For retail investors looking to practice a long-term approach to stock selection that focuses on buying inexpensive companies, there are few better teachers than billionaire value investor Charles Brandes.
Earlier this month, I, along with a group of MBA students from the University of Toronto's Rotman School of Management, had the opportunity to be schooled in the Brandes way by the man himself, as well as many of his staff at the headquarters of Brandes Investment Partners in San Diego.
With more than four decades of experience managing money, Mr. Brandes is adamant that the market is usually irrational: Stock prices do not typically reflect the true value of companies.
A defender of active management, he calls the trend toward passive investing, in which investors buy exchange-traded funds that track certain stock indexes, a "we give up" approach.
But that doesn't mean that value investing is easy. According to Mr. Brandes, it actually goes against human nature. The average person is highly risk-averse, and prefers attempting to ride the wave of popular stocks that are rising.
"People want an excuse to speculate," he said. Retail investors also have an improper definition of risk, believing it to be short-term volatility rather than the odds of permanent capital loss.
As Robert Schmidt, director of the Brandes Institute think-tank, put it, the firm seeks to "take advantage of biases without succumbing to them."
The asset manager does this by disregarding day-to-day price fluctuations, and focusing on individual firms' fundamentals.
Brandes Investment Partners uses a variety of metrics, including price-to-book and price-to-earnings ratios, as well as discounted cash flow analysis, to calculate an "intrinsic value" for a given company.
This is an inexact science, but a necessary prerequisite for the firm's success. If investment committees overestimate the intrinsic value of a company, they will have likely overpaid for a stock and limited their potential returns.
A trio of research associates said that the humility and diligence of all staff is the key that allows them to avoid hanging on to losing holdings. Analysts waste no time in passing along information that may contradict their original thesis, and constantly reassess whether their estimate of intrinsic value holds true whether a stock is surging or struggling.
In general, the firm likes to have a 33-per-cent margin of safety – that is, the gap between a company's share price and its intrinsic value – before buying a stock, according to portfolio manager Michael Israel.
However, metrics will only take you so far in this world – what's really required is an in-depth examination of the operating environment of each individual company to determine whether its unloved status is a product of cyclical or structural issues.
Consider the firm's stance on banks. Brandes's U.S. equity value fund is overweight American banks, counting Bank of America, Citigroup Inc. and JPMorgan Chase & Co. as sizeable holdings. This group is trading at price-to-book ratios well below their longer-term norms.
Director and senior analyst Brent Fredberg explained that over time, these banks were likely to see the fading of two large headwinds – small net interest margins along with regulatory and litigation overhand. In addition, he noted that there is the potential for the share of net income that is returned to shareholders in the form of buybacks and dividends to growth.
On a price-to-book basis, Chinese financials appear to be much more attractively valued than their American counterparts. However, this is an area that Brandes Investment Partners avoids entirely.
Director Louis Lau explained that this segment of the market appears to be a value trap, noting that it is difficult to get a handle on the quality of the true value of the assets on Chinese banks' balance sheets. And while non-performing loans are small, a substantial portion of corporate creditors are not covering their interest payments with cash flows – an unsustainable situation.
As of 2014, the Brandes Global Equity Strategy has outperformed the MSCI World Index over the past 15, 20, and 30 years; during shorter periods, it has trailed this benchmark.
However, is it possible for an individual investor to practise the Brandes approach and outperform the market?
The firm's founder certainly thinks so. "While managing money requires a high level of dedication and commitment, a value investor with sufficient time and expertise could realistically expect to improve on the returns earned by many professional managers," he writes in his latest book, Brandes on Value.
But I'm skeptical.
Friedrich Nietzsche wrote, "In individuals, insanity is rare; but in groups, parties, nations and epochs it is the rule."
This adage can be turned on its head when it comes to value investing: it is much more likely for an individual to act irrationally than it is for a group.
In meetings with Mr. Brandes and his staff, all emphasized that a team approach – having multiple voices and points of view when making investment decisions – was a crucial tenet to its success.
Individual investors do not have this luxury – nor the ability or the stature to travel to visit companies abroad at their headquarters and speak to management, as analysts at Brandes Investment Partners (and most large firms) do.
As such, it appears to be a much more difficult task for retail investors to avoid becoming "anchored" to their initial estimate of intrinsic value, which could cause one to stubbornly cling to a flagging holding and averaging down instead of re-evaluating the situation and cutting their losses.
Robert Schmidt pointed out that the value premium – that is, the extent to which value stocks outperform growth stocks – is the biggest in emerging markets. However, this is also an area in which accounting irregularities make it very difficult to glean the true picture of a company's sustainable earnings power.
Retail investors can take the time to educate themselves on how to examine balance sheets and do thorough analysis of companies in hopes of generating alpha, or choose from many alternatives, such as spending more time with family and friends or taking better care of one's body. The risk/reward proposition is qualitative but clear, and does not appear to favour the active style.
My advice: Buy low-cost index funds – not a "we give up" approach, but a "we've got something better to do" worldview.
Conversely, if you are convinced of the supremacy of value investing, allocate your savings to money managers who adhere to this discipline.