The guest commentary below was written by Jesse Felder of The Felder Report.
Last week I argued that the greatest mistake value investors are making today is trying to find value within the most popular segments of the market – that is, anything within the major market indexes. Today, I want to discuss a related mistake I believe they are making.
Value investing, as it is widely understood as a discipline, involves owning cheap stocks. This seems very simple on its surface. Just buy the cheapest decile of the market based on some metric or another and you can call yourself a value investor. As my friend, Toby Carlisle, has demonstrated this has actually been a very worthwhile strategy in the past.
Where I probably differ with Toby is that I believe this sort of quantitative approach to value is not investing at all. While value investing seems very simple on its surface, the successful practice of it requires much more than just buying cheap stocks; it requires a great deal of thinking about individual businesses.
Ben Graham famously wrote, “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.” The only way to have confidence in the “safety of principal” in an individual stock over any period of time (aside from requiring a “margin of safety”) is to have a great deal of confidence in the strength and sustainability of its business model as well as management’s ability to maintain it. The only way to have this sort of confidence is to spend a good deal of time understanding the business and, most importantly, the major risks to its survival.
Similarly, Warren Buffett famously wrote, “If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.” To confidently buy something with the intent to hold it for at least a decade requires the very same sort of thinking about its long-term risks and the company’s probability of overcoming these.
Because buying a value-based index requires no such thought and thus carries no “safety of principal” it cannot be called investing at all. It is merely speculating on some factor or other due to its history of outperformance. In other words, quantitative value investing or buying a value-based index is just another form of performance chasing.
The true value that can be found in the markets today is that which lies outside of the purview of most popular strategy of the day, passive investing, and requires truly thinking about individual businesses. It is not the sort of thing that can be effectively captured by a computer model and it represents a minuscule slice of the equity universe.
Warren Buffett may currently recommend a diversified approach using index-based products but true investors may care to remember that is not even close to how he made his fortune. He did so by selecting a very small number of companies with unusual staying power and insisting on not overpaying for this rare quality. And when it comes to investing, as in every other area of life, actions always speak louder than words.
EDITOR'S NOTE
This is a Hedgeye Guest Contributor piece written by Jesse Felder and reposted from The Felder Report blog. Felder has been managing money for over 20 years. He began his professional career at Bear, Stearns & Co. and later co-founded a multi-billion-dollar hedge fund firm headquartered in Santa Monica, California. Today he lives in Bend, Oregon and publishes The Felder Report. This piece does not necessarily reflect the opinion of Hedgeye.
