The temptation to "fix" a great strategy is almost irresistible.

Every week I run new backtests and analysis on a small-cap deep value approach to picking stocks. The results are spectacular over the past 26 years.

You run a backtest like this, you see a 24% to 25% compound return over nearly three decades, and then your eyes drift to the part that makes your stomach turn.

The drawdowns.

The gut punches.

The stretches where the system feels broken even though, in hindsight, it was doing exactly what it was supposed to do.

A 61% drawdown will do that to you.

It is one thing to talk about volatility in polite company. It is another thing entirely to watch more than half your capital disappear and sit there wondering if it is ever coming back.

That is where the idea shows up.

What if we just hedge it?

The Hedge That Sounds Smart (But Isn't)

What if we spend a little each year — call it 2% of the portfolio — and buy insurance against those catastrophic declines?

Surely that smooths things out without doing too much damage to returns.

It sounds reasonable.

It feels prudent.

It is also where most investors quietly kneecap a great strategy.

What This Strategy Actually Is

Before going further, it is worth remembering what we are actually doing.

This is not a black-box model built by a team of quants who have never held a stock through a bear market.

It is a simple, disciplined small-cap deep value strategy built on two ideas that have worked for generations:

  • Buy cheap assets
  • Insist on financial strength

That is it.

You are buying statistically cheap companies — low multiples of earnings, low enterprise value relative to operating income, and often at or below tangible book value.

These are not glamorous businesses.

They are ignored, neglected, and often actively disliked.

Then you apply the second filter that separates investing from speculation:

Financial strength.

You look for companies with:

  • Manageable debt
  • Sustainable cash flow
  • Enough operational stability to survive the period of neglect

You are not buying lottery tickets.

You are buying assets that are cheap enough to forgive their flaws and strong enough to endure them.

That combination is powerful.

Where the Opportunity Comes From

Small-cap stocks are inefficient by nature.

  • Institutions cannot own enough to matter
  • Analyst coverage is thin
  • Liquidity is limited

When something goes wrong — or even appears like it might — prices can overshoot dramatically to the downside.

The crowd in this part of the market is not patient.

It is emotional, reactive, and often wrong at the extremes.

That is where the opportunity lives.

You are not trying to predict the future.

You are not building a narrative about dominance ten years out.

You are simply exploiting overreaction.

When a financially sound small-cap company is priced as if it is permanently impaired, you do not need perfection.

You need survival — and a little mean reversion.

That is how you get the big years.

The 50%, 60%, even 100% gains are not accidents.

They are the result of buying when fear is excessive and holding long enough for the market to realize it went too far.

The Drawdowns Are the Cost

Of course, that same dynamic produces the drawdowns.

You are buying what nobody wants.

Sometimes nobody wants it for longer than you would prefer.

Sometimes the market gets more pessimistic before it gets better.

That is how you end up with:

  • 30% declines
  • 40% declines
  • Occasionally 60% declines

That is not a flaw.

That is the toll you pay for access to the opportunity.

Why Constant Hedging Fails

Now go back to the hedge.

A 2% annual hedge sounds harmless.

It is anything but.

Over time, it becomes a relentless drag on compounding.

A strategy earning roughly 24.9% annually does not stay there once you siphon off 2% every year. You are suddenly in the low 20s.

Still very good.

Not even close to the same outcome.

The difference between compounding at 25% and 22% over decades is enormous.

The math does not care that the hedge felt prudent.

What You're Actually Hedging

This strategy does not suffer from daily volatility.

It suffers from occasional, violent drawdowns tied to market-wide stress.

That means you are buying tail protection.

You pay year after year.

Most of the time, you receive nothing.

Occasionally, you get paid.

And with a 2% budget, you are not eliminating drawdowns — you are reducing them.

  • A 60% drawdown becomes 40%–45%
  • A 30% drawdown becomes something in the 20s

Helpful.

Not transformative.

More importantly, this strategy earns a large portion of its returns after those drawdowns.

When valuations are crushed and fear is widespread, that is when the portfolio is loaded with the best opportunities.

That is when the rebound begins.

That is when the outsized gains occur.

If you are constantly hedging, you are reducing exposure at exactly the wrong time.

You are paying for protection when expected returns are highest.

You are dulling the recovery that drives long-term performance.

A Better Way to Think About Risk

Risk is not constant.

It changes with:

  • Valuations
  • Liquidity
  • Credit conditions

If you are going to hedge, do it selectively.

Watch credit spreads.

When high-yield spreads are historically tight, investors are being paid very little to take meaningful risk.

That is not safety.

That is complacency.

Watch valuations.

When multiples are stretched and optimism is widespread, downside risk becomes asymmetric.

That is when hedging makes sense.

Not every year.

Not as a permanent expense.

Only when conditions justify it.

When You Should Not Hedge

On the other side of the cycle:

  • Credit spreads widen
  • Fear is obvious
  • Small-cap stocks trade at distressed valuations

That is when you want to be fully invested.

That is when the strategy earns its keep.

In other words:

Hedge when the market feels safest — not when it feels most dangerous.

A constant hedge fights the strategy.

A selective hedge respects it.

This Is a Behavior Problem

At its core, this is not a math problem.

It is a behavior problem.

A small-cap deep value strategy will never feel comfortable.

It is designed to exploit discomfort.

It buys what others are abandoning.

It relies on financial strength to survive.

It waits for mean reversion to do the work.

That is why it works.

That is also why most people cannot stick with it.

If you can, the rewards can be extraordinary.

Names That Fit the Model Today

Koppers Holdings – (NYSE:KOP)

Koppers operates in wood preservation, railroad infrastructure, and carbon materials.

It generates steady cash flow from essential but unglamorous markets.

The stock trades at a modest valuation relative to earnings and cash flow, and management has improved the balance sheet meaningfully.

This is classic deep value:

A durable business priced for stagnation, with upside if conditions simply remain stable.

TaskUs – (NASDAQ:TASK)

Once viewed as a high-growth outsourcing company tied to tech, TaskUs has fallen out of favor as sentiment shifted.

The result:

A company with solid margins, good cash flow, and a manageable balance sheet trading at a sharply reduced valuation.

This is what overcorrection looks like.

The business did not collapse.

Expectations did.

Embecta – (NASDAQ:EMBC)

A spin-off focused on insulin delivery that has quietly slipped under the radar.

Spin-offs often face indiscriminate selling as legacy shareholders exit.

That appears to have created an opportunity here.

The business offers:

  • Recurring demand
  • Consistent cash flow
  • Manageable leverage

The valuation reflects pessimism that does not match operational stability.

GAMCO Investors – (NYSE:GAMI)

A traditional asset manager with:

  • Fee-based income
  • Strong balance sheet
  • Capital returns via dividends

The stock trades at a low multiple and near tangible book at times.

Asset managers fall out of favor when flows weaken.

That is often when valuations become most attractive.

A familiar deep value setup.

The Under the Radar Takeaway

None of these companies will dominate headlines.

None will attract crowds chasing quick gains.

That is the point.

Small-cap deep value works because it is:

  • Uncomfortable
  • Ignored
  • Occasionally painful

It rewards patience, discipline, and the willingness to look wrong before being proven right.

The goal is not to build a portfolio that feels good every day.

The goal is to build one that compounds capital over time.

If you can remember that when the next drawdown arrives, you will already be ahead of most of the market.