Value Studies Outperform Value Gurus: A Study of the Long-Term Returns

During their latest episode of the VALUE: After Hours Podcast, Taylor, and Carlisle discussed Value Studies Outperform Value Gurus: A Study of the Long-Term Returns. Here’s an excerpt from the episode:

Jake: Yeah. Well, part of this too came from a little study that I did back when I was teaching way, way back in the days. It was an examination of all of the value studies. Comparing that to the value gurus and looking at them in a longitudinal study of like, “Okay, in this year, how did the studies do? Aggregated? How did the managers do?” And then just running through in time. Of course, all of the caveat emptor in this world of studies where it’s like, transaction costs, trading costs, and taxes, all these things that people cite for why you can’t fully depend upon these studies. That’s fair. By the way, the studies absolutely trounced the managers, the gurus. It just killed them across every single time period.

One of my hypotheses as to why this might have been was that if we think about taking advantage of some behavioral bias, I think we would all agree that the market can undershoot and also overshoot. Both of those extremes are illogical from the actual price, when it’s price and value matching each other. So, the value studies, because they’re so mechanical, they buy when it’s cheap and they hold for a year or two years or three years, whatever the prescription is, and then they sell, and then they trade up. Well, it’s possible that they because it’s a time-based effect, it’s not necessarily valuation based, they might participate in capturing both the inefficiency to the downside as well as if it runs up to a stupid amount that the guru would have sold out of. And so, they’re not capturing that upside inefficiency.

Tobias: 100%.

Jake: I don’t know how true that is. It was always just a hypothesis.

Tobias: That makes sense to me. Of course, you can definitely see it. Some things just get hot for whatever reason and they run up way beyond what anybody.

Jake: You never would have held it, right? If you had discretion over that, it would have felt like you were taking a really stupid risk at that point. You’d already won, you would want to punch out to lock in the gains. Like, every single psychological thing would be making your finger want to push that button to get the hell out, right?

Tobias: Particularly, because the nature of these things is they do tend to return to Earth. They’re not like the compounders where– [crosstalk]

Jake: Very rarely do you catch Apple as a net-net and ride it to the [crosstalk] land.

Tobias: Look, it’s fine to overpay for that stuff. There’s such good businesses, eventually they catch up. That’s fine. Don’t worry about it. I’ve never bought anything like that in my life. [laughs]

Jake: [laughs]

Tobias: That’s not true. I bought plenty of them and sold them when they got to-

Jake: Got to like a reasonable price.

Tobias: -fair value.

Jake: Yeah, exactly.

Tobias: Bought them at half book, sold them at book.

Jake: Right.

Tobias: Then ran to 10 times book.

Jake: Well, if we think about the return profile, a lot of times, it is a couple of names that will drive the entire outperformance of the portfolio, a power law type of outcome. If you trim those extreme return profiles, boy, you really truncate the total portfolio return at that point. If everything else is just, call it, a bunch of okays and then a few dogs out of there, you really might be giving up a lot of that potential total return from an aggregated basis.

Tobias: The VCs always used to say our portfolios have got parallel distributions. That’s why we have 10 positions and one or two [crosstalk] all of the returns.

Jake: Well, 100 positions.

Tobias: Well, that’s Y combinator. That was there. They said, “You get such good right tails, you can’t afford to miss the right tail. Therefore, have many more smaller positions and you’ll get more money into increase your chances of catching one of those. Given that any one of them can return the entire value of the portfolio, you might as well be in as many as you can to catch it.”

Jake: Yeah.

Tobias: There must be– [crosstalk]

Jake: Spray and pray, they call it.

Tobias: That must be true across. I don’t know why that would be different for listed portfolios as well. I think it is all fairly similar. It’s just over. People don’t hold for those periods of time, you’re selling all the time. But in those long studies that I have done where you just tell the system not to sell, just to hold everything, so it’s not real. You don’t get any of the capital back. It’s imagining that you’ve got this unlimited supply of capital to invest to, although you do end up getting about a third of the portfolio capital back over five years, which is extraordinary. To me, that it’s as much as that.

But it actually makes sense, if you think, if you’re buying on a cheap on a free cash flow basis and free cash flow yields like 10% after three years, that’s 30% of the cap of your starting capital has been plus some growth.

Jake: Recycled.

Tobias: It does make some sense that that’s what ends up happening. I think it would be hard to run a portfolio on that basis, unless you were explicit at the start like we’re doing a Y combinator, we’re going to buy 100 positions. We know that there’s going to be a lot of dead weight in here and the median stock might not do that well. But the payoff on the right tail is so huge, we don’t know which ones it is. That’s the funny thing. I go back and look at them. I have no idea. Prospectively, some of the names I recognize, that’s a bit of a cheat, but many of them I don’t.

Jake: I think if we compare time periods too, I think that’s important to realize the opportunity sets and the way that they’re structured. So, Buffett in 1950, it was a continuous conveyor belch mortgage board of inefficiently priced securities. And so, every single time you were trading up, you were just keeping that edge sharp on the portfolio. Like, buy something, it would run up, trade up into the next thing that was cheap. Two years later, that had run up. That’s how he made his best returns was basically just always keeping that cheapness edge on his portfolio. You had a nice run rate that you could just continually keep recycling into.

I think now, it’s possible that the inefficiencies come in punctuated time periods now where it’s like, “Yeah, the market’s a hell of a lot more efficient over most periods of time, but then occasionally, it just gets stupid one direction or another.” So, you have to wait around that whole time period when it’s mostly pretty efficient. And then when those things come, you have to be willing to swing big. So, that’s much more of a Munger Daily Journal management approach. Like, do nothing for a really long stretch and then feast when it’s put out for you. The industry is not really structured to capitalize on that style of opportunity set and flow. I think it’s much more the little continuous version always turning the portfolio over. That’s sitting on Treasuries for eight years, like, Munger did before you load up completely on three names. I don’t know if you can run a business that way, right?

Tobias: If you’re in an industrial and you have businesses that you’re ostensibly running, even though you’re not necessarily doing anything, you’re at the top making sure that the capital is not being reinvest, they’re not making silly acquisitions and doing things like that. You probably can do that, just that you wouldn’t expect an ordinary operating business to be making an acquisition every single year or every few years.

Jake: No, of course not. You would know that cyclically, there will be times where your competitors will be weakened and you want to have the resources available to take advantage of that, whether it’s taking their customers or their best employees or buying them out completely. That’s what a good anti-fragile operator is always thinking about.

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