What is the key objective of an investment adviser or a fund manager like us in the public equity market? Grow your invested capital, as per our advice, at a rate higher than other investment classes in absolute terms year after year with low variability of return.
And the return calculation should be simple – how much one earns net of tax, fees, brokerage and any other incidental costs. This calculation should be done every year, but performance should ideally be judged every 3 – 5 years.
If we keep this basic measurement objective as key monitorable and ignore the noise around investment philosophies, methods, strategies, tactics, then we will understand that the classifications of value, growth, quality, thematic and momentum are very legitimate, appropriate, effective and rewarding investment methods, because adherents of all these paths have the same objective.
If the above objectives are not met, whatever method you use is fruitless, as you won’t have much money to manage and no long-term return record to show.
If I say all have the same objective and all categories have successful investors, then why do I say this categorisation is wrong for an adviser or fund manager? Because it can severely limit our thinking as market cycles change, liquidity conditions swing, underlying macroeconomic conditions change, relative market attractiveness transforms (especially applicable for an emerging market fund manager).
Also, different methods become attractive in different external environmental situations. Unless we quickly identify and adjust our thinking paradigm with the changing external realities, there is every possibility of us underperforming and losing funds or clients, or both.
Now the question is, why were these categories created in the first place, when all investors are investing to grow capital? Everyone may have different reasons to sell a stock, but everyone has one reason behind buying one – to sell at a profit on a future date.
To begin with, all investors are paying today to buy something (fractional ownership of a business), expecting the value of it to grow in the coming days and years and decades, beating inflation and returns on other asset classes after covering all the costs.
So, all investment is a value investment (buying something whose present price is cheaper than its future value) and growth, quality, momentum are different components of value. And indeed, all are important components of value.
According to the basic and classical definition, the intrinsic value of a business can be defined as the present value of a set of future cash flows that it expects to generate by solving some human problems in a profitable way. Depending on the present cost of capital, an investor in an ideal world can invest in the fractional ownership of these companies through open market bidding, when the current price is less or significantly less than present value of these sets of future cash flows.
Now, the world is not ideal and if valuing the cash flows were so easy and predictable, then in a market place where information dissemination is almost instantaneous, the value and price would have matched so quickly that there would have been no edge to a professional manager or adviser compared with the programmed computer or even a trained monkey!
And it is mostly true, as theorised by university professors in economics and finance (Efficient Market Theory), and in an ideal world, there would have been no two-way quote in a market for buying and selling. In effect, every asset class would always be optimally valued. In that scenario, all edges of all asset managers would have withered away and most money would have remained invested in index funds (most managers fail to beat index returns).
With a powerful computational arsenal available to almost anyone and democratic dissemination of investment knowledge, the work of a fund manager is getting more and more challenging with every passing day.
With the passage of time, since the time Ben Graham wrote the basic and inviolable principles of investing some 90 years back, the world has changed in unimaginable ways. It brought in newer and newer ways of valuing future cash flows. With cheaper cost of money, low savings bank interest rates and an increase in cumulative gross wealth in the hands of potential investors (pension funds, endowment funds, wealthy individuals and retail investors) the bidding rate has gone up for the same set of cash flows.
It has increased market volatility, as it has become more and more sensitive to small changes in interest rates. Humans didn’t become more greedy or fearful in the last 90 years to pay a higher price for the same set of values, but technology, long-term interest rate and the wealth ready for market deployment increased manifold along with a very wide array of investment options as well as investment managers.
Add to this concoction the cheap technical analysis software and powerful algo trading software backed by huge sums of leveraged money and 24X7 news media! The result is very high volatility at times and an extended period of extreme valuation and relatively shorter periods of depressed valuations.
It is important to mention that the bottom valuations never go to levels seen during Ben Graham’s time. The market recovers before reaching the bottoms as seen in 1970s or 1980s when S&P500 reached single digit PE multiples on several occasions during bear phases.
To me, the proliferation of investment options and investment managers necessitated many market-positioning tools for pitching cogent stories to prospective investors and most importantly to the institutional capital allocators. These institutional capital allocators, who deploy large sums of money, have low or no skin in the game and due to various institutional imperatives, rightly or wrongly, follow a rule-based process to allocate capital.
Fund managers and advisers create marketing pitches by positioning themselves as followers of a specific thought process and thus help their potential investors in slotting and categorization. It also helps allocators to diversify funds across different categories.
But it’s seldom helpful for an individual investor to limit himself or herself in one or two silos. In this market positioning, the term ‘pure value investment’ rests in a corner (pejoratively, but rightly, termed Cigar Butt investment). It intrinsically assumes the market to be wrong in valuing the future cash flows of a stock and that the market would agree to the investment manager’s conclusions in some undefined future date. Now if the market takes very long to agree or never agrees, then this approach can kill the CAGR (cumulative average growth rate). Also the kind of bargain, as frequently available then, is not that frequent in the modern era.
The second set of investors intrinsically assumes that growth of their companies would be much faster than what is reflected in current price and that growth would be profitable and cash flow positive. So, they seek value from their ability to project future market demand, dominance of their investee companies in the market place and the ability to sell their products profitably and generate cash to redeploy for a long period to sustain a good return on employed capital.
This set of investors goes beyond numbers and makes much more subjective judgements on various externalities confronted by a business. With the passage of time, regulations became stronger, accounting disclosure standards became stringent and the company-investor interactions became more democratic and frequent.
These resulted in the most important positive effect on the stock market. Serious investors can evaluate the business and promoter quality more objectively – can keep more faith in a set of management or businesses, which performed across cycles and over many years, communicate in advance about opportunities and challenges that their companies face.
In a disruptive world, business and management quality became a basic filter for putting money to work in a specific stock. Any investor not checking it but investing are mere speculators or incompetent or amateur.
No value can be realised if the promoter is crook, business is structurally in a downtrend or the operational team is weak or company is highly leveraged in a hyper-competitive low-margin business.
Lastly, momentum traders who checked all the above boxes correctly are out to capture value in the shortest possible time. They think it’s futile to wait for the market to agree to their valuation and wait instead for the market to signal when to enter a trade. It works well in an uptrending market cycle, but not in other phases.
Thematic investment based on macro factors, sectoral themes, special situations (merger and spin offs) are sporadic opportunities and can’t be a single arsenal in a fund manager’s armoury.
So don’t think any single strategy will always work in the market – every strategy works, but in different situations. The focus should be on how to generate steady returns year after year. As an advisory, we refuse to be categorized! We are flexible and opportunist to exploit the situation presented to us by the market.
Banks don’t ask if the money is generated by value, growth, momentum or thematic investment! The total runs count – not whether it is scored by hooking or driving or pulling or cutting – all are valid as long as you know when to play which shot with confidence and how to stay on the crease for a long haul without getting out!!
(Aveek Mitra is Founder & CEO, Aveksat Financial Advisory. Views are his own.)
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