Thursday, June 15, 2006

The Perfect Value Investor

by James Montier

Occasionally when I present on the seven sins of fund management, someone at the end (obviously a valiant soul who has managed to stay awake) will ask me how I would structure an investment process. In the spirit of good politicians everywhere, I am going to save my answer to that question for another weekly. However, I recently read a paper along similar lines that I thought was worth sharing. Louis Lowenstein of Columbia University examined 10 value managers selected by Bob Goldfarb, CEO of Sequoia Fund. Lowenstein asked him to select ten dyed-in-the-wool value investors who all followed the essential edicts of Graham and Dodd; obligingly, Goldfarb selected the list below. To this list we have added a second Tweedy Browne fund, Tweedy Browne Global Value.

This may not be the most scientific of approaches, but nonetheless should allow us to draw out some of the characteristic behaviors of some of the best value investors. We have updated and extended Lowenstein's work.

The table below shows the funds and some of their key characteristics.

Trait I: High concentration in portfolios

Contrary to the proclamations of classical finance, these investors tend to run highly concentrated portfolios. No portfolio diversification for these guys. Tracking error has little or no meaning to this group of investors.

Across these funds, on average, nearly 40% of the assets are in the top ten holdings. Across a wide universe of funds, the top ten holdings account for only around 10% of assets. The average number of stocks held is around 35 (and this is raised by the presence of three international funds, it would be closer to 20 for the domestic-only funds). In contrast, the average US domestic mutual fund holds around 160 stocks!

This seems to reflect a different philosophy on two counts. Firstly, these value managers seem to need a reason to invest - not investing is their default, so in order to actually go out and buy a stock, these investors need to be convinced of the merits. Presumably in accordance with Graham and Dodd's guiding principles, this is represented by a margin of safety. As Graham wrote, "The margin of safety is the central concept of investment. A true margin of safety is one that can be demonstrated by figures, by persuasive reasoning and by reference to a body of actual experience".

Secondly, the average fund management outfit appears to be run either by the risk management department or the marketing department. I've come across several examples of this in the last few years. One client was relaying to me the joys of his risk managers telling him that he had to deploy more risk, because he was under his risk budget! Of course, when markets fall, those very same risk managers with their trailing correlation and volatility will be the first in line to tell you to sell your positions. Risk managers are the financial equivalent of those who give out umbrellas on dry days, but snatch them back as soon as it starts to rain.

Another informed me that they were setting up a commodity fund. Why? Because the marketing department said there was an appetite for such a product. Does this not strike anyone as vaguely (and perhaps alarmingly) like the TMT bubble?

The result of these bizarre dynamics is that the average fund manager is more worried about tracking error and benchmark risk, than about finding the best investment for his clients. So their default is likely to be ownership. Hence they need a good reason not to invest in a stock. The fiduciary responsibility to the client is forced to take a backseat. Perhaps investment managers should take an equivalent of the Hippocratic Oath to do no harm.

As is often the case, Maynard Keynes sided with the value investors. He wrote:

To suppose that safety-first consists in having a small gamble in a large number of different companies where I have no information to reach a good judgement, as compared with a substantial stake in a company where one's information is adequate, strikes me as a travesty of investment policy.

Letter to F.C. Scott, February 6, 1942 (The collected writings of John Maynard Keynes).

This was a view shared by Loeb in his classic, The Battle for Investment Survival. He opined, "Diversification is an admission of not knowing what to do, and an effort to strike an average".

It should be noted that concentrated portfolios are not, in and of themselves, a deliberate choice on the part of these funds, but rather stem from their investment discipline. There simply aren't that many good value opportunities to be found. The Brandes Institute published a paper in late 2004 exploring the use of concentrated portfolios. They concluded, "In aggregate, and across peer groups, we find that concentrated portfolios, in and of themselves, do not provide improved returns, nor do they provide improved volatility-adjusted returns". This emphasizes the fact that the concentration amongst our group of value investors is the result of a process rather than a deliberate decision in its own right.

A graphic illustration of this point can be seen by examining the performance of a basket of stocks that Fortune assembled in the year 2000. The basket was labeled "10 stocks to last the decade - here's a buy-and-forget portfolio". The aim of the stocks was to allow you to "retire when ready", according to Lowenstein. The list of companies is shown below. Only one of these stocks had a PE of less then 50x!

The performance of this basket is shown in the chart below. At least Fortune got one thing right - it was a portfolio to forget! It is still down around 40% from the time at which Fortune suggested its purchase. A prime example of what Ben Graham would have described as a permanent loss of capital.

The investors in our value group focus themselves upon business risk - will profit margins shrink? Are there risks on the balance sheet? - rather than market risk (stock volatility), which these investors seem to treat with the scorn it deserves. They know that the market as a whole is best characterized as suffering bipolar disorder (the proper name for manic depression). As Ben Graham wrote:

One of your partners, named Mr. Market, is very obliging, indeed. Everyday he tells you what he thinks your interest is worth and furthermore offers either to buy you out or sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or fears run away with him, and the value he proposes seems to you a little short of silly.

Trait II: They don't need to know everything, and don't get caught in the noise

The investors in this group seem to be aware of the need to focus on a few key items of information, rather than attempting to try and overload themselves with noise. Lowenstein quotes Marty Whitman of the Third Avenue Value Fund as saying, "the fund doesn't have superior information; ?the trick' is to use publicly available information in a superior manner". To this end, these funds don't employ legions of analysts wasting time forecasting next quarter's EPS; instead, they spend their time trying to understand the valuation and associated risks.

Trait III: A willingness to hold cash

Their willingness to hold cash is clearly visible from a cursory glance at the table on page 2. Currently they hold around 11% cash, nearly 3x the level held in the average US mutual fund. The average hides a wide range of current cash levels. For instance, FPA Capital is holding nearly 39% cash whilst Legg Mason Value holds a mere 1.1% cash.

Most of the traits displayed stem from the underlying philosophy of the funds in question. The generalized willingness to hold cash is the result of lack of investment opportunities. In his year-end letter to shareholders of 2003, Seth Klarman wrote that his large cash position was the "result of a bottom-up [and failed] search for bargains". The guiding principle amongst our group of value gurus is, to borrow Buffett's expression, "holding cash is uncomfortable, but not as uncomfortable as doing something stupid".

Trait IV: Long time horizons

I have often remarked that inherent within a value approach is the acceptance of long time horizons. You never know when a stock will reflect a sensible value. A good example was provided by the UK market in early 2003. The dividend yield on the UK market was higher than the 10-year government bond yield, suggesting that dividends were expected to decline on a decade view. This struck me as just plain wrong. A plethora of valuation work showed the UK to be unambiguously cheap (for details see Global Equity Strategy, 30 January 2003). The presence of forced sellers was making the UK market a bargain.

However, as with all bargains, they can repay you in one of two ways. Firstly, prices could correct. Secondly, they could just generate a high return via paying out high dividends for a long period of time. You never know which path will be taken. Hence the need for long time horizons.

Our selection of value managers all display long horizons. The average stock-holding period amongst these funds is over five years. The maximum is 17 years, the shortest 3 years. All compare favorably with the mutual fund industry's average stock-holding period of just 1 year (according to Morningstar).

This is supported by the chart below showing that average holding period for stocks on the NYSE. Back in the 1950s/1960s, investors used to do exactly that: invest. The average holding period was 7-8 years. However, today it appears as if everyone has become a speculator, with an average holding period of just 11 months.

When I present these findings, investors often dismiss the picture as yet further evidence of the way in which hedge funds have altered the investment landscape. However, the Morningstar data above, and the data from John Bogle below, show that long-only fund managers are just as much to blame for the time horizon shrinkage as the hedge funds. This may be because they feel the need to compete with the hedge funds but, regardless, they are certainly complicit in the shift from investment to speculation.

As Munger and Buffett have noted on many occasions, "If the job has been correctly done when a common stock is purchased, the time to sell it is - almost never".

Trait V: An acceptance of bad years

Nearly all of the funds in our list have witnessed periods of negative returns, and/or underperformance relative to a benchmark (although note Trait I on the disregard for such items). Many of them saw large redemptions during the TMT bubble, but were prepared to stick to their tried and tested approach to investing. Lowenstein cites Eveillard (manager of the First Eagle Global Fund) as saying, "I would rather lose half my shareholders than lose half my shareholders' money".

Despite the very impressive performance data contained in the table on page 2, many of the funds examined have underperformed the index in as many as seven years out of the last ten! Absolute losses are relatively rare, with only 2 or 3 years seeing negative returns in the last 10.

In a paper published by Tweedy Browne, they report a study that showed for a group of value investors with excellent long-term track records, that underperforming an index some 30-40% of the time was perfectly normal. This fits well with our previous study of underperformance using an artificial universe of skilled fund managers who, despite having an information ratio of 0.5, saw 70% of their numbers witness 3 or more years of consecutive underperformance (see Global Equity Strategy, 7 June 2005).

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