What is a Value Investor?

Recently we have discovered that a manager we admire has changed his investment strategy. The individual in question initially managed capital looking for well managed companies in the world (with a focus on emerging markets) that were available at a discount relative to peers and in an absolute sense (relative to the historic valuation of the market).

The manager is now focused on using a long – short strategy. Management explains the idea is to reduce market directional effects on the performance of the fund. Unfortunately, the fund has underperformed the general market over the last few years.

We remain a little skeptical. The individual has proven himself to have a fantastic ability to discover hidden companies that are fantastic businesses, but have not yet been discovered by the mass market. Going long such positions with a long term investment philosophy combines well his abilities with the needs of his client base who are looking for such an investment approach (hence the importance of the manager selecting the client base as well as the client selecting the manager).

Attempting to reduce market volatility (i.e. with the aim of generating better short term performance) will therefore only reduce the total return generated from the manager’s key skill of finding undiscovered great businesses, by introducing the cost of going short and the possibility that the short position will go against the fund.

It seems the pressure of generating aesthetically pleasing results (i.e. a gentle continuously upward sloping graph, rather than lumpy returns which in the long term may turn out to be better) can often create such large peer pressure that it forces managers to change their approach if they don´t want to lose client money. Indeed, many exceptional managers have experienced large capital outflows in periods where performance has been poor and management has continued with their approach. Often, capital has flown back once there outperformance returned. It is impossible to outperform everyday, or even, every year. Consistent returns in the long term is as good as it gets. Changing your approach may mean using a method which may never lead to above average market returns, as your skills are not tuned to working in that particular manner - you do it because you have yielded to peer pressure. For many, this path is the beginning of the end...

To continue with the manager we were above discussing. The idea of forcefully selecting companies in the same sector that seem relatively over valued or may suffer from negative news in the short term to go short, in our view, dilutes the high quality research and thinking applied to find the long positions. It seems silly (in my view) to introduce a short position on a relatively low conviction idea to reduce market risk on their best idea.

Value managers look for businesses that they understand, and from that understanding, invest in the securities that seem grossly undervalued relative to their estimation of fair value. Fair value is a subjective concept, hence knowing ones limits and sticking to what you understand, is vital.

When markets fall, value investors, like all other investors, will suffer. When there are fewer opportunities, i.e. markets are expensive, the cash position of a value investors fund is likely to increase. A true value investor will not act on the pressure to forcefully buy anything – no good ideas at good prices – no buying, therefore cash increases if funds are received or positions are sold.

To fear the market may fall, and the consequential affect this may have on short term performance, and to react by changing your management style in a manner that can reduce your total returns by diluting your primary skills, is the greatest sin of the value investor.

Though we appreciate there is an important role for macro economics in the management of a value investors portfolio, we see this reflected in the asset allocation, rather than the idea of developing a long – short portfolio where no gross over valuation is present, but simply the idea to reduce market directional effects on portfolio performance.