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Robert Abbott
Robert Abbott
Articles (592)  | Author's Website |

Strategic Value Investing: Barriers to Success

Identifying and overcoming hurdles that can affect value investors

August 07, 2019

To kick off chapter three of their book, "Strategic Value Investing: Practical Techniques of Leading Value Investors," authors Stephen Horan, Robert R. Johnson and Thomas Robinson wrote about the bad timing of many investors.

Timing that worked out to give them the exact opposite of what they were seeking. They get into or get back into the market when prices are high, and they get out when prices have just collapsed. In recent years, it happened during the dot-com bubble and bust and again in the 2008 financial crisis.

The net effect in these and other past cycles has been to reduce returns rather than enhance them. Investors who stayed invested in essentially the same stocks or mutual funds fared much better than those who jumped in and out.

And it’s not just individual retail investors who are affected by events. The authors wrote, “Institutional investors chase returns as well. Research has found that professional investors chase past investment performance in the pension fund industry, among hedge funds, among private equity funds, between venture capital funds, and among arbitrage strategies.”

However, the authors argued that none of us, amateur or professional, should give up on investing. By knowing and addressing the barriers that drag on our performance, we can become more competent and more successful.

There are three categories of barriers to successful value investing:

  1. Cognitive and emotional biases that are “ingrained in our DNA.”
  2. Market-related matters.
  3. Investment constraints that affect us in some way.

Cognitive and emotional biases

Many barriers exist in this category, and the behavioral investing school has helped us identify many of them. The authors focused on these issues:

  • Social pressure, including the resistance to going against conventional wisdom.
  • Basing decisions on information that comes to mind easily (the availability heuristic).
  • Being biased in favor of companies that employ us, are in the same industry or are close to where we live. There’s also Peter Lynch’s classic advice: Invest in what you know.
  • Overconfidence in our own abilities, especially for men (who are less successful investors than women).
  • Media influences; be careful about investing in companies that receive enthusiastic cover stories in magazines. Remember, too, that value investors usually invest in out-of-favor stocks.
  • Loss aversion because we have strong and negative emotional reactions to even small losses. Initial losses are the hardest to bear.

Market obstacles

  • Arbitrage: According to the authors, “there are many risks associated with capitalizing on this pricing even when the mispricing is obvious. It is all the more difficult for the strategic value investor who is relying on his or her analytical and economic intuition to determine this pricing.”
  • Transaction costs refer to commissions, bid-ask spreads and other fees. The authors call these opportunity costs because they represent cash that cannot be invested.
  • Horizon risk comes into play when investors do not know how long it will be before a pricing discrepancy resolves itself. Value investing almost always involves waiting for the market to recognize the discrepancy.
  • Funding risk is the possibility that price discrepancies can—and often do—get worse before they get better.
  • Volatility drag: As discussed in the previous chapter, the higher the volatility, the lower the accumulation of capital.

Investment constraints

The authors defined this as: “Investment constraints are factors that affect a particular investor and limit that investor’s opportunity set in any number of ways.”

These constraints include:

  • Liquidity: The need to keep a certain portion of a portfolio liquid and in low-volatility assets to cope with expected and unexpected needs for cash. Thinly traded stocks and private equity investments are examples of assets that are not very liquid.
  • Time horizons affect how much risk investors can take. Investors who expect to need their money in a year or two have insufficient time to recover if they take a loss.
  • Taxes: Are your stocks and other assets held in tax-sheltered accounts or not? If not, you must consider the taxman as well as investment factors when making buy and sell decisions.
  • Legal constraints are not likely to be an issue for individual investors, but will be for investment managers who take care of money for other people. Specifically, investment managers are constrained by the Prudent Investor Rule; pension fund managers must stay within the bounds of the Employee Retirement Income Security Act (ERISA).

Barrier busters

In addition to identifying and explaining the barriers to successful value investing, the authors also offered some solutions:

  • Disciplined investing: You can have your own unique style of investing, but you must use it consistently. Part of that discipline should be knowing a company’s fundamentals and being aware of the valuation model you are using.
  • Stay diversified to help minimize risk. The authors further recommend that no value investment should be more than 10% to 15% of a portfolio.
  • Create your own investment policy statement, a document that helps you to maintain focus and control your impulses.
  • Keep an investment diary for each investment decision. It should articulate the investment action, the investment thesis and the possible risks.
  • Sunk costs: Past losses and gains should be irrelevant in making new investment decisions. Among other benefits, ignoring sunk costs should help us avoid holding on to losers too long.
  • Use calming techniques; for example, deep breathing and similar exercises.
  • Drink something sweet before making important decisions because our glucose levels become depleted when we are thinking hard.
  • Stay away from excessive leverage (too much debt) and excess trading. Value investing plays, by their nature, can take a long time to play out. Excessive debt and trading may knock you out of the play before it completes.

Conclusion

The authors wrapped up with these words:

“There are many barriers to successful strategic value investing. Some come from the marketplace; others reside in us or our investment constraints. Either way, they need not condemn us to a fate of lackluster investment results. The first step to overcoming them is identifying them. We can then use a series of techniques to increase the chances that we will stay disciplined, objective, and prudent in implementing our investment strategy.”

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution." In his book, "Big Macs & Our Pensions: Who Gets McDonald's Profits?" he looks at the ownership of McDonald’s and what it means for middle-class retirement income.

Visit Robert Abbott's Website


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