Why Isn't Value Investing Working?

A correspondent writes,

This sort of stuff really killed it in 2001-2007 because investors totally abandoned "real asset" business in favor of tech in the late 1990s.

In the 2009-2012 period some of this stuff did well because commodities all came back so quickly (look at something like FCX in that timeframe)... a lot of stuff went 10X, but this time it was probably just trading up with commodities rather than trading up for half-off and then the commodities go up.

I learn more and more every day how much "value investors" have a serious psychic need to quantify value because they think the most important thing is buying something half off.  Even though Munger and Buffett have been saying the opposite for a long time, people don't understand that and go back to "half off".

Since you can't value most good businesses (i.e. what is google worth?  20X the analyst estimate of 2018 earnings????).  Buffett has always stayed away from tech and growth, but I think this has been an interesting period because a lot of the really good businesses have been tech/growth businesses. 

so all the value guys spend most of their time with commodities.  you can model and "stress test" everything.  And you can model the future... good businesses like google will never tell you "we think we can grow FCF from here at 20% for a couple of years", but almost every commodity company will tell you something like that.

Probably the most seductive thing is that you can quantify the downside.  So you get an investment "that doesn't lose money even if oil falls 50% and can double in two years at flat prices" and this investment fits perfectly into the Kelly Criterion, just like Mohnish said in his first book (which he has also walked back).  Unfortunately the "best" investments that look like this are companies like SD and EXXI 12 months ago.

Most value guys aren't stupid, so they say "why is this so cheap" and "why am I so lucky?"  Unfortunately, the crappier the company, the easier it is to answer this question.  With "good companies" like LNG and KMI (obviously jury still out on both), most value guys always put them in the two hard pile, because they weren't dirt cheap, and there wasn't anything wrong with them to suggest that the value guy had an edge by doing more work and being braver.

Unfortunately, with Sandridge Energy or some other terrible company, it is easy to understand why the company is so cheap.  Now that a value guy knows everyone hates it, he can concentrate on modeling the upside and downside "just like Buffett did with American Express during the Salad Oil Scandal period"....

Basically I think all the value guys have put together a bunch of "mental models" like Munger says they should, but they have all the wrong models because the right ones are too hard to understand.  Buffett buying AXP is easy to understand and quantify, but his best purchase ever might have been See's Candy.  What the hell do any of us know about See's Candy?  He paid like 20X earnings for a maturish chain of stores selling chocolates and made a long term IRR of the type that has only recently been replicated by some of the most successful tech companies. 

So after all the "real value guys" had a tough time in 1995-2000, they got a huge reward in the next 6-7 years, due in no small part to rising commodities... not that far off from claiming "Asset Allocation" is the best money management strategy or Bill Gross is a genius after a 30 year bull market in bonds.

I can't recall a decent investment Buffett has made in the last 10 years, other than his "loan sharking" investments from the crisis.  I'm not really sure what the moral here is, other than that I believe markets have gotten much more efficient since around 2005 (when everyone became a value guy).  There is so much brainpower going towards valuing assets that all you have left is the type of stuff Klarman has been doing (only buy stuff with forced sellers), or a lot of what Buffett and Klarman are doing that no one is talking about - basically buy the safe 8% IRR that is overlooked because everyone is looking for the 15% IRR.

I would add that small caps have probably allowed great value guys to continue to add value over the last 30 years even after everyone became a value investor and all the corporate raiders showed up, but in the last 15 of those year, rates have been so low that private equity has become a major player.

Private equity has killed it in the small/mid cap space over the last 15 years because they can go to any company and say, "let me see your books, and if we like them, we will buy your company and double your pay"...  value investors have been left with all the companies that looked like crap after private equity looked over their books, or have management teams that weren't interested in maximizing value.

Great Critical Post On Einhorn

From Value and Opportunity:

"Either Einhorn assumes implicitly that cost of capital goes down dramatically or he has some 'secret' that I don’t know. If I look at Einhorn’s last pitches, especially AerCap, SunEdison and Consol, there seems to be a common theme: He is always pitching capital-intensive companies with significant debt where he assumes pretty low cost of capital in order to show upside."

A correspondent writes,

"I think there's a mix of macro and micro forces at work here: on the macro side, by pressuring investors to reach for yield, the Fed has made it possible for crappy companies like SUNE to pursue the financing strategies they have. On the micro side, value guys like Einhorn have great historical returns, which has led to inflows, and now they're managing more money than they can realistically invest, which has forced them to put money into increasingly marginal stocks."

SUNE has been completely obliterated. Seems like a decent chance that the bear market has finally arrived.

Buy and Hold Investors Hit Hard Yesterday

A favorite retail investor said this morning,

"By the end of the day my Fidelity account had now officially lost all its gains of the past couple of years. My Vanguard index funds (which are held in a Vanguard account) all dropped a whopping 4% Monday. I am heavily in cash, But clearly not sufficiently. I need to raise more cash."

Wow, one bad day wiped out gains for past couple years? That's really astonishing.

But is it unusual for long-only, true believer investors? Maybe not! Look at well-respected value investors Southeastern Asset Management and their Longleaf Partners Fund which has $4.8 billion. They've gotten crushed this month, down almost 14 percent. They're down 20% year to date, and the bear market is maybe two days old!

Notice that despite some "very good years" in 2009, 2010, and 2013, their most recent fund value peak (quite a while ago now) was in June 2014. They're actually close to being down over the past five years. They've never exceeded their peak more than 8 years ago in June 2007 - and they're down 35% since then, not counting whatever dividends have been paid. [It's hard to figure out exactly what the total return including dividends has been over the last, say, twenty years. It doesn't seem great.]

So is this guy shunned and reviled? No, he's a billionaire. He gets profiled in Forbes.

There's something really odd about the psychology of most investors: they don't care how much they or their managers lose in bear markets. They're interested in how much they make at the "casino" during bull markets. So, nobody ever goes to cash. Being able (and willing) to go to cash is an advantage, but only over >1 market cycles which is too long to be relevant for any investor's career. Remember career risk:

"[B]ecause asset class selection packs a more deadly punch in the career and business risk game, the great investment opportunities are much more likely to be at the asset class level than at the stock or industry level. But even if you know this, dear professional reader, you will probably not be able to do too much about it if you value your job as did the nearly 1100 analysts in my survey. Except, perhaps, with your own assets or, say, your sister’s pension assets."

Career risk is what makes the mutual fund performance charts look like sine waves - no net progress - over the past 30 years.

Hopefully Football Will Go Away

Because it's too harmful:

NFL Commissioner Roger Goodell might have been grateful for the deflation controversy because it distracted from what otherwise have been the season’s two dominant storylines: the league’s reluctance to discipline players who commit domestic violence and its failure to protect its players from brain damage. But Goodell didn’t need the help. Every thinking fan must, in order to enjoy any NFL game, consent to participate in a formidable suspension of disbelief. We must put aside our knowledge that nearly every current NFL player can expect to suffer from chronic traumatic encephalopathy, a degenerative disease that leads to memory loss, impaired judgment, depression, and dementia.

Football players are also four times more likely both to die from ALS (a fact that Goodell, despite participating in this past year’s ALS ice-bucket challenge, refuses to acknowledge) and to develop Alzheimer’s disease. An NFL player can expect to live twenty years less than the average American male. The average NFL career lasts 3.3 years. By that measure, each season costs an NFL player about six years of his life. Football fans, in other words, must ignore the fact that we are watching men kill themselves.

Can Common Stocks Be Sound Investments?

"It has been frequently asked whether the time may come when the life insurance companies should be authorized to invest in common stocks. That day may come, but how near or distant it may be, would be hazardous to predict. The contention that the earning power of a common stock, demonstrated over a long period, might be considered sufficient security for the funds of fiduciary institutions, has a surface appeal. It must be recognized, however, that the problems involved in such a proposed policy are very grave."

- Forbes, November 15, 1929

"Predicting economic market crises using measures of collective panic"

Wow, I wonder if Falky (mimicry theory of recessions) knows about this paper: "Predicting economic market crises using measures of collective panic" [pdf]? Abstract:

"Panic may be due to a specific external threat, or self-generated nervousness. Here we show that the recent economic crisis and earlier large single-day panics were preceded by extended periods of high levels of market mimicry — direct evidence of uncertainty and nervousness, and of the comparatively weak influence of external news. High levels of mimicry can be a quite general indicator of the potential for self- organized crises."

This reminds me of Prechter's theory of endogenous causation. The paper goes on,

"[E]ven when price changes are small, we expect that co-movement itself is the collective behavior that is characteristic of panic, or panicky behavior that precedes a panic. Thus, rather than measuring volatility or correlation, we measure the fraction of stocks that move in the same direction. We find that this increases well before the market crash, and there is significant advance warning to provide a clear indicator of an impending crash."

And, speaking of the Chicago Spire condo tower mentioned in our mimicry post, that ludicrous project has been cancelled.

Worse Than Just Crowded Trades: Investing "Anti-Strategies"

I wrote recently that "There are no evergreen investment strategies that will always work."

That may sound like an obvious statement, but I would strongly argue that many investors are blithely implementing strategies that are so crowded and tired that they should now be considered "anti-strategies."

The two examples I have thought of recently are spinoffs and merger-arb. This year the two really good spinoff plays were shorts; both comically obvious "garbage barge" just-in-time dumpings of obsolete assets: CVEO and PGN. Similarly, the rare opportunity to make worthwhile money in merger arb would be to look for the deals that are going to break.

My point is that: Many shall fall that are now in honor, and many shall be restored that are now fallen. Looking at the "ecosystem" of investment managers, what you would expect to happen is for the fat, old, lazy managers who are coasting on something novel that they did decades ago to rotate out of the business after some shock to the system. (Equity crash with interest rates staying low would be one scenario.)

A correspondent contributes:

I've been meaning to do a post on activist investing. I think it qualifies as another anti-strategy. In addition to being overcrowded, it has a few issues that make it inherently likely to fail:

1. Most of the activists are bean-counters with little or no operating experience. They can claim that a company is being mismanaged, and they may be right, but that doesn't mean they have the skills they would need to manage it better.

2. This is speculative, and I haven't seen any studies that verify this, but my impression is that activism becomes more common as valuations rise and it gets later in the economic cycle. When a bull market is in its infancy, there's less need for activism because stocks are cheap enough to deliver strong returns without any governance changes. Once valuations have risen and multiple expansion is off the table, investors need to see cost cuts, governance changes, or something similar to justify further appreciation. There is a "squeezing blood from a turnip" aspect to activism.

3. As a result of 1 and 2, most activist campaigns are gimmicky: calling for spinoffs, issuing debt to buy back stock, or other actions that are designed to juice the stock price but don't improve risk-adjusted returns.

Between the spinoff and the activist campaigns, CVEO is like an anti-strategy singularity. Along with POST, I think people will look back at it as the canary in the coal mine for popular HF strategies. I'm not really familiar with merger arb but I saw your review of Guy Wyser-Pratte's book. Joel Greenblatt wrote about merger arb getting too crowded in the late '90s, and I imagine it's only gotten worse since then.

The review of Risk Arbitrage by Guy Wyser-Pratte is here.

Is Investing Groupthink Caused By The "Urban Versus Rural" Culture Divide?

This is old, but I thought this essay "How Diversity Punishes Asians, Poor Whites, And Lots Of Others" was interesting.

Besides the bias against lower-class whites, the private colleges in the Espenshade/Radford study seem to display what might be called an urban/Blue State bias against rural and Red State occupations and values. This is most clearly shown in a little remarked statistic in the study's treatment of the admissions advantage of participation in various high school extra-curricular activities. In the competitive private schools surveyed participation in many types of extra-curricular activities -- including community service activities, performing arts activities, and "cultural diversity" activities -- conferred a substantial improvement in an applicant's chances of admission. The admissions advantage was usually greatest for those who held leadership positions or who received awards or honors associated with their activities. No surprise here -- every student applying to competitive colleges knows about the importance of extracurriculars.

But what Espenshade and Radford found in regard to what they call "career-oriented activities" was truly shocking even to this hardened veteran of the campus ideological and cultural wars. Participation in such Red State activities as high school ROTC, 4-H clubs, or the Future Farmers of America was found to reduce very substantially a student's chances of gaining admission to the competitive private colleges in the NSCE database on an all-other-things-considered basis. The admissions disadvantage was greatest for those in leadership positions in these activities or those winning honors and awards. "Being an officer or winning awards" for such career-oriented activities as junior ROTC, 4-H, or Future Farmers of America, say Espenshade and Radford, "has a significantly negative association with admission outcomes at highly selective institutions." Excelling in these activities "is associated with 60 or 65 percent lower odds of admission."

In an attempt to find out what kind of diversity exists -- or doesn't exist -- on the Princeton University campus, I once asked students in a ten-member discussion group to raise their hands if they knew one or more Princeton undergraduates who had served a year or more on active military duty (in the late 1940s or early 1950s, of course, undergraduates at Princeton would have encountered legions of such people coming back from WWII and the Korean War). I made it plain that I wasn't asking if the students had a close friend or roommate who was a veteran, just a single person with military experience that they had at sometime encountered during their Princeton undergraduate careers. Only one student -- a female -- raised her hand: this student once met someone who had served in the Israeli military.[...]

Military veterans and aspiring military officers, like poor whites and future American farmers, are clearly not what most competitive private colleges have in mind when they speak of the need for “diversity”. If nothing else the new Espenshade/Radford study helps to document what knowledgeable observers have long known: “diversity” at competitive colleges today involves a politically engineered stew of different groups. drawn from the ingredients selected by reigning campus ideology. Since that ideology is mainly dictated by the Left, it is no surprise that the diversity achieved is what the larger American landscape looks like when it is viewed through a leftist lens.

The Espenshade/Radford study is available here.

This has investing implications because institutional investment managers are drawn overwhelmingly from selective colleges. They are screened for particular ideologies and personality types, and they are by definition very unfamiliar with vast portions of the country and its population. (Vail and Aspen are not rural.)

My guess is that this contributes to the groupthink that we see in investing, and in particular to the inability to imagine negative outcomes. Has anyone at Princeton (or an asset manager with over $10 billion AUM) ever come from a town where the mine or paper mill closed?

But also, in high school and college these type A personalities learn an abiding faith in the power of hard work (busywork). I've written that

"the VIC/value investors don't say 'it's too hard, there's nothing good, I'm going to cash'. Instead, they say, 'look what I found digging by DEEP into the trash pile', with the implication that they are geniuses for knowing just where to dig in the trash pile."

There's never a time in these people's formative experiences that the right answer is to just sit and do nothing. So, they don't know how to.

Jeremy Grantham On Market Cycles And Career Risk

This is important:

"[B]ecause asset class selection packs a more deadly punch in the career and business risk game, the great investment opportunities are much more likely to be at the asset class level than at the stock or industry level. But even if you know this, dear professional reader, you will probably not be able to do too much about it if you value your job as did the nearly 1100 analysts in my survey. Except, perhaps, with your own assets or, say, your sister’s pension assets."

These days, the asset class opportunity is to stay out of profoundly overvalued equities, an opportunity which is now presenting itself for the third time in less than 20 years.

Football Is Going to Zero?

I shouldn't get my hopes up, but this would be great:

"Millions of parents have already decided that youth football brings serious health risks to the brain, and science may ultimately prove those worries correct. If it does, lawsuits will follow on behalf of former players, much as the N.F.L. has agreed to pay hundreds of millions of dollars to injured ex-players. 'When universities and school boards have to start paying out substantial settlements, the debate will change'"

Remember, boxing and bowling used to be more popular than football and basketball.

Value Investors Obsessed With "Compounders", ROE; Don't Care About Liquidation Value Or Margin Of Safety

Young Money did a post called "Two great posts from Credit Bubble Stocks":

"I find this fascinating because it shows how much valuation standards can change over time. Today, a company is praised for earning a high return on equity (ROE). In Graham's time, companies were praised for having significant assets, even if reporting significant assets depressed their stated ROE."

I sent this to Oddball Stocks, who responded with a great comment:

"It seems the high ROE trend has been born out of the crash of 2008. I don't remember anyone talking about it before then. Now I see things all the time saying 'they earn 4% on equity so they're only worth 40% of book value'. Of course that's insane, someone could purchase them and unlock the value. Or new management could unlock the value.

It seems since the crisis investors have lost their imagination. We have investors believing that anything good will go on forever; these are the growth companies. A company doesn't grow to the sky. Wells Fargo isn't going to grow at 15% a year for decades, if they do in something like 15 years they will be 100% of the banking market in the US. The other are value investors who can't imagine a bad company changing. Things happen, management changes, people change, things change. Nothing is static, yet we live in this static market. It's weird."

I would summarize this by saying that "value" investors are currently obsessed with "compounders" (i.e. "quality" businesses with high returns on equity, and they don't care about liquidation value or margin of safety.

I'm not saying you can never make money buying a high margin, high ROE business at over five times book value, but that's not value investing as the style was traditionally known.

To me (and to Graham), value investing is buying a consistently profitable bank at 60% of book, or closed end muni funds when they are trading at historic discounts to NAV.

Wired: "The Most Fascinating Profile You’ll Ever Read About a Guy and His Boring Startup"

Ha:

"Everyone at hot startups drinks a lot of coffee. But you can’t drink just any coffee. Nobody can drink just any coffee anymore and be taken seriously. (Except for those who proudly and intentionally do so. The key is doing it with intention. But you can’t just saunter up to Starbucks or Dunkin’ Donuts and get a coffee and actually think it’s good.)"

"Baby Boomers have lived in a world where almost any financial decision was rewarded"

A correspondent sent in an excellent comment found in a blog comments section:

"While it doesn’t make for a very pleasant society to have a large and growing wealth divide, the VAST majority of people simply couldn’t care less about having any financial competence. This study [pdf] shows that 70% of the US population cannot answer three extremely basic questions about finance.

This correlates almost perfectly to the number of people who are losing wealth. The questions should be incredibly easy to answer for any functional adult. Here is one:

'Suppose you had $100 in a savings account and the interest rate was 2 percent per year. After 5 years, how much do you think you would have in the account if you left the money to grow: [more than $102; exactly $102; less than $102; do not know; refuse to answer.]'

If you are unable to answer that you fit into the 'fool and his money' portion of society. I have personally found the complete lack of interest in finance to be a strong feature of society. More and more I am beginning to wonder why my knowledge of the field is expected to count for nothing and why the fact that my wealth routinely grows during good and bad times is seen as some type of pathology. If I train two hours a day on the golf course why would you expect to beat me as a once a year player?

Baby Boomers have lived in a world where almost any financial decision was rewarded. They are clueless that things have changed. When they were young adults 10% cap rates on real estate were routine. Now they are typically negative in many markets! They have seen wild asset price appreciation on a multi decade timeline on EVERY asset class. There simply was nothing they could buy that didn’t increase in value. Those days are over – almost certainly for many decades. Having some interest in the basics of money going forward is essential if you don’t want to go backwards. Being lazy and winning financially has worked since 1980 but is very dead."

"A simple theory of college, elites, parties, women, and fraternities"

Interesting theory:

"The authors tell stories of students seeking upward social mobility switching their majors from sensible professional majors to easy majors that lead to jobs available only through family contacts, not through credentials. Nobody is alerting these students to the risks they are taking."

"Theory: The Four Phases of Extreme Bull Market Complacency"

Must read:

• Theory: The Four Phases of Extreme Bull Market Complacency
• Bull Market Complacency After the Great Depression

This is very compelling.

There are so many indicators signalling that it's time for a comeuppance.

"Internet Investment Game Plan"

Makes sense?:

"This leads us Harry’s simple Internet Investment Game Plan. Get in early on all the promising Internet companies. Don’t even think about whether they make sense to you, or whether you’ll use their services or whether you think they’ll succeed, or whether they’ll have some bumps in their early days (Think Facebook). Get in on all. Ride the good ones up. Kick out the bad ones. As your winners succeed, take a little money off the table. Try to play this game with the bank’s money."

The Etruscan Forgery - The Style of Your Own Time is Always Invisible

The story of the Etruscan forgery,

"Hugh liked to tell the story of a statue that had been exposed as a forgery. In the nineteenth century, it had been passed off as an ancient Etruscan sculpture; but in the twentieth century a sharp critic had detected its recent origin. How? The forger had endowed it with the ancient Etruscan mannerisms he could see; but also, unconsciously, with the nineteenth-century mannerisms he couldn’t see. His contemporaries couldn’t see them either, so for a while the counterfeit succeeded. But as fashions changed, those nineteenth-century mannerisms 'rose to visibility.'

As Kenner put it, 'The style of your own time is always invisible.' This was a favorite moral of his. You have to be alert for the unconscious assumptions you share with your own era. Conservatives and radicals, thinking themselves opposites, may actually share the same prejudices without being aware of them."

What Time is It?

Down on the Corner of Berkshire & Fairfax, someone was reflecting that

"[T]hings are getting pretty expensive when I have to buy crap like DGIT [Digital Generation] to try and make a buck."

It made me think of looking at the value investment ideas on the Value Investors Club that were on offer at this time in 2007. There was a Georgia Gulf long idea, for example. You might remember that the company had to all but wipe out shareholders in 2009 in order to deleverage.

It makes me realize that it would be useful to read research from the last business cycle (if a company is that old) to get perspective. I don't think many people do that.

Anyway, when the market gets really expensive, the VIC/value investors don't say "it's too hard, there's nothing good, I'm going to cash" (which I happen to be saying right now). Instead, they say, "look what I found digging by DEEP into the trash pile", with the implication that they are geniuses for knowing just where to dig in the trash pile.

I looked at a number of 2007 research reports of dogs on the VIC, and what I notice is the breathless enthusiasm combined with a casual dismissal of potential problems.

"Evgeny Morozov: 'We are abandoning all the checks and balances'"

Guardian article.

What I've tried to do in my reviews is engage seriously with these bullshit concepts, as if they were serious – to see whether an idea such as "cognitive surplus", of which Clay Shirky is very fond, has any meaning at all. I do close readings of things that aren't meant to be read very closely. That is how our technology discourse works, there are lots of great bloggers, soundbites and memes, but once you start putting them together you realise that they don't add up.

Does it bother you that Jeff Jarvis and Clay Shirky have many more Twitter followers than you?
Many of the internet pundits have more followers because Twitter plugged them on the suggested users list. They also happen to agree with Twitter's position and celebrate the very same things as Twitter celebrates. It shows how far from neutrality and objectivity all of those platforms are, they are sold to us as essentially ways in which anyone can become anything but they have all sorts of ways to manipulate who gets heard and seen.

Quiet

Great essay,

"In a 2006 interview David Foster Wallace said, 'it seems significant that we don’t want things to be quiet, ever, anymore.' Stores and restaurants have their ubiquitous Muzak or satellite radio; bars have anywhere between 1 and 17 TVs blaring Fox and soccer; ads and 30-second news cycles play on screens in cabs, elevators and restrooms. Even some libraries, whose professional shushers were once celebrated in cartoon and sitcom, now have music and special segregated areas designated for 'quiet study,' which is what a library used to be."

I wonder what Prechter would say about increasing noise? Is it because of technology, or is it something mood-related and cyclical?

I think that noise drives groupthink. Not "noise noise" as in din, but having CNBC on your trading (investing?) floor or riding in cabs playing the "news". That ubiquity is going to couple people's decision cycles together.

We have a whole category about groupthink.