This is a story about value investing and risk: specifically, the risk inherent in value investing and how to manage it. As with many things, value investing is perhaps best understood by starting with what it isn’t; it’s not growth investing. Growth investing is the anticipation that a given company’s earnings will increase under the almost always accurate theory that when earnings rise so does a firm’s stock price. The time frame during which most growth investors expect this anticipated earnings growth is typically measured in days, weeks or occasionally months, raising the question of whether it might be more accurately deemed speculation, rather than investing at all.
Value investing, on the other hand, is “investing” in the truest sense of the word, and value investors are, at least to my mind, at the top of the investment heap. Through diligent research and keen insight, value investors identify companies that have been undervalued by the rest of the investment community. That is, they believe the general consensus of the market is wrong about the underlying value of a company’s stock, and then put their (and often, other people’s) money where their mouths are. The success of their investments is dependent upon the rest of the investment community admitting their mistake in the future by driving the price up.
And there’s the rub: Rather than a relatively quick spike in earnings that is obvious for all to see, value investors usually have to wait months (if they are lucky) or even years for the market to recognize the value they correctly identified early on. Value investing is not for the faint of heart, with the strength of their investment convictions often tested by more short-sighted investors, impatient bosses and the waning of their self-confidence. The history of investing is littered with value managers (and ex-value managers) who succumbed to the pressure to sell a correctly valued position before the market vindicated them.
Risk, of course, is a conundrum of its own. In the investment world, we tend to talk about risk as if it were just one thing, as measured by price deviation. For investors with very large portfolios and very long time horizons, standard deviations and price correlations probably do accurately describe their risk. But most retail investors don’t see risk that way. For them, risk is the prospect of losing their money, a specter that is kept at bay only by investments that go up.
That brings us to the additional risk in value investing: being right while everybody else is wrong and watching your investment languish—or even lose value—while you’re waiting for them to catch up. Again, we in the advisory community tend to talk about the relatively low correlation between growth and value returns as a good thing, but investors often don’t have the perspective or the patience to see it that way. Consequently, they can be easy marks for salespeople who claim an ability to predict which asset class is poised to outperform.
To talk about how value managers can reduce the risk of long-term portfolio drag, I recently talked with Brien O’Brien, the CEO and president of Advisory Research Inc. in Chicago, Ill. ARI is a dyed-in-the-wool value investment house with some 37 years of experience searching out undervalued stocks that don’t take too long to realize their true value. In 1987, the firm started using its proprietary bottom-up strategy, designed to mitigate the risks that result from the divergence between underlying investment values and the market’s often-lagging valuation. Currently, ARI manages $9 billion, largely for institutional investors such as banks, insurance companies, and corporate, state and local government pension funds.
The firm’s strategy appears to succeed in tightening the performance range of value investing: From Jan. 1, 1987, through June 30 of this year, ARI’s aggregated portfolios have captured 107% of the up markets in the Russell 2000 Value Index, while losing only 79% of the down markets. On a quarterly basis, they’ve outperformed the Russell 2000 Value Index 63% of the time (71% of the rolling one-year periods, 93% of the rolling three-year periods and 100% of the rolling five-year periods), with an average outperformance of 5.1% and an average underperformance of -2.5%.
To get that kind of consistency, O’Brien and his team employ a Warren Buffett-like approach to identifying opportunities, with less emphasis on brand and more weight on downside protection. “Buffett puts more value on the brand,” said O’Brien. “We tend to look at asset values to reduce our risk exposure, and, of course, we emphasize small- and mid-cap value companies. For our bottom-up analysis, we do all of our own research; we don’t use any Wall Street research at all. We want unbiased thinking. And we don’t look at future profit projections; nobody’s smart enough to predict the future. Instead, we concentrate on what we can really know about a business: to identify stocks that have limited downside risk, with significant assets on the balance sheet and a management team that will utilize those assets to the benefit of the shareholders.”
In addition to substantial net asset value, O’Brien believes that the key to reducing the risk of value investing is a strong identity of interest between a company’s management and its investors. “We put a lot of emphasis on our management interviews, in which we’re looking for two things,” he said. “First, we’re looking for a burning desire to be successful in senior management. Then, we look for a commitment to shareholders.”
To support their positive impressions from good management interviews, the ARI folks then look to a company’s track record in effectively allocating resources to achieve growth and increased profitability. Finally, they have to identify “a catalyst that will unlock the value on the balance sheet.” That is, they want to see a concrete strategy designed to generate additional revenues and profitability.
Next, ARI looks to the overall composition of its portfolios with an eye toward maintaining a broadly diversified sector balance. Typically, they take positions in between 35 and 50 companies, with not more than 40% in finance and 20% each in other sectors. They stay fully invested as much as possible. On the sell side, their discipline is to sell stocks when their full value has been realized.
“We take a Darwinian approach to our portfolios,” said O’Brien. “We constantly invest in the best opportunities we see and sell the weaker stocks. We have some stocks that we’ve owned for many years, where management has shown the ability to keep growing their balance sheets. That’s the ideal situation. If we think a firm has reached its full potential, it’s time to let it go. We also sell stocks if the company is acquired, if there is news that alters our original investment thesis, or if management is unable or unwilling to unlock shareholder value. We think it’s vital to avoid the value trap: when you have dead money that’s going nowhere. ”
About eight years ago, ARI began applying its small- to mid-cap value investing strategies to international markets as well. There they invest in small and midsized global companies that are based in developed Asian countries like Singapore, Japan, Hong Kong or Taiwan, trading on the established exchanges in those countries, but doing a majority of their business in emerging markets. “By approaching emerging markets and their potential for double digit growth this way,” said O’Brien, “we limit the investment risk and regulatory concerns associated with investing directly in the emerging space while gaining most of the upside potential. It lacks some of the sexiness of emerging markets, but lessens the effect of macroeconomics.”
In March 2010, ARI began offering its value strategies to retail investors through independent advisors in four mutual funds: All-Cap Value (ADVGX), Global Value (ADVWX), International Small-Cap Value (ADVIX), and International All-Cap Value (ADVEX). These funds are designed to give clients much of the upside of small-cap stocks, both here and abroad, while mitigating some of the downside risk in the same ways that institutional investors have been doing for decades. Sure, there probably will be periods of underperformance while waiting for the markets to catch on to the real values, but ARI seems to have come up with a formula to shorten them considerably. “As value investors, we still need to have a thick skin,” admitted O’Brien. “Sometimes you won’t have the sexiest product in the room.”