Picking stocks: Be brave or be patient

Quite heavy reading but after going through another round, finally realise that author subdivided value investment into 2 sub-categories - Brave or Patient...

I think my St****** investment belong to the patient value...

Picking stocks: Be brave or be patient

Patient investors buy and hold cheap but solid stocks; the brave risk capital on distressed firms

Published on Mar 09, 2014


The blazing remnants of offshore oil rig Deepwater Horizon, which exploded in the Gulf of Mexico in April 2010. Investing in cheap stocks, such as BP shares during the oil spill, can feel as if it will not work out for a very long time. -- PHOTO: REUTERS

By James Saft

There are two main ways to get paid as a value investor: One is by avoiding the mistakes of your peers; the other is by making some mistakes of your own.

Avoiding other people's mistakes is all about buying stocks which are cheap but solid and letting the dividends pile up and compound.

Buy quality companies which are cheap and you, by definition, miss out on Pets.com or, dare I say it, Facebook.

In a very real sense, and I'll explain later, by doing this you are generating a stream of returns based on other money managers' fear of losing their jobs.

The alternative value strategy is to buy the downtrodden: companies begging to be restructured or even gasping for air.

This can generate big returns but, obviously, it means making mistakes, suffering losses and, sometimes, losing your own job.

Mr Andrew Lapthorne, a quantitative strategist with a value bent at Societe Generale in London, frames this as being a contrast between patient value investors and brave ones.

He describes patient investors as essentially taking advantage of behavioural mistakes by other market participants, who buy the expensive and glamorous stock of the moment.

In contrast, the brave, who buy distressed companies, are getting paid the kind of premium that the efficient market hypothesis predicts: Take on risk, suffer volatility and get paid accordingly.

As for the risks of the two value strategies, they are quite different.

"For the patient value investor, the risk comes from underperforming a rising market and waiting for the next crisis to demonstrate the strategy's downside resilience," Mr Lapthorne writes in a note to clients.

"The brave value investor requires capital to be put at risk. Losses are absolute, not relative, and maintaining a position despite mounting losses while waiting for a problem to be resolved can be difficult.

"Historically this brave risk premium is the best around, but keeping your assets and job in a crisis can prove challenging."

It is more than a little ironic that career risk - the risk of losing your job - is central to both strategies but in contrasting ways.

Some research has indicated that pressure to follow a rising market, in essence career pressure, is part of the reason you get an outperformance through value investing, as most institutional investors are paid to beat a benchmark, making them less likely to arbitrage unusually cheap or expensive stocks.

Because many money managers feel they cannot take the risk of selling the expensive and buying the cheap because it causes them to underperform in strongly rising markets, a value investor, so long as he has a patient boss, can make a decent premium.

The brave investor faces a different set of risks. Sometimes investments in the cheapest stocks don't work out, quite spectacularly. And sometimes even when they do, they can feel for a very long time as if they won't.

Take, for example, shares in BP during the lamentable Gulf oil spill.

While it was easy to figure out that BP was cheap when its shares more than halved while the spill was uncapped, it was not in any way obvious that a low share price was going to make a cap possible.

You were forced to buy, if you wanted to, and hope, in the meantime living with the risk that your risk was, in a very real sense, uncapped.

A look at how these types of shares perform as a group over time illustrates this.

Mr Lapthorne and his team at Societe Generale have devised an index of high volatility value shares, an equal weighted basket of the cheapest 200 global stocks on five measures.

This index for the brave outperforms markedly an index of cheap, sturdy high-quality stocks, but it does so with some ugly periods of underperformance. Over 20 years to 2014, the SG Value Beta Index returned 15.2 per cent on average per year, against 12 per cent for a quality income index and just 9.3 per cent for a benchmark global index.

However, the maximum loss, or drawdown, was a breathtaking 62 per cent, suffered during the recent crisis, as opposed to just 33 per cent for quality income stocks and 51 per cent for the market benchmark.

So if you, or your employers, can live with the risk and keep drawing pay cheques, you can likely outperform.

The moral of the story seems to be that it isn't just money that makes the world go round, or in this case drives market pricing, but more specifically it is a combination of how people get paid and how they hold on to their jobs.

Reuters

In short it is called institutional imperatives MSCI rebal is most evident of this mindset.

But as per any academic analysis, they missed the point that value investing is primarily not concern about volatility. We are concerned about downside risk and MOS to valuation. And buying strategy need not be binary, it can be phased across, which is why I am a believer in market timing in execution for value strategy.

Actually the latest BH AR shows an example of this high risk play... 2 lessons I re-learn: don't play with things you don't understand except knowing that prices have halved and secondly cashflow increases margin of safety and reduce downside risk

"Most of you have never heard of Energy Future Holdings. Consider yourselves lucky; I certainly wish I hadn’t. The company was formed in 2007 to effect a giant leveraged buyout of electric utility assets in Texas. The equity owners put up $8 billion and borrowed a massive amount in addition. About $2 billion of the debt was purchased by Berkshire, pursuant to a decision I made without consulting with Charlie. That was a big mistake.
Unless natural gas prices soar, EFH will almost certainly file for bankruptcy in 2014. Last year, we sold our holdings for $259 million. While owning the bonds, we received $837 million in cash interest. Overall, therefore, we suffered a pre-tax loss of $873 million. Next time I’ll call Charlie"

"It’s vital, however, that we recognize the perimeter of our “circle of competence” and stay well inside of it. Even then, we will make some mistakes, both with stocks and businesses. But they will not be the disasters that occur, for example, when a long-rising market induces purchases that are based on anticipated price behavior and a
desire to be where the action is.
Most investors, of course, have not made the study of business prospects a priority in their lives. If wise, they will conclude that they do not know enough about specific businesses to predict their future earning power."

I don't think the brave category would be considered value investing. It is more like distressed investing, high risk but high returns if correct. Does SMRT and NOL fall into brave category? Fundamentally and technically they are very bad now and possibly dropping somemore. But if one believe it can turn around sometimes in future (which cannot see in the near future), one could be handsomely rewarded if invest as it drops somemore.

So if invest now in SMRT or NOL, which category it is now? High risk high return or high risk no return? i like to think we have to be both most of the time-Patient and Brave too.

(10-03-2014, 04:09 PM)Temperament Wrote: So if invest now in SMRT or NOL, which category it is now? High risk high return or high risk no return? i like to think we have to be both most of the time-Patient and Brave too.

When the investment is low risk high return, it wouldnt exist for long as people will jump in. Similarly, if it is high risk no return, why would people invest?
when a stock trades a lower price, it is probably investors demand a higher risk premium. When it trades at a higher price, some investors are still willing to buy cos he may be willing to accept a lower risk premium. It can be the same investor and his risk appetite changes. In short, risk is perceived and differs between every investors and changes over time.

Back to your qns, it has to have some return, if not, it should be trading at $0? But this return depends on your perceived risk and risk premium you willing to take.

Yes, I share the same thinking that we have to be both most of the time.

What is brave ? And what is patient?
Is buying a stock at the extreme North Point (peak of the bull market) can be considered brave too?
So is buying at the extreme South Point 2008/2009 (peak of the bear market) is not only brave but patient too?
Is this market timing or value investing with market timing?

Are all value investors actually trying to beat the market's bench mark?
Some financial authors think it is even though some value investors don't think so.
Some value investors don't even know why they want to be VI.
i only know i am a "Rojak Investors"
Who likes to learn anything from anybody-good stuff or bad stuff.
How can i know the stuffs are good or bad if i only know one type?

Beating the market's bench mark?
i don't know what is that.
i only know absolute RO$ for all the years i have been in the market till now.
That's only me-Simple.