February 19, 2013
Value traps are more prevalent
Seth Klarman, the highly regarded manager of the value-oriented Baupost hedge fund, has warned of an especially dangerous value trap that occurs during times of distress: the low prices of value stocks, rather than being bargains, could be market forecasts of deteriorating business conditions.
Southeastern’s outperformance of the market since March 2009 may, in part, be due to its wariness of increased value traps. Harper said that following the financial crisis, the fund’s managers did not normalize revenues or margins in their appraisals. They assumed that businesses had stabilized at their then-depressed levels.
“This helped us avoid the value traps from deteriorating conditions that Klarman described in the post-2009 period,” she said. “Perhaps this is a part of the explanation for our outperformance versus peers.”
Security selection has become more difficult
By pushing investors into riskier assets, the Fed has increased the demand for – but not the supply of – equities. Some might contend that imbalance between supply and demand has inflated prices, reduced the margin of safety that value investors demand and made stock-picking more difficult. The success of value investing over long timeframes has attracted more and better-funded practitioners, and that competition has intensified as a result of monetary policy.
The difficulty in selecting securities is illustrated in the valuation of Berkshire Hathaway, which is a top-10 holding in Weitz’ fund. To determine Berkshire’s fair value, Weitz said it is necessary to understand the value of the insurance float and the wholly owned subsidiaries. But he said he relies on the market to correctly price the subsidiaries and for those prices to be reflected in Berkshire’s stock. Those valuations did not increase over the time period we studied.
Harper echoed the sentiment that security selection has become increasingly difficult. Active equity managers have tended to favor stocks such as healthcare and consumer staples that are seen as more stable and “tend to fall into the growth camp,” she said.
Successful value investors must be patient, and one explanation for the underperformance is that the time period we studied was not long enough to allow the values of the holdings in the funds to realize their full potential. Perhaps three years is too short a time for evaluating such a long-term strategy, and the expected rewards could appear in the future.
Indeed, since trading at $126,900 in November 2012, Berkshire Hathaway’s price has increased to nearly $150,000 today. In Harper’s case, she noted that some of those stocks hit hardest in 2008 were among those that have more than doubled since March 2009, including Liberty Interactive, Pioneer Natural Resources, Cemex, FedEx and Disney. And several names that Southeastern bought in the depths of 2008 or in subsequent downturns, particularly Marriott and Intercontinental, did very well.
There is overlap among the four factors described above. The slowing of reversion to the mean, for example, has made security selection more difficult. This analysis is more art than science, and nobody can offer a definitive explanation for value’s underperformance.
The managers we spoke with are undeterred. “Since the 2009 low, we have continued to follow the Graham and Dodd principles that have been in place at Southeastern for 38 years,” Harper said. “The severe deterioration in business conditions in 2008-2009 led to our writing down our appraisals on average by 15%, which partially explains our weak returns. Our assumptions were wrong.“
The market crash of 2008 had a disproportionate impact on classic Graham and Dodd value managers who rely on the availability of 60- and 80-cent dollars and on the market’s willingness to run those prices up to fair value.
Value is a strategy that requires patience and risk tolerance. Underpriced stocks can become more underpriced, rather than reverting to fair value. This is even truer now, in a time of large index-driven funds flows, than it was when stock selection was a more visible part of the institutional investment setting. Investors who want to profit from Graham and Dodd’s insights — and they can lead to substantial profits — need to adopt a long-term horizon and stick with it, despite temporary setbacks.
Laurence B. Siegel is the Gary P. Brinson director of research at the Research Foundation of CFA Institute and senior advisor at Ounavarra Capital LLC. Before he retired in 2009, he was the director of research for the investment division of the Ford Foundation, which he joined in 1994 from Ibbotson Associates, a consulting firm that he helped to establish in 1979.
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