Value Investor or Value Pretender ?

There was a very nice post over at beyondproxy about the varieties of value investors.

The top 10 characteristics to spot the so called “Value Pretenders” from beyondproxy were the following:

Reason #10: You invest based on chart patterns,
Reason #9: You assume multiple expansion in your investment theses
Reason #8: You try to figure out how a company will do vis-à-vis quarterly EPS estimates
Reason #7: You base your decisions on analyst recommendations
Reason #6: You use P/E to Growth (PEG) as a key valuation metric
Reason #5: You use EBITDA as a measure of cash flow
Reason #4: You would worry about your portfolio if the market closed for a year.
Reason #3: You make investment decisions based on the activity or tips of others
Reason #2: Your investment process centers on the market opportunity.
Reason #1: Your investment theses do not reference the stock price

David Merkel at the Aleph blog has (as always) a very good reply to all the 10 points which I strongly support.

As I think this topic is quite interesting and funny, I tried to come up with some of my own characteristics which, in my opinion, could help to detect “Value Pretenders”:

My Top 10 list for detecting value pretenders would be the following:

10. Portfolio turnaround of 50% or more p.a.
“True value investments” are almost never short term bets. Sometimes if you are lucky, value gets realised more quickly but on average those ideas need at least 3-5 years for full potential.

9. Buy and sell decisions because of macro events or macro expectations
As a value investor, you have to be a fundamental investor and analyse on a company level. Macro expectations play a certain role but should never ever be the basis of a buy and sell decision as no one is able to really and consistently to predict them. In contrary, negative macro events are .sometimes very fertile hunting grounds for fundamental investors

8. Investment process does not include reading several annual reports per company in detail
As a fundamental investor, there is no replacement for reading the “original” source of information.

7. Investments in companies with questionable / aggressive accounting
As a value investor, you first thought should be: Can I lose money with this. Whenever a company looks cheap but accounting is questionable, there is no real margin of safety. Conservative accounting and integrity of the persons involved is key.

6. Investor does not discuss risks and weaknesses in detail
Again, the main point in value investing is not loosing. There is never a sure thing, every investment can go belly up. But as a value investor you should be able to identify and price in at least all the obvious risks. And communicate them.

5. Investor does not have a (to a certain extent) structured investment process or a very complicated one
A structured investment process is no guarantee for success, most asset managers pretend to have one. However, if the process is to complicated, with lots of committees and stuff, it is not a positive sign as responsibilities get diluted. No real proces at all is also a waring sign, although for the rare genius (WB) this might work. For pure mortals no process means the big risk of being vulnerable to all kind of behavioural biases.

4. Performance record consistently shows higher draw downs in negative periods than the market
Clearly, even the best value portfolio can underperform in a bad market. However if one sees this more than once, the portfolio is most likely not a “value portfolio” but a high beta portfolio of low quality stocks.

3. Investor offers you redemption on a daily basis
One of the big issues with investors is the tendency to second guess the investment manager. A value investor should “protect” his investors from their animal instincts and align their expectations with his investment style. Joel Greenblatt had a great article on this as he showed how individuals underperformed the Magic Formula by a wide margin because of jumping in and out of the strategy. For me, offering a daily redeemable investment vehicle (mutual fund) and claiming to be a value investor does not go well together.

2. Investor can tell you a great “story” for every stock he owns
On the one hand, any value investor should be able to lay out his investment thesis in a few simple sentences. Anything which is too complicated to explain is most likely not a good investment. On the other hand, “story stocks”, especially those touting some new invention or change in business strategy etc. are mostly never good investments. Good investments often don’t have “catchy” stories but rather are simply good and reliable businesses.

1. Investor uses only last year’s earnings / book value / cashflow plus projections as basis for an investment
This is one of the worst mistakes one can make. One year numbers are to a certain extent more or less meaningless. This is also one of the main reasons why I am very sceptical of “statistical value” strategies where people try to “data mine” investments. Clearly one can use this as a starting point for further analysis, but every company is the sum of its past and looking only at one year is like judging a book purely by its cover.

Finally a few words in general: there is clearly more than one way to success in investing and also more than one way to do “value” investing”. But at the core of value investing are in my opinion:

A) detailed fundamental analysis
B) protection of the downside
C) long time horizon
D) patience

7 comments

  • Does a value investor sell short?

    • in my opnion, short selling is part of the value universe.

    • one follow up on that one: Although he is normally not called a value investor, Jim Chanos in my opinion is currently one of the best value investors out there and he is a dedicated short seller.

      His talent is to spot value traps and short them. For this you need a very good understanding of value investing.

  • I like your theses more than the original ones, because your theses are more strictly valid. beyondproxy’s theses are lesser flaws, which can be often omitted to some degree. Your theses point to some no-goes. Nevertheless there is one thesis I don’t agree with: “9. Buy and sell decisions because of macro events or macro expectations”

    In my opinion macro driven investing can work in principle, but it needs some properties which virtually nobody possesses. Most of all: A working macro theory (most macro eco is useless), which only you knows. Most people overestimate their advantage in macro.

    Nevertheless it was possible in 2007 to know, that the emerging financial crisis was going to become more serve, than most people would expect. So at this time macro driven investing had worked. (At this time I stopped buying stocks and got into gold instead. Back then I were still in university and lacked the confidence to invest in uncommon assets like single stocks or gold.)

    • #Robert,

      don’t get me wrong. MAcro driven inevsting can work pretty well, as for instance Ray Delio shows with Bridgewater.

      However Value investing and Macro don’t work well together. In 2007, as a value investor you would have not found many places to invest into, without looking at macro at all.

      MMI

      • If I remember correctly, you would not invest in Chinese companies. Isn’t this to some degree a macro driven approach?

        • Hi Martin,

          no, I said I would never invest in “German-Chinese” companies mainly because of the Governance issue and the promoters behind them. This is a company specific reasn.

          mmi

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