Excess Returns 2 – Styles and Strategies

This article is part of our ‘Guru’ series – investor profiles of those who have succeeded in the markets, with takeaways for the private investor in the UK.

You can find the rest of the series here.

Today we complete our scene-setting introduction to Excess Returns by looking at the various investment styles and strategies that successful practitioners can use.

Excess Returns

Frederik describes two basic approaches: bottom-up and top-down.

Bottom-up style

This is the traditional popular approach based on the analysis of individual companies:

• financial statements (quantitative)
• competitive position (qualitative)
• management (qualitative)

The Macro picture – the economic outlook – is usually ignored, often on the basis that successful economic forecasting is difficult. Many bottom-up Investors try to find companies that will do well regardless of the economic environment.

Successful examples of this approach include:

• Benjamin Graham (quantitative only)
• Philip Fisher (quantitative and qualitative)
• Warren Buffett
• Joel Greenblatt

Sub-styles

This approach can be divided into eight sub-styles: ((I have used slightly different categories than Frederik ))

1. value investing
2. growth investing
3. pairs trading
4. risk arbitrage
5. vulture investing
6. activist investing
7. private equity (venture)
8. control (takeover / buyout)

Many Investors use more than one approach, either depending on market circumstances, or simultaneously at all times.

Value Investors

Investors like Benjamin Graham and David Dreman solve the problem of how to determine the intrinsic value of a stock by only buying stocks that are cheap according to certain valuation measures:

• Price to earnings (PE) or
• Price to Book Value (PBV or PB)

This inevitably means that they focus on ignored and unpopular stocks.

Some value investors only buy high quality stocks and hold them for years. Others ignore quality and sell as soon as the stock price reaches intrinsic value.

Growth Investors

Growth investors will buy high-multiple stocks, so long as they predict (earnings) growth much higher than the market average (typically 15% pa or more). This is the “pay up for growth” argument.

Growth investors usually buy for the long-term, and expanded multiples do not trigger a sale.

Peter Lynch is a good example of a growth investor. He popularised the “Growth At a Reasonable Price” (GARP) approach. GARP investors like sales and earnings growth of 20% to 30% pa, and are suspicious of higher rates.

Pairs trading

This is a long-short strategy often used by hedge funds. You buy a cheap stock and sell an expensive one within the same sector.

• This makes you market neutral, and you hope to profit as the valuation gap between the two stocks converges.
• A popular variation for private investors is to use pairs of large well-traded stocks from a main index.

For example in the UK, BP and Shell might be used as a pair, and traded whenever the gap between their valuations was large in historic terms.

Risk arbitrage

This is a transaction based form of investing which usually involves a merger or takeover.

• It forms part of what is known in the UK as “special situations” investing. Warren Buffet calls these types of situations “workouts”.
• The idea is that the Investor exploits the difference between the current value of a stock and the expected value at the end of the transaction.

Often the stock price of an acquisition will stay below the offer price because of market uncertainty over whether the deal will go through.

This is riskier than it sounds, and closer to trading than investing.

Vulture investing

This is all about buying securities (mostly bonds) in companies on the verge of collapse.

• As with merger arbitrage, the investor expects to profit from an increase in the value of the security at the end of the process.
• Thus it is another special situations / workout approach.
• In another sense, it is an extreme form of value investing.

The “process” might be a recovery in the company’s fortunes, or the administration / bankruptcy process.

With bonds, prices may be pushed too low by forced selling from institutional investors no longer able to hold a distressed security.

This kind of investing can provide decent uncorrelated returns, but is best left to the specialists.

Activist investing

Sometimes Investors buy a stake in a business they think is badly run and try to turn things around (often by replacing the management).

Usually they take a big enough position to force their way onto the board. Carl Icahn and Bill Ackman are well-known examples.

Venture capital and private equity

Venture capital (VC) investors buy significant but non-controlling stakes in companies (usually equity, sometimes also debt) and aim to hold them for several (say five to seven) years.

Private equity (PE) is similar, except that VC is usually concerned with early stage companies and PE often targets mature companies that are underperforming (like activist investors)

Both VC and PE investors usually have a directing involvement in the management and strategy of the company. PE investors in particular like to load up companies with a lot of debt.

Control (takeover / buyout)

The souped-up version of VC and PE investing is to take over the company, through either a friendly or hostile takeover bid.

When PE investors do this they typically take the company private, if it already has a listing.

Sometimes the existing management will take over the company (buyout).

Top-down investing

Top-down Investors analyse the economy first, working their way down to the industry sector and then the companies that should do well from their macro analysis.

Economic forecasting is difficult and has a poor track record, so this is harder than it sounds.

Requirements for success

Frederik thinks that successful investors need two things:

1. skill in estimating the fair value of companies
2. the right mindset for investing

How much estimating skill is needed is open to debate. You don’t need to be the best in the market, just better than most of the market, or willing to put in more work than most of the market.

I would also argue that the different perspectives of other market participants (career-risk avoiding index huggers) can mean that private investors managing relatively small pots have a built-in advantage.

Important psychological aspects include:

• independent / contrarian thinking
• patience / long-term thinking
• discipline (sticking to the process)
• emotional detachment (calmness in the face of irrational markets, lack of attachment to stocks they own etc.) – this will limit the impact of the cognitive biases we discussed last time

For Frederik, successful Investors are the true rational market participants that much of the theory assumes make up the entire market.

But in fact they are a rarity, and rather than driving the market, they take advantage of its deviations.

Conclusions

From the perspective of the typical UK Private Investor, the various approaches to investing can be split into three groups:

1. “Easy”
   • Value investing
   • Growth investing
   • VC and PE  – there are easily accessible investment trusts and ETFs for exposure to PS, and tax-advantaged VCTs for VC
2. Advanced
   • pairs trading is reasonably straightforward to implement with spread betting (or CFDs or options)
   • top-down investing can be used to trade indices, commodities and currencies (eg. via spread bets), but this is not easy
3. Best left to the professionals
   • risk arbitrage
   • vulture investing
   • activist investing
   • control (takeover / buyout)

Moving forward, we will focus on the “Easy” and Advanced groups.

As well as developing skills in these areas, the potential investor needs to assess his personality against the desirable qualities listed above.

Active investing isn’t for everyone.

Until next time.