This week I came across an article referencing the recent Shareholder Letter of Longleaf, a value investing fund. This letter contains a familiar treatise on value investing vs growth investing and I wouldn’t say was particularly notable. However, I was struck by a couple of things in this letter. There is a strong emphasis on how value investing is contrarian and unpopular. There is nothing unusual about this view, but unlike other times I have seen it expressed, quality investing was characterised as the ‘popular view’, against which value investing was contrasted. As a self-described quality investor and contrarian, this made me sit up a bit and question: ‘who’s the real contrarian here?’
Here are a couple of quotations from the letter:
Many consider a single point estimate of value arbitrary. They view appraising a business down to a single number as a static waste of time, because real life is actually full of ranges and scenarios. They also disregard the idea of buying “60-cent dollars,” believing multiples do not matter as much as the franchise, moat, and/or competitive advantage that will drive the long-term outcome. We concur with the importance of business quality and strength, but the price paid also impacts results […]
[…] real value investing has a humility not present in today’s more popular method of heavily weighing the qualitative factors of the business and minimizing the importance of valuation. Paying a low multiple admits to not knowing the future. The discount helps guard against a negative outcome rather than banking on the future to turn out as we predict. Conversely, paying a fair or high price based on confidence in a business’s great prospects means more room to suffer if things actually go wrong.
I’ll just make a couple of observations on these paragraphs. First, the characterisation of a quality investor’s criticism of overly focusing on valuation multiples in the first paragraph seems pretty ‘on the money’. I would agree that valuation multiples are short sighted, compared to the qualitative factors that determine long term success, like competitive advantage.
Second, the apparent dichotomy put forward between quality and value investing is revealed almost immediately to be false. Apparently, the author concurs that business quality is important too, but the price paid ‘also impacts results’. I’m not sure anyone would disagree with this statement. Clearly, the underlying point being made is more nuanced – it’s about the relative weight ascribed to valuation multiples versus qualitative long term factors by different investors. I’m interested by the author’s suggestion that putting more weight on valuation multiples is unpopular: is it really? Why is there such a desire to appear contrarian anyway?
The virtue of being contrarian
Investors generally tend to regard being contrarian as a virtue. Most will be familiar with investment aphorisms about ‘going against the crowd’ or ‘buying when others are fearful’. Thinking independently and doing things differently is generally seen as a good thing.
However, this needs a bit of qualification. Being different for different’s sake is not generally a good idea. You probably wouldn’t support my idea for a ‘Truly Contrarian’ fund that goes against all conventional thinking and invests only in low quality, expensive businesses. While conventional wisdom is not always right, it is more often than not. It only pays to be contrarian in specific ways or circumstances, when the crowd is actually wrong. For contrarianism to be useful it needs to be defined in opposition to a mistake. In investing, being contrarian should be about exploiting the systematic behavioural biases of other investors.
Contrarian investment strategies
I would say that all good investment strategies should have a contrarian element, in the sense that they should exploit a systematic error or bias. This is because in general the market is an efficient mechanism for valuing businesses – obvious mispricings will be profitable opportunities and so will be arbitraged away. Systematic mispricing can only occur when investors make systematic errors.
Following from this, it is not necessarily the case that one strategy is more contrarian than another – there are several different dimensions to be contrarian in. Just as investors suffer from several different biases, it is possible to be be contrarian in several different ways.
This is part of what I think is behind the false dichotomy of value versus quality (or growth) investing. One way to be contrarian is to buy shares when they are most unloved and another is to buy shares whose long term growth prospects are perennially undervalued by short-sighted investors. These are not opposite strategies to one another, nor are they mutually exclusive.
This point can be obscured a bit by the description of value investing as ‘buying businesses for less than their intrinsic worth’. This doesn’t really distinguish ‘value investing’ from most other sorts of investing – it is a description of the basic premise behind any sensible investing strategy. I think the vast majority of investors would recognise that the price you pay and the quality you get are two sides of the same coin. All that matters is whether you are getting a good deal. Investing strategies just provide different ways of identifying circumstances when businesses are likely to be worth less than their intrinsic value.
So what behavioural biases do different strategies exploit?
Momentum investing may seem like an unlikely candidate for a ‘contrarian’ investment strategy. A widely held view is that momentum investing is the opposite of contrarian in that it involves chasing what is ‘hot’. However, this view misses that a large part of the reason momentum works is actually that powerful behavioural biases, such as the disposition effect and price anchoring, work in the opposite direction. This means that share prices respond to new information much more weakly and slowly than they should. See my post on momentum for more on this.
While value investing has a more obvious appearance of being contrarian, I’ve always been a little sceptical about how contrarian it actually is. Valuation multiples seem to be one of the main things investors look at and the idea of buying something when it is cheap or ‘on sale’ hardly seems contrarian. It’s one of the most fundamental ideas behind investing (or shopping in general for that matter).
However, evidence on the outperformance of the value factor over the long term is well-established, even if it has done less well in recent years. There is clearly something behind it. Value investing is about exploiting mean reversion – the tendency of prices to overshoot to the upside or downside before readjusting back to their long term level or trend. I think of the bias behind this simply as irrational fear, or to a lesser extent euphoria. Investors are prone to panic when news is bad and when they do prices can fall far in excess of what is rational. Value investing in businesses in cheap valuation multiples is a systematic way to take advantage of this. Another benefit of value investing is that discipline in assessing valuations also helps investors avoid ‘story’ or ‘glamour’ stocks.
The reason investing in the highest quality businesses delivers outperformance is that investors are prone to be short-sighted. Much more attention and emphasis is placed by investors and analysts on historical financial metrics and growth projections for the next three years, than on identifying whether the business has unique long term advantages. Trying to predict the long term is difficult and uncertain and this deters many investors from putting in much effort. Many are uncomfortable with the more qualitative assessment required to assess factors such as whether a business has a competitive advantage. Short-sightedness also leads investors to under-appreciate of the significance of compound growth in profits over the longer term and what this implies for valuations.
Polarised thinking is the real danger
The reality is that there are a number of contrarian investment styles. The main ones (quality, value and momentum) are well supported by empirical evidence across time and geography. Each can be fairly intuitively explained by investor behavioural biases (myopia, fear, anchoring and disposition), which we know consistently distort decision-making in a wide variety of contexts.
These biases occur along different dimensions and time periods. This means that they are not mutually exclusive – why capitalise on one systematic bias when you can capitalise on them all? I think there is a natural desire for investors to join a ‘contrarian’ tribe and define themselves in opposition to everyone else. I’d be very wary of this sort of tribal mentality and the polarised thinking it can lead to. It is a common phenomenon and a form of behavioural bias in itself.
I just stumbled across your blog and am enjoying reading it.
Do you think that over the last few years stock markets have over-rewarded your quality momentum approach relative to other combinations of the three performance factors? If so, does this not suggest that “the crowd” are generally pursuing momentum and quality strategies and “the contrarians” are focussing on conventional value right now? What does this mean for the future returns of the strategy pursued by “the crowd”?
Current conditions look like those leading up to the end of 2000 and Autumn 2007 to me and the subsequent bear markets delivered significant outperformance of value relative to quality/momentum addressing the imbalance that existed then as it seems to now.
Thanks for your comment. I think you raise some excellent questions.
As I say in the article, I don’t think the different factors are mutually exclusive or directly oppose each other. I wouldn’t say the markets have ‘over-rewarded’ my quality-momentum approach in recent years or that its outperformance necessarily shows the ‘crowd’ has been following it. Conversely, I would describe high quality’s continued outperformance in recent years as demonstrating that it was previously under appreciated and undervalued (as it is most of the time). Following quality is definitely becoming ‘less contrarian’ as valuation spreads are increasing, but it’s not necessarily overvalued yet.
I think whether you would still see quality investing as ‘contrarian’ (according to my definition) depends on your perspective of what valuation high-quality businesses should trade at relative to lower quality businesses. Are we currently still converging on the ‘correct’ valuation differentials or have we overshot already? In some ways this feels like a bit of an arbitrary question, as you need to forecast and discount the long term uncertain future and there isn’t a very clear objective benchmark to judge from.
It also depends on how tightly you define quality. My strategy is in principle all about finding the very small minority of the highest quality businesses. These are less prone to mean reversion as they are able to deliver sustained profit growth for far longer time periods than most investors anticipate. Historically, the highest quality business are revealed to have been undervalued almost all the time. Of course this is with the benefit of hindsight – identifying them correctly in advance is no easy challenge!
WRT the value factor, I would wholly agree with the suggestion that at some point the market will judge valuation differentials between high and low quality to have become too extreme and we will experience a period of ‘mean-reversion’, where conventional value will start to outperform and quality will do less well. I’d say it’s a question of ‘when’ rather than ‘if’.
‘When’ is a question that causes me quite a bit of concern. One that I don’t think anyone can really know the answer to with much confidence – perhaps we are already there? Possibly, but in my view we are more likely to be some way away. Valuations are still some way off those achieved in the dot-com bubble and I don’t think we have the same issue with the systemic build up of leveraged bad debt liabilities we had in 2008. However, you can see the storm clouds brewing on the horizon. Valuation multiples are pretty high and the US economy looks like it might be in the latter stages of the business cycle, with interest rates starting to rise, albeit from exceptionally low levels.
My perception is that the bull market still has some way to go and that there is still currently an investor bias towards excessive fear and pessimism (as I believe there is most of the time), though I don’t say this with a great deal of confidence. I am ready to accept that I may have got this wrong and if so hopefully I can react quickly!
PS from what I’ve read my understanding is that the best time to focus on conventional value is just after a market crash rather than just before, though probably this depends on the nature of the crash. I expect ‘economic-shock’ driven crashes (like 2008) would hit cyclical value shares especially hard – in which case the time to buy value is definitely after the crash. In rarer bubble-driven crashes (like dot.com) you might expect more of a gradual rotation from quality to value…