire business, just as in a private deal!  When someone is acquiring a business outside public markets that is what the acquirers look at!  It’s not without reason that Carlisle called his newest book “The Acquirer’s Multiple”.   Note that if you invert EY you get a multiple!  Particularly, I prefer to use the EY, but it’s the same thing, written differently (see: Everyday Deep Value in Brazil).  The higher the EY (or the lower the multiple), the better!

Me: Can you explain it better?

BH: Okay, but you know where to search for the details! Take a look at the post Everyday Deep Value in Brazil! In a private transaction it’s customary practice to use a multiple of the EBTIDA in the valuation of a company.  EBITDA is a cousin of EBIT and both are proxies of the cash a company generates.  For these purposes, to use one or another makes no difference.  Using a metric like this is to have a valuation shortcut similar to the valuation that is widely used in private markets.

Me: In summary, you’re saying that EBIT/EV is a good proxy to buy cheap?

BH: Exactly!  But we have to take a look at the mechanics of the portfolio formation.  Buying cheap is only part of the work.

Me: Wait, wait! How about the quality of the invested company?  I guess you know the Magic Formula of Joel Greenblatt.  Greenblatt describes a very similar approach, but he takes quality into consideration in the Magic Formula.  You know quality compounds into the future.  The way you described it, you can invest in bad companies.

BH: Yes, I know the Magic Formula, I read The Little Book that Still Beats the Market.  The book is wonderful!  Very clear, another must read.  Carlisle tested it as well.  In his tests the quality element was reducing results in fact! Gee, can you imagine my surprise when I read that?!? You read tons of books about Warren Buffett, much of them about the quality of the company, the compounders, moats, etc. Then you realize that quality may reduce results.  I cried for an entire night!  You had to see BB!  I drove her nuts! That night, she almost resigned! Even the neighbors could not sleep!  The rationale to skip the quality element has to do with pillar 1.  People end up paying too much for quality.

Me: Have you tested the Magic Formula in Brazil to see if it works here too?

BH: Yes, but my tests were very limited.  Deep value performed better, but I really need to better test the Magic Formula in Brazil. It’s in my plans for the future.

Me: This approach that doesn’t take quality into consideration doesn’t sound like a Buffett investment style.

BH: You’re right, it isn’t a Buffett approach.  But there is a common ancestor, Benjamin Graham.  Graham was a rule-based investor as well.  It’s all about forming a portfolio.  Diversification is key!  No investment without proper diversification!

Me: Why do you think diversification is so important?

BH: Well, wahh, wahhhhhh, waaaahhhhhBH Chorando

[BH starts crying a lot, BB arrives and takes him in her arms.  He doesn’t stop crying.]

BB (holding Baby Herman in her arms): He gets very emotional when he talks about diversification.

Me: Why?

BB (still holding Baby Herman in her arms): The Mercedes-Benz.  He lost a Mercedes-Benz.

BH (babbling some words, and still crying): wahhh, wahhh.  It was blue!! Brand new!! Wahhh, wahh.

BB to Baby Herman:  Don’t cry, baby.  You have already recovered it.  Don’t cry.

BH (already recovered, but still with a very sad face): Sorry, but diversification is very dear to me.  There is a famous Brazilian investor, Lírio Parisotto, who tells that when he started investing, he lost a VW beetle.  I can say I had a much better beginning: I lost a Mercedes-Benz!  In a single word, the cause of my loss was lack of diversification.

Me: I’m really sorry for that!  Tell me about the mechanics.

BH: Okay! The mechanics!  I’ll be brief here, just to convey the main message.  It’s all about portfolio formation.  The details are in the post Everyday Deep Value in Brazil.  People should read it.  It’s the core of what I’ve been doing.

Me: I know, but let’s keep it simple.  I’ll ask you some basic issues about portfolio formation, and you tell me what you did, okay?

BH: Perfect!  That’s why I like lawyers! They’re good at organizing ideas.

Me: You used the EY as ranking criterion, right?

BH: Yes, you’re right.  This time I formed four kinds of portfolios.  I wanted to see the performance of the best and worst ranked stocks.  I formed two groups, Top and Bottom with 40 stocks each.  The top 20 formed the Top G1 (the best 20 stocks) and the next 20 formed the Top G2 (the second best 20 stocks).  The bottom 20 formed the Bottom G1 (the worst 20 stocks) and the next 20 formed the Bottom G2 (the second worst 20 stocks).

Me: When were the portfolios formed and why?

BH: I formed portfolios in June, September and December.  I wanted months in which I could know the last financial statements disclosed at the time.   Brazilian regulations about the date of disclosure of financial statements changed over the years (see Annex I to the post Everyday Deep Value in Brazil).  In practice, if I restricted my research to June, September and December I could cover a longer period knowing the last financials available at the time.  I started my research in 1995.  After choosing the research month, I decided to have four portfolios in almost all the trading days (18 days in June and September and 17 days in December).

Me: Do you mean you have four portfolios in virtually everyday in June, September and December since 1995 until 2019?

BH: Yes, you’re right.  1995 is the first full year after Brazil adopted the Real, its current currency.  I wanted to avoid the hyperinflation period (late 80’s and early 90’s).

Me: What was your holding period?

BH: I held each portfolio for one year.  For example, I selected the stocks in the second business day of June, 1995, and in the second business day of June 1996 I formed a new portfolio for that day.  I repeated it for every selected business day of June, September and December until 2019.

Me: Do you really have to hold the stocks for one year?

BH (with a big smile on his face): I’m really happy that you asked me this!  You know, I have a couple of friends that take me really seriously!  They believe in a baby smoking a cigar wearing diapers! These guys must be nuts, crazy or whatever, for sure.   Can you believe it? I hope they don’t read this interview!  One of these crazy guys keeps asking me this.  In the end, this one-year period is arbitrary.  I want to test different holding periods, such as 3 or 6 months.  Maybe they are better, I don’t know.  This testing is something I will do in the future.  I’m using this one-year period based on what I read and heard about rule-based investing.  Jim O’Shaughnessy, the author of What Works on Wall Street, another must read book, tested tons of strategies in the U.S. market.  He used one year as holding period.

Me: Did you control for market capitalization?

BH: Yes, I did.  I created three categories of portfolios: DVA, DVB and DVC.  DV means Deep Value.  DVA portfolios accepted any size of company (small, mid and large caps). DVB portfolios excluded the bottom 1/3 of the companies ranked by market cap (only mid and large caps). DVC portfolios accepted only the top 1/3 of the companies ranked by market cap (only large caps).  For example, I had the following DVA portfolios, each with 20 stocks: DVA Top G1 (the very best), DVA Top G2 (second best), DVA Bottom G1 (the very worst), and DVA Bottom G2 (second worst).  I also had equivalent DVB and DVC portfolios.

Me: How did you deal with the risk of fictional results, I mean stocks that are not actively traded?

BH: I excluded from the investable universe stocks that were present in less than 80% of the trading days in the previous year and that negotiated less than R$100k per day adjusted by inflation since 1995.  It’s around R$500k in 2019.

Me: Any control for trash and credit risk?

BH: Yes and no.  I excluded from the investable universe negative equity value companies, but I had no control for credit risk in the research.  I wanted first to see the “raw” results.  A version of the research controlling for credit risk is in the pipeline.  But in real life investments, I control for credit risk.  No investments in companies with a ratio Net Debt/EBIT higher than 3.5.  I can be a baby, but I’m not a fool!  Very few companies have been excluded from my investable universe by the Net Debt/EBIT threshold.

Me: How about your results?

BH (showing a big smile): I’m very happy with them!  Take a look at this chart showing the main results:

Chart 5

BH: You can see that the Top G1 had a much better performance than the Bottom G1.  In my research it happened all the time.  All Bottom G1 portfolios had worse results  than Ibovepa.  Also, in almost all cases, we had an order of results as follows: Top G1 (cheapest stocks), Top G2, Bottom G2, and Bottom G1 (most expensive stocks), but in some cases there was some confusion in the middle groups (Top G2 and Bottom G2) and Top G2 beat Top G1.  My guess is that the Brazilian market is too small and we can see real differences only in the extremes.  If you’re around the top you’ll do well and if you’re in the bottom your performance will be poor.  It’s my speculation.

Me: Have you tested such numbers statistically?

BH: Not yet, a test is in the pipeline.  But I want to call your attention to the fact that this research is an “out of the sample” one, if we take the tests in the U.S. market as reference.  There is another way of looking at the deep value strategy, that is to consider it as factor investing.  There is a lot of research about factor investing.  Larry Swedroe and Andrew Berkin wrote a book called Your Complete Guide to Factor‑Based Investing, in which they  summarize lot of researches about factor investing (must read for factor investing).  In short, factor investing is the systematic investment in a portfolio of assets that have certain characteristics.  Their research identified the “true” factors out there.  Although they don’t mention the deep value strategy in particular, they cover several other variations of the value factor.  The value factor showed the required characteristics to be a reliable factor.

Me: What are the characteristics of a reliable factor?

BH (he shows his two hands opened): There are five characteristics!   I can use my left hand to memorize them!  You see, this is perfect.  I use the five fingers on my right hand to memorize the pillars of deep value and the five ones on my left hand to memorize the five characteristics of a reliable factor!  [Baby Herman now shows his left hand opened]. The first is persistence, meaning that the factor has to persist for a long time and in different economic environments.  The second is pervasiveness, meaning that the factor holds in different countries, sectors and assets.  The third is robustness, meaning that different versions of the factor have similar performance (such as value investing defined using price-to-book, earnings or cash flow). The fourth is to be investable, meaning that an investor has to be able to invest in it in practice.  The fifth is intuitiveness, meaning that the factor has to have a risk or behavioral explanation.

Me: Too complicated! Summarize it please!

BH: The value factor (the broad family to which deep value belongs) has been tested abroad and passed the test.  It’s reasonable to believe that it’ll work in Brazil, right?

Me: Understood!   Have you been investing your money using your research?

BH: Yes, with some modifications.  Basically, since 2011 it’s possible to know that the financial statements dated March 31, June 30 and September 30 are the most recent ones available in May and June (for the March 31 financials), August and September (for the June 30 financials) and November and December (for the September 30 financials).  To have a better diversification, I have five sub-portfolios, one for each month.  Also, I have the trash control that I mentioned before, that is to exclude from the investable universe negative net equity companies and a threshold of maximum 3.5 Net Debt/EBIT.

Me: Five? You mentioned six months.  Can’t you count if it’s more than five (laughing)?

BH: Very funny, very funny.  No that is not the problem.  I got toes on my feet was well! No money to make the September sub-portfolio, that is the problem.

Me: I see. I still don’t understand why you don’t have portfolios in other months of the year.  Why?

BH: It’s arbitrary.  Firstly, I wanted to be closer to the research.  But there is another reason.  If you take the beginning of the year, for example, the release date of the financial statements varies a lot.  It means that the market in general has updated information about some companies, but old information about others.  I prefer fresh information about all.  It gives me a better comparison of the options in the market.

Me: How about the results?  Tell me the results!

BH (with a big smile on his face):  Well, 2019 was sensational.  Around 70%! Can you believe, a baby getting a 70% result in the stock market? The Ibovespa result last year was around 27%.

Me: Congratulations!

[2020 Crisis Update: there is no discrimination in the market.  Even a baby in diapers it beats up. My performance up to April 15 was around -17%, but helped by some shorts on the Ibovespa.  In the same period, the Ibovespa performance was around -32%]

BH (still with a big smile on his face): But 2019 was too good! Even monkeys did well last year.  I don’t have such high expectations for the future!

Me: I see, but congratulations anyway! I followed your reasoning, but there is one thing that intrigues me.  How can you be sure that you have margin of safety in the deep value approach?  You’re following a relative valuation approach, not an absolute one.

BH:  I can’t be sure.  You’re totally right, if the market is too hot, EY will be low (or multiples high).  What I could do is to use some absolute threshold, such as a minimum EY of X% or no multiple higher than Y.  In this scenario, if no opportunity obeys the threshold, I should leave the market, for example.

Me: What is risk for you?

BH: Gee, this question is tricky!  There are million ways of responding to it!  Do you think that it’s fair to ask a baby the definition of risk?  To run out of diapers is risk for me! [Baby Herman starts laughing.]

Me: No jokes, please! I know the issue is tricky, but you’ve got a view of risk, right?

BH (still laughing):  Sorry, sometimes it’s good to be a baby.  You got some special jokes!  You know that certain people see volatility as risk and other people as opportunity.  I think risk is related to the permanent loss of capital and I don’t see volatility as risk per se.

Me: How can you deal with risk in the case of a long-term strategy, such as deep value?  Because there will be volatility and there isn’t much you can do if the rule guides the investment.

BH (appearing to be very concentrated): You have to be a contrarian at heart. The rationale of deep value appears quite strong to me.  I’m an old baby.  I’ve seen lots of things in the last decades in my M&A practice.  Tech booms, rural land booms, banks going bankrupt, money coming into Brazil (and leaving Brazil).  The fashion changes.  Don’t take the future as granted.  No guarantee that the future will repeat the present. Indeed, there is no kind of guarantee about the future at all!

Me: Is it a matter of faith when dealing with risk?

BH: To some extent, yes.  Someone once said that risk is like beauty, it’s in the eyes of the beholder.  I agree.  There is no such thing as “risk per se”.  Risk is always a relationship.  It’s you in relation to something.  Can you follow me? Also, I think the perception of risk is something very particular.  From a psychological point of view, it’s hard to be one hundred percent rational, when the issue is risk.  Did you know that it’s speculated that we have two systems in our heads a conscious and an unconscious one which do the same things, but from different perspectives?  They work at the same time, but we’re unable to access the unconscious one.  I know it sounds crazy, but we’re human, of flesh and blood are made born to make mistakes, as the song “Human” [3] says.

Me: Wow, wow, wow! This looks too philosophical! Can you better explain it better?

BH: I’ll try, but this stuff is really deep and I’m just a baby!  Your ability to follow a strategy has to do with your view of the world, I guess.  This stuff is really deep.  Sometime ago, I heard two statements that at first may appear the same, but are totally different.  In fact, I think they stand for opposite world views.  The statements are “I may die tomorrow” and “I will live only once”.

Me: I can’t understand what you’re saying, both statements are just the same!  They show how finite things can be.  I think you’re drunk!  Don’t you want to burp again?

BH (looking angry): I’m not drunk! And I don’t need to burp again, but to be in her chest is always a good idea… But let me go back to what I was saying.  Follow me on this.  Don’t say both statements are the same and don’t take both at face value.  One of them is terrible, mainly if you want to build something deep for you.  Yes, this is deeply philosophical!

Me: Okay, okay! I follow you on this.  But it looks much deeper than investing.

BH (looking very emphatic): Of course, it’s deeper!  I’ve learned it the hard way, but let me continue.  If you say “I may die tomorrow”, your focus is on the end of your life.  If today is the last day of your life, why don’t you just relax and have fun?  There is no tomorrow!  You can do any shit you want and forget about the consequences!  Free pass to screw up anyone!  The important thing to do is the one that is here and now.  Easy pleasures and superficial life.  But, think about “I will live just once”.  There is no focus on the end.  The focus is on the singularity and fragility of life.  You have just one life, better handle it with care!  That is the way to build something deeper.  You may give up  some immediate pleasures, but the reason for that is noble.

Me: I see, but both expressions still look pretty similar to me…

BH (looking angry again):  Do you know Charlie Munger, Buffett’s partner?

Me: Yes, of course.

BH (still looking angry): Invert, always invert, as he says.  You have to invert!  What if, instead of saying “I may die tomorrow”, you say “I may not die tomorrow”?  Do you see the difference? Will you be reckless if you have to face the consequences?  Will you screw up important things? I don’t think so.  And what if, instead of saying “I will live only once”, you say “I will live more than once”.  Will you be reckless only because you can live again?  Will you screw up something or somebody important just because you can live again?  I don’t think so.  You will handle all of your lives with care!  That is why I don’t like this “I may die tomorrow” thing.  It’s too shortsighted.  You may behave in a way that blows things up on your face and still say it was not your fault.  How can you be wrong, if you may die tomorrow? You see?

Me: I got it! Give me a financial example, please.

BH: Let’s use as example an investment that has been very profitable for a while.  You did a lot of due diligence before investing, you spent some years in the due diligence!  Then, you decide to invest.  You invested heavily and got juice profits for a while.  After that, your investment starts to plummet a lot… It’s almost a disaster, but process was sound!  I don’t mean that you don’t run any risks.  Of course, you do take lots of risks!  The investment process may be the best in the world and your investment can still blow up on your face.  The risk is there and it is part of life.  It’s in this stressful moment that you see the differences in the mindsets.  A person that has a “I may die tomorrow” mind will at this very moment cut the losses, throw the investment away and move on!  He doesn’t have the guts to bet on the recovery.  Maybe any sign of recovery is disregarded.  A new investment fad may have appeared in the horizon.  Never mind if it’s a shit, let’s invest!  An investor with a “I will live only once” mentality would not leave a good opportunity for any investment fad.  Things have to be handled with care.  In the end, good opportunities in life are rare and ephemeral things appear all the time.

Me: There is no guarantee that this “I will live only once” mentality will assure you good profits.

BH I know, you’re absolutely right.  But the approach is different.  If you have grounds to believe in an investment idea, you will not throw it away for an investment fad.  This “I may die tomorrow” is no more than a superficial approach to life trying to appear as something deep.

Me: You seem to deal pretty well with the risk in the stock market.  Are you afraid of something?

BH:  Of course!  I’m afraid of the dark.  I know there are some monsters under my baby crib, for sure!

Me: What are your plans for the future?

BH: Basically, I have three plans.  Two trivial ones and an important one.  The trivial plans are testing different strategies in Brazil (dividends, momentum, low volatility and more) and starting a small portfolio of discretionary investing.  If I destroy value, it’ll be terrible, but that is the risk.

Me: And how about your other plan, the important one?  What is it?

BH: Stop using diapers!

End Notes

[1] See video here:

[2] See video here:


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