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Value Investment Philosophy: Absolute Performance
In general, value investment philosophy is made up of three parts. The first is using bottom-up strategy which identifies specific undervalued investment opportunities. Second, value investing is absolute-performance, not relative-performance based. And third, value investing is a risk-averse approach meaning attention is paid as much to what can go wrong (risk) as to what can go right (return).
Let’s look at the absolute-performance. Most investors, both institutional and individual have adopted a relative-performance orientation. Meaning, they invest with the goal of out performing either the market, or other investors and are indifferent as to whether the results achieved are an absolute gain or loss. Value investors, in contrast, are absolute-performance oriented. They are interested in the returns of their investments and not how they compare to the overall market or other investors. Good absolute performance is achieved by buying undervalued securities while selling holdings that become more fully valued.
Absolute-performance-oriented investors typically take a longer term perspective than relative-performance-oriented investors. A relative-performance-oriented investor is generally unwilling or unable to tolerate long periods of underperformance and therefore invests in whatever is currently popular. To do otherwise would jeopardize near-term results. Relative-performance-oriented investors may actually shun situations that clearly offer attractive absolute returns over the long run if making them would risk near-term underperformance. By contract, absolute-performance-oriented investors are likely to prefer out-of-favor holdings that may take longer to come to fruition but also carry less risk of loss.
One significant difference between an absolute and relative performance investor is evident in the different strategies for investing available cash. Relative-performance investors will typically select to be fully invested at all times, since cash balances would likely cause then to lag behind a rising market. Since the goal is at least to match and optimally beat the market, any cash that is not promptly spent on specific investments must nevertheless be invested in a market-related index.
Absolute-performance oriented investors, by contrast, are willing to hold cash reserves when no bargains are available. Cash is liquid and provides a modest, sometimes attractive nominal return, usually above the rate of inflation. The liquidity of cash affords flexibility, for it can quickly be channeled into other investment outlets with minimal transaction costs. Finally, unlike any other holding, cash does not involve any risk of incurring opportunity costs (losses from the inability to take advantage of future bargains) since it does not drop in value during market declines.
Next time we’ll address the third part being risk and returns.
This is primarily sourced from Seth Klarman’s book entitled “Margin of Safety, Risk-Averse Value Investing Strategies for the Thoughtful Investor” published in 1991 and never published again. The book contains many valuable lessons for the value investor despite it is no longer available.
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