Value and Growth are Joined at the Hip

Warren Buffett famously said that growth and value are joined at the hip. Both are areas of fundamental analysis. I think most business owners wouldn’t even understand what you mean if you would ask them if they focus on growth or value in their capital allocations. They just allocate capital to the projects with the highest expected IRR, irrespective of any category. 

Personally, I really like the framework put forth by the late Marty Whitman. In his opinion, there are are 5 main areas of fundamental finance: 

  1. Value Investing (limited to minority positions in public co’s) 
  2. Distress Investing
  3. Control Investing
  4. Credit Analysis
  5. First and Second Stage Venture Capital Investments

Buffett, as an example, has been active in all of those categories, either directly or indirectly. Singleton, as well, is someone you could not classify as a value investor specifically. He just went where he thought the highest IRR was at any given time.

Peter Lynch: “I Love Volatility”

There is this great short clip on YouTube with the legendary former mutual fund manager Peter Lynch (of Magellan Funds). In the video, Lynch declares his love for volatility and explains how he approached it: 

Volatility will occur. The markets will continue to have these ups and downs. I think that is a great opportunity, if people can understand what they own. If they don’t understand what they own mutual funds. And keep adding to it. Basically, corporate profits have grown about 8% per year, historically. So corporate profits double every nine year. The stock market ought to double every nine years.

The operative phrase here is “if people can understand what they own”. We can also invert what Lynch is saying in the video and ask ourselves what value we can provide by understanding the assets that have a volatile price?  

The Social Value of Active Investing

There’s a fantastic podcast interview with Micheal Mauboussin on the Invest with the Best Podcast, where he talks about the value that active investors bring to the market. Mauboussin says the following: 

Now, one of the things we’ve talked about quite a bit is, is there a role for indexing? And the answer is, absolutely yes. And I think for many people, that’s a very sensible solution. But that does not mean that the active management industry can go away. It’s not going to go away, because there are two things that it does that are still really important. One is price discovery, and again, indexing benefits from that positive externality, I think we can never lose that.” 

Essentially the fees paid to active management subsidize the indexing industry. And the other is liquidity. And even in these environments, we see that index people don’t trade that much. And so we need liquidity if you have it. I think those are public goods, those are vital, and those will continue to play a role. So the debate should be, what percent of the assets should be active versus passive?” 

By this logic, you could also posit that as an active investor the best way for you to add value is to find areas where you can add value by pricing the securities in question (research, know-how, etc), especially in securities where (or time when) liquidity is scarce.

Largest S&P 500 Single Day Drop

One of the things that has preoccupied my mind lately are the underlying differences in approach between active investing and passive investing.

Imagine the two following hypothetical money managers: One of them is an active investor. He performs bottom-up fundamental research of companies, trying to determine their “intrinsic value”.

The other investor is passive. He uses quantitative analysis in order to find factors would have lead to out performance compared to a specific benchmark (these strategies are called “smart-beta” as they are passive in nature, but still aim to outperform the benchmark).

Analytical vs Statistical Approaches

For lack of better terminology, lets say that the active investor has an analytical approach, while the passive investor has a statistical approach.

The active investor is focused on the future cash flows of the company. He is tries to understand the business model of the company he is analyzing how the company creates value. He might try to study historical transaction multiples or how similar public compare in terms of valuation ratios. But primarily, the fundamental investor is trying to analyse future events.

The quantitative investor, however, is looking at a universe of stocks. He mines datasets to find a relationship between factors and performance. He designs different strategies and uses backtesting to see how these strategies would have performed.

The Limits of History

But what is data? Data is history.

Consider the following: Suppose you ask the investors about the largest single day drop in the S&P 500. The quant tells you that the largest single daily drop of the S&P 500 occurred on October 19, 1987, when the index fell by 20.47%.

The fundamental investor, however, tells you that the largest single day drop hasn’t happened yet.