Value investors are feeling the heat – but that is integral to the strategy
This year has felt a hugely difficult time to be a value investor but, as this piece on medieval justice from January 2017 reminds us, value investing has to feel hugely difficult or else it would not work
Trial by ordeal was an ancient way of determining someone’s guilt or innocence by making them undergo a painful, often potentially lethal, experience. If they survived unscathed – or at any rate survived – they were deemed to be innocent of whatever charge had been levelled against them and, by the Middle Ages, the theory ran that this was because God was on their side and performing miracles to help them out.
We get to talk about the subject here on The Value Perspective courtesy of Think like a Freak, the third book in the Freakonomics series from economist Steven Levitt and journalist Stephen J. Dubner. In it, the pair seek to offer a blueprint for an entirely new way to solve problems – “whether your interest lies in minor life-hacks or major global reforms” – and, in a chapter on incentives, they touch on the work of Peter Leeson.
Another economist who takes the Freakonomics-type approach of thinking laterally about his subject, Leeson ranges far and wide through history – taking in pirates, witch trials and, yes, trial by ordeal. Using as his source material the Regestrum Varadinense – an ‘ordeal register’ from 13th Century Hungary – he considers the raw data of hot iron ordeals administered by the priests in one large church between 1208 and 1235.
The hot iron ordeal involved a defendant carrying a red-hot iron bar and, as with other trials by ordeal, tended to be used by the powers that be when there were no witnesses to a crime or when the word of the accused was deemed insufficient evidence. The belief at the time was, if the defendant was burned, they were guilty and, if they were not burned, they were innocent – but Leeson suggests the process was not quite so binary.
Of the 308 cases of hot iron ordeal recorded in the register between 1208 and 1235, 100 were called off with the iron bar left unused. The implication here, Leeson suggests, is that these were cases where the defendants knew they were guilty of whatever they were accused of and really did not fancy the idea of carrying around a lump of red-hot metal when there was absolutely no chance of God intervening to help them out.
In the remaining 208 cases, when the defendants actually underwent the ordeal, they were found to be guilty in 78 cases – so just 38% of the time – while the remaining 130 people apparently suffered no adverse reaction to hauling around a scalding iron bar. So we are either looking at 130 miracles, some very hard Hungarians or the possibility, as Leeson suggests, the priests were rigging the system.
If he is right and the priests either switched bars or did not heat them up so much if they had some reason to believe someone was innocent, then the way hot iron ordeal worked was rather different to what was widely believed among the citizens of 13th Century Hungary. Fear of what was to come weeded out those who knew they were guilty and then, of those who underwent the ideal, almost two-thirds emerged unburnt.
Of course, if the priests were smart enough to know the mere threat of the hot iron ordeal would encourage people to confess their guilt, then they were also smart enough to know something else: that a sufficient number of people would have to end up burnt in the ordeals that did go ahead to ensure only those who thought they were not guilty would elect to undergo one.
And this important point – that the process only worked because it seemed so scary – is something the hot iron ordeal has in common with value investing. The other day, I overheard some people discussing ‘the perfect screen’ – a way of whittling down stocks so as to offer investors a portfolio displaying a great combination of value, momentum and quality factors – and I thought, good luck with that.
Whether or not that might be a possibility with momentum or quality assets, we will leave to others, but one thing we do feel confident in saying, here on The Value Perspective, is that if value investing works, it is not as a result of certain factors or ratios or any magic formula. No – value works by buying the assets from which other people run away.
Investments that do not look like they are going to hurt you do not sort the wheat from the chaff. Any investor can buy into the latest must-have stock or trend but, precisely because everybody wants a piece, they do not offer excess returns over the long term – and, ironically enough, often these investments will leave you with your fingers burnt too.
But value works by buying the assets of which the wider market is overly fearful and being willing to undergo that ‘trial’ is what rewards value investors in the long term. Our faith in the discipline and in our numbers means we are prepared, so to speak, to grasp the iron bar, which will always appear red-hot – and will sometimes turn out to be precisely that.
Even in those instances, we know the pain will eventually go away and hopefully we will learn from our scars. And through it all we are reassured by well over a century of history that tells us that, although it may look dangerous and painful – indeed because it looks dangerous and painful – over the longer term, ordeal by value will help us outperform.
I joined Schroders in 2010 as part of the Investment Communications team focusing on UK equities. In 2014 I moved across to the Value Investment team. Prior to joining Schroders I was an analyst at an independent capital markets research firm.
The views and opinions displayed are those of Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans, Simon Adler, Juan Torres Rodriguez, Liam Nunn, Vera German and Roberta Barr, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated.
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