The patient and the brave

March 5, 2014

(James Saft is a Reuters columnist. The opinions expressed are his own)

By James Saft

(Reuters) – 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 different.

“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 contrasting ways.

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 stocks. (pages.stern.nyu.edu/~jwurgler/papers/faj-benchmarks.pdf)

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 premium.

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 market benchmark.

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.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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