[I had originally published this on LinkedIn in July, in two parts. So, this one’s extra long.]
I’m a value investor. A proud, card-carrying one. However, I avoid using this moniker in general and in my essays, due to its confusing connotations. While I know exactly what I mean by this, you don’t. But it does bug me when I see a drumbeat of “Is value dead?”. The question itself is flawed and the methods used to answer it even more flawed.
Style boxes such as ‘value’ and ‘growth’ are nonsense.
They combine two of the dumbest ways to make sense of our messy world – formulas and labels. They shed more light on the academics who came up with them than on the topic being studied. ‘Value’ is blindly calculated as a ratio of price to earnings, sales, dividends or book value, with zero weightage given to the entity that generated these metrics. ‘Growth’ is numerically linked to progression of similar metrics, partly from an un-extrapolatable recent past and partly from notoriously unreliable future estimates. They focus on what’s quantifiable over what’s meaningful. For added joy, the two ‘labels’ are neither mutually exclusive nor collectively exhaustive. The same company can switch back and forth between the labels every few months. They are also hypothetical, as the number of real-world investors who conform to either label is exactly zero. On a personal note, while value is a critical input into my investment process and growth isn’t an input at all, the style-box approach would tag me as a ‘growth’ investor. Ouch!
To make their absurdity even starker, let’s look at the Indian context. Applying the aforementioned ‘value’ style-box would create a portfolio comprising shareholder-unfriendly PSUs, unwieldy conglomerates, levered commodity businesses and highly levered commodity businesses with dodgy accounting (AKA banks). On a first principles basis, equity value of many of these companies is negative, making it a tad difficult to find value in them at any price. The irony of this formulaic idiocy is that what’s labelled ‘value’ is actually overpriced crap. Value may or may not be dead, but owning the value style-box portfolio isn’t a life worth living.
Whatever I’ve said about style boxes holds for other formulaic approaches that assign oversimplified labels to so-called strategies (e.g. ‘value’ index). All I’ve argued for so far is that evaluation methods are flawed. It doesn’t clarify value’s status, which is still that of Schrodinger’s cat. To attempt this in a less nonsensical manner, we have to address the question of how to think more generally about investment strategies.
Investment methods are messy, just like the world they operate in.
So, what’s a real world investment approach like? Study long history to spot broad patterns, across business and investing. A few such patterns end up as useful pointers to improving investing odds, especially when qualitative underpinnings of those patterns are decipherable. Such patterns fall way short of the fake precision of back-tests or similar gibberish. Translate these into a set of rough guidelines, partly on what to do but mostly on what not to do. Adhering to a coherent set of guidelines over a long enough period yields something resembling an investment process. This entire exercise involves heavy doses of fuzzy inputs, subjective assessments and judgment calls. There’s a lot of trial and error, especially in the early years. And there are no formulas at any stage. Reasonable people with similar skills, inputs and orientation may end up with differing approaches and portfolio. There’s also a heavy element of inconsistency over time and across situations. Even an investor with the best of intentions and discipline isn’t 100% consistent around a process, since an occasional idiosyncratic decision is inevitable. An average investor may fall well short of 100%, muddying the premise that there’s a coherent method behind an investor’s performance. A few may even confusingly claim that opportunism is a feature and not a bug in their process.
The one thing fuzzier than the investment process itself is the ability of others to figure out what that process is. Even when a large part of behaviour, portfolio and returns are available in public domain, decoding the method is essentially about reverse engineering someone else’s thought process. As with any mind-reading, transmission losses are high. Further, correlation between outcomes and process is also fuzzy, across both past and future. While I might even be able to describe my process to others, there’s no oversimplified label that can do it justice. As I am prone to self-delusion, my description may not match my behaviour. Even if I have justifiable, though biased, faith in my process, it’ll take many years to know for sure. If it doesn’t work, it’s hard to tell if the problem was with me or the process.
All of these confusingly buggy, messy aspects have to accounted for before we can (a) Figure out what approach an investor follows and (b) pass judgment on its efficacy, irrespective of what we label it as.
Value lies in the eye of the beholder
Everyone’s a value investor. No one is a value investor. Lest I sound like drunk Dickens, an explanation is in order. Judged by words, everyone is a value investor, because no one admits to the opposite. All investors claim to invest in good businesses at sensible valuations. No one claims to overpay for deadbeats run by lowlifes. However, investors end up with wildly varying actions under the garb of similar-sounding claims. Claims of value are mostly rooted in assumptions and projections, not facts. Anything can be labelled value with a forecast of sufficient duration and laxity. At the extreme, I’ve seen self-proclaimed value investors make VC investments. Value is limited by imagination, not reality.
One of the few reliable rules in the messy world is to judge based on actions than on words. Judged by actions, no one is a value investor. Certainly, not in the formulaic sense through which ‘Is value dead?” papers are written. After the passing of the exceptional Walter Schloss, I know of no investor of note or scale whose method mirrors the value style-box. Claimants of the ‘value’ label may not actually merit it. Those who merit it may not claim it, realizing that oversimplified labels are silly. When that label is derived using hare-brained formulas, it becomes too surreal for any real investor to either claim or merit.
In the real world, investors can be judged, not strategies.
A useful idea that I have internalized over time is the notion of “unit of analysis”. In my day-job, my unit of analysis is company. I view the world one company at a time. No more, no less. Any other level of analysis is pointless, unless it has tangible implications for a specific company.
For a genuine student of investing, the unit of analysis is investor. To be more precise, an investment firm. We can study one investor at a time. No more, no less. Any higher level of abstraction is muddled up, due to the fuzziness and differences that I’ve mentioned. Any generalization into an overarching strategy that is common to a group of investors is usually misguided and erroneous.
Assuming that we have a decadal track record and some visibility into what went into it, we can judge how that investment firm has done. A part of that judgment includes a best-guess description (not label) of the firm’s approach. In a limited sense, we can judge if the approach works, or at the least, isn’t dead. There’s a crucial nuance, though. It is impossible to separate the method from its practitioner. All that we can reliably infer is that the approach worked for the people concerned. We cannot extrapolate to claim that the approach works in a general sense, for any new set of investors who sincerely attempt a similar approach.
With all this messiness in investing methods, subjectivity in defining value, wide variance across seemingly similar investors and inability to separate method from practitioner, can we even answer the “Is value dead” question? Let me attempt an answer.
Value investing is sound; Buggy humans aren’t
Value investing is very much alive. Value works wonderfully well, but is simply one of many critical inputs into a sensible investment process. It might not even be the most critical one. Value is necessary but far from sufficient. Singling it out for a special label is unnecessary and misleading. What follows is my opinion, based on my lived experience. My conviction isn’t baseless, but I can’t prove it in a universally-applicable, back-tested, peer-reviewed, p-valued manner. Then again, I’m looking to share learnings, not market a fund or publish a paper.
Investing’s a mug’s game. Over 80% of us fail to beat the benchmark. Since future outcomes are unknowable, even the 20% have no guarantee of staying there. Against such terrible odds, there’s no silver bullet, value or otherwise. Philosophically, even the notion of having a single factor as a silver bullet for success in any part of our messy world is absurd. What is required is a whole set of tailwinds, each of which improve odds and are coherent enough to work in tandem. Each factor is fuzzy, but grounded in history. Here are the factors that I have found to be generally helpful, individually and collectively.
Having a long-term orientation is a tailwind, when most live in 6-month chunks. Having a fund source and structure that allows this orientation to be actioned is another. This tailwind gets stronger if the investor has some control over quantum and timing of inflows. Adopting an absolute view, without being fixated on benchmarks, certainly helps. Most investors are handicapped by institutional constraints on the last three points. Thinking in terms of owning businesses instead of buying stocks is a tailwind. Entirely avoiding blow-up risks is another. So is avoiding what we can’t reliably understand. So does having a bias towards better businesses (ones with sustainably high returns on capital) that are likely to endure if not compound. Having the conviction to make concentrated bets when other tailwinds line up adds a tailwind. So does being paranoid after investing about whether the business is still worth owning. If it is so, giving enough time to allow compounding to do its thing is another.
Combining all of the above, we have a set of businesses, a way of thinking and an institutional setup that offer above-par odds of business compounding. Assuming we didn’t screw up so far, it would be a shame to overpay and allow valuation to become a headwind. That’s where value investing comes in. Being disciplined about what we pay adds a valuation tailwind to other tailwinds of time, structure, safety, quality, concentration, focus and skill. Value isn’t an independent factor either, as it’s entirely dependent on what came before it. Much as I hate saying this, value is less important than prior factors, at least in one non-intuitive sense. An error on safety or quality has profoundly non-linear consequences, while valuation errors tend to be linear. Thinking there’s a moat when there’s none or trusting a crooked promoter is a sure path to a wipe-out. If my only mistake is to overpay a bit, I’m off by exactly that bit. However, linear doesn’t meant immaterial. The return spread between 75th and 25th percentile managers is ~3% a year. Systematically overpaying by 10% is all it takes to end up at the wrong end of the inter quartile range.
I inadvertently trivialized value by calling it last, least and linear. To undo this damage, we need to understand the difference between proximate and ultimate causes. Valuation discipline is a proximate cause of improved investing odds. The ultimate cause underlying valuation discipline is a peculiar temperament that’s highly non-trivial. Buying at sensible prices is one manifestation of this temperament. A more significant manifestation involves waiting for years without succumbing to temptation or envy, while adhering to a process whose outcome is unknowable. Most buggy humans get frustrated into buying good businesses at any price or worse, settling for crappy businesses that are optically cheap. Before we know it, we’re down a slippery slope to abandoning the original process we started with. This temperament gets tested even more at the other end. Reasonable valuations arise when the world seems to be ending. Imagine living through October-08 or March-20, without benefit of hindsight. The conviction of August-08 or Jan-20 turns into a fading memory within a few months. As Mike Tyson said, “Everyone has a plan until they get punched in the face”. At a fundamental level, there’s no such thing as valuation discipline. There’s just discipline.
This brings me to the most important tailwind, the one ring to rule them all: having the right person in charge. There’s no getting around individual judgment and temperament, especially at the extremes. Much as we cannot separate an investment method from a firm, we cannot separate a firm from the person the buck stops at. Since everyone sets out to buy good businesses at sensible prices, the gating factor for investment success isn’t the method, but the buggy human at the helm.
Given how stiff the odds are, we need all of the above tailwinds to even stand a chance. And skimping on any one of them can undo it all. While I do think of this approach as value investing, value comes last and cannot be isolated from all the other factors that come before it. That’s why it’s absurd to define it in a formulaic way, unrelated to what’s being purchased. The other factors first tell us what to avoid and what’s worth owning. Value merely tells us what to pay, as a final step. The value style box starts and ends with “What’s cheap”. The approach I’ve described never asks that question. It asks “For a short list of businesses worth owning, what’s reasonable”.
Ninety years back, using just eight words, Benjamin Graham articulated the tenets of sound investing: Mr Market, margin of safety, intrinsic business value. His timeless wisdom is as valid now as then, in both letter and spirit. I know of no other approach that offers better odds for investment excellence. It’s a travesty to selectively retain the last of his eight words as an oversimplified label. To make it worse, the style-box crowd conflated this with “liquidation value”, which was merely a practical technique to safely value the businesses of his time.
In my experience, value investing works. Wonderfully well. In the original sense of the term. Business value investing, with business coming before value. “Buy good businesses at sensible valuations” isn't any different from “Eat well and exercise”. The method is sound. Most buggy humans who attempt it aren’t.