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  1. Home
  2. / Investing

How to Use Deep-Value and Special-Situation Investing to Beat the Market

But only if you have the patience and liquidity to be in it for the long term.
By TIM MELVIN May 06, 2016 | 12:00 PM EDT
Stocks quotes in this article: UIS, VISI, DAKT, KTOS

Building on my article from yesterday, which looked at ways to deal with the possibility of diminished returns over the next 20 years, another strategy is to practice a combination of deep-value and special-situation investing. This is a much more hands on approach than running a quantitative portfolio -- and really only works for a certain personality type. You have to love to read and have a pretty good understanding of accounting and valuation techniques. You have to be patient in the extreme and disciplined in your approach. You have to be smart enough to say I don't know and secure enough to ask someone who does. You have to be able to stand the pain of periods of underperformance -- where you often will feel like the dumbest guy in the room. 

If you are an action junkie, it is not for you -- unless you can use the racetrack and casino to satisfy your action jones and keep your investment portfolio all business. If you need liquidity, it is not for you. Investing should be just like owning a business - and buying and selling a business can take months. The same is true of many of the best deep-value opportunities. If you cannot go away for a week without checking prices, it is definitely not for you. Both deep-value and special-situation investing only work for very patient investors, willing to do a ton of research and own securities for a long period of time. If you can do that, however, history tells us that it can work very well and give you market-beating returns over time.

Special-situation investing is the place where I would probably focus much of my attention if I was looking to break from the pack and earn returns that allowed me to ignore low-performing equity markets. Searching for companies with the potential to double, triple or more over the next few years can be incredibly productive. In the years since the end of the credit crisis, I have become a little more flexible in my approach to the market, and non-traditional value stocks -- like Unisys (UIS), Volt Information Sciences (VISI), Daktronics (DAKT) and Kratos Defense & Security Solutions (KTOS) -- are now included in my portfolio. 

In my younger days, they never would have made the cut, as they are not true value in the Grahamite sense of the word. However, they all have the potential to be long-term winners that trade for several multiples of the current stock price. If I am right about three of the four of these names, the long-term returns will be extraordinary. And I am counting on special-situation investments like these to help increase the library space in the house in the Florida Keys that we will be buying the minute our youngest leaves for college. 

You can't be afraid to load up in a specific industry, and I will go so far as to say that specializing in certain key industries probably increases your chances to beat the markets by enough to offset lower expectations over the next 20 years. Much of my success has come from focusing on community banks with strong balance sheets and loan portfolios, purchased below book value with at least one activist involved in the stock. I am comfortable owning lots of them, and at times -- including right now -- as much as 80% of my portfolio is in these stocks. I treat them as I would if I owned the whole bank, and have no intention of selling unless they appreciate to unreasonable valuations or get taken over.

I have also come to the conclusion that if you really want to earn higher returns, you probably need to own more real-estate-related securities. I have read the National Association of Real Estate Investment Trusts' (NAREIT) studies, and REITs beat stocks over just about every time frame for the past 40 years. From experience, I know that if you buy real estate portfolios below net asset value and own them for a long period of time, good things tend to happen. We are also seeing the rise of activism in the REIT space, and that may increase the returns iover shorter time frames for REITs purchased at the right valuations.

There is a very good chance that the lower returns suggested by McKinsey and Co., GMO Capital and Charlie Munger may well come to pass. We can either accept that, save more and work longer, or look for ways to exceed the averages. A combination of deep-value and special-situation investing may well be the answer for those with the right personality and willingness to do the research. 

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At the time of publication, Melvin was long UIS, VISI, DAKT, KTOS, although positions may change at any time.

TAGS: Investing | U.S. Equity | Stocks

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