Memo: Value Investing Revisited
Rethinking volatility, conviction, and Mr. Market
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Value investors tend to soak in the teachings from the same great investors (Buffett, Graham, etc.), read the same books, and describe their investment philosophies in very similar ways. There is a core set of tenets that forms the modern day value investing syllabus. I’m sure we’ve all heard of expressions like “volatility is not a risk”, “Mr. Market is irrational”, the importance of “conviction”, and so on.
There is no doubt that these concepts are useful, and when applied properly, can help us become better investors. However, while they may sound great on paper, what we’ve also learned over time and through our own mistakes, is that there are always nuances and trade-offs to these tenets that one will encounter through practice. Here, we want to revisit five of the most popular tenets of value investing, and provide sort of a “practical footnote” to them, viewed through our own lens and experience.
At times, our takes might be controversial. The point in writing these wasn’t to get ourselves blacklisted by the value investing community but to encourage further discussion of the nuances that we feel are under-discussed by mainstream investing literature. Investment philosophy is always a work-in-progress. All thoughts and feedbacks - whether positive or negative - are welcome!
“Volatility is not a risk”
This one is a true value investing classic. Every value investing book ever written will tell you that volatility is not a risk, and that rather, it should be thought of as kind of a “friend” that can be taken advantage of. But in practice, what we observe is that those who do not take into account volatility as part of their processes do so at their own peril.
Volatility drives behavior: The odds that investors do something irrational with their holdings increases exponentially as volatility rises. Stock prices drives narrative. You may have no cash to contribute, your clients may leave and your job (PM or analyst) may be in peril as a result of volatility. You bought a stock at $50 and may be right that the stock is worth $100, but if it goes down to $25 and stays there for some time not only will this affect your returns but also your confidence.
Path dependency of returns: You may not be able to realize your intrinsic value. The company you bought at $50 gets taken private at $25, then re-listed for $100 in a few years. You’ve lost 50% even when you have actually never been wrong on your business thesis. There are market participants other than yourself, who have the means of realizing value in ways that you do not. In today’s world, minority public shareholders simply have far less luxury of being able to disregard volatility.
We are not saying to avoid volatility. But it’s important to have an educated expectation of volatility as part of one’s process, and make sure to be properly compensated for taking it on. And that starts with an understanding in the first place that volatility does indeed have real return consequences and is a real risk component.
The follow-up questions that should be asked are: what is your risk management philosophy around volatility? What is your cash allocation or do you own cash-like securities? Do you have clients that will contribute more during drawdowns? Do you have a process and a culture that will be supportive during heavy drawdowns? Warren Buffett makes it sound very simple but this is not easy.
“Mr. market is irrational”
Another value investing classic is the allegory of Mr. Market, which is taught to us as an “irrational, manic depressive” character. This is related to the volatility discussion earlier, but here we explore this from another perspective.
One of the ways that “Mr. Market” can turn into a slippery slope, is when investors starts to default to the assumption that “Mr. Market can only be rational when it agrees with me”. We often see investors truly question themselves only after their positions have declined by a substantial amount (> 50%) and much damage has already been done. We wonder to what extent this kind of behavior is reinforced by the constant self-conditioning of the “Mr. Market must be irrational” narrative. Could this seemingly benign allegory have contributed to forming some bad investor habits? Perhaps it’s worth reflecting.
The other narrative espoused by value investors is that while Mr. Market focuses on the short term, we have a longer time horizon than that of most market participants. While this is indeed a competitive advantage, we must emphasize that the long term is made up of many short terms.
PM: The earnings were not good and the stock is down 10%. What’s your opinion on this Mr. Analyst?
Analyst: Yes, but management said they are solving the problem and it will get better over time. I recommend we add. Mr. Market is irrational!
PM: The stock has been weak and there is a new competitor in the space. What is your opinion Mr. Analyst?
Analyst: I talked to management and conducted three expert calls. This is a non-issue. I have conviction here.
PM: The stock is down further and there is this new regulatory change that is affecting the whole sector. What do you think?
Analyst: Oh…let’s hold and monitor the situation closely? (Oh sh*t…)
PM: Yeah, we have too much cash in the portfolio and we know this stock *super* well. Holding seems to make sense.
These situations are all too common.
But also, over time we’ve began to think that Mr. Market may not actually be irrational at all. Mr. Market could be looking at the same sets of financials and metrics as you, but coming to different conclusions, because it is simply playing a different game. One thing doesn’t change regardless of what you think of Mr. Market - which is that you need it to agree with you at some point in the future. That manic depressive guy? Yes, you’re at his mercy, sooner or later.
Here’s an alternative approach. Rather than think of Mr. Market as an irrational character, it might be more useful to think of Mr. Market as a group of smart, rational players, playing a different game than you, but with changing expectations. The key is to ask what needs to happen or change, before they are willing to look at things your way. Try to understand rational explanation for current prices, and how those expectations could change as new information becomes available.
Frankly, we think this is a word that tends to get overused in the investing community. Investors love to talk fondly about their “high conviction” ideas. Conviction is too often talked like a virtue, when in fact it’s actually a double edged sword. Far fewer investors talk about the times when conviction cost them dearly. When conviction led them to double down on the wrong name, or when conviction led opportunity cost to be ignored, resulting in prolonged periods of underperformance.
Don’t get us wrong, conviction is important and we are for all the creative scuttlebutt that help investors develop and grow conviction. Conviction is great, but there is far less discussion on how investors should ensure it doesn’t end up killing them. How big are you willing to let your positions become? One of the common ways conviction kills is by doubling down on the wrong names as they go down. What is the process for doubling down (or, when NOT to double down)?
This is beyond the scope of discussion here, but one of the investors that has written thoughtfully on this is John Hempton in his popular Bronte Capital blog. We agree with John that every investor can benefit from having a risk management framework for dealing with the perils of their own convictions.
“Diversification is for losers”
"Diversification is for the know-nothing investor; it's not for the professional."
- Charlie Munger
Charlie Munger has probably been the most prominent of all the vocal critics of diversification. Many value investors share his sentiment, and over time have relegated diversification as a topic that’s only of interest to the academia, and not by the superinvestors of the real world. The problem here is two-fold. First, Charlie may or may not be right. And second, even if he is right, most of us do not have a partner named Warren Buffett.
We agree with Charlie that mindless diversification makes no sense, and that diversification should never be an excuse or substitute for doing proper research. But perhaps this anti-diversification view held by some of the most purist of value investors have gone to an unhealthy extreme. We question if value investing has swung too far on emphasizing the role of the “magical touch of stock picking”. Taken to the extreme, we’ve see plenty of investors who are content in owning a “portfolio” of just 3-5 companies. You can watch this basket carefully but many investors delude themselves into thinking that they can control the basket. Businesses are dynamic and anything can happen to derail your well thought out thesis.
The benefit of diversification is revealed only in a down market. It provides investors dry powder when they need it the most. A well-diversified investor has the valuable optionality to reallocate into their beaten down names, thereby improving returns at the portfolio level. The value of this optionality has been evident in the recent drawdown, when investors who were not adequately diversified had no chance to double down during times when they needed it the most.
“Focus on wide moat businesses”
Perhaps the biggest contributions that Warren Buffet has made in the field of investing literature is popularizing the concept of an economic “moat”. There is no arguing that all things equal, we want wider moat businesses. Focusing on moats is great, but we do have a few observations here.
Most companies that have “proven” moats are highly valued, since that becomes common knowledge. Opportunity resides in those companies that seem to have a narrow moat, when in fact it is wide (and becoming wider over time). However, in an age of rapid change, as businesses innovate and iterate at faster rates, the classic method of pattern-matching based on a “proven” concept is becoming more challenging.
A good investment case should start with seeking base rates from a thorough review of historical industry performance and financials. But it should also draw on first principles way of thinking to explain changes as well as new value drivers. Most classical value investors have a tendency to lean on the former, when the latter is the one that’s becoming more important over time.
Obsessive focus on moats can make one overly focused on new entrants and competition. Sometimes, this can lead to overlooking other risk factors, such as technological obsolescence, demand and market changes, and regulatory risks – all just as important leading to terminal value losses. In fact, we’ve tended to observe that it’s often the other types of risks where investors are caught flat footed, other than just an outright breach of moat which happens actually quite rarely.
Thank you for reading this far! We hope you enjoyed the rant (and the memes). Are we onto something, or are we straying far? Feel free to leave any comment!
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Totally agree on conviction. it killed me before. Now I have almost none and I diversify.
The cost of conviction is under-discussed.
It is not easy to solve. We have to do enough work to go past "Mount Stupid". Yet not too much work, especially on non-critical factors, where our "conviction" miscalibrates the actual probability of getting it right (e.g. the illusion of knowledge effect).