While it?s fun to write about razing villages and executing your enemies to get M&A deals done, such extreme violence is not everyone?s cup of tea.
Plus, you might just want to invest in companies rather than buying or selling them outright.
So if you dream of starting your own hedge fund or asset management firm one day ? or even investing independently ? you?ll need to learn about all the different strategies you might pursue.
At the top of that list is value investing, made famous by financial luminaries like Ben Graham and Warren Buffett.
Whether you?re interested in more passive strategies or you consider yourself a contrarian, there?s something for you in value investing.
And if you really are a barbarian and you?re interested in burning down villages and ransacking civilizations so that you can use the proceeds to buy your own country one day, there?s still a value investing strategy for you.
Why Value Investing?
The core concept is pretty simple: you buy stocks for less than their underlying values.
Then, once you hold onto the stocks for some period of time, you can sell them and earn a profit assuming that their share prices increase and approach the true underlying values.
Let?s say that a commercial bank?s stock is currently valued at 0.9x Price / Book Value and based on your value screening metrics, you think it?s worth 1.3x Price / Book Value.
Value investing would tell you to buy that stock because the market is undervaluing it.
Although the concept is simple, value investing is extremely difficult to implement properly and requires rigorous analysis to determine what the ?underlying value? of a stock is.
Thanks, Ben Graham
Back in the 1920s and earlier periods, investing focused mostly on bonds since common stocks were viewed as ?too speculative.?
Yes, those really were the 2 main asset classes: this was long before financial weapons of mass destruction, CDOs, and all the ?creative? inventions of the financial services industry since 1980 or so.
Since investors focused so much on bonds, common stocks were under-analyzed and that created many investment opportunities ? assuming you properly estimated the values of those stocks.
In this period, Ben Graham came along and earned a reputation as an up-and-comer on Wall Street by consistently finding profitable investing ideas ? and he decided to record his investment knowledge for posterity.
He started with a series of lectures at Columbia University, and later turned them into the seminal book Security Analysis in 1934.
If that book had never been released, ?investing? would still be viewed the same way as gambling today ? and your parents would be even more pissed off that you want to go into finance rather than becoming a doctor or lawyer.
He followed it up with The Intelligent Investor, which brought his investment philosophy to the masses; Warren Buffett later described it as ?the best book about investing ever written,? and I don?t disagree with that assessment.
Ben Graham?s students and followers went on to enjoy huge success on Wall Street by applying his philosophy, which is why the concept of value investing spread far and wide: you couldn?t argue with the results.
What Is Value Investing?
It?s easiest to think of value investing on a continuum from passive to active (yes, we?ll get to the part about razing villages and ransacking civilizations in a bit).
With passive strategies, you simply buy cheap stocks and wait for the market to recognize their full value.
On the other end, with active strategies, you buy cheap stocks and then attempt to ?make? the market realize the value of the stock by changing the company itself.
In the middle, most value investors use contrarian strategies.
Passive Value Investing
With passive value investing, you screen for undervalued stocks based on certain financial criteria, such as Price / Book Value (P/B) or Price / Earnings (P/E) ratios.
In Ben Graham?s day, these screens were often simple and involved only P/B ratios or simple comparisons of market value to net cash.
When you think about it, if you could find a company priced?less than the net cash (cash minus debt) on its balance sheet, your downside is minimal unless management is so incompetent that they destroy value. Ben Graham used this same simple process to great success for many years.
But then other investors started noticing what he was doing, and imitators sprang up ? and the number of stocks trading below their net cash dwindled to 0.
So over time, other, more complex value screens have emerged: one famous example is the Fama-French three-factor model to describe stock returns.
Rather than just using Beta to describe the returns of a portfolio or stock, as with the traditional CAPM model, the Fama-French model also adds in other factors such as whether the stock is a small-cap company and whether it has a high book-to-market ratio.
Investors continue to debate which screens ?work? most effectively and how complex you should make the screens, but the fact remains that value screens outperform over time.
Sometimes the exact metrics and screens change, but the value philosophy of buying only discounted stocks remains the same and continues to outperform the market.
What Firms Do Passive Value Investing?
Almost anyone could use passive value investing as part of their investment strategy, so it?s not limited to just pension funds / insurance companies / hedge funds or anything like that.
If you?ve ever invested in a stock because you believe it was undervalued based on a value screen and then left your investment alone, that?s an example of passive value investing.
On a bigger scale, there are plenty of asset management firms ?that use passive value investing ? a better-known example in recent years has been the rise of fundamental indexing. Traditional index strategies weight stocks by market cap, whereas fundamental indexing strategies weight by fundamental value metrics such as book value or earnings yield.
Contrarian Value Investing
Contrarian value investing is the most common type of value investing.
Most of the big names in value investing, from Warren Buffett to Seth Klarman to Marty Whitman, are of the contrarian type. Contrarian value investors take delight in zigging when the market is zagging; they like to buy stocks on the cheap when everyone else has assumed that the companies have died or are on their deathbed.
The idea here is that the market often overreacts to news or events ? maybe Apple missed its quarterly projected iPhone sales but then sold 4 million units of its new model in 3 days.
In that scenario, their stock price would likely drop as investors overreact to one part of the news and ignore other positive signals ? so the contrarian investor would pick up on that and invest in the stock as everyone else is selling it.
Academic studies have supported contrarian value investing and have shown that buying a portfolio of stocks that underperformed the prior year outperforms a portfolio of stocks that outperformed in the prior year.
If you want to be a contrarian investor, you need to be patient. If you get a rush off of day trading and investing based on momentum, this is a horrible strategy for you to use.
Just because you?ve found a stock that?s undervalued and that has been abandoned by everyone else doesn?t mean that the stock price will immediately go up just because you bought it ? it might take months or years for the market correction to occur.
Great companies that the market loves are often priced like great companies the market loves ? as Warren Buffett has said, ?You pay a very high price for a cheery consensus.?
So with contrarian value investing, you buy when the market is selling and wait for the market to recognize the true value of the asset you?ve invested in.
What Firms Do Contrarian Value Investing?
The most famous example, of course, is Berkshire Hathaway ? Warren Buffett has practiced contrarian value investing for decades, and in the wake of his success numerous imitators have sprung up.
Other well-known firms that practice contrarian value investing include Tweedy Browne, Paulson & Co. (yes, that Paulson), Oakmark, Oaktree Capital, and Third Avenue.
Once again, both asset management firms and hedge funds practice this investment strategy.
Insurance companies and pension funds tend to use asset allocation strategies rather than following the market quite this actively, so it?s not as common there (with a few exceptions, such as Swenson at Yale).
Activist Value Investing
Finally, what you?ve been waiting for: vanquishing your enemies to earn high returns.
Activist investing is similar to contrarian investing, except the companies you target are cheap because the management team can make changes to boost their value.
Let?s say that the activist investor identifies a conglomerate that has multiple subsidiaries in different businesses ? retail, consumer staples, and healthcare.
The investor might value each different line of business and determine that one of them ? consumer staples, let?s say ? is ?dragging down? the value of the entire company by under-performing and being valued at a lower multiple than the other segments.
So the activist investor might then acquire a small portion of the stock and then meet with the management team to ?convince? them to sell off the under-performing subsidiary.
Usually discussions ends there because public company CEOs rarely want to rock the boat and do something dramatic ? so that?s when the activist investor takes his case public and starts lobbying the Board of Directors to adopt his proposed changes.
If the management and Board refuse to sell off that subsidiary, then a proxy fight might result and the activist investor might bring their proposed changes to a vote of shareholders and persuade other investors in the company to join their side.
While it?s not quite the same as invading countries and killing your enemies, you can see how activist investing is the most aggressive of the value investing strategies: you come into direct conflict with the leadership of the company, and there may well be ?casualties? on both sides.
Keys to Success in Activist Investing
As an activist investor, you could propose almost anything to ?unlock? more value in the company you?ve targeted:
- Spinning off subsidiaries
- Using cash to buy back stock
- Selling the company to a private equity firm or another public company
- Rejecting an acquisition offer from another company
- Liquidating certain assets
- Changing the capital structure
- Issuing dividends or otherwise disbursing of cash
- Changing the management or Board or cutting compensation
You need to analyze every aspect of the company and situation in question and figure out which action would increase its value the most.
The whole process can take months, if not years. Even though you come into direct conflict with management, it?s more of a drawn-out war of attrition rather than a quick skirmish.
You need a lot of patience and persistence because management teams often defend the status quo at all costs ? even when everyone else knows they?re wrong.
And you need lots of capital because you need to control a significant enough portion of the company to make yourself noticed ? no one will care what you think if you only own 0.001% of shares outstanding.
When you?ve acquired over 5% of the company, though, your demands are taken more seriously.
What Firms Do Activist Value Investing?
Overall, fewer firms practice activist investing because it?s more resource-intensive and prone to failure; with other forms of value investing, you might lose money or not make as much as you expect, but you don?t spend years locked in a war of attrition with an entire company.
The most well-known activist investor is Carl Icahn, who has won Board seats at numerous companies and attempted to break up huge firms like Time Warner over the decades (sometimes succeeding at doing so).
Other examples of famous activist investors and hedge funds include Dan Loeb at Third Point, Bill Ackman at Pershing Square, and even ?boring? mutual fund managers like Bruce Berkowitz at Fairholme (see the St. Joe turmoil) can get into the activist business.
Activist investing is far more common among hedge funds than other types of buy-side firms because it?s such an aggressive strategy ? the average pension fund or asset management firm is not prepared to spend years staging a public battle with a company.
How to Break Into Value Investing
Regardless of whether you want to get into a value investing-based hedge fund, asset management firm, or anything else that manages money, you need the proper mindset.
If you lack patience and need immediate gratification, you?ll never make it.
How you get on the radar of these firms and land interviews in the first place is already covered in the hedge funds vs. asset management article, as well as all the other networking advice on this site.
Many hedge funds are secretive and list little to no information online, so you?ll need to be more creative and go through sources like LinkedIn to find names; it can be easier to find information on asset management firms, but even there you?ll have to do a lot of aggressive networking because smaller firms don?t do much recruiting out in the open.
Another strategy is to target the large asset managers like Fidelity and focus your efforts on their value-based strategies. Most of the big asset management firms have multiple strategies and ?value? is usually on the list.
In interviews, they will spend a lot of time not only assessing your investment ideas, but also assessing your personality ? even down to something seemingly irrelevant like your retail shopping habits.
When you pitch stocks in these interviews, you need to focus on investment ideas where the value investment philosophy applies: you shouldn?t go in and pitch an idea that depends on short-term momentum or volatility because they?ll assume that you won?t mesh well with their investing philosophy.
Instead, make a list of 2-3 stocks you think are undervalued ? based on value screening metrics, recent events or changes at the company, or the ability to unlock value through specific actions ? and explain what you see in each one, what the potential upside is, and what the potential risks are as well as how to mitigate them.
Even better yet, show them investments you?ve made in your own portfolio, explain why you made them, and how each one fits in with the value investing philosophy.
And be prepared for those seemingly unrelated questions on your behavior: if they ask you how you buy your clothes at the mall, what would you say?
If you don?t know the correct answer by now, you don?t understand the value investing mindset.
The only correct answer is, ?On sale. I only buy when what I want is on sale.?
What Next?
You can find tons of information online about value investing, but you?re best off going to the original source and reading Ben Graham?s The Intelligent Investor. Read and re-read this book if you want to absorb the full mindset and understand the fundamentals that will never change.
And if you still have your sights set on destroying villages and beheading your enemies to succeed, give up on investing and go into M&A ? or give Carl Icahn a ring, pitch your activist investing idea to him, and hope that he has positions available.
This is a guest post from Mike Moran, CFA, a portfolio manager at a long-only asset management firm. He started?Life on the Buy Side?to teach you what it?s like working in asset management, hedge funds, and more.
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