By James Saft
March 5 There are two main ways to get paid as a
value investor: one is by avoiding the mistakes of your peers,
the other is by making some mistakes of your own.
Avoiding other people's mistakes is all about buying stocks
which are cheap but solid and letting the dividends pile up and
compound. Buy quality companies which are cheap and you, by
definition, miss out on Pets.com, or, dare I say it, Facebook.
In a very real sense, and I'll explain later, by doing this
you are generating a stream of returns based on other money
managers' fear of losing their jobs.
The alternative value strategy is to buy the downtrodden:
companies begging to be restructured or even gasping for air.
This can generate big returns but, obviously, means making
mistakes, suffering losses and, sometimes, losing your own job.
Andrew Lapthorne, a quantitative strategist with a value
bent at Societe Generale in London, frames this as being a
contrast between patient value investors and brave ones. He
describes patient investors as essentially taking advantage of
behavioral mistakes by other market participants, who buy the
expensive and glamorous stock of the moment. In contrast, the
brave, who buy distressed companies, are getting paid the kind
of premium that the efficient market hypothesis predicts: take
on risk, suffer volatility and get paid accordingly.
As for the risks of the two value strategies, they are quite
"For the patient value investor the risk comes from
underperforming a rising market and waiting for the next crisis
to demonstrate the strategy's downside resilience," Lapthorne
writes in a note to clients.
"The brave value investor requires capital to be put at
risk. Losses are absolute, not relative, and maintaining a
position despite mounting losses while waiting for a problem to
be resolved can be difficult. Historically this brave risk
premium is the best around, but keeping your assets and job in a
crisis can prove challenging."
It is more than a little ironic that career risk (the risk
of losing your job) is central to both strategies, but in
Some research has indicated that pressure to follow a rising
market, in essence career pressure, is part of the reason you
get an outperformance through value investing, as most
institutional investors are paid to beat a benchmark, making
them less likely to arbitrage unusually cheap or expensive
BEING EMPLOYED IS JOB ONE
Because many money managers feel they can't take the risk of
selling the expensive and buying the cheap because it causes
them to underperform in strongly rising markets, a value
investor, so long as he has a patient boss, can make a decent
The brave investor faces a different set of risks. Sometimes
investments in the cheapest stocks don't work out, quite
spectacularly. And sometimes even when they do, they for a very
long time can feel as if they won't.
Take, for example, shares in BP during the lamentable Gulf
oil spill. While it was easy to figure out that BP was cheap
when its shares more than halved while the spill was uncapped,
it was not in any way obvious that a low share price was going
to make a cap possible. You were forced to buy, if you wanted
to, and hope, in the meantime living with the risk that your
risk was, in a very real sense, uncapped.
A look at how these types of shares perform as a group over
time illustrates this.
Lapthorne and his team at SG have devised an index of high
volatility value shares, an equal weighted basket of the
cheapest 200 global stocks on five measures.
This index for the brave outperforms markedly an index of
cheap, sturdy high-quality stocks, but it does so with some ugly
periods of underperformance. Over 20 years to 2014 the SG Value
Beta Index returned 15.2 percent on average per year, against 12
percent for a quality income index and just 9.3 percent for a
benchmark global index.
However the maximum loss, or drawdown, was a breathtaking 62
percent, suffered during the recent crisis, as opposed to just
33 percent for quality income stocks and 51 percent for the
So, if you, or your employers, can live with the risk and
keep drawing paychecks, you likely can outperform.
The moral of the story seems to be it isn't just money that
makes the world go round, or in this case drives market pricing,
but more specifically it is a combination of how people get paid
and how they hold on to their jobs.