The distinction between price and value is the sole requisite principle of value investing. It’s the only must. Beyond that, there are valid differences in approach. I see eight.
1. First is asset class.
Listed equities return best over time, as addressed. But there are practitioners able to squeeze performance out of other sorts of holdings. Bonds work for some, real estate works for others. They’re tougher rows to hoe, but some hoe them well.
2. A second valid difference is holding period.
Some value investors plan to hold what they buy for just months. Others hope to hold indefinitely. Different timelines occasion different priorities. For example, short-term holders consider catalysts. A catalyst is a reason that a price could soar from the depressed level that helped to make a security attractive. Unexpectedly good quarterly results could be a catalyst, as could the dismissal of an unpopular executive.
Catalysts are less interesting to long-term investors. They’re too near-term a concern. Never intending to sell, I don’t give them a thought.
3. A third valid difference is activism.
Activist investors agitate for change in the companies that they own. They might be viewed as their own catalysts. The alternative is staying uninvolved. It’s the choice of most investors, both good and bad. I call it inactivism, since passive implies index fund investing.
Activism requires an extraordinary level of gravitas and tenacity. People who are feared and skilled in this specialty are the ones that achieve the best results. Activism is not something in which one fruitfully dabbles.
4. Fourth is diversification.
Some value investors have diversified portfolios, with perhaps 50 or more names. Others prefer concentration, with fewer than 10.
These thresholds depend somewhat on the amount of money managed. A $50,000 portfolio spread out among a dozen different stocks might be considered diversified, while a $10 billion fund invested in a dozen names might seem concentrated.
Diversification tends to decrease volatility, should that be a goal. But, the more diversified a portfolio is, the harder it is to beat a relevant index.
One way to appreciate this is through the law of large numbers. It’s a principle from probability. It says that the more times an experiment is run, the closer the average result will be to the expected result. In investing, the expected result is the index’s return. So the more names in the portfolio—each name being an experiment, in the parlance of the law—the closer the portfolio’s return will
be to that of the index.
Some stripes of value investing force one into a diversified portfolio. Small cap investing can, since there aren’t that many shares traded of each company. They’re small. So a small-cap investor that adds $100,000 to assets under management might have to find a new name because the ones already owned don’t have enough shares available to buy.
5. A fifth valid difference is quality.
Our approach has been to focus on how good a business is in an absolute sense, before considering price. We labor over historic performance metrics, strategic positioning, and shareholder-friendliness. We look for quality.
But an equally convinced group focuses on buying companies that are inexpensive relative to how good they are. To them garbage is fine, as long as it’s cheap garbage. Some in this group get exceptional results.
My focus on company quality reflects three of my other preferences: inactivism, concentration, and a long holding period. What I buy has to be good because I’m not going to fix it, I’ve only got a few others like it, and it’s mine forever.
These preferences aren’t about great foresight or morality. They’re about taxes. Unrealized appreciation isn’t taxed in the United States, so everything else being equal, holding is advantageous. I draw a straight line from tax policy to investment policy.
6. Sixth is leverage.
Leverage is debt. What is true for operating companies is true for investors: debt amplifies results. When an investor buys on margin, results that would otherwise be good become exceptional, and results that would otherwise be bad become catastrophic. The potential of the latter keeps many value investors away from debt. But not all.
7. Seventh is complexity.
Some value investors prefer simple setups. They like common stock in straightforward companies. I do, as the model makes clear. But others like it complicated. They may seek convertible bonds that become equity only under hard-to-forecast circumstances. They may prefer stock in development-stage pharmaceutical companies undergoing clinical trials, or in technology companies whose fortunes are dependent on the outcome of pioneering research.
They adore these complications not because they’re falling prey to the cleverness bias. They adore them because it gives them less buy-side competition. Other investors will simply abstain from trying to sort out convoluted situations. This can keep prices lower than they would be otherwise.
8. Eighth is shorting.
Shorting is a way to bet on a stock price’s decline. It involves selling stock without actually owning it, by renting it from someone who does, with the goal of profiting when the price falls.
Shorting is theoretically attractive. It promises a way to benefit from a finding that a security is overpriced. But it’s thorny to implement. Shares to rent can be hard to find, fees can be high, and a short squeeze can cause a price meant to plunge to actually soar.
Despite these complications, some value investors do short. But many do so as agents, not as principals. That’s because it increases their compensation. Shorting is a hallmark of a complicated fund. It’s the kind of stunt that managers attempt in order to justify compensation schemes of 2 percent plus 20 percent. It’s a ticket out of the land of 1 percent.
Dicey Strategies: Can work and Doesn't work sometimes
Of the eight dimensions on which value investors can differ, two invite suspicion.
1. Shorting is one.
It just doesn’t work that well. I know of no principals that both rely on shorting and outperform over the long term.
2. Leverage is the other.
While debt can be milked for bonus returns much of the time, one big margin call can be enough to foul years of solid results.
I nonetheless include shorting and leverage on the list to allow for the possibility that they could be made to work under some circumstances.
Summary
Dimensions on which bona fide value investors can differ include:
1. Asset class
2. Holding period
3. Activism
4. Diversification
5. Quality
6. Leverage
7. Complexity
8. Shorting
1. First is asset class.
Listed equities return best over time, as addressed. But there are practitioners able to squeeze performance out of other sorts of holdings. Bonds work for some, real estate works for others. They’re tougher rows to hoe, but some hoe them well.
2. A second valid difference is holding period.
Some value investors plan to hold what they buy for just months. Others hope to hold indefinitely. Different timelines occasion different priorities. For example, short-term holders consider catalysts. A catalyst is a reason that a price could soar from the depressed level that helped to make a security attractive. Unexpectedly good quarterly results could be a catalyst, as could the dismissal of an unpopular executive.
Catalysts are less interesting to long-term investors. They’re too near-term a concern. Never intending to sell, I don’t give them a thought.
3. A third valid difference is activism.
Activist investors agitate for change in the companies that they own. They might be viewed as their own catalysts. The alternative is staying uninvolved. It’s the choice of most investors, both good and bad. I call it inactivism, since passive implies index fund investing.
Activism requires an extraordinary level of gravitas and tenacity. People who are feared and skilled in this specialty are the ones that achieve the best results. Activism is not something in which one fruitfully dabbles.
4. Fourth is diversification.
Some value investors have diversified portfolios, with perhaps 50 or more names. Others prefer concentration, with fewer than 10.
These thresholds depend somewhat on the amount of money managed. A $50,000 portfolio spread out among a dozen different stocks might be considered diversified, while a $10 billion fund invested in a dozen names might seem concentrated.
Diversification tends to decrease volatility, should that be a goal. But, the more diversified a portfolio is, the harder it is to beat a relevant index.
One way to appreciate this is through the law of large numbers. It’s a principle from probability. It says that the more times an experiment is run, the closer the average result will be to the expected result. In investing, the expected result is the index’s return. So the more names in the portfolio—each name being an experiment, in the parlance of the law—the closer the portfolio’s return will
be to that of the index.
Some stripes of value investing force one into a diversified portfolio. Small cap investing can, since there aren’t that many shares traded of each company. They’re small. So a small-cap investor that adds $100,000 to assets under management might have to find a new name because the ones already owned don’t have enough shares available to buy.
5. A fifth valid difference is quality.
Our approach has been to focus on how good a business is in an absolute sense, before considering price. We labor over historic performance metrics, strategic positioning, and shareholder-friendliness. We look for quality.
But an equally convinced group focuses on buying companies that are inexpensive relative to how good they are. To them garbage is fine, as long as it’s cheap garbage. Some in this group get exceptional results.
My focus on company quality reflects three of my other preferences: inactivism, concentration, and a long holding period. What I buy has to be good because I’m not going to fix it, I’ve only got a few others like it, and it’s mine forever.
These preferences aren’t about great foresight or morality. They’re about taxes. Unrealized appreciation isn’t taxed in the United States, so everything else being equal, holding is advantageous. I draw a straight line from tax policy to investment policy.
6. Sixth is leverage.
Leverage is debt. What is true for operating companies is true for investors: debt amplifies results. When an investor buys on margin, results that would otherwise be good become exceptional, and results that would otherwise be bad become catastrophic. The potential of the latter keeps many value investors away from debt. But not all.
7. Seventh is complexity.
Some value investors prefer simple setups. They like common stock in straightforward companies. I do, as the model makes clear. But others like it complicated. They may seek convertible bonds that become equity only under hard-to-forecast circumstances. They may prefer stock in development-stage pharmaceutical companies undergoing clinical trials, or in technology companies whose fortunes are dependent on the outcome of pioneering research.
They adore these complications not because they’re falling prey to the cleverness bias. They adore them because it gives them less buy-side competition. Other investors will simply abstain from trying to sort out convoluted situations. This can keep prices lower than they would be otherwise.
8. Eighth is shorting.
Shorting is a way to bet on a stock price’s decline. It involves selling stock without actually owning it, by renting it from someone who does, with the goal of profiting when the price falls.
Shorting is theoretically attractive. It promises a way to benefit from a finding that a security is overpriced. But it’s thorny to implement. Shares to rent can be hard to find, fees can be high, and a short squeeze can cause a price meant to plunge to actually soar.
Despite these complications, some value investors do short. But many do so as agents, not as principals. That’s because it increases their compensation. Shorting is a hallmark of a complicated fund. It’s the kind of stunt that managers attempt in order to justify compensation schemes of 2 percent plus 20 percent. It’s a ticket out of the land of 1 percent.
Dicey Strategies: Can work and Doesn't work sometimes
Of the eight dimensions on which value investors can differ, two invite suspicion.
1. Shorting is one.
It just doesn’t work that well. I know of no principals that both rely on shorting and outperform over the long term.
2. Leverage is the other.
While debt can be milked for bonus returns much of the time, one big margin call can be enough to foul years of solid results.
I nonetheless include shorting and leverage on the list to allow for the possibility that they could be made to work under some circumstances.
- But they’re dicey.
- They’re back doors out of the kingdom of value investing and into a land of some other, less practical strategy.
- Some would say that this invalidates them as intelligent tactics.
Summary
Dimensions on which bona fide value investors can differ include:
1. Asset class
2. Holding period
3. Activism
4. Diversification
5. Quality
6. Leverage
7. Complexity
8. Shorting
