Value Investing Gets Its Comeuppance

by: Amit Chokshi, CFA

The past eighteen months were difficult for many investors and fund managers across a variety of strategies. The credit crisis resulted in major market stress that yielded correlations of nearly one across equities such that performance was largely dictated by the net long exposure of investors. Nearly halfway through 2009, investors seem willing to view 2008 as a “six sigma” year and probably have little interest in attempting to learn much from it. While in many cases all investors can do is throw their hands up in exasperation, the past 18 months have provided some interesting lessons to those in value investing circles.

Since 2001, value investing has experienced a surge in popularity. Part of this stemmed from the increased popularity of new, younger fund managers over the past decade. Fund managers like Bill Ackman, who was given a second life with Leucadia’s seed investment in Pershing Square, Mohnish Pabrai, and other value-oriented fund managers achieved rock star status in recent years. The status of many value fund managers was well deserved given their performance, but many of these managers were assumed infallible by the media as well as value investors. Value investing “tradeshows” such as the Value Investing Congress, where attendees fork over several thousand dollars to hear about choice investments held by some heralded managers, and various “value investing newsletters” further proliferated this notion.

None of these items was bad in isolation but in conjunction, value investing became institutionalized in recent years at both the fund manager and individual investor level. This resulted in placing many fund managers on a pedestal and forgetting the relatively short-length of some of their track records. In addition, it also greatly reduced two important qualities of value investors – independent, individual analysis and a healthy dose of skepticism – as many followers of these investors exhibited lemming-like behavior by following these investors into bad investments.

I started to realize that the value investing arena could suffer from some institutional biases in 2007 when I publicly wrote about why Pershing Square’s plans for Target Corp. (NYSE:TGT) were flawed. I received about 10 emails from self-professed value investors stating that my analysis was incorrect and that it was unwise to bet against someone as smart as Bill Ackman. When I asked them to point out flaws in my analysis, the email correspondence would ultimately end up with “Pershing Square manages billions and knows what they’re doing.” These emails reminded me of similar ones I received when I first began discussing Downey Financial Corp. (NYSE:DSL), as a potential short in late 2006. In spring 2007, Jim Cramer suggested it was worth over $100 in a buyout and I had been regularly discussing the downside inherent with DSL and received quite a few emails from Cramer fans telling me how wrong my analysis was. Surprisingly, the intensity of the defensiveness of the Pershing Square emails was at least equal to that of the Cramer defenders.

Another area of concern was that I found that the number of ideas openly discussed shrank amongst value investors and would center around what the upper echelon of fund managers were doing rather than actively analyzing stocks. The topic du jour was many times what Eddie Lampert’s next move with Sears Holding (NASDAQ:SHLD) would be and how “delighted” some investors were to have the opportunity to continue to buy SHLD at a discount, or how large a return Pabrai’s Pinnacle Airlines (PNCL) would generate. The “analysis” of these ideas by other fund managers and investors would generally parrot the known investment thesis but would offer very little additional insight or discuss the risks of these investments.

About five years ago, it was not uncommon to have a healthy debate on the merits and more importantly the risks of investing ideas among value investors. However, over the past 2-3 years I found myself to be the enemy in discussions when I would question the investment merits of some companies held by star fund managers. This became abundantly clear when I attended the 2007 New York City Value Investing Congress and was given quite a few quizzical looks by a handful of investors at a happy hour when I mentioned I would avoid PNCL, an idea presented by Pabrai as a possible 3-4 bagger when the stock was at $16-18. I’ve had more than my fair share of disastrous investments too, but have always welcomed a healthy debate on investments. I found that some investors in recent years took criticism of a potential investment as a personal affront to their idols.

Another area I felt exposed some vulnerabilities and/or laziness in value investors in recent years was the increased reliance on 13Fs by investors and fund managers for idea generation. For those that are not familiar, 13Fs are filed with the SEC by fund managers with generally over $100MM in assets. Following the investments of good fund managers can be useful but I found that in certain cases the basis for a lot of idea generation was simply copying what other fund managers were doing and that the actual analysis of the investments was given short shrift. Even worse, this was being practiced by many fund managers and was clearly evident as the 13Fs of a variety of hedge and mutual funds, irrespective of capital under management, would have the same holdings.

The reliance on 13Fs by fund managers and the increased level of cross-holdings among value fund managers were particularly troubling to me. This could just be a philosophical issue as some could say that we’re all in it to maximize gains and that if everyone thinks stock A is dirt cheap, then by all means, everyone should own it. This is certainly true in theory but I’m a bit more of a pragmatist. With 8,000+ stocks available, I find it hard to believe that an idea like SHLD, for example, would make the most sense for concentrated value fund managers that run under $100MM to $6B+. Yet this is generally what many 13F filings indicated in 2008.

For example, through Q2 2008, SHLD holders included Lampert, Pershing Square, Greenlight Capital, Pabrai, Fairholme, T2, Spencer Capital, and other value-oriented fund managers that control assets under the SEC filing requirement. What was interesting is that Pershing Square and Greenlight exited their SHLD position in Q3 08 and soon after it appeared as though other fund managers "got the memo" as the 13F of T2 revealed by Q4 08, it had also dumped its SHLD position. For me, the question is what value are some fund managers offering to their clients if in many cases a large portion of their portfolios are just copycats and tag-alongs? In many cases, these fund managers followed one of the star fund managers over the cliff as was the case with TGT.

Some of these firms manage $200MM or less and could really delve into areas where real value creation can occur in terms of small and micro cap situations but instead have glommed onto large caps that are widely followed. At times it seems many fund managers are quick to parrot Warren Buffett but have never considered what their idol would really be doing if he was managing $200MM. It’s unlikely he would be engaged in tagalong investing or would hold many widely known and followed stocks that are more efficiently priced than smaller opportunities.

Nonetheless, the purpose of this article is not to denigrate top value managers, but rather present some takeaways for individual investors and smaller fund managers. Nearly halfway through 2009 and following a powerful rally, investors are coming off a bit of a clean slate where many fund managers were brought low in the prior year and are now feeling -- right or wrong -- more confident. It’s important to note that while many stocks fell markedly in 2008, many will stay down or continue to decline due to the initial investment thesis being flawed, which ultimately comes down to overpaying for a specific asset. TGT could be a good buy at $35 but was hardly a “value” investment at $70. In contrast, SHLD might still be overvalued at $60.

The basic point of this rant is that individual investors and fund managers should stop idolizing the majority of fund managers and instead spend more time analyzing stocks on their own rather than reading up on what their favorite fund managers are doing. Investing is like any other skill and requires practice. It's not hard to find a lot of value investors that can tell me everything about Warren Buffett and the last ten stocks Bruce Berkowitz of Fairholme purchased, but might only be able to speak about 1-2 stocks at an in depth level. Once individual investors begin engaging in more thorough work on investments, their confidence will build such that they can openly question some investments and not follow fund managers into big blunders.

Another important aspect of research is knowing what a specific set of data can and can’t tell you. 13Fs only disclose long positions and many value-oriented fund managers engage in selling short. It’s often difficult to know what positions contributed to a fund manager’s returns. Being right when selling short can offset a lot of bad long investments, and not “bad” from the perspective simply of a stock going down but “bad” from the perspective of a flawed investment thesis. Unfortunately, with 13Fs, many investors are not aware of what is really the main engine driving returns.

Investors should also do their best to closely study the track record of their favorite fund managers. Many times, the bios of successful fund managers will state that the 5 year track record is 20% annualized or some sort of market beating figure. To the casual observer, all that matters is that the fund manager outperformed the market. In that case, that’s fine but if an investor is considering an investment in that fund, he/she should know what drove those historical returns.

Consider two fund managers that have five investments of $100 in each position for a total portfolio of $500. In five years, Fund Manager A has a portfolio is now worth $1,100 resulting in an annualized return of 22% while Fund Manager B’s portfolio is worth $950 with an annualized return of 17%. Someone reviewing the returns would probably view Fund Manager A as the superior investor. However, that’s not enough to make an informed decision. What if Fund Manager A’s portfolio was driven by just one holding? If one investment was a nine bagger, two were down 50% over five years, one was flat, and one was down 100%, would a prospective investor view Fund Manager A as a genius? What if Fund Manager B’s portfolio had one investment up 250%, two others up 50%, one down 50%, and one up 150%? Fund Manager A delivered better returns without a doubt but who would the prospective investor feel better investing with? These are important considerations prospective fund investors must consider to avoid backing the wrong horse.

In addition, value investors have generally crowded around the same ideas and consequently, it’s not mandatory that one invests with many value-oriented funds. This may sound crazy coming from a self-professed value investor and fund manager, but many times it’s being part of the right set of companies or in the right industry that benefits a manager. As a result, there could be a handful of managers that have had the same holdings that have outperformed over a period of time. By investing in that same group of fund managers, fund investors open themselves up to greater risk and unfortunately many investors learned that in 2008 when they realized managers like Wally Weitz, Bill Nygren, and dip-buyer Bill Miller had massive holdings in financials. This comes back to knowing what the manager owns and what has driven his/her performance. How many tag-along ideas are in a portfolio versus truly original ideas? If a manager is running $50MM in capital, does it make sense for this Buffett-follower to invest in megacaps and if he/she does, is that adding value to your overall portfolio which likely will include megacaps across other holdings?

Ultimately, value investing attracts followers because it works. Nonetheless, it’s been clear to me that value investing in recent years has suffered from institutionalization and from some of the same biases value investors are quick to point out with other investing styles. However, recognizing these shortfalls can help get value investors back on track and by broadening their horizons past what the Lamperts and Einhorns of the world are doing (and to be very clear, I think some of these guys are phenomenal investors irrespective of any short-term performance), value-oriented investors really have an opportunity to seize on a transition period in 2009 where they can capitalize on attractive ideas by doing their own work and also rebalance their portfolios from institutionalized fund managers to those that can be more creative.