Monthly Archives: February 2013

The Pain of Value Investing

“Value Investing is pain, Highness. Anyone who says differently is selling something.”

— The Dread Pirate Roberts

“The Princess Bride” is one of my family’s favorite movies.  At any point during the last decade or so one could hear someone in the Goodson household quoting any of the famous lines from it.  From random shouts of “Inconceivable!” to a heavily accented, “Hello. My name is Inigo Montoya,” the lines from this charming film would fill our home with warmth, humor and much laughter.  Even now whenever I hear someone end a sentence with “mean it,” I reflexively think to myself, “Anyone want a peanut?” In my opinion, it’s one of most entertaining movies of my lifetime.

The original quote from the Dread Pirate Roberts in the movie is “Life is pain, Highness.  Anyone who says differently is selling something,” which is, in my view, an amazing quote worthy of a philosophy textbook.  My alteration of it was inspired by a quote from a famous value investor, Jean-Marie Eveillard.  He was cited in a recent Wall Street Journal article saying, “Most people aren’t cut out for value investing, because human nature shrinks from pain.”  This is something I have been trying to articulate for years.

Conceptually, most people understand buying something at a discount, or when that something is on sale.  Yet, when it comes to stocks, this notion is much harder to implement.  Most value stocks trade below fair value exacting because they have something “wrong” with them.  These “flaws” usually turn off the average person (“Why not buy something better?” they would argue), and often turn on the value investor.  This is why most people loved Apple (AAPL) at $700 (“The company could do no wrong” was the consensus view), and loathed Avon Products (AVP) at $14 (ousted CEO, bribery scandals, dividend cut, etc.).  As shown below, AVP has outperformed AAPL by near 60 percentage points over the last six months.

AVP was a classic value stock.  But what about the pain of value investing?  Let’s suppose that AVP’s share price had gone down over the last six months.  Anyone holding it or recommending it would look doubly foolish. Not only did you lose money, but you lost money on a stock that was “obviously” troubled and deemed likely to disappoint.  This is why the average individual investor is likely to bail on value investing at the first sign of trouble.  The average person cannot tolerate the pain of owning something that looks ugly and is losing money.  In some perverse way, it feels better to lose money owning Apple than in some other less quality name.

Studies have shown that value stocks have outperformed growth stocks by an average four percentage points per year since 1926.  Yet, most individual investors who buy mutual funds specializing in value investing tend to do much worse than this. Why?  They tend to bail on these funds whenever they underperform.  Human nature is averse to pain.

My favorite value investing story comes from John Neff.  In the early 1980s he began buying metal stocks – gold, silver, nickel, iron, etc.  He felt that all of these stocks were incredibly cheap relative to his estimate of fair value.  He continued to buy them while his fund lagged the broad market for about 3 years.  Then, all of sudden, the market found favor in these names and they went up something like five-fold in a short period of time.  For years he was tagged as being “wrong” on his metals call, when he was just “early,” something we often see with value investors.  His long-term track record is a clear testimony of his approach to value investing.

I consider myself a value investor, and have had my fair share of feeling apart from the consensus view.  For those willing to stick to the game plan and ride out the hard times, I believe value investing can be a very rewarding way to invest.  Maybe value investors should adopt a new slogan, “No pain, no gain.”

The Only Game in Town

During the course of my career, I’ve a heard a lot of Wall Street stories.  Not surprisingly, some of the best ones have to do with investing.  One of my favorites is about the junior trader who bought something like $60,000 worth of leveraged puts on the S&P 500 in the middle of October 1987.  I worked at the same firm at the time, so this fellow’s fame quickly spread.  He closed out his position a few days later, took his $7 million profit and retired from the business!

Another one features a “little grey-haired nun.”  One of my colleagues, who was a seasoned investor, served on the board of some endowment fund for a non-profit organization.  Also on this board was in his own words, “a little grey-haired nun.”  As the board met and began to consider the fund’s asset allocation, the “little grey-haired nun” argued strongly for a higher exposure to stocks because, in her own words, “everyone knows the stock market is going up.”  My colleague concluded that this was a classic signal of a market top and argued to reduce equity exposure.  His views were overridden, but he was able to make a tidy profit by buying some puts in his personal account following this meeting.

Another time in the late 1990s, I spoke at a huge regional conference of stock brokers in Atlanta.  My discourse on the Asian markets was met with polite, but mostly indifferent attention.  The most popular speaker was the young fellow who preached with great enthusiasm the merits of buying tech and telecom stocks.  The crowd was electrified.  One could have mistaken him for Elvis or the Beatles in their heyday.  The next speaker was our biotech specialist who had the best line of the day, “The best TECH stocks are biotech stocks!”  He too had the brokers going bonkers.  The final speaker was the oldest person in my group, someone (unlike the previous speakers) who had actually seen a bear market and understood the concept of valuation (something that was quite out of favor in the late 1990s).  He spoke of the merits of stocks with low betas and high dividend yields.  I thought his remarks were very sensible and intelligent.  The crowd all but ignored him.  I thought this very ironic when after only a few quarters all the tech, telecom and biotech names touted at this conference were down 50-80%, the stocks recommended by the last fellow were all clear winners in a relative sense.  This experience highlighted to me the idea that it is easier to sell someone a stock that “makes sense” than to sell them something that will make them money.

Just recently I heard someone remark that they were buying stocks because they were “the only game in town.” That is to say that the alternatives (cash, bonds, commodities, etc.) were much less attractive.  In my opinion, this is a very tepid reason to buy any investment.  I’ve been of the opinion that stocks have been very attractive relative to bonds, cash and commodities for many years.  There have been times when I felt very much like a voice in the wilderness for my opinion.  There have been occasions when my confidence was nearly shattered by the bearish gyrations of stock prices.  Yet, to this date, my bullishness has been well rewarded.  The stock market has been able to recover from its “Great Recession” lows and have provided healthy returns to investors over the last four years.

Only now, after the market has risen over 100% am I hearing comments like “I’m buying stocks now because they are the only game in town.”  I’m reminded of Sir John Templeton’s oft quoted saying, “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” Perhaps we are seeing this bull market shift from its “skepticism” phase into its “optimism” one.  One can also make the case that individual stories/companies are driving the market more than macro factors.  It’s become more of a “stock picker’s” market.  I still see good upside in stocks from here, but I am keeping a careful eye on retail investor sentiment for signs of euphoria.