The evolution of value investing: thinking deeply
The death of value investing has been greatly exaggerated.
For the last few years commentators and talking heads have been wondering if the recent weak results from ‘prominent’ value investors has been the result of the value investing philosophy and strategy becoming outdated and ineffective.
In fact, we have been asked several times in the last couple of years if in the face of significant underperformance against ’growth’ and the market: Is value investing dead?
The short answer is: the premise couldn't be further from the truth!
The basic principles and premise of value investing is quite simple. Value investing seeks to identify the true value of an underlying business. An investor can then purchase that business at a discount to its intrinsic value and eventually sell that business when its true and full value has been realised. It is not rocket science. It is in fact intuitive and based on a principle of common sense.
The challenge lies not in understanding the basic principles of the philosophy but instead in identifying ideas that satisfy that philosophy and principles and which provide a profitable investment outcome.
In our experience, for an idea to qualify as both philosophically sound and likely to generate an acceptable return, the company in focus needs to be either misunderstood, or dull.
There are many companies that satisfy the criteria, either due to some complexity within the business or due to a lack of broker coverage and institutional interest. However, in a world dominated by believers in the efficient market hypothesis we would posit that many of the best ideas are ignored (due to ignorance).
Value investing and the efficient market theory:
Many mainstream and popular financial thinkers are strong proponents of the efficient market theory. In short, the efficient market theory suggests that there is no point in attempting to identify mispricing. They claim that the markets are so efficient that all information available about any company is immediately considered, calculated and incorporated into share prices.
Many proponents of index funds and ETF’s find the foundation for their advice within the efficient market theory - that is, if the market is always right, investors can only profit from general economic growth, in which case stock picking is counterintuitive.
Value investors don’t all together disregard the concept that markets are efficient, but simply that markets are occasionally efficient and occasionally inefficient. It is within those inefficiencies that we seek to identify opportunities for profit.
Over the generations, this view has been cemented with the exceptional long term returns of the students of Ben Graham and Phil Fisher. Most famous are investors Warren Buffett and Charlie Munger, but there are hundreds of other followers of the philosophy that have quietly built incredibly successful careers and returns based on the principles of value investing.
The above portrait includes early Ben Graham students:
- Walter Schloss of WJS Partnership: 1956-1984 return of 21.3%p.a vs 8.4% for the index.
- Tom Knapp and Ed Anderson of Tweedy, Browne Inc: 1968-1983 return of 20%p.a vs 7%.
- Bill Ruane of Sequoia Fund: 1970-1984,18%pa vs 10% from the market
- Warren Buffett (partnerships): 1957-1969, 29.5% pa vs 7.4% from the Dow
- Charlie Munger (partnerships): 1962-1975, 19%pa vs 5% for the Dow
- Rick Guerin of Pacific Partners (partnerships): 1965-1983, 32.9%pa vs 7.8%
- Stan Perlmeter of Perlmeter Partners Ltd (partnerships): 1965-1983, 23%pa vs 7% from the Dow.
Given the exceptional outperformance of this set of investors (and many others), the question no longer remains: “does value investing work or is the market efficient”, but rather: “given that value investing is proven to work, how do we identify market inefficiencies”?
The questions isn't: “are markets efficient?”, but rather “how do I find the inefficiencies?”
To that end we believe that there are two kinds of investment ideas. Both may appear to comply with the principles of value investing but profit outcomes are likely to be substantially different.
- The first type of investment ideas are straightforward. Ideas that require no special insight or technical skill.
These ideas are simple to understand and easy to identify. As such, any mispricing tends to be rare and any arbitrage between ‘value’ and ‘price’ tends to be short lived.
- The second type of idea are those that require consideration, special judgment, and expertise.
They are complex enough that not all investors will identify them, and so the recognition of intrinsic value will be more slowly realised.
Where the markets are inefficient in a way that is useful, we believe they are inefficient in the second type of idea. Those ideas that are different, complicated, uncomfortable, or are likely to be realised over a longer than average time frame.
It is within these slower moving ideas, those ideas that require special expertise, patience and understanding, that true value arbitrage opportunity exists.
This is not to say that these ideas require a special degree of intelligence or a higher than average intellect to understand. Simply that they are more complicated than identifying a company trading on a low price to earnings ratio, a high dividend yield and on a low price to book ratio.
Slow and Fast moving ideas:
In his book “Thinking Fast and Slow” Daniel Kahneman writes of two modes of thinking. He calls them System-1 and System-2 thinking.
System-1 thinking is simple and straightforward.
It takes very little intellectual computation or consideration to calculate a System-1 problem. A problem like opening a door, avoiding a hazard, or calculating 5x10 would each qualify as a System-1 problem.
In the investment world identifying a company with a low price to earnings ratio or a high dividend yield would qualify as an idea identifiable by System-1 thinking.
Identifying it is easy, it requires very little effort and so provides no special advantage.
System-2 thinking requires reflection, judgement and often special expertise.
That's not to say that a person with an average IQ cannot make use of System-2 thinking. Rather that System-2 thinking requires time, effort and energy.
The discomfort associated with the effort of System-2 thinking results in fewer investors prepared to deeply consider the more complex ideas, and therein lies the opportunity.
It would seem that something so obvious could not be true. Surely if all it takes to generate superior long term investing performance is a willingness to think, then everyone would do it.
The proof however is in the objective assessment of people’s actions. Human nature is such that otherwise clever people will rely on mental shortcuts to avoid discomfort. We all do it and it costs us all.
See how simple it is to let our instincts mislead us. Answer the following three questions (answers at the end of the article):
- A bat and ball costs $1.10. The bat costs $1 more than the ball. How much does the ball cost?
- If it takes 5 machines 5 minutes to make 5 widgets, how long would it take 100 machines to make 100 widgets?
- In a lake, there is a patch of lily pads. Every day, the patch doubles in size. If it takes 48 days for the patch to cover the entire lake, how long will it take for the patch to cover half the lake?
Ask your friends and family these same three questions without the forewarning and see how they do.
This same test was presented to a group of Ivy League students from Harvard, Princeton, and MIT. Despite the reasonable assumption that this set of people had a higher than average IQ, over half the students got the answers wrong.
The reason mistakes were made was not because the participating students didn't have the requisite intellect of skills to identify the correct answer, but instead because people (especially smart people) tend to create and rely on mental shortcuts - shortcuts that can often lead to incorrect outcomes.
What does it all mean for investing?
The simple takeaway from these pages is that mispricing will exist, but it will exist in places, companies and thematics which are different, complicated, or uncomfortable.
This is great news for value investors.
Markets are and will continue to be inefficient. In identifying those inefficiencies, we identify an information advantage.
The challenge for value investors lies in the popularity and public success of value investing as a philosophy. With success comes imitation. As the pool of value investors grows, so too does the number of investors looking for the same easy to recognise identifiers. The low hanging fruit of yesteryear are no longer available.
Old Rules Still Apply:
While much has been said about changing markets and the need for traditional valuation based methods to change, the facts on the ground suggest that nothing could be further from the truth.
True, the easy to identify businesses, (cigar butts) with assets worth far more than their market cap, or companies trading at price to earnings ratios far too low for their prospects are no longer available like they were when Ben Graham first wrote his book on Securities Analysis in 1934, but far from becoming obsolete, value investing has simply required a little evolution.
The principles of value investing remain the same today as they did in 1934. All that has changed is how those principles are implemented in modern markets.
- Ignoring the emotional entreaties of Mr Market - pitching prices (to buy or sell shares) day by day, minute by minute.
- Identifying and filtering out all the noise created by the millions of participants in the stock market every day, motivated more by their sense of wellbeing than their understanding of value.
- Employing logic and calculation over reading signs and patters.
These basic principles are eternal.
At the heart of value investing is identifying an information advantage.
The philosophy is simple, and the opportunities are available to everyone. All it requires is a willingness to think a little harder than the next guy, and a willingness to embrace the discomfort that is key to uncovering that information advantage and the profits that lie within.
What you can do:
Instead of fishing in the same pond as everyone else, seek an advantage in areas that are more complex. Ideas that are different, complicated, uncomfortable or long term. Within these classes of ideas rests the truly profitable opportunities for value investors.
- 5 minutes
- 47 days
Michael is the MD and one of the founding partners of the Collins St Value Fund. The Collins St Value Fund is one of the best performing Funds in Australia - having ranked among the top 10 performing funds across all Australian Equity mandates by...