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Con air – A good investment strategy should admit its cons as well as its pros so here are value’s

23/04/2014

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

How might one characterise the ‘best’ investment strategy? After all, there is no such thing as an investment strategy that outperforms all the time – and, just in case you were about to make a joke about Bernie Madoff managing to do so, we would note, in the end, his approach did not work out well for either him or his investors.

Here on The Value Perspective, we believe the best investment strategy is not one that offers some unachievable dream of zero volatility or no periods of underperformance. It is not the absence of flaws that makes for the best strategy but an ability to lay out both the pros and the cons of the approach in advance of its implementation. So how does value investing measure up in that light?

We will focus here on the cons rather than the pros – after all The Value Perspective is hardly short of articles, such as Sticking to the basics, that explain how the approach outperforms over time. If we are going to be totally upfront therefore, what is the downside to value? Well, for one thing, it does not outperform all the time and, in particular, there are two environments in which it will struggle.

the first is at the tail-end of a bull market when the majority of investors are playing games such as ‘hunt the upgrade’ and ‘spot the M&A target’ – buying a business for a hoped-for earnings upgrade or take-out in the belief that, whatever they pay for the shares, someone will be prepared to pay a higher price further down the line.

At this point – when price and thus value cease to matter – value investors will struggle because they care about something that most people do not. Value investors will therefore find themselves left behind in a market that is rallying aggressively because they are in the minority and the weight of money is moving against them.

The other environment in which value investors will struggle is at the start of a recession since, driven this time by fear rather than greed, most people will now be selling irrespective of price. A recent example of this would be 2008 when the market decided the UK economy was in a bad way and, as a result, sold off indiscriminately anything exposed to the UK consumer.

At that point, you could buy some unbelievable bargains. however, just because a stock has fallen to an attractive price, that does not mean it has stopped falling – especially when people are selling irrespective of price – and so value investors will often buy into a business, as it were, too early. That can be painful until the market reaches an inflection point and start to rise once again.

So those are the two times when value will struggle and, while we are being so transparent and honest, we should also note that the strategy’s performance tends not to be smooth. More often than not, progress is volatile and value investors can find themselves questioning both the businesses they have bought and the approach itself. You can feel foolish – and you need to learn to live with that feeling.

Value investing inherently involves a willingness to deviate from the crowd and, because you will deviate on the upside some of the time, some of the time you will deviate on the downside. The reason you are doing things differently, however, is because that crowd is behaviourally ill-suited to value investing – frequently succumbing either to fear or greed. That is why the strategy has outperformed over 130 years of history – a significant pro to weigh against those three cons.

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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