The rise of the value pretender

Plenty of fund managers are telling us it's a tough time to be a value investor. Is it time to look at things differently?

'It has been a tough period for value stocks'. If you've read through a report issued by a fund manager lately, you've probably heard this line too.

It's hard not to be cynical. Blaming 'challenging' conditions is far easier than saying 'we haven't picked the stocks that have done well'. But is it true? And if conditions are bad for value investing now, why should they be better in the future?

Why value?

After all, there are real people making real money doing very different things to Warren Buffett.

Buying dot-com stocks during the tech bubble was the antithesis of value investing - but even George Soros is on the record as saying it can be rational in some cases. Would you want to disagree with a man that made a billion dollars in one day shorting the English Pound?

Or consider firms like Renaissance Technologies, that have used quantitative rules-based trading to make immense returns; more than 70% annually over a fifteen year stretch.

Momentum strategies are widely used to make money, with momentum having been shown to be a statistically significant predictor of returns, particularly in the short term, as encapsulated in the Carhart four-factor model.

Even the laughing stock of the value community, technical analysis (or charting), has been utilised to make money. Take Richard Dennis, the 1970's commodities speculator, who used a few price-pattern based rules to turn a $1,600 loan into $200 million. He then taught the same rules to a number of novice traders, known as the 'Turtle Traders', who went on to apply his techniques and made millions themselves.

Value pretenders

It's true that value investors find more bargains in a depressed market - and can be left behind in frothy markets. The trouble is, while we've definitely had a bull market, it's hard to describe it as 'frothy'. Over the past ten years, the ASX300 Accumulation index has returned 8.46% per annum - a healthy amount, but nothing out of line with the average expected from stocks over the long run. It's also worth considering that's from the depths of the GFC. So although stocks haven't been plummeting and presenting screaming bargains, it's hard to argue that markets have been performing irrationally.

ASX300 Accumulation Index (AXKAO)
Years 1 3 5 7 10
Holding period return (%) 2.88 26.81 33.81 83.49 125.19
Annual growth rate (%) 2.88 8.24 6.00 9.06 8.46
*to October 2018

It becomes even harder to make the case that there are tough conditions for value when you also consider that, in the past twelve months, the median stock in the ASX200 had a difference of 50 per cent from its 52 week low to its 52 week high. It's simply not the case that there have been no opportunities to build a position.

When people say 'It has been a tough period for value stocks', I think what they are really saying is that the market doesn't think what they own is as valuable as they do - and hasn't done for some time. But therein lies the problem; the market won't pay more for something just because you think it should.

Value realisation

In Chapter 6 of Seth Klarman's 'Margin of Safety', there is a section entitled 'Beware of Value Pretenders'. In it, Klarman explains that much of what passed as value investing then was actually managers focused on trying to guess what the market will pay for an asset in the future. But value investing has little to do with guessing what the market will pay for an asset. Value investing is the idea of valuing a business on conservative assumptions and having the patience to wait until you can buy it for substantially less than that value. 

And in the very best value situations, it won't matter what the market does. That's because you can benefit in the form of distributions, a liquidation or acquisition situation, asset sales or by seeing the underlying net assets or earnings power of the firm increase over time. It's the reason why Buffett says you should be comfortable owning a stock even if the market were to close for the next five years. 

Another sentence in Klarman's book reads: 'The misuse of the value label accelerated in the mid-1980s in the wake of increasing publicity given to the long-term successes of true value investors such as Buffett'.    

It's possible that little has changed.

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