Our Three Tenets of Value Investing

“Value investing” is one of the most overused and inconsistently applied terms in the investment business. Those words are as true today as they were when value investing legend Seth Klarman first wrote them in Margin of Safety back in 1991. From a single intellectual seed sowed by Benjamin Graham and David Dodd almost a century ago, a hundred styles of value investing have blossomed. Value investors have evolved divergent views on issues like the importance of hard assets relative to operating cash flows, how to factor growth into intrinsic value estimates, and the degree to which investments should be event-driven, among many others. It is easy to find prominent value investors among both the bulls and bears on companies running the gamut from Sears Holdings to Amazon.com. As a result, anyone who labels themselves a value investor should be able to answer a simple question: “What exactly do you mean by that?”

At Hinde Group, we identify ourselves first and foremost as value investors. When we refer to value investing, we have a specific definition in mind:

Value investing involves making investments at prices that offer excess risk-adjusted returns based on conservative assumptions with minimal risk of materially adverse outcomes.

Our definition of value investing has three tenets.

Invest at Prices that Offer Excess Risk-Adjusted Returns

One of the most fundamental concepts of finance is that investors require compensation for bearing risk. If you want to induce someone to make an investment that involves risk, you need to offer a return that is some amount above the prevailing risk-free rate. Regardless of how one measures risk and derives appropriate risk premiums, every investment in theory has a “fair” or “market-level” return that appropriately compensates for its risk.

When we say value investing involves making investments at prices that offer excess risk-adjusted returns, we simply mean returns that are some increment higher than a fair or market level. If a fair expected return for a given investment is 8.0% per annum, a value investor might only be willing to pay a price that offers 15.0% or more. All else being equal, price and return have an inverse relationship, so a security offering an excess risk-adjusted return can also be thought of as trading at a discount to a fair price. They are two sides of the same coin.

This element of value investing is common to all active investment strategies. All active managers aim to generate excess risk-adjusted returns, regardless of how they may articulate that goal.

Use Conservative Assumptions

Taking the price of an investment as a given, your expected return will depend entirely on your assumptions. Most investments involve both risk and uncertainty. There is a dispersion of possible outcomes, and the information you have about that dispersion is imperfect. Your cup will runneth over with investments offering “excess risk-adjusted returns” as long as you are willing to make aggressive assumptions. Of course, you’ll be lucky if the actual returns from those investments prove to be even acceptable, much less excess. The standard way to value an investment is to discount the investment’s mean or expected outcome. That generally means there is roughly an equal chance of actual outcomes being favorable or unfavorable. In contrast, value investing involves using assumptions that are more likely than not to result in favorable outcomes. If a typical investor targets assumptions that have an equal chance of outcomes deviating favorably or unfavorably, a value investor might strive to use assumptions that should result in favorable deviations 90% of the time and unfavorable deviations only 10% of the time.

Combining this element of value investing, using conservative assumptions, with the first, targeting excess risk-adjusted returns, is what distinguishes value investors from other active managers. A growth or momentum investor aims to achieve excess risk-adjusted returns, but does so primarily with assumptions based on extrapolation, not conservatism.

Limit the Risk of Materially Adverse Outcomes

Value investing involves focusing not only on using conservative assumptions, but also on the potential severity of unfavorable outcomes. An investment may only have a 10% chance of an unfavorable outcome, but that unfavorable outcome result in anything from a positive, but lower than expected, return to a total loss. Regardless of the level of expected returns or how conservative one’s assumptions may be, an investment is only a value investment if the chance of a materially adverse outcome is remote.

Any investment that has more than a remote risk of a materially adverse outcome is better thought of as a speculative investment than a value investment. If it fulfills the first two tenets, it could even be an attractive investment, but it would be a speculative one nonetheless.

What about Valuation Multiples?

There is one thing that may seem conspicuously absent from our definition value investing: any mention of valuation multiples. Value investing is often defined as making investments priced at valuation multiples below some level, typically the average of the market. That definition is overly simplistic. Price is certainly inversely related to expected return, all else being equal, and investments that meet our three tenets are surely more likely to be priced at modest valuation multiples. But there absolutely are companies with material, durable competitive advantages and large growth opportunities for which conservative assumptions for growth over the next several years are not low numbers. The equities of those companies could satisfy our three tenets at valuation multiples higher than those typically associated with value investing. Conversely, an equity investment priced at multiples that you might expect to make a value investor salivate could fall far short of our criteria if the issuer were so troubled that even maintaining the current level of its business would be a fantasy.

These three tenets guide our approach to value investing at Hinde Group. Our precise definition of value investing may be unique, but we believe the underlying tenets are universal to any sound value investment approach.

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