Much as we all like to see ourselves as individuals, the truth is that human beings tend to think about things similarly and investment is no exception. Here on The Value Perspective we have noticed that, whenever we are explaining the tried and tested benefits and process of value investing to whomever it might be – clients, journalists, random passers-by – they will ask similar questions at similar points in time.
So, for example, when we say the period of time we hold a stock for tends to be in the region of three to five years, people will often ask about the ones that take longer than that to come to fruition. What, they say, about the stocks that have not changed for the better after five years and so end up being in our portfolios for seven years or even 10? Isn’t that a problem?
Similarly, when the subject of ‘value traps’ – stocks that are ‘cheap’ for a reason – is raised, people want to know if it is not a problem when a company in one of our portfolios does not see the recovery we thought it would. Or when, in exchange for a very attractive valuation, we buy into a company with a bit more debt than it should have and it goes bust, again they ask – is that not a problem?
Now, in and of themselves, these are all perfectly fair challenges for which one would reasonably expect a value-oriented manager to have an answer. However – and we do appreciate the possible irony of value managers telling other people to look on the bright side of life – these questions all seem to come from a pretty negative angle.
That may just be the way people’s minds tend to work but the reality of value investing is that, for every stock idea that takes seven or 10 years to come good – or perhaps never comes good at all – there is one you think will take three to five years but in fact it is only 12 or 18 months before the market falls in love with it again and so you see the upside much more quickly than our typical holding period.
Again, for every stock that turns into a value trap, there will be one that reinvents itself, as businesses often can, to a much greater extent than we ever imagined would be possible at the start and so yields a much better return. And when we take on businesses with a bit more debt on account of their very attractive reward profile, yes, perhaps some will go bust but there will also be some that go up five or tenfold in value.
But people rarely focus on the potential for these positive surprises to happen, concentrating instead on the way things in the portfolio might go wrong. That, of course, is a perfectly reasonable concern, but the impact of the ideas that go wrong can be mitigated by diversification – having the odd company go bust or turn out to be a value trap is only a problem if you have too large a portion of your assets invested in them.
It is important not to let fears about potential stock-specific outcomes be a distraction from the bigger picture – namely, if you pursue a value investment approach diligently over the long term with a sensibly diversified portfolio of stocks, there is a compelling weight of historical evidence that suggests the good bits will outweigh the bad to deliver healthy returns.
In the long run, the questions of which companies go bust and which go up tenfold, which are value traps and which manage to reinvent themselves are all irrelevant. All that matters is how these ideas come together as a group to deliver investors with an overall return on their money.