Value Investing in the Age of Speculation
FOMO, jealousy, and waiting for the inevitable crash
This Substack platform is a place for me to try all kinds of new and interesting things. Last week I published a review of a great podcast I listened to. Eventually I will write up an investment idea, in addition to sharing my perspectives on investing and the business of investment management. I am also going to be sharing some of the quarterly letters I wrote while at my last role. My guess is that most people didn’t read Cove Street’s website every time I posted a letter. Plus, I have a new audience that may have never been exposed to any of my previous writing.
It goes without saying that I am going to cherry pick some of my favorite pieces. Every writer with a deadline—either a journalist or a fund manager writing a “mandatory” quarterly letter—is going to produce pieces he or she loves, and some that are not as good. There are plenty of old letters where I talked about the investment cases associated with Viasat and Lumen and Lionsgate and Millicom. Mistakes—all of them—and I don’t see any real need to revisit those discussions. However, there were some that I really enjoyed writing and would like to share once again.
I have no idea if this will work or if people will find it interesting. I personally think it is fun to go back and see what I was thinking during different market environments. In this case, we are going to use our DeLorean to go all the way back to April 2021, a point just after the meme stock frenzy had started to subside a bit, and revisit one of my favorite letters. At the end, I will talk about what I got right, what I got wrong, and lessons from my experiences.
As a value investor, you know the feeling intimately. In fact, it has been so prevalent over the last decade that you have almost gotten used to it. It takes you back to being the last person picked to play kickball at recess. It also reminds you of the feeling you have when you learn that one of your old college friends has been much more successful than you have—at least financially. You are happy for him or her but you also can’t help but be just a tad bit jealous. The combination of feeling left out and slightly jealous of other people’s success can be demoralizing and even lead to having that annoying pit in your stomach. Deep down you know that being a good investor is as much about psychology and managing your own emotions as it is about performing diligence on companies. But that sure doesn’t make it any easier when the market is consistently telling you that you are wrong—or out of step with what other people see as a new paradigm.
As an antidote, you revisit the gospel and re-read the scriptures. Buffett and Klarman and Marks have told us many times that we have to be able to endure looking wrong, silly, and early to achieve long-term success. When many others are focused on the next month or next quarter, the person with a multi-year time horizon has a distinct advantage. When other people are acting greedily, it pays to be fearful. Intellectually you know the investing luminaries are right, but this time feels different. When people are creating generational wealth by selling Non-Fungible Tokens (NFTs), speculating on cryptocurrency, being the board member of a hot tech IPO, and buying Gamestonks, even the most dedicated, Zen-like value investors inevitably feel a tinge of FOMO (Fear of Missing Out).
To keep sane, you review the long-term history. No doubt that being a contrarian and a value investor has worked. Yes, there have been periods of underperformance relative to Growth, but Value has always come back when people most doubted the philosophy’s efficacy. As such, you want to trust your process, but when you see investors who bought stocks for an already insane 10-times revenue glowing as their positions more than double—and now are trading at 20-times revenue—it is very hard not to press. Maybe if you worked harder, slept less, read more, and made decisions faster, you could find the hidden multi-bagger that could help you make up for recent relative underperformance. Maybe if you took some more risk, changed your strategy slightly, and paid up for the types of businesses that are currently in favor, you could get back into the good graces of the institutional investor crowd.
In meetings with the aforementioned group, including both potential and existing clients, you get the same question: “When do you think Value will be in favor again?” The humility of being a conservative investor requires you to reply that, of course, you don’t know and then you proceed to talk eloquently about mean reversion and the historical precedents that are suggestive of a big Value comeback—similar to what happened in the early 2000s when the Nasdaq crashed and value stocks were up. Inevitably, you have to explain why this time is NOT different and that stocks are unlikely to trade at permanently high valuations. Yes, yes, the stocks you own can’t satisfy the vaunted Rule of 40, but the price you pay still matters. The investing laws of supply and demand and gravity have not been repealed or replaced by however the (now very, very wealthy) people on Sand Hill Road tend to value companies. Eventually, companies have to earn profits, right? If so, you own some great, cash flowing companies that have moats and global brands. Eventually, SOMEONE will care about that…
After a long enough period of underperformance, you start to feel like you need an AA-like support group for value investors. Thus, you call your friends in the community to commiserate about what is going on. So much speculation. So many signs of rampant greed and very few people being fearful. New asset classes going wild, retail traders pushing around hedge funds, and your hairdresser asking you questions about GameStop Corp (Ticker: GME). These are the signs of a top or a regime change towards Value and away from Growth, you say. Plus, the astute guys from Research Affiliates and the ever-articulate Cliff Asness have done some incredible research that indicates that value investing is still alive and well. Reading these papers and scrolling through your Twitter feed—which is inevitably populated with people who already share your point of view—confirms everything you see and believe in your bones. You are well aware of the downside of, and risks associated with, succumbing to confirmation bias. However, you just can’t believe that you and all of your erudite compatriots could be wrong in this case.
So, you continue to walk a seemingly impossible tightrope. Be patient and long-term focused but continue to find the drive to dig deeper into new and existing positions. Attempt to expand your understanding of what “value” is by studying new business and valuation models but be careful not to get caught up in the relative valuation game. (All of Company X’s peers trade at 15x revenue and Company X only trades at 8x revenue—so Company X is totally underpriced.) Stay true to everything you have been taught about investing but still seek disconfirming information just in case the world has indeed changed in a way that is incompatible with your past experiences. And finally, be OK with watching someone who was lucky enough to be on the Board of CrowdStrike Holdings (Ticker: CRWD) owning $100mm worth of stock while still maintaining a high-level skepticism regarding the prices investors are willing to pay for the companies that are currently in favor.
The foregoing represents a lot of what it has felt like to be a value investor in an age of speculation and excess. It is an unequivocal fact that we can’t change the past or influence the future. So, during challenging psychological times what can you do to make sure that you stick to what you were hired to do, not be subject to “strategy creep” and be simultaneously forward-looking and short-term vigilant? My suggestion is to try to better understand how your brain works and therefore be intentional in your attempt to mitigate the biases to which you are most susceptible.
For instance, I recently listened to an episode from one of my favorite podcasts, Hidden Brain. The general theme of all of the episodes is the somewhat hidden ways we are influenced as well as the hidden brain functions of which we are mostly unaware. This particular episode was about the stories of our life and the research that particularly interested me was the idea that people could get past their trauma or loss by writing about it or by writing stories that have different endings. The relevance of this to value investors is that there are a lot of us who likely have some lingering trauma after watching growth stocks essentially stomp value stocks for more than a decade. I personally find that writing about the crazy things I currently see in the market (and yes even Tweeting about it—feel free to follow me @benclaremon) and explaining the rationale behind sticking to a consistent strategy and philosophy tends to reduce the FOMO and the desire to “make something happen” that juices returns. I also find that writing down my thoughts helps to crystallize my own ideas. As investors, we all live with millions of data points swirling around in our heads, and corralling those thoughts onto a piece of (virtual) paper can be illuminating and cathartic at the same time.
Why is developing these outlets and hacks so important at the current moment? If there were ever a time not to take unnecessary risk, I would argue that the degree of speculation we see in the market would suggest this is the closest thing anyone has seen since the tech bubble in the late 90s. As such, straying from the value path right now might put your clients at risk of permanent capital impairment and be kind of like selling all of your stocks at the bottom of a bear market. We may be on the cusp of a regime change towards Value and you definitely don’t want to be the person who jumps off the sinking ship right before the hull is fully repaired.
As such, our humble advice is to find a way to stick to your process and discipline, and if anything, find the conviction to add a little more to your most favorite positions. That is what we have done within this strategy. It is almost fully invested and we recognize that may sound paradoxical given all of the previous discussion of froth and speculation. However, we will say it again that our companies have weathered the COVID-related crisis remarkably well and have not only avoided a severe decline in intrinsic value but also have continued compounding upwards, at least from our perspective. I will even say that—with a little trepidation given the events of the last year—after a very rough 2020, we are as excited about our companies’ prospects over the next three years as we have been at any time running this strategy.
We are not expecting that institutional investors are going to reduce their exposure to what has worked really well (i.e. growth stocks) to 0%. All we need as a Small and SMID cap manager is for allocators to trim their exposure a touch and start once again to look seriously at Value. Call us cautiously optimistic.
As I reflect on the raw emotions I was dealing with when writing this letter, it was clearly a tough time. I felt out of step and was pressing. You even get a hint of envy in the discussion. With the benefit of hindsight, I can’t help but feeling somewhat vindicated by what happened in 2022. The euphoria I was describing and the mini-mania we lived through that infected multiple asset classes certainly received a dose of reality as the Fed started raising interest rates in March of 2022. As rates have continued to rise, a lot of those prior excesses have been washed out. But the truth is that, as of just of few weeks ago, the speculative elements of the market and the animal spirits appeared to be alive and well. It is just the focus that has changed. Back in 2021 it was meme stocks, tech IPOs, crypto, and NFTs. Now it is AI, weight loss drugs, and a Vietnamese EV company that, at the end of August, was the world’s third largest auto OEM. Alas, the froth has started to subside, leading to one of the craziest stock charts I have ever seen:
This company went public in August and has already seen its stock go from $22 to $90-something down to $8, all in less than 3 months. In the end, the market is a pretty good weighing machine, but the short-term voting crowd remains quite a powerful force.
The point of revisiting this letter is not to crow about the accuracy of my instincts from 2021. The speculative frenzy could have lasted another three years and I would have looked terribly wrong—or simply early. It is to remember that valuations that don’t make any sense based the cash flows a company can eventually earn are unlikely to be maintained. Also, trust your instincts. If something looks too good to be true, it probably is—and you have to be OK with it going parabolic without you. You can make money investing in a way that suits your temperament and skillset. Let other people become Dogecoin millionaires.
And what about the value renaissance that I was hoping for? Still waiting. And what about people getting excited about small cap stocks again? The opposite appears to be occurring when it comes to where investors are focused. (Those 7 stocks that are driving the S&P’s returns.) Additionally, my conversations with people who focus on the smallest companies are suggestive of almost zero interest from institutions. As such, I was wrong to be optimistic. Going even further, if I were to be self-critical, I would say that I spent far too much of my time thinking and pontificating about when certain styles would gain favor as opposed to simply focusing on finding companies that could be worth a lot more in seven years. (The last part of the letter reflects that.) Yes, allocators do care about style boxes but they also care about investors who can consistently put up good returns. When you work for a firm whose success and even existence are predicated on people writing big checks to value managers again, it is easy to participate in what has become almost a sport amongst scorned investors: complaining about the lack of love for value strategies.
I recently wrote a long piece on control and being precise about what you can and can’t control as an investor. Certainly, what allocators are doing with their money is not something any individual manager can control. So, it is probably better to avoid speculating about regime changes and to instead focus on finding the best handful of stocks in your universe. Or, find a firm with a broad mandate that allows you to take advantage of long or short, private or public opportunities that don’t fit perfectly into a style box. After a decade-plus of worrying about being on the wrong side of the growth-value trade, that is precisely what I am pursuing.
Humbly yours,
Ben Claremon