By David Kaiser
When investors decide to supplement their core equity exposure with an allocation to a value stocks strategy the next allocation decision they must make is about which investment approach to choose. Investors should think through the implications of selecting one approach over another; but the value investing strategies they will come across are far from being the same. With this comes variability in the number of risk elements one strategy may have to face and overcome versus another.
We call this the ‘How much has to go right’ portfolio management challenge.
There are a number of ‘How much has to go right’ portfolio risk exposures choices allocators should be aware that they are making when choosing among value equity portfolio managers and their differing investment processes.
Portfolios largely dependent on holding companies that suffered company-specific setbacks vs. portfolios whose company holdings likely did not.
Manager willingness to allocate to companies that lack profitability and other important metrics vs. those requiring company strength characteristics.
Duration risk — There are essential actions that impact the duration needed to achieve desired capital appreciation. A basket of stocks that needs to recover from company-specific setbacks before marketplace perception of those businesses turns positive will likely require a longer holding time period than a basket of stocks that does not need to recover from setbacks, as they await marketplace perception to turn positive for them.
Value strategies employing traditional fundamental-based analysis, relying on the manager’s subjective evaluations of companies, moats, management, competitive dynamics and long time-horizon forecasting of market conditions vs. strategies where stock selection and portfolio construction decisions are solely driven by conducting objective, data-based evaluations of companies and their combined characteristics at the portfolio level.
Most of these ‘How much has to go right’ portfolio risk exposures choices can be categorized into one of two camps. We classify these as Turnaround Value and Clean Value.
Turnaround Value
Turnaround Value is our name for what investors have typically come to expect of traditional value equity investing strategies. The portfolio manager follows the traditional, analyst-driven, fundamental investment approach where reliance on expertise and subjectivity is high and prognostication about macro trends and a company’s abilities to better its situation is explicit and central to the investment process being deployed.
The focus of such stock picking and portfolio construction is on companies that often suffered one or more business setbacks. The stocks are cheap because something is genuinely wrong right now: declining revenue, margin compression, excess leverage, a broken product cycle, or weak management/capital allocation. The market is not necessarily making a sentiment error; it is pricing in real, current business problems.
With a Turnaround Value portfolio approach to investing, an event must occur at companies held in the portfolio that fixes one or more problems they have in order to improve the companies’ conditions and move them into Turnaround successes.
Further, a company in need of a Turnaround usually needs actions to be taken to enable a setback situation to get fixed. Next, it requires time for the fix to be carried out. And then, assuming success in resolving the company’s problem(s), it will take time for the marketplace to recognize and appreciate the improvement to the company’s condition.
This could require a series of successful judgment calls by a portfolio manager on what could be complex, event-driven catalysts.
Therefore, generally speaking, there is additional potential added duration risk that must be accepted to buy and hold stock of a company in need of ‘repair’ as compared with potentially allocating to companies not in need of a Turnaround. This is another risk exposure the prospective allocator has to consider when evaluating value strategies from different investment firms.
Add to this other investment strategy risk considerations: how the Turnaround Value portfolio manager assembles and manages his or her basket of stocks: portfolio construction, weightings, sector exposures, and how and when they might rebalance the portfolio.
Might there be an alternative investment approach to value-oriented equity investing that has fewer ‘How much has to go right’ portfolio risk exposures? We believe the answer is Yes. We call it the Clean Value approach to value stock investing.
Clean Value
A Clean Value approach to value stock portfolio management has the potential to avoid the four aforementioned ‘How much has to go right’ portfolio risk exposure issues.
This is important because the fewer ‘How much has to go right’ portfolio risk exposure issues an investment strategy faces the greater its potential to succeed.
Said another way, these are value equity investment process considerations that fit with a comment Warren Buffett is credited to have made: “An investor needs to do very few things right as long as he or she avoids big mistakes.”
So, how do we define a Clean Value approach to value equity investing?
It focuses on the quantifiable, current company characteristics numbers a company has already produced that document how well it is running its business.
We believe that applying data-based multi-factor analysis filters to a value stock universe can help identify undervalued companies that already possess quantifiable company strength characteristics that equate with high quality, and usually do not require having some company-specific event driven Turnaround success to become quality companies.
Importantly, this is all without needing to conduct subjective analysis and make subjective decisions about a company’s business, its management, its industry or non-company specific global macro factors that may have an impact on the company.
With the Clean Value approach, model construction is the one area where subjectivity comes to play: deciding which quality and value metrics to use and how to combine and weight them in multi-factor analytics for screening the value investment universe and selecting stocks for the portfolio, and setting rules for when to sell positions, and when and how to rebalance or refresh the basket of holdings.
Clean Value differs from traditional systematic value investing
Systematic-based value investing strategies tend to rely on the statistical tendency of cheap stocks, as a group, to outperform expensive stocks over long periods, based on academic factor research. Here, value may be treated as a measurable factor (e.g., low P/B, low P/E, low EV/EBITDA) applied mechanically across thousands of stocks, and the stocks held may fit what some allocators may categorize as being broad value-factor investing or deep value. While no individual company narrative is required, company quality factors can be lacking and, as above with the fundamental based stock analysis and selection approach, a Turnaround success is needed to drive the stock performance for price appreciation.
With Clean Value investing, quality serves as a filter and company strength characteristics are a requirement
It is said that there is a natural negative correlation between traditional value investing and traditional quality investing. The traditional value stock universe includes companies with lower quality fundamentals, some of which are value traps. In contrast, the quality focused investing universe includes companies with strong financial health and performance metrics, but within that has many fully valued and expensive, richly-valued companies. Traditional quality focused investing portfolios takes the allocator into the world of growth stock investing, growth at a reasonable price (GARP) investing and growth at any price investing. No value investing there.
This is why combining the two — quality plus value — becomes interesting to investors as quality can act as a filter that separates genuinely undervalued companies from value traps and gives the catalyst for price appreciation potential.
Perception Turnaround, Not Company Turnarounds
So, what must go right for such a basket of Clean Value stocks where data-documented quality and value combine? The Turnaround that is needed is one of investor perception; recognition that holdings in a portfolio of value-priced, profitable companies that have not suffered company-specific setbacks from which they would have to recover can offer a lower risk means of taking a value equity exposure. As savvy investors will appreciate, an investment strategy facing a shorter ‘How much has to go right’ list of performance challenges is likely a more prudent choice than a strategy that must overcome a larger list of ‘How much has to go right’ performance challenges. With taking a Clean Value approach, fewer things may need to go right for growing value equity exposure portfolio returns.
David Kaiser
Managing Partner & CIO
Methodical Investments
David Kaiser has over 20 years of industry experience and is the founder, Managing Partner, and CIO of Methodical Investments, a different type of value investor. We take a proprietary, data-based fundamental analysis approach to small and mid-cap value investing. Our investment process filters, screens, ranks and re-ranks companies within the SMID-Cap value universe to identify those possessing what we believe to be the strongest combinations of operating and valuation metrics. We believe a satellite allocation to our portfolio has the potential to diversify an investor’s core equity exposure and deliver stronger risk return characteristics and greater catalysts for price appreciation than the value benchmark.
