Coronavirus crisis: does value investing still make sense?

The strategy that once worked for Keynes and Buffett has performed badly writes Robin Wigglesworth in The Financial Times

When Joel Greenblatt went to Wharton Business School in the late 1970s, the theory of “efficient markets” was in full bloom, approaching the point of becoming dogma among the financial cognoscenti. To the young student, it all felt bogus. 

Mr Greenblatt had already developed a taste for calculated gambles at the dog racing tracks. Reading the wildly fluctuating stock prices listed in newspapers also made him deeply sceptical of the supposed rationality of markets. One day he stumbled over a Fortune article on stockpicking, and everything suddenly fell into place. 

“A lightbulb went off. It just made sense to me that prices aren’t necessarily correct,” recalls Mr Greenblatt, whose hedge fund Gotham Capital clocked up one of the industry’s greatest ever winning streaks until it was closed to outside investors in 1994. “Buying cheap stocks is great, but buying good companies cheaply is even better. That’s a potent combination.” 

The article became his gateway drug into a school of money management known as “value investing”, which consists of trying to identify good, solid businesses that are trading below their fair value. The piece was written by Benjamin Graham, a financier who in the 1930s first articulated the core principles of value investing and turned it into a phenomenon. 

One of Graham’s protégés was a young money manager called Warren Buffett, who brought the value investing gospel to the masses. But he isn't the only one to play a role in popularising the approach. Since 1996, Mr Greenblatt has taught the same value investing course started by Graham at Columbia Business School nearly a century ago, inculcating generations of aspiring stock jocks with its core principles. 

Mr Greenblatt compares value investing to carefully examining the merits of a house purchase by looking at the foundation, construction quality, rental yields, potential improvements and price comparisons on the street, neighbourhood or other cities. 

“You’d look funny at people who just bought the houses that have gone up the most in price,” he points out. “All investing is value investing, the rest is speculation.” 

However, the faith of many disciples has been sorely tested over the past decade. What constitutes a value stock can be defined in myriad ways, but by almost any measure the approach has suffered an awful stretch of performance since the 2008 financial crisis. 

Many proponents had predicted value investing would regain its lustre once a new bear market beckoned and inevitably hammered the glamorous but pricey technology stocks that dominated the post-2008 bull run. This would make dowdier, cheaper companies more attractive, value investors hoped.  

Instead, value stocks have been pummelled even more than the broader market in the coronavirus-triggered sell-off, agonising supporters of the investment strategy. 

“One more big down leg and I’m dousing my internal organs in Lysol,” Clifford Asness, a hedge fund manager, groused in April. 

Value investing has gone through several bouts of existential angst over the past century, and always comes back strongly. But its poor performance during the coronavirus crisis has only added to the crisis of confidence. The strength and length of the recent woes raises some thorny questions. Why has value lost its mojo and is it gone forever? 

Search for ‘American magic’ 

Berkshire Hathaway’s annual meeting is usually a party. Every year, thousands of fans have flocked to Omaha to lap up the wisdom of Mr Buffett and his partner Charlie Munger, the acerbic, terse sidekick to the conglomerate’s avuncular, loquacious chairman. Last weekend’s gathering was a more downbeat affair. 

A shaggy-haired Mr Buffett sat alone on stage without his usual companion, who was stranded in California. Instead of Mr Munger, Greg Abel, another lieutenant, sat at a table some distance away from Berkshire’s chairman. Rather than the 40,000 people that normally fill the cavernous CHI Health Center for the occasion, he faced nothing but a bunch of video cameras. It was an eerie example of just how much the coronavirus crisis has altered the world, but the “Oracle of Omaha” tried to lift spirits. 

“I was convinced of this in World War II. I was convinced of it during the Cuban missile crisis, 9/11, the financial crisis, that nothing can basically stop America,” he said. “The American magic has always prevailed, and it will do so again.”

Berkshire’s results, however, underscored the scale of the US economy’s woes. The conglomerate — originally a textile manufacturer before Mr Buffett turned it into a vehicle for his wide-ranging investments — slumped to a loss of nearly $50bn in the first three months of the year, as a slight increase in operating profits was swamped by massive hits on its portfolio of stocks. 

A part of those losses will already have been reversed by the recent stock market rally triggered by an extraordinary bout of central bank stimulus, and Mr Buffett’s approach has over the decades evolved significantly from his core roots in value investing. Nonetheless, the worst results in Berkshire’s history underscore just how challenging the environment has been for this approach to picking stocks. After a long golden run that burnished Mr Buffett’s reputation as the greatest investor in history, Berkshire’s stock has now marginally underperformed the S&P 500 over the past year, five years and 10 years. 

But the Nebraskan is not alone. The Russell 3000 Value index — the broadest measure of value stocks in the US — is down more than 20 per cent so far this year, and over the past decade it has only climbed 80 per cent. In contrast, the S&P 500 index is down 9 per cent in 2020, and has returned over 150 per cent over the past 10 years. 

Racier “growth” stocks of faster-expanding companies have returned over 240 per cent over the same period.  

Ben Inker of value-centric investment house GMO describes the experience as like being slowly but repeatedly bashed in the head. “It’s less extreme than in the late 1990s, when every day felt like being hit with a bat,” he says of the dotcom bubble period when value investors suffered. “But this has been a slow drip of pain over a long time. It’s less memorable, but in aggregate the pain has been fairly similar.”

Underrated stocks 

Value investing has a long and rich history, which even predates the formal concept. One of the first successful value investors was arguably the economist John Maynard Keynes. Between 1921 and 1946 he managed the endowment of Cambridge university’s King’s College, and beat the UK stock market by an average of 8 percentage points a year over that period. 

In a 1938 internal memorandum to his investment committee, Keynes attributed his success to the “careful selection of a few investments” according to their “intrinsic value” — a nod to a seminal book on investing published a few years earlier by Graham and his partner David Dodd, called Security Analysis. This tome — along with the subsequent The Intelligent Investor, which Mr Buffett has called “the best book about investing ever written” — are the gospel for value investors to this day. 

There are ways to define a value stock, but it is most simply defined as one that is trading at a low price relative to the value of a company’s assets, the strength of its earnings or steadiness of its cash flows. They are often unfairly undervalued because they are in unfashionable industries and growing at a steadier clip than more glamorous stocks, which — the theory goes — irrational investors overpay for in the hope of supercharged returns. 

Value stocks can go through long fallow periods, most notably in the 1960s — when investors fell in love with the fast-growing, modern companies like Xerox, IBM and Eastman Kodak, dubbed the “Nifty Fifty” — and in the late 1990s dotcom boom. But each time, they have roared back and rewarded investors that kept the faith. 

“The one lesson we’ve learnt over the decades is that one should never give up on value investing. It’s been declared dead before,” says Bob Wyckoff, a managing director of money manager Tweedy Browne. “You go through some uncomfortably long periods where it is not working. But this is almost a precondition for value to work.” 

The belief that periodic bouts of suffering are not only unavoidable but in fact necessary for value to work is entrenched among its adherents. It is therefore a field that tends to attract more than its fair share of iconoclastic contrarians, says Chris Davis of Davis Funds, a third-generation value investor after following in the footsteps of his father Shelby MC Davis and grandfather Shelby Cullom Davis. 

“If you look at the characteristics of value investors they don’t have a lot in common,” he says. “But they all tend to be individualistic in that they aren’t generally the type who have played team sports. They weren’t often president of their sororities or fraternities. And you don’t succeed without a fairly high willingness to appear wrong.” 

But why have they now been so wrong for so long? Most value investors attribute the length of the underperformance to a mix of the changing investment environment and shifts in the fabric of the economy. 

The ascent of more systematic, “quantitative” investing over the past decade — whether a simple exchange-traded fund that just buys cheap stocks, or more sophisticated, algorithmic hedge funds — has weighed on performance by warping normal market dynamics, according to Matthew McLennan of First Eagle Investment Management. This is particularly the case for the financial sector, which generally makes more money when rates are higher. 

The usual price discount enjoyed by value stocks was also unusually small at the end of the financial crisis, setting them up for a poorer performance, according to Mr Inker. Some industries, especially technology, are also becoming oligopolies that ensure extraordinary profit margins and continued growth. Moreover, traditional value measures — such as price-to-book value — are becoming obsolete, he points out. The intellectual property, brands and often dominant market positioning of many of the new technology companies do not show up on a corporate balance sheet in the same way as hard, tangible assets. 

“Accounting has not kept up with how companies actually use their cash,” he says. “If a company spends a lot of money building factories it affects the book value. But if you spend that on intellectual property it doesn’t show up the same way.” 

As a result, GMO and many value-oriented investors have had to adapt their approach, and focus more on alternative metrics and more intangible aspects of its operations. “We want to buy stocks we think are undervalued, but we no longer care whether it looks like a traditional value stock,” Mr Inker says. 

Mr McLennan points out that while the core principles won’t change, value investing has always evolved with the times. “It’s not a cult-like commitment to buying the cheapest decile [of stocks]. We invest business-by-business,” he says. “I don’t know what the alternative is to buying businesses you like, at prices you like.” 

Bargain hunt

Can value investing stage a comeback, as it did in when the dotcom bubble burst in the early 2000s, or the “Nifty Fifty” failed to justify investor optimism and fell to earth in the 1970s? 

There has clearly been a shift in the corporate landscape over the past few decades that could be neutering its historical power as an investing approach. It is telling that the recent stock market rebound has been powered primarily by big US technology companies, despite value investors having confidently predicted for a long time that their approach would shine in the next downturn. Value stocks tend to be in more economically-sensitive industries, and given the likelihood of the biggest global recession since the Depression, their outlook is exceptionally murky, according to an AQR paper published last week.  

“If value investing was like driving my four kids on a long car ride, we’d be very deep into the ‘are we there yet?’ stage of the ride, and value investors are justifiably in a world of pain,” Mr Asness wrote. However, the odds are now “rather dramatically” on the side of value. 

Redemption could be at hand. there has in recent days been a cautious renaissance for value stocks, indicating that coronavirus may yet upend the market trends of the past decade. This stockpicking approach often does well as economies exit a recession and investors hunt for bargains. 

Devotees of value investing certainly remain unshakeable in their faith that past patterns will eventually reassert themselves. Citing a common saying among adherents, Mr Wyckoff argues that “asking whether value is still relevant is like asking whether Shakespeare is still relevant. It’s all about human nature”. 

Mr Greenblatt, who founded Gotham Asset Management in 2008, says that his students will occasionally quiz him on whether value investing is dead, arguing that computers can systematically take advantage of undervaluation far more efficiently than any human stockpicker can. He tells them that human irrationality remains constant, which will always lead to opportunities for those willing to go against the crowd. 

“If you have a disciplined strategy to value companies, and buy companies when they’re below fair value you will still do well,” he says. “The market throws us pitches all the time, as there are so many behavioural biases . . . You can watch 20 pitches go by, but you only need to try to hit a few of them.”

Arun Shourie on disinvestment in his times and the current CBI investigation

Written by Arun Shourie in The Indian Express| September 5, 2014 8:04 am

CBI move to investigate the disinvestment of Udaipur’s Laxmi Vilas hotel on the basis of an anonymous oral complaint, 12 years after the decision, holds a lesson for those who are trying to get the bureaucracy going.

Hindustan Zinc was privatised in April 2002. The privatisation was challenged on various grounds in the Supreme Court. In December 2012, after hearing counsel, the SC rejected the challenge.

-----

Also read 

The Sale of the Century

To Fight the Privatisation dogma look at the US Military, Singapore and Taiwan

The Public Sector isn't perfect but at least it doesn't fleece us

----

That did not deter the CBI. In February 2014 — TWELVE years after the disinvestment, and with HARDLY A YEAR having passed since the SC delivered its judgment — the CBI launched a new “investigation” into the disinvestment. 

When its officers came to me, I asked them about the complaint on the basis of which they had commenced the investigation. They said that there had been nothing in writing, just an oral complaint!

The same pattern has now been repeated in the case of the disinvestment of Laxmi Vilas Hotel in Udaipur. The hotel was disposed of in 2002. Of the ITDC’s 20-odd hotels, this one had distinguished itself by incurring the highest loss: to earn gross revenue of Rs 2 crore a year, the hotel spent Rs 3 crore — a loss of 51 per cent. The occupancy rate of the hotel had fallen to 26 per cent. Far from being a luxury palace, the place was in shambles — the plant and machinery were defunct, the furniture, etc were in the sorriest state that you can imagine. This will be evident from two elementary facts. ELEVEN parties expressed an initial interest in bidding for the hotel. FIVE of them carried out thorough due diligence. Such was the condition of the property that four of the five dropped out. I am informed that Bharat Hotels — the winning bidder — had to spend Rs 25 to 30 crore on renovating the place and getting its plant and machinery in working order. Furthermore, the quality of the staff was such that Bharat Hotels had to spend another Rs 3 to 5 crore on voluntary retirement schemes.

TWELVE years after the disinvestment, the CBI has registered an FIR — naming, among others, the then secretary of the disinvestment ministry and accusing him, among other things, of “dishonestly and fraudulently and with mala fide intention” doing this, that and the other. On what basis? The FIR itself states that it has been registered on the basis of “an anonymous complaint”. I will come in a moment to the utter indefensibles that mar the FIR, but the first point to consider is: Should any agency have the authority to harass civil servants for decisions taken 12 years ago? Should it have the power to ruin the reputation of civil servants and to put them to endless trouble 10 years after they have retired? Should it have the power to ruin people’s reputations on the basis of “anonymous complaints” and “oral complaints”?

One of the main objectives of the prime minister, and key to the other objectives he has in mind, is to energise the bureaucracy. Which is the civil servant who will take decisions, who will accept responsibility, who will stick his neck out, if 12 years from now, 10 years after he has retired, when he has no access to lawyers or records, he is going to be hauled up by sundry inspectors and SPs of the CBI?

Courts of no consequence

Nor does the parallel with Hindustan Zinc end there. That privatisation had been challenged and the challenge was rejected by the SC. The privatisation of this hotel too was challenged — and that challenge too was rejected, this time by the Rajasthan High Court. And the central ground on which the privatisation was challenged, and the ground that was decisively rejected by the high court, is the very ground on which the FIR focuses — a ground to which I shall revert in a moment. But first, the question that arises from that simple fact of rejection by the courts: when a high court has upheld a sequence of decisions, when the SC itself has done so, should an agency such as the CBI be able to open the matter yet again and start harassing officers and others?

And to open it TWELVE years after a decision has been taken? Shouldn’t there be a period of limitation?

Ruined reputations

Nor is it just a matter of harassment, though that is bad enough. No one who has not been put through the mill can imagine the strain and distress to which the person and his family are subjected by such inquisitions and “raids”. What about the irreparable damage to the person’s reputation? What bunkum did the CBI not put out just the other day about two distinguished civil servants, C.B. Bhave and P.C. Parakh? And what has it said now, while closing the cases against them? Should the CBI not be made to pay for the calumny it had hurled?

But I do feel that in this regard others also are at fault — the press, civil servants as a group and even the victims.

Has the CBI not somersaulted a sufficient number of times for the press to realise that it must not swallow and propagate what such agencies put out?

And the civil servants — haven’t they seen a sufficient number of times how they have themselves behaved in the wake of investigations against their colleagues? The moment the CBI says it has commenced an inquiry against X, his erstwhile colleagues treat him as a leper. Till yesterday, he was your colleague and friend, and now you avoid him. Shame on such colleagues and friends! That is no way to be: on the contrary, we must be fortresses around the honest, and all the more so around one who has been a colleague and friend, and of whose competence and integrity we have had personal knowledge.

And the victims — they are so easily felled, most of all by the apprehension that their reputation has been ruined. Such agencies and their concocted FIRs can ruin our reputation. Being calumnised by the dishonest is actually a badge of honour! I address audiences once a week or so. On these occasions, as is custom, the hosts use superlatives to introduce me — the positions I have held, the awards that have been given me, the books I have written… When my turn comes, I always say, “But the organisers have left out my two main distinctions. First, I am the only editor who has been dismissed from his job, not once but twice. Second, I have what none of you have — I am the only one here who has three certificates of honesty from the CBI.” So: thicker skins and a little contempt for the calumners!

The hotel

And now a few points about the hotel that is the subject of the new FIR.

The CBI has put out that the actual value of the property was Rs 151 crore, and government sold it for Rs 7.5 crore.

To substantiate that Rs 151 crore figure, the CBI says that the Rajasthan government itself had asked Bharat Hotels — the company that won the bid — to pay Rs 15 crore as stamp duty. True to character, the CBI conceals the fact that this demand, made by the local officer, has been stayed by the courts!

Next, it says that the hotel has 29 acres of land. It conceals the fact that this land, being adjacent to the lake, falls within the Coastal Regulation Zone and that nothing can be built on it. I am told that Bharat Hotels sought permission to add some rooms. And that the municipality refused permission on the ground that the land falls within the Coastal Regulation Zone. I am told that a case is currently before the SC against establishments that have constructed or added to structures along the lakeshore. Bharat Hotels has NOT been arraigned in the case.

But assume for a moment that, in spite of the regulations and in spite of the refusal of permission by the municipality, Bharat Hotels has built additional accommodation.

In that case, Bharat Hotels and the persons with whose connivance it has built the additional accommodation should be arraigned — not the disinvestment process and those who were associated with it.

Moreover, such absurd figures were the gravamen of the grounds on which the disinvestment was challenged. While rejecting them, the court rightly pointed out that a buyer does not buy assets in the abstract. He buys them for their business potential, that in the instant case he was buying not assets but shares of a company considering their earning potential.

There is another telling point. I am not sure if the CBI investigators remember that 10 per cent of the shares of the ITDC, the government company that owned the hotel, were owned by none other than the Indian Hotels Company of the Tata Group. It was compensated for its equity at exactly the same rate that the government got from the disinvestment. Had the property been worth Rs 151 crore, would the Tata Group — a private company, answerable to its shareholders — have accepted Rs 70 lakh (10 per cent of the value for which the hotel was sold) and thereby sacrificed Rs 15 crore (the 10 per cent share that would have accrued to them if the value of the hotel had been Rs 151 crore)?

Contrary to what the CBI has insinuated, the asset valuer was jointly chosen by the financial advisors (Lazard) and the ITDC from among the list of government-approved valuers. Five or more valuers from the government-approved list were invited to make presentations. Their qualifications and experience were jointly examined, and then alone was the particular firm chosen for the task.

That care marked every other step also. As in every case of disinvestment, every single one of the prescribed procedures was meticulously followed. Every step of the process, including the setting of the reserve price and the acceptance of the final bid price, was taken with the explicit approval of the Cabinet Committee on Disinvestment. In particular, the shareholders agreement was cleared by the law ministry thrice over — at the draft stage, at the stage when it was frozen and finally when the bids were to be accepted. The then law minister is the one link between that cabinet committee and the present government: he was law minister then and a member of the Cabinet Committee on Disinvestment, and is in-charge of the disinvestment department in the present government. He has stated in an interview that he is well acquainted with every aspect of the disinvestment and that everything about the transaction was in order.

Telling figures

A young analyst, well acquainted with valuations, draws my attention to a series of facts that show how way off the CBI’s imaginative figure of Rs 151 crore is. I will list just a few of them.

* Laxmi Vilas Palace was one of the 20-odd properties owned by the ITDC and amongst the smallest. Further, of its properties, it was the one that was making the highest losses.

* Between 1996 and 2001, the occupancy of Laxmi Vilas Palace came down from 41 per cent to 26 per cent and the hotel faced heavy losses.

Note that the overall occupancy in Udaipur was still 41 per cent in 2002.

* Given the abysmal performance, the net profit margin reduced from 34 per cent to a loss of 51 per cent; to earn gross revenue of Rs 2 crore, the hotel spent Rs 3 crore! At the time, the average hotel in India made Rs 4.5 crore in revenue and Rs 1 crore of net profit (assuming a 25 per cent margin).

* A valuation of Rs 151 crore for the property, as suggested by the CBI, would imply a valuation of over Rs 3,000 crore for the 20-odd ITDC hotels in 2001-02. Compare this figure with the valuation of the Tata Group’s Indian Hotels (one of the most efficient private operators, which owns the Taj Group of hotels and had at that time 65 properties with around 8,100 rooms). This latter chain had an equity valuation of barely Rs 800 crore in 2002.

* The full enterprise value of the Taj Group in 2002 was Rs 2,400 crore for the 65 hotels it owned; each Taj hotel had an average of 125 rooms. At that valuation, each Taj property was being valued at Rs 36 crore. Laxmi Vilas was and is a 55-room hotel; so, even on Taj benchmarks of valuation per room, it would be worth Rs 15 crore! At the Rs 3 crore a room that is implied in the CBI’s figure, Indian Hotels (with a portfolio of around 8,100 rooms) should have been worth Rs 24,000 crore in 2002 itself; that is, more than twice what the company is worth in 2014!

Other comparables also highlight the imaginativeness of the Rs 151 crore valuation:

* HVS are one of the leading consultants and valuation experts in the hotel space globally. They do a detailed assessment of hotel values by city. While they did not do a study for Udaipur, they did one for Jaipur. Their estimate for a hotel in Jaipur in 2002 was Rs 12 lakh per room for a medium-class hotel and Rs 30 lakh per room for a luxury property. Similarly, their range for Agra was Rs 9 lakh to Rs 12 lakh per room.

Udaipur was not part of the golden triangle and had lower occupancy rates and far lower rentals in comparison with both Agra and Jaipur. Based on their assessment and an average rate of Rs 12 lakh per room (accounting for the poor profitability of Laxmi Vilas), one gets a value of Rs 6.6 crore for Laxmi Vilas. Even at the high-end valuation of Rs 30 lakh per room, one gets a value of Rs 16 crore!

* In accordance with the HVS studies, even today a luxury hotel in Jaipur would be worth Rs 77 lakh per room; that implies a value of Rs 42 crore for a 55-room property, 14 years after the disinvestment of the Udaipur hotel!

* Lands End Hotel in Mumbai was purchased by the Taj Group at Rs 80 lakh a room in 2002. This was the highest prime property sold in India in that year. However, if we go by the CBI allegation of a value of Rs 151 crore for Laxmi Vilas (a 55-room hotel), we would have to place the value at Rs 3 crore a room in Udaipur. Udaipur had an occupancy rate of 41-42 per cent over 1999-2002 and room rates of Rs 1,900, as against Rs 3,500 for Mumbai.

* In 2011, Sinclair Hotels purchased Savannah Hotels in high-end Whitefield in Bangalore for Rs 38 lakh per room. At this 2011 valuation, Laxmi Vilas would be valued at Rs 20 crore.

* In 2008, Mahindra Holidays & Resorts purchased Hotel Ooty Villa Park from PVP Ventures — a 100-room property — for Rs 33 crore (including all amenities and assets). This is in 2008 — six years after one of the fastest growing periods in terms of real-estate pricing in India.

* In 2014 (12 years after the Laxmi Vilas transaction), Royal Orchid sold its 155-room property in Hyderabad for Rs 175 crore. Even at this price of Rs 1.2 crore per room, the Laxmi Vilas property would be worth Rs 70 crore. How is the price for a five-star property in Hyderabad 12 years later still unable to justify the supposed Rs 151 crore valuation in 2002?

I can go on adding to the list. But the point will be obvious: we can be fairly certain that the CBI officials in Jodhpur would be innocent of such comparisons. There is a real problem here, and it holds a lesson. Even if one sets aside conspiracy theories, the problem is that the CBI staff, especially at the lower level, just do not understand valuation and other aspects of such transactions. I have had personal exposure to this innocence — when the CBI officials came to ask me about the disinvestment of Hindustan Zinc, for instance.

At the least, that holds one lesson for all who are today trying to get the bureaucracy going: among the reforms that are urgently required is to upgrade the domain knowledge of officials working in our investigating agencies. Otherwise, goaded by pep-talks, honest officers will take decisions on complex matters, only to be hauled up 10-12 years later by persons innocent, at least of considerations that bear on those decisions.