In a recent letter to investors, credit-focused hedge fund Arena Investors looked back at how value investing has evolved over the years.
When many people think about the history of investing, Benjamin Graham is often considered to be one of the founding fathers of the value mindset.
Graham's books, "Security Analysis" and later "The Intelligent Investor," became investment bibles for many readers. They taught readers how to value stocks and developed the idea that a business would always be worth its liquidation value.
From here, Graham developed his net-nets strategy, which was based on the idea that if a stock was trading for below the value of its net current asset value, it was cheap. By owning a diversified basket of these securities, Graham believed investors would do well.
The father of value investing and his student, Warren Buffett (Trades, Portfolio), used this approach incredibly successfully. However, something that's often overlooked when reviewing the past investments of these legends is the fact that when buying deep-value stocks, they often kept buying the shares until they had a favorable outcome, either through liquidation, takeover or restructuring.
This wasn't always the case, but some of their best investments were pushed toward a favorable outcome.
There's nothing wrong with this approach, but it is very different from the value investing style that prevails today.
As Arena's letter reported, most value investors today try to value businesses and then buy at a discount to what they believe is their estimate of intrinsic value. After that, they hope the market reverts to the mean.
This approach differs from Graham's method for two reasons.
First of all, intrinsic value is much harder to compute than book value. It's pretty easy to work out how much a company's buildings or construction equipment will be worth to another buyer.
It's far more challenging to work out how much the value of a company's brand is worth.
The second reason is that by relying on the market, the investment falls out of investors' hands. They lose control.
The market weighing machine
One of Graham's most famous sayings was, "In the short run, the market is a voting machine but in the long run, it is a weighing machine." This is a phrase many value investors cling to today.
The concept is still relevant, but Graham often pushed for change and ignored this idea.
In its letter, Arena explained that it does not follow the modern value mentality. Instead, it focuses on finding investments where it is sure it is buying for less than liquidation value. It is also looking for securities where there is a clear path to value realization.
This isn't the only company that uses this mentality. Seth Klarman (Trades, Portfolio) has also expressed a preference for only buying securities where there is a clear level of undervaluation and a path to realizing value. To put it another way, he's not willing to wait for the market to correct itself. He wants to know when he will get the payoff.
This approach has worked incredibly well for both funds over the years. Klarman's Baupost as well as Arena have both achieved annualized returns in the high teens.
These funds have achieved substantial returns by acquiring deeply undervalued assets that have a catalyst for value realization.
Unfortunately, in some cases, these deals are only available to larger firms. So the strategy is not going to be suitable for all.
However, the idea that value investing has become too hung up on Graham's idea that, in the long term, the market will revert to the mean is an interesting one. Targeting a set payoff at some point in the future may be a better regime rather than hoping the market provides a reward.
Read more here:
- How the Best Investors Have Used Debt to Improve Returns
- Warren Buffett and the 'Degree of Difficultly' in Investing
- Finding an Investment Strategy That Works for You
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