A Constructive Criticism of Value Funds

The month of May has been particularly difficult for value funds, which widely underperformed major indices. Their underperformance, in my opinion, should be a warning sign to investors of these funds, as it is not entirely clear that value managers have learned from the mistakes made in 2008.

Although I am a big believer in value investing, there are several things about value funds that seem contrary to common sense investment principles. Not only have these well-known value funds underperformed, but in most of the cases they have done so significantly.  According to Tickerspy.com, their May performance looks like this:

To the credit of most of these funds, they have performed well historically, and their investors have been rewarded handsomely in most cases, some even achieving triple digit returns since inception. However, as an avid follower of the strategies they employ, I have spotted several weaknesses and somewhat disturbing trends:

1)    More Preaching Than Doing

 Unfortunately, a lot of value managers spend more time preaching value investing than actually practicing it. From writing books to spending a significant amount of their time on TV, it seems that a lot of managers wave the value investing banner to attract capital rather than to deploy it. Consequently, there are more funds which label themselves as following a “value” strategy than actually doing so.

2)    Blind Following of Warren Buffett and Berkshire Hathaway

Make no mistake, Warren Buffett is the best investor of all times, and Berkshire Hathaway is an amazing cash generating machine which competitive advantage is firmly built within the company’s high-quality (and low cost) float. If someone is looking for billions of dollars to deploy effectively, Berkshire is probably the best bet.

However, given the small size of most value funds, it is absurd in my opinion for these funds to own shares of Berkshire Hathaway. It is absurd because small funds have the ability to invest in thousands of other companies with better profitability and growth prospects than Berkshire. If Buffett was running his partnership today, would he invest in Berkshire Hathaway himself? I think the answer would be no. Because of its large size, Berkshire cannot possibly offer small investment partnerships investors the 20%+ annual returns that smaller companies could achieve.

Contrary to the thinking of most value investors, Berkshire is not a substitute for cash. For example, Mohnish Pabrai explained back in 2008 how he considers Berkshire Hathaway as a kind of money market account, something akin to cash. After Berkshire dropped 50%, he was forced to change his strategy.  To this day, top value funds hold Berkshire with the expectation of achieving above-market returns.

 3)    Blaming Capital Losses to “Aberrations” and “Dislocations”

 Abnormal market conditions should not be an excuse. In fact, because the value strategy is dependent on always investing with a margin of safety, I would expect value managers to outperform by the greatest margin at times of abnormal market conditions. Why blame the market for your mistakes? For an example of what NOT to do, see latest letter to investors by Scottwood Capital, a $900 million hedge fund in Greenwich, CT which lost big-time during the month of May.

4)    More Copying Than Developing

Most value managers copy what previous value managers have said and done to justify their strategy rather than developing their own methods. It is my view that they confuse value investing as a strategy, and not an investment framework. The structure of hundreds of value funds is often an exact copy of previously existing funds, such as the Buffett Partnership. The result has been a bunch of Buffett-like funds in terms of structure, but with an investment performance far below those achieved by the Buffett Partnership. Additionally, a lot of funds keep the same proportion of cash to equity that Berkshire does without realizing that what’s good for Berkshire may not be good for their funds. This lack of self-identity is something that plagues a lot of value funds.

An example is hedge fund manager Sardar Biglari, who runs Indianapolis-based fast-food chain Steak ‘n Shake. Under the “Buffett” banner, Biglari wants to diversify away from burgers and milkshakes and transform the company into an all-purpose investment vehicle similar to Warren Buffett’s Berkshire Hathaway. In what I believe to be a show of arrogance, Mr. Biglari renamed the company “Biglari Holdings”. He is even quoted as saying

“if an artist created a masterpiece, it would be absurd to ask him to not put his name on it”

While Buffett generated a high stock price for Berkshire through sheer growth, Mr. Biglari decided to create a high stock price through an artificial 20-to-1reverse stock split. And that was all before increasing his salary from $300K to 900K. Even Biglari’s company website looks suspiciously similar to Charlie Munger’s Wesco.

Again, this is not an attack on value investors, it is a call for more self-identity and originality. Value investing is not a strategy, it is a framework. Instead of resorting to copying what Buffett and other investors built through their lives, value funds should abide by what Graham once said:

If you can really beat the market by charts, by astrology, or by some rare and valuable gift of your own, then that’s the row you should hoe. If you’re really good at picking the stocks most likely to succeed in the next twelve months, base your work on the endeavor. If you can foretell the next important development in the economy, or in the technology, or in consumers’ preferences, and gauge its consequences for various equity values, then concentrate on that particular activity. But in each case you must prove to yourself by honest, no-bluffing self-examination, and by continuous testing of performance, that you have what it takes to produce worthwhile results.

 

5 Responses to A Constructive Criticism of Value Funds

  1. Mariusz Skonieczny

    Interesting article. It is amazing to watch many value investing managers just copying each other or Buffett. If you manage less than $50 or $100 million, you have so many choices. You are absolutely right that Buffett would not be investing the way he is investing if he had less money.

    Thanks for this post.

  2. Ankit Gupta

    Tickerspy’s results are only based on long positions from the 13F’s right?

  3. Amit Chokshi

    I just discovered this site, pretty cool. I hear what you are saying, I wrote about it last year, check out this link on my blog

    http://www.kinnaras.com/cblog/index.php?/archives/52-Value-Investings-Comeuppance.html

    It’s even more frustrating for small fries like myself. I like the TV and follower comments, plenty of “independent” value investors are lemmings. Following 13fs, etc. Look at T2 for example (I discussed it in that post). These guys buy everything Pershing Square and Greenlight do.

    But the one thing is investing is about marketing more so than investing acumen and the business has changed big time in just the past 3-5 years.

  4. Pingback: What I’m reading today

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