Why Value Investing Works
Board: Berkshire Hathaway
Jack D. Schwager’s new book “Hedge Fund Market Wizards” is series of interviews with twelve hedge fund managers. What these managers all have in common is a great record, and that they run huge sums under hedge fund rules. Few of them do the same thing, and there is only two that claim to be value investors. There are quants, long equity, and long-short equity, long-short fixed income, Statistical arbitrage and commodity traders. Curiously there is even a sprinkling of day traders two of these claim to make in excess of 500 trades a day. After reading the book we are left with notion that while out-performance is rare it is real in most cases the methods used are eclectic and mostly transitory. The material here puts paid to the rather silly notion that market are efficient. Markets may be efficient collectors of data, but what they do with that data after they collect it is rarely rational.
The book holds some important lessons for value investors. First a high percentage of institutional money is very short term oriented (“What have you done for me this month, quarter, and year?”). Since their customers are only looking at the short term many professional money managers cannot afford to hold long term positions. This together with the fact the amount of money in pension funds, 401Ks, IRAs private equity, and endowment funds has grown from next to nothing at the end of World War II to many trillions today means that there has been a fundamental change in the way markets will behave. Market trends will tend to last longer and volatility will increase.
Value Investing does not work all the time.
There has been and will be are long periods where value investing doesn’t work (1998-1999, 2005-2007) when the hot money all goes someplace else. Value will have periods of a year or two where it under-performs the market so the hot money flows out of the value sector. Since Hedge Funds deal with large institutions and mutual funds with the investing public there are many trillions of dollars in the markets with very nervous feet, and when short term performance lags it leaves.
Value gets a negative image with the big money, so hedge fund managers mostly do something else. Even for value managers with their assets under management going south the pressure becomes intense to nudge your style toward the short term. But as Schwager helpfully points out Value Investing works but does not work all the time, and that is why it works. If it worked all the time every one would do it, and then it would not work anymore.
The lessons for investors are many but the most important is that value investing works because of its long term bias. So while recent changes in market structure can work to the benefit of the investor this is true only if you remember that long term performance is critical, and that decisions based on short term performance make long term out- performance difficult. To be successful the investor has to become a true contrarian and add to value investments when the style has been under-performing and stocks in the sector have become unpopular. When market get bubbly and high risk is ruling the market it is time to raise cash.
Of course it has always been important to be a contrarian, but it is even more important today with all that hot money running in and out of things, and because it is important it is harder to do. With so much information available and so many internet tools it keeps getting harder to sort out the noise.
Keep in mind that invasion of the market by huge quantities of investment dollars and large numbers of investment advisers may have changed the definition of value investing away from the old style Benjamin Graham value more towards the Charlie Munger style of buying really great companies and sitting on your ass. I do not have much luck with cigar butts instead of a few cheap puffs I usually just end up with a bad taste in my mouth. The increase in information available to the investor makes it more likely that what looks like dog really is a dog. The huge increase in hot money increases volatility and that volatility can make stocks with good long term prospects temporarily cheap when their short term develops problems.