Value Investing: wasn’t meant to be easy

The result of the demise of value investing and investor withdrawals has been financial erosion, stressful to us all. And there is no real indication that a quick end is in sight.

And what do I mean by, “there is no quick end in sight?” What is “end” the end of? “End” is the end of the bear market in value stocks. It is the recognition that equities with cash-on-cash returns of 15 to 25 percent, regardless of their short-term market performance, are great investments. “End” in this case means a beginning by investors overall to put aside momentum and potential short-term gain in highly speculative stocks to take the more assured, yet still historically high returns available in out-of-favor equities.

There is a lot of talk now about the New Economy (meaning Internet, technology and telecom). Certainly the Internet is changing the world and the advances from biotechnology will be equally amazing. Technology and telecommunications bring us opportunities none of us have dreamed of.

“Avoid the Old Economy and invest in the New and forget about price,” proclaim the pundits. And in truth, that has been the way to invest over the last eighteen months…

I have great faith though that, “this, too, will pass.” We have seen manic periods like this before and I remain confident that despite the current disfavor in which it is held, value investing remains the best course … The difficulty is predicting when this change will occur and in this regard I have no advantage. What I do know is that there is no point in subjecting our investors to risk in a market which I frankly do not understand. Consequently, after thorough consideration, I have decided to return all capital to our investors, effectively bringing down the curtain.

Don’t panic. That’s not me talking.

It’s famous hedge-fund manager Julian Robertson, announcing the closure of his highly successful Tiger Fund in March 2000.

An early investor in the Tiger Fund made 85 times their money in the two decades prior to its closure. That wasn’t enough. A few years of poor performance in the tech bubble led to a wave of redemptions that was too powerful to resist.

It’s probably no coincidence that it has been a full generation but, almost twenty years later, value investing is going through another crisis of confidence. While Neil Woodford might beg to differ, it’s a crisis that is particularly severe in our home market of Australia.

In recent months, fund managers including Adam Smith Asset Management, Sigma Funds Management, JCP and Kis Capital have all pulled down the shutters or suffered significant outflows. The ASX has the most expensive growth stocks in the world and, once again, everyone is questioning whether value investing works in the modern economy. Even some of its more loyal advocates are concluding that, no, it does not.

Concentrated investing is dead

This has little to do with the value versus growth argument that has been raging in recent years. While “value” has been underperforming “growth” since the financial crisis, I’ve written a lot about the stupidity of distinguishing between the two.

Future growth in cashflows is an important component of any business valuation. Value investors should and do buy businesses that grow. Our specialty has historically been underperforming businesses that we think can resurrect themselves. Plenty of successful investors have made their returns finding businesses where the growth prospects are underappreciated. I’d still call them value investors — they are trying to value businesses and buy them for less than they are worth. They are simply using higher valuation metrics because they think the profitability is going to grow significantly.

In today’s market, we are all losing out to the speculators.

Here is a list of ASX-listed companies with less than $50m of revenue and market capitalisations of more than $500m. Excluding mining, oil and gas and investments companies, there is a round 10 on the ASX that meet that criteria. The combined market capitalisation is more than $10bn (that’s billion, with a B). As a group, these companies lost $227m in the most recent 12 months, so we won’t bother with earnings multiples. The average ratio of total enterprise value to revenue is 71 times.

Well done if you owned them a year ago. The 12-month share price movement for this basket of stocks averages out at 186%.

This speculative pocket of the market — there are many more than these 10 — is a bubble. I’m happy to be on the record saying that.

Bubbles don’t cause sensible fund managers to shut the doors, though. And there is an aspect to this period of underperformance that is meaningfully different to the tech bubble.

This time around, the market rally has also been lifted by a dramatic decline in long-term interest rates and a correspondingly large rally in Australia’s dividend-paying blue chips. If you own the index, driven by banks and the large miners, you are also up 20% this calendar year alone.

Index investing is doing well. Speculative gambling is doing well. Is it any surprise that clients are leaving active managers in droves?

Unfortunate side effects or essential prerequisites?

Since we started Forager almost 10 years ago, we have told our investors to expect significant periods of underperformance. That’s one promise we have delivered on over the past year. The net asset value of the Australian Shares Fund is down from more than $1.82 a year ago to $1.30 today. Factoring in last year’s $0.21 distribution, that’s a 19% decline in a market that has risen 12%. And the market price that was trading at a premium now trades at a discount to the net asset value, exacerbating the decline for those watching the traded price.

We have made genuine mistakes over the past year. Part of our poor performance has nothing to do with industry turmoil. But periods of dramatic underperformance like this are not just part of investing with us. They are an essential prerequisite to future outperformance.

Hard to compete in a rational market

We have been able to earn decent returns since the founding of our business almost a decade ago, despite a woeful past 18 months. Most of the performance has come in smaller stocks where there is less institutional competition. That’s a reflection of the fact that for every buyer who thinks they know something, there is a seller who thinks they know something at least as well.

I’m not willing to back myself in a battle of wits with Julian Robertson. Which is why we have capped the funds under management in our Australian strategy at $200m.

Once in a generation, though, people as smart as Julian Robertson are forced to sell us stocks that they know full well are screamingly cheap. These market dislocations don’t just coincide with a loss of faith in value investing. They arise because of it.

We still have almost 20% cash in the Forager Australian Shares Fund and I want to see it put it to work. There are quite a few attractively priced small caps in the portfolio and we have been adding selectively as the value fallout spreads. What I’d love to find for the remaining 20% cash is some great businesses, preferably larger than the average stock held at the moment, at wonderfully cheap prices. That would set the portfolio up perfectly for the inevitable recovery and, in its absence, a higher dividend yield than we have today.

As unpleasant as the past 12 months has been, those dislocations are not going to arise without a further loss of faith.