September 12, 2012

Why are there so few value investors here in the UK?

For clarity’s sake, we use the term “value investing” to mean looking for companies trading at prices that imply a double digit return without relying on an assumption of growing earnings streams.  Essentially this means there is a margin of safety as per the investment guidelines of Ben Graham.

A lot of investors in the UK talk about “finding value” but few directly use the value label to describe their investment philosophy.  Most managers in the UK still think of themselves in the traditional “growth” or “income” groupings, and there are those who don’t profess to an explicit style.  There is a tolerance in the UK for such managers – they can invest as they see best: for example moving towards growth stocks when that looks best, or towards defensives when the manager was concerned about the outlook for the markets, and following momentum when the manager feels that “the market wants to run”.

We can see the obvious appeal of this flexibility – in theory, it should allow investment managers to achieve the highest returns as they move between investment styles, timing the changes in the market perfectly.  They should be able to make money in all markets, with limitless returns.

The problem is that it works so rarely in practice.  Even the very best managers can’t consistently achieve that oh-so-difficult task of correctly timing the market.  The market is inherently chaotic and unpredictable, due to a plethora of reasons: the sheer volume of players involved; their differing perspectives and time scales; the inclination of individuals to move in a herd; the tendency to over-react to ever-changing short-term news; the significance and inherent variability of economic and liquidity cycles; the positive feedback mechanisms (such rising markets causing excess wealth which is then reinvested in stocks pushing prices higher) to name but a few.  Predicting the future correctly and consistently has defied humanity for its existence.  Even the best managers will say that they expect to be wrong regularly, and this intellectual humility is necessary to avoid being overconfident about that which is very difficult to forecast and over which you have no control.

Putting aside the fact the a large number of managers do not explicitly define their style at all, it is still interesting that of those that are willing to nail their colours to a mast, very few are value investors.  The reason is that value investing itself is hard to do.  Despite evidence (and in fact common sense) saying you should “buy low and sell high”, fighting against the crowd is difficult for three broad reasons.

Firstly, from an individual professional’s point of view, the career risk is high.  Being different from a benchmark (as you are bound to be when you are contrarian in your share purchases) produces higher career risk for the fund manager, despite the risk for clients’ capital being lower.   “It is better to fail conventionally than succeed unconventionally” is the old saying, and this is because an underperforming fund manager is much safer when they can’t be singled out from the crowd, and can use the excuse that all their peers look just as bad.  It is very difficult to fire the entire fund management industry (although tempting at times, we’re sure).  As well, pressure on investors who buy things that look unconventional is enormous.  This is particularly true when you are wrong.  “Why did you buy that dog of a stock?  Even I could tell you that was a disaster”.  But, as Warren Buffett says, you pay a high price for a rosy consensus.

Secondly, the timing of a value manager’s performance does not fit well with the asset-raising cycle.  Value managers tend to underperform running markets (as they find fewer and fewer companies meeting their valuation criteria), and outperform falling markets (as companies with already low expectations built in to the prices hold up).  The problem is that it is when markets are running that the most money is being put into equities.  Conversely, a value manager’s performance is often most attractive, when potential clients are shunning equities all-together.  This is not an easy way to build a business, and would be especially hard in a large institution where the fund manager’s bonus, and sometimes their job, depend on growing assets under management.

Thirdly, and most importantly, is the fact that most people find it very attractive to buy into stocks that are fashionable, that have a positive write-up, and whose share price has risen and is continuing to go up.  Stocks, and the stock market as a whole, are largely a Giffen good – one for which there is higher demand at a higher price.  Perversely, the vast majority of investors like a stock much more when the share price is much higher.
It takes a certain temperament to buy a stock whose short term outlook is cloudy, that will see few positive news stories in the near future, and that could take a long time to produce a return.  Few people have the analytical skills, the patience, the right corporate environment and the bloody-mindedness to find these situations and then wait them out.  However, precisely because so few people invest in this way, it is natural that these investments provide excellent returns in the long term.

At Kennox we are value investors: buying on low valuations, looking for an asset backing, searching for a margin of safety, seeking assets that the markets haven’t already fallen in love with and often contrarian.  This is the strategy that entirely aligns with our personal philosophies and temperaments.  Why should we do anything differently?  We know that there are great growth stocks out there but we also know that it is difficult enough to find great value stocks without trying to do anything else.  Our core strength is building a robust portfolio by finding value stocks.  Distracting ourselves from our core strength is not the way to improve our performance.

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