Sunday, April 13, 2008 2 comments ++[ CLICK TO COMMENT ]++

The Downside to Value Investing

Let me present some of my impressions relating to the downside of being a value investor. I personally don't consider myself a value investor, but am heavily influenced by it; I consider myself a contrarian with a value tilt. Now, the definition of a value investor varies greatly but one common characteristic I find in value investors is their avoidance of macroeconomics. This is the cause of the major downside to value investing.

Pure value investors do not pay much attention to macroeconomics because you can never predict the future--which is precisely what most of macroeconomics deals with. Who really knows if things are going to be much worse now than before? We are just pretending to be soothsayers, are we not?

The macro picture still enters the investment decision of value investors but usually with a lower emphasis. Warren Buffett, for example, doesn't care what the Federal Reserve does or what the future expectation of GDP growth in China is, but he reads a lot of industry journals (supposedly). So, he actually gets a feel for the macro picture from industry trends.

The downside of ignoring the macro picture (or at least not putting much weight into it) is that you will invest in seemingly questionable assets than can blow up. For example, if one looked at the macro picture in the US over the last few years, it would have been hard to invest in homebuilders (Bill Miller), building material suppliers (Warren Buffett), retailers (William Ackman), and bond & mortgage insurers (Martin Whitman). People wonder how these superinvestors can invest in those companies (PHM, CFC, USG, TGT, RDN, MBI, etc) and I suspect it's because of the de-emphasis on the macro picture. Having said all that, what seperates these superinvestors from newbies like me is that they can evaluate the value of the business to a reasonable degree of accruacy, and end up buying the business with a large margin of safety. If anyone thought about the importance of margin of safety, it is precisely in these circumstances where it helps.

In addition, value investors tend to miss "macro trends" which can yield hugely profitable investments. For instance, very few value investors have capitalized on the recent commodities boom. Yes, you had Warren Buffett invest in PetroChina and ConocoPhillips; yes, you had Jean-Marie Eveillard invest in gold; etc. But these investments are a small portion of their portfolios. Similarly, very few value investors (except Bill Miller) capitalized on the technology and internet boom in the 90's.

I personally pay attention to macro quite a bit. I likely miss out on a lot of opportunities this way, but I also avoid a lot of problems.

Before I get trashed, I should make it clear that I'm just pointing out the downside of value investing so that investors are conscious of what can happen with value investing. This post does not deal with the upside. Needless to say, the upside is far greater than the downside so value investing is attractive in the long-run.

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2 Response to The Downside to Value Investing

April 14, 2008 at 2:48 AM

I have to say, I don't really get your "macro trends" critique. The internet run-up was a bubble, and value investors are bad because the wouldn't have benefited from it? You should read MJW's letters from the time period, and after the bubble burst. And read the Janus letters after the bubble burst and they had to discuss their chasing of internet stocks to prop up their performance. Oops, did they ever discuss that?

April 14, 2008 at 10:44 AM

Good post John. My thinking is...

The tech sector was a bubble near the end but if you look at the whole trend from mid-90's, a lot of real wealth was created. Companies like Dell, Cisco, Microsoft, Intel, etc became large, solid, companies. Most value investors completely missed the creation of the modern tech industry. The bubble was near the end (say 1998 to 2000).

Similarly, a lot of value investors missed the current commodities boom. I feel like commodities are in a bubble right now (who knows?) but that wasn't the case a few years ago. Many value investors missed this "trend".

That's the flaw with value investing. You miss the large macro trends.

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