With GAIM and GAIM Ops Amsterdam getting underway in rainy Amsterdam, we spoke to Scott Davies of CDAM about why value investing is making a comeback.
How has value investing performed since the crisis?
Reading the recent press it would seem that value investing and all active investing have underperformed most conventional benchmarks since the crisis, but I don’t think that is an accurate reflection of value investing’s performance. Firstly, the term ‘value’ has probably been diluted to include strategies that have elements of the institutional definition of value. The underlying theme that differentiates value investing from other investment strategies is not a metric but a philosophy of ensuring each investment offers a margin of safety. Secondly, available data being used to compile the statistics is not representative of the industry. The data that is being analysed is solely by those funds that chose to report. A significant number of funds (which in my opinion would boost returns) are private and only report to their investors.
What in your view is the reason so many other value investors are reconsidering their strategy? Has it given you any concern recently?
As I mentioned previously, value investing is more of a philosophy than a strategy. There are various ways to be a value investor: no two are exactly the same. If an investor has been bitten by the value bug it would be very difficult to approach investing in any other way. From our perspective markets move in cycles and sometimes a particular approach may not lead the pack, but over the long term the value approach has proven to be the best way investors can preserve capital and compound returns. Passive investing has had a good run since the crisis due to the Fed’s influence. It will always do well in a one-way market but has a poor track record in the second half of the cycle. I would always rather manage security exposure than market exposure over the long term.
How dependent is value investing on the current low interest rate environment? Do you believe that everything is currently priced to give lower returns?
At CDAM we believe that the cost of capital is the largest determinant on security returns. Most of our analysis focuses on a company’s cost of capital versus its return on invested capital. We look for investments where that spread is wide and stable, making us indifferent to interest rates from a security perspective. If you are managing market exposure interest rates and the value of a specific index can create some anxiety, but if you are looking for companies that are good allocators of capital, interest rates play a different role.
Being a company focused on interest rates we don’t ignore the influence that higher rates can have on overall asset prices. In our experience equity market valuations probably don’t need to adjust until long term good quality credit yields breach 6%.
Do you believe that small is beautiful when it comes to a value-based portfolio?
Smaller companies definitely provide a better opportunity set, mostly because of the lack of coverage. If 80% of allocations have gone into the largest managers there is only one place they can hunt for investments, leaving less concentration and better returns to smaller companies.
How much are you involved in the value-creation process?
Generally, we don’t like to interfere with management. We see our role more as constructivist, helping to provide capital if needed and supporting management. Part of our investment process is to ensure that the industry and company are viable.
We often hear that value investing requires patience and confidence to see the prices of assets fall after purchase. How are investor relations different in the value space?
At CDAM we take a different approach. We believe all investments should have an IRR and an expected time frame, which makes it much easier for our investors to gauge returns. We do not believe in the ‘buy it because it’s cheap’ method. Our approach is to prove that a company is cheap and then prove why and when the valuation gap will close.