Kevin Harris, SumZero: What do you think is most misunderstood about the discipline of value investing today?Michael Mauboussin is currently the Director of Research at BlueMountain Capital Management. Prior to his role at BlueMountain, Michael was Head of Global Financial Strategies at Credit Suisse and Chief Investment Strategist at Legg Mason Capital Management. He has also authored three books, and a bevy of articles for the Harvard Business Review, The Journal of Applied Corporate Finance, and other finance publications. Michael has been an adjunct professor of finance at Columbia Business School since 1993, and has won the Dean’s Award for Teaching excellence several times.Kevin Harris from SumZero sat down with Michael to discuss value investing, active management, and the state of the market.
Michael Mauboussin, BlueMountain Capital Management: My sense is that there has been a simplistic association between value investing and the basic idea of buying statistically cheap stocks. While many famous value investors, including Ben Graham, favored cheap stocks, the idea that value investing is all about buying stocks with low price-to-book or price-to-earnings ratios was propelled by the Fama-French paper, published in 1992, on factors that are associated with excess returns. It’s worth noting that GEICO, then a growth company, played a large role in the success of both Graham and his most famous student, Warren Buffett (Chairman and CEO at Berkshire Hathaway).
Charlie Munger, Buffett’s partner at Berkshire Hathaway, has said that all intelligent investing is value investing. At its core, value investing is buying something for less than what it’s worth. The present value of future free cash flow determines value. The key is that sometimes the market’s expectations for future free cash flow is too optimistic or pessimistic. Value investing takes advantage of mispriced expectations.
While cheap stocks do tend to have lower expectations than expensive ones, two mistakes can arise. The first is buying a statistically cheap stock that deserves to be even cheaper. That’s a value trap. The second is shunning a statistically expensive stock that represents a good value.
Buffett, in part reflecting Munger’s influence, has evolved from an investor looking solely for statistically cheap stocks to someone willing to pay more for quality and growth. Buffett has cited Graham and Phil Fisher as his big influences. Fisher was comfortable buying stocks of growth companies if he found the valuations reasonable.
Harris: Would you walk us through your take on the current state of active management? In your Jan. 2017 ‘Easy Games’ article, you detail the broad shift from active to passive. What sort of inefficiencies or distortions in the market do you think are being caused by the relative decline in active management?
Mauboussin: This is a very rich topic that we could spend all day discussing. But perhaps I’ll limit myself to a few comments.
First, participating in markets through index funds or other low-cost options makes sense for many investors. If you do not have the time or inclination to seek value, either directly in markets or through investment managers, indexing is a reasonable path.
Second, it stands to reason that not all investors can be passive. Active managers perform two vital functions: they promote price discovery—a fancy way to say they make prices largely efficient—and they provide liquidity. There’s important academic work that shows these are valuable societal functions. So there will always be active management. The question is: how much is necessary?
Third, the follow up thought is that markets have to be sufficiently inefficient to lure active managers to do their job and there needs to be an offsetting benefit in the form of excess returns to compensate. Markets cannot be perfectly informationally efficient, a result shown nearly forty years ago. Lasse Pedersen, a professor of finance, has come up with the catchy phrase that markets have to be “efficiently inefficient.”
Fourth, where does active management make sense? Essentially, you want to look for where there are inefficiencies. One proxy is the variance in returns for investors in a particular asset class. If the dispersion is extremely narrow, it is hard for an active manager to distinguish him or herself. If dispersion is wide, opportunities exist. So you have to ask an investment manager why they believe they can generate excess returns. It can be better access to investment opportunities, better information, or better analysis. But it’s often being in the position to take advantage of the behavioral mistakes of others or mispricing as a result of technical factors.
Finally, there is emerging research on the impact indexing is having on markets. There are two areas worth monitoring closely, in my view. First, there is evidence that stocks that are actively held are more efficiently priced than those that are passively held. Second, we don’t really know what the impact will be on liquidity. In the case of a material drawdown, we will see how stocks and bonds react. My suspicion is that there will be less liquidity in a period of stress than most academics and professionals anticipate.
Harris: What is your reaction to the rise of quantitative strategies versus the relative decline of more traditional discretionary ‘value’ strategies? Any particular thoughts on the rise of ‘smart beta’ products/ETFs?
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