Value investor's take on the *value* of the charter

CFA General
#41

I think you will somewhat agree with me that just as we value meritocracy in our work place, the transparent track records of super investors are the only way to give ANY credibility to a particular investment strategy. Ample evidence of 15+ yrs of outsized returns from some big names exist: Baupost, GMO, Berkshire, Oaktree, Schloss Associates, Sequia Fund, Tweedy Browne, Heine securities, MFP Partners, GAMCO Investors, Dreman Value Mgmt, Gotham Capial, Greenlight Capital, Pershing Square - this is what I can think of from top of my head but there are plenty more.

This might sound like a cliche - but quite simply nothing in investing is ‘black-and-white’. Buffett has said he is 85% Graham and 15% Fisher - maybe start by studying these two gurus? You may be hinting at Buffett’s recent performance (due to his portfolio size) - he’s had his share of critics over a number of cycles over the years (especially during bull markets) - and although he’s a rare breed there a few others who’s been as well able to muster the techniques into outperformance results over the long term. Any underperformance in the short-run however is not given much weight as long as outperformance is prevalent in the long term (in the eyes of value investors). Have a look at the article ‘are short-term performance and value investing mutually exclusive?’ (V E Shahan) which rationalizes this view.

This is one of the key areas where experience and skills play a bigger role. If you stay within your area of expertise with deep industry knowledge and *truly* understand the competitive advantages of the business you’re trying to analyze then the value traps can be avoided with some certainty. Value traps are, however, most prevalent when these types of analysis are completely avoided and/or absent from (either absolute or relative) quant-based valuation. A few (of the many) tips to avoid value traps:

  1. Assess (mega)catastrophe risk at the onset

  2. Are the changes in earning power temporary or permanent?

  3. If a position goes against you - an immediate back-to-the-drawing-board is warranted - in rare cases (where a timely review is omitted) patience can be a disaster

  4. Check for deteriorating fundamentals or bad accounting - or anything that can kill a company

  5. Firms that may be at the peak of their profit cycle (and may slide downhill from there)

  6. Supposedly great products or services

  7. Thinking strong market share can be sustained long term

  8. Having (over)confidence that management is great

All valid points - and understandable - your definition of value stocks, however, is a common misconception. A stock with P/E of 5 or low P/B does not necessarily mean it is a value stock. I take the view that there are no distinctions between value and growth stocks. This is because when I do my valuation, growth (not necessarily in sales but growth in intrinsic value) is as much of a factor as is the value of capital. So, if my valuation is lower than the current market price with acceptable MoS but has a P/E of 30 then that is considered undervalued in the value world (given it passes all the qualitative factors). With that definition, all that value paradigm really means is buying a dollar for fifty cents - and if you do that none of the relative metrics really matter. Buffett has said that in investing, value and growth are joined at the hip.

That said, the following are possible reasons for Buffett’s purchase (of what Berkshire didn’t already own) of BNSF:

  1. Energy play - Buffett thinks energy prices will soar including oil prices - this will benefit BNSF as goods being shipped will shift from truckers to rail companies

  2. Transportation - Overall growth in population will increase the need to ship goods across the country, i.e. ever increasing Chinese demand for raw materials such as coal to be carried towards the pacific coast ports

  3. Cheap price - Buffett bought BNSF at a relative bargain at a time when everyone was panicking

  4. Huge moat - similar to the way Buffett professes about the impossibility of costs to replace Coca Cola from scratch he thinks it’s nearly impossible for anyone to build another 50,000+ miles of train tracks that BNSF owns and operates

His war chest had been dramatically increasing and he needed to deploy huge sum (BRK stock was also part of the deal) with a purchase - and there weren’t many firms as big as BNSF that he could possibly purchase. And it’s worth mentioning that BNSF paid some $3.5b in dividends to BRK last year - that’s about 10% return on a $34b investment - on top of that BNSF was still able to spend the same amount on growth CapEx. Although cyclical, high-capital-intensity companies such as BNSF grow faster than other companies during the growth phase (however little). So, it appears the elephant gun he pulled out in 2009 is justified in my opinion.

With IBM, it’s all about strategic moat (although looking at just the P/E will automatically label the purchase as overvalued):

  1. IBM has been aggressively buying back its own shares for the last 10 years on top of stable dividend payments

  2. Huge improvements in ROE, from 15% decade ago to more than 50% this year

  3. IBM’s reinvestment of earnings is clearly returning more than a dollar for every dollar invested

  4. IBM’s monopoly on some products and services, as well as its intellectual property speaks for itself

  5. Evidence of higher increase in earnings relative to an increase in assets, i.e. assets grew only 2% while NI grew by 15% over the last 10 years

These are just from top of my head - but there could be other ‘strategic reasons’ for the IBM purchase.

These two purchases exemplify an adage to his motto that “it’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”.

#42

I’m having trouble reconciling these two Trekker viewpoints.

#43

Agreed that decreases in price over the long term could be a result of (unsystematic) fundamental issue BUT it could also be because the stocks are *truly* undiscovered - those that are neglected because the industry is out of favor for a long time or there are no big (bulge bracket) analyst coverage - and hence, due to these circumstances - no change in risk. Depending on the circumstances of the firm some value guys practice distressed or special situations investing to take advantage of this.

Agreed, well said.

I’m a big fan of transparency - take for example, John M Keynes is hailed as a great economist of our times – but he failed terribly as a macro investor - if I can’t see proven track records using the theories these great theorists embark upon then I have no practical use for them. In my view, sound logical investments are very different to tech start-ups, ‘mud-slinging’ shaky structured financial products, and statistical based analysis.

I just don’t like the idea on the whole premise of making a bet based on statistics. Beta, after all, is a statistical tool where the element of systematic risk is assumed. To me, looking at such a statistic to define the risk of equities is downright speculation. And we can be pretty transparent on some of the aftermath that can be result of such speculation - of the big ones LTCM and Enron comes to mind (their derivative speculative moves were beyond the scope of our discount rate discussion). But we’ve had this sort of debate from practitioners to academics alike for many decades. There are plenty of interesting discussions out there on this topic. We might be better off just agreeing to disagree. I’m OK with that.

I spend very little time on the quantitative aspect of valuation though, maybe 10% - and do not find it difficult unless the industry is cumbersome to slice and dice. The majority of my analysis, upwards of 90%, is spent on industry landscape, business dynamics, corporate strategy and management. By doing so, I am able to figure out their ability to generate incremental capital, validate catastrophe risk (among others) - and combine these with a low price - and I have my *defined* risks in front of me.

Out of curiosity, how much time do you spend on your quant based valuation on equities - and do you look at anything else.

#44

I can see how they might seem contradicting - but happy to clarify. In general, a macro view that is outward-in is ignored - but a inward-out is not. Let me explain what I mean by that.

Outward-in macro events are those that are outside the scope of the firm being analyzed. Bernanke’s 50 basis points increase would be ignored almost all of the time, so would a slowdown in consumer spending for a given year, for example. However, if the firm benefits from a greater macro outlook because it is part of its core competitive strategy then inward-out macro event is taken into consideration.

Munger has publicly stated that one of their strategies in buying Coca Cola during the '80’s was because of their bet in Coke’s ability to expand to the masses overseas where it would benefit from the greater population explosion.

#45

I do tactical asset allocation, so you could say that I’m always and only thinking about beta, although you could also say I’m almost never thinking about beta, because I’m almost never considering individual companies with which to measure a beta. We do look at our portfolio’s beta to the S&P500, but that’s more for reporting and information offered to potential investors.

That said, I did make my personal portfolio beta neutral yesterday, because I suspect a good deal of taking risk off of the table during September rebalancing. That’s a discretionary call on my own stuff and not part of the professional portfolio we manage, which is purely quant based. I don’t do these discretionary things very often, but when I think the models we use are clearly not considering something, I will occasionally do it. I find I am good at pulling risk off the table at good points, but it is more challenging to figure out when to put risk back on. As a result, I’ve been substantially in cash over the last 12 months, and that’s proven to be a mistake, but not necessarily a terrible one, because I did pull the plug before the debt downgrade debacle.

In my work, I find that quant work helps more with the portfolio construction side of the question. For me, that’s more important, because different asset classes have dramatically different volatilities and are not so highly correlated.

BTW, I have no particular opposition to value investing. At some level, all investment is predicated on some idea of buying something for less than it is really worth, and the difference between value and growth is more where you expect to find the source of that value. Trading may be a bit different, because there is a role for speculation, which may be predicated on some idea of value, or possibly just momentum/greater-fool-theory.

I read something in Damodaran a long time ago that stuck with me, which was that value portfolios tend to outperform growth portfolios over time, but that growth managers outperform their benchmarks more often than value manager outperform theirs. I have some ideas on why this might be, as well as some thoughts on what that means for investment practice.

I think that value investing is a perfectly sensible approach to outperforming market indexes, but I don’t go so far as to say that the performance of market indexes is irrelevant to portfolio performance or that that kind of risk shouldn’t be managed to the best extent possible.

#46

You have to keep in mind that a) CFA is supposed to be pretty broad, so if you’re a security analyst, a lot of the stuff in L3 is not relevant, if you’re a wealth manager, the FSA stuff is not relevant. So you will only be using a subset to begin with. b) In many cases you internalize the stuff, and the stuff you don’t use is part of the broader knowledge of the field that you should know in order to be educated about finance. c) There is a big gap between theory and practice, and that’s not limited to CFA.

Believe me, I know a lot of the stuff is not that relevant, L3 is a pain for me, as I have no interest in FP or asset allocation. That being said, it is supposed to be broad and not limited to value investing. As for whether it is the best use of your time, that differs from person to person…there is no right answer.

#47

I can’t believe we’re talking about all this over beta, unbelievable. Such was waste of time and energy, lol.

Trekker, not saying this in a rude way, but you can only convince people that believe that they can benefit from being convienced. You obiviously don’t, which is fine, I just don’t sense much humility from you. Anyways, best of luck.

#48

TAA seems pretty dynamic macro strategy - and definitely out of my level of competence.

… which just means value managers tend to set their benchmarks too high - maybe this is due to their absolute performance outlook - not sure.

#49

Well, this is not about being right or wrong.

I think we should appreciate the fact that risk is defined in accordance with one’s views and beliefs. To an academic (and thus the CFA curriculum) beta is risk, to a portfolio manager risk is defined in terms of relative performance, for potential retirees it’s the time horizon as they come close to consuming their investments - and for a value investor, risk is the permanent loss of capital.

And it’s OK to assume and take hold of risk in those ways, as long as the analysts are comfortable with their style of investing. Statistical analysis alone does not in any way make the analysts superior in predicting the riskiness of a particular asset (as studies have shown). There is no ONE explicit definition of risk that everyone agrees with - which is perfectly fine. Ultimately, how we have utilized and calculated for it comes implicitly through our investing track records (and to an extent, if we were to judge the analyst’s ability in forecasting risk).

#50

bchad out of curiosity, what are your strategy’s returns like?

Also what exactly is TAA? Do you have examples of recent trades that could illustrate some of the thinking behind this strategy?

#51

TAA is tactical asset allocation…it means you market time your allocations…sorry, not market time, but you adjust your asset allocation given certain variables (i.e. equities have gone up, better sell)

#52

Returns have been fairly flat this year (still positive), but with low volatility. The model portfolios give about 10% per year (arithmetic average) with about 1/3 the volatility of equities, only one down year (Jan-Dec) IIRC over the last 35, and our current performance matches our model performance. It’s essentially stock-like returns over the long run, with bond-like volatility and a decent sharpe ratio. We know that this method doesn’t perform all that well in choppy markets like we have today, but it does a good job of preventing outsized losses, which is critical over the long run. Going forward, I think it will likely not perform as well as the past, but neither will the asset classes and strategies it is competing against.

We also have a simpler system that has larger drawdowns but is always fully invested, and that one is a little better off this year, up 6%.

I don’t mind calling it market timing, because that’s a fair description of what it is. We try not to use that term in marketing documents, because market timing comes with a lot of embedded assumptions about whether you can do it or not. On the other hand, buying a stock is stock timing too and people think you can time buying and selling stocks based on information they gather, if you can do it with stocks, why wouldn’t you be able to do it with markets? We’ve gotten chopped up on our commodities exposure these days, but we have done well in our fixed income and equity allocations.

The challenge with TAA is that there just aren’t that many assets to play with. In a stock universe, there are potentially 1000s of names, so that you can do well by being “mostly right” because a few losers will generally not detract from the portfolio too much. But it’s harder to diversify that way when you only have 4-10 indexes that are liquid enough. On the other hand, we are able to incorporate a wider variety of asset classes than an equity manager and can take advantage of lower correlations to reduce portfolio risk.

#53

I believe Graham also mentioned, later on, that the market got too efficient… finding decent net-nets, for instance, is much harder today. The point is that you’ll probably need to think about earnings and growth to some extent - with or without DCFs you must think about the future, even without quantitative analysis.

One thing I think you may be missing is that, although it is hard to find single sources of content that will be directly related to what you want to do, it is easy to find helpful stuff in popular materials, such as CFA and Damodaran.

You know the first 2 levels of CFA quite well. If you just glance at your books again, even though you disagree with a lot of stuff there, you’ll probably will recall a lot of information that can be helpful. Damodaran on Corporate Finance is probably an easier example - he spents several classes discussing strong and weak points of corporate governance and other qualitative assessments - later on he goes to beta and stuff like that. The point is, even if you think beta is completely useless, his info about how to evaluate the character of a corporation and how this can influence the future from an investor/owner viewpoint it’s probably useful for almost any kind of investor.

CFA has probably 2500 LOS or so overall, and you can pick and choose what you think is helpful and you think it isn’t. The same can be said for any author or course. If you disregard anything that’s different from what you already believe, it will be hard for you to learn new things.

One thing that may be helpful to your decision, as said here before, is to buy Schweser’s materials and take a quick read through it. It’s not that much money (300 bucks I think) and can help you glance around the materials and decide if you think that stuff can be useful to you. Behavioral Finance is probably good to have in mind to any style of investing, and so is CorpGov. Also some of the equity and derivative stuff may provide you with some options (for instance, if you want to bet on the company but not on the market, you can go long the company while shorting the index - you take most of the systemic risk away without a need for any forecast calculations). Well, I think this can provide you with more perspective than our opinions.

On another note, I’m also a fan of value investing, but I don’t think “the superinvestors of graham and doddsville” makes for a very fair argument - even though I love WB. I think there are many more value investors than quants, for instance, and so it will be statistically easier to find successfull value guys.

For any style, the average guy isn’t that great, and the top guys are awesome (be it value, macro, quant or whatever). The average value investor actually seems to do better than most average “others”, but having the luxury of patience helps a lot (if your fund has a longer time horizon, you don’t need to do as many stupid things to avoid people getting out).

I don’t really have the experience to tell anybody what to do with their lives. But, since you’re looking for advice, and now that I understand your viewpoints a little better, I think that to be a better long term value investor you should probably focus hardcore on FSA and Strategy. You’ll probably have to establish your own circle of competence - it is hard to get really good at valuing companies at multiple sectors when there are sector specialists doing the same thing. This is also an argument for a focus on small caps or international stocks (whatever has less analyst following it, basically). And keep reading whatever good value investors share.

Things like FSA and Strategy may be your core, but that isn’t the same as neglecting everything else. Lots of other subjects may be useful to some extent (as CFA Level 3 stuff may).

I got very interested in your post because I’m also trying to find my way into becoming the almighty “better investor”, and I am less certain than you of which paths I want to follow.

A note of caution: Being a good long term value investor isn’t the same as being very employable or delivering results in your job. Depending on where you work, you may need to deliver decent annual results, or to compare yourself against specific benchmarks (even by using Sharpe, IR and other volatility based stuff). Also, in looking for jobs/promotion, having the CFA looks better than stopping at L2. If you have such concerns, you may devote some of your time to them as well.

PS: Check the ValueInvestorsClub website, if you haven’t already. That may be interesting for you.

#54

the post on this thread are so long…

#55

That’s awesome, are you managing institutional money? That seems to be the goal of many of these large managers.

So broadly, is it more of a momentum driven strategy? For some reason I thought you were doing macro.

#56

This post is so informative.

#57

The TAA part is mostly a momentum strategy. There is definitely more to it than that, but it’s fair to say that momentum is probably the dominant driving factor. It’s technically more trend-following than momentum, but the two approaches overlap a fair amount…

We also have a macro portfolio, and and our TAA models feed into our macro views, so in some ways the TAA is a kind of benchmark that we feel free to depart from if we see macro opportunities. That’s important because a lot of macro value comes from waiting for the fat pitch. The TAA input is nice because it helps us feel like we are doing things while waiting for the fat pitch, and reduces the temptation to put capital on low-quality trades just in order to feel like we’re doing something.

Much of the macro value added has to do with how volatility is shifting between asset classes and over time. To be frank, I don’t do that trading directly, but I do contribute analysis and trade ideas that go into the macro stuff. I also do good deal of writing about whether we think our TAA allocations are sensible given the macro environment. We don’t have the freedom to depart from the system signals unless we think that we’re in a Lehman-like moment or some environment where the model is clearly unsuitable, but we can talk about what the outlook looks like and when there is a good fit between quantitative signals and the qualitative feel.

#58

Hey Trekker, you talk a good game. How about giving us 3 stocks that you think have MoS and telling us why, in detail, so we can dissect your reasoning? Otherwise, you just sound like a virgin spouting off about orgies.

#59

#1 through #8 are applicable to any stock, not just value traps.

I would like to submit humbly (since I lack your superior instincts, intellect and knowledgge) that when people talk of value stocks, they are specifically talking about stocks with certain metrics, such as a low P/E and a low P/B. Within those parameters, value investors don’t tell you how to tell which ones are value traps and which ones are 50-cents-on-the-dollar types.

You can change definitions as you see fit but that’s an exercise for Gods like you, not us mortals.

So let me restate my question - if I find a stock that has one or more of:

  • low P/E

  • low P/B

  • low EV/EBITDA

  • moderate to high dividend yield

and, forgive my trespass, call it a value stock. How do you know if this “value stock” (as I have defined it) is a value trap or a true bargain?

Being a human, I can’t guess if a megacatastrophe will strike the company or how to gauge its impact. Also can’t tell where the company is in its profit cycle. And wait, that’s a macro guess that true value investors don’t care about anyway. I can tell if earnings power has changed but can’t predict whether it will remain the same or go up or down. I am easily blinded by companies with great products and services, as I foolishly believe that they will survive better than those with crappy products and services. I don’t know how to predict changes in market share. I frequently think great management makes all the difference (in fact that’s exactly why I own BRK, WFC, and L.)

I will give you #3/#4 - get out if fundamentals go bad and #4 bad accounting or fraud. the CFA curriculum has given me some weapons there.

#60

WTF is this?