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%.