This is an article comment on an article previously published in Sharesansar. Both authors are guest writers. Sharesansar is pleased to host a healthy platform for open discussion of ideas and investment strategy. Like always, Sharesansar as an entity refrains from endorsing a strategy over another. Reader discretion advised.
- Bivek Neupane
On April 2, 2021, the article titled “Value Investing? Really ?” was published in ShareSansar. You can find this article here. Here is my take on this article.
First, the author claims that venture capitalists cannot do a simple DCF analysis. Now, I will have to admit I am still confused as to whether that was a euphemism for something deep or he really thinks that the VCs cannot do a mere arithmetic calculation of discounting CFs by a discount rate. If the author really believes that VCs cannot even do a simple discounting of cash flows, he should re-evaluate his perspective on the whole VC industry. A VC firm has many expert teams that span from legal to technology to finance. In other words, they are not a bunch of high school dropouts. There are actually so many extraordinary minds in the VC industry. I would recommend everyone interested in this stuff to check out the Patrick O'Shaughnessy podcast “Invest like the best” where he interviews VC fund managers.
Then, the author goes on to mention a bunch of high-profile value investors. And by the way, Ray Dalio is not a value investor. He is a macro guy. The author also claims that the so-called value investing preachers do not know what they are talking about. I completely agree with this point. Over the years, I have met so many Warren Buffett disciples that do not know how to read financial statements and just rely on buying low P/E stocks without actually considering other fundamentals of the company. Although one could make a point about buying low valuation companies, this strategy alone does not comprise the systematic value investing category which works in the long run, as research confirms. Anyone interested in understanding how to value a company should take lectures from Aswath Damodaran from his YouTube channel. It’s completely free and the “Dean of Wall Street” is himself giving you a lesson.
Like the author, I have also shifted my perspective on how I look at investments. I am no longer a traditional stock picker. I started as a value investing disciple and still, to this day, I am glad that I followed the route laid out by Graham and Dodd. However, my reasoning to walk away from that is what we know as a Principal-Agent problem. This means there is a huge deal of information asymmetry between the shareholders and managers of a company. Hence, the public shareholders would always have less information than the people on the board or the CEO. Hence, no matter how good is your valuation and financial statement analysis, as the time t moves from 0 to 1, the whole scenario might change and you have to constantly update your model. This means more and more assumptions and forecasting. These are the two biggest sin words in empirical research: “Assumption” and “Forecasting”. I have written about this extensively in my blog. If you are interested, you can find it here.
Third, the author tries to convey his point by giving an example of a bad trade that Bill Ackman made with Herbalife. I completely agree that Bill’s trade got it wrong here. He should have gotten out soon. He also made a disastrous trade with Valeant. That being said, he is also responsible for taking the “Bet of the century” just last year when he bought credit default swaps while Covid-19 was just starting to hit the western markets. Long story short, he made USD 2.7 billion of profits from that single trade in a span of few months.
What I am trying to say here is that the author gives an example of a value manager blowing up but completely ignores the fact that there were also thousands of quantitative funds out there who have lost millions and billions. A period that comes to the top of my head right now would be the “Quant meltdown” in 2007. All the big players like AQR’s Cliff Asness, PDT’s Pete Mueller, Citadel’s Ken Griffin were losing hundreds of millions every day. Granted that this was a far outlier and a tail-end event in a distribution, it does not change the fact that in this business of investment management, some will lose and some will win. That’s the name of the game.
The author gives examples of Rentech, D.E. Shaw, TwoSigma which are undoubtedly excellent quant-shops. But there is nowhere any mention of hundreds of quant hedge funds who started by promising alpha to the investors but soon that changed to supplying betas and when that happens the flows stop coming in and eventually they have to close down the shop because the operating costs is just too high.
The very fact that the author cherry-picked only the most successful quant funds is nothing but a case of promoting a survivorship bias. This is the thing every empirical research student is taught in their first introductory class. Survivorship bias leads to distorted analysis and results.
Finally, the author seems to encourage the importance of learning statistical concepts and probability theory. I couldn't agree more with the author here. I believe that if a person is an active trader (which I don’t necessarily recommend), they should at least have a good grasp of these techniques like Kelly Criterion. Ed Thorpe used this exact technique while he was deciphering techniques to beat the blackjack house. Similarly, quite contrary to the author’s point, I don’t really believe that learning "machine learning" in YouTube and advanced math will guarantee you riches. Nonetheless, it will certainly make you think from a different perspective.
So, in a nutshell, I would like to tell the author:
"I accept your conclusion, but I have to reject your premise."
Author's note: I hope the author takes this as constructive feedback and expression of another opinion, just like his. I am open to any comments from the author or anybody reading this. I believe in open communication and sharing my ideas with people. A healthy debate is always good for all the parties involved.
Bivek Neupane is a MSc. Finance and Economics student. He is also a CFA candidate. He is specializing in quantitative finance and research. His other interests include Factor modeling, Portfolio optimization, Behavioral finance, Alternative asset management, etc. Connect with him via LinkedIn or his blog.