|
The value process has always maintained that risk is best
viewed in terms of margin of safety. The preservation of capital is a central tenet
of the value investment philosophy, which espouses that risk is absolute and
avoiding permanent loss of capital is paramount. Holding a portfolio with
securities trading at a premium to their intrinsic value exposes investors to
unwarranted capital loss.
This philosophy is in direct contrast to that of an index. By
its very construction, an index does not take valuation into account. This means
that at any given time, an index may include significantly overvalued securities.
Common sense says that a value portfolio, containing only a subset of undervalued
securities, is less risky than an index in its entirety.
Over the last decade, however, the investment industry has
gradually evolved away from examining absolute risk to tracking error. This
transition was supported by a prolonged period of positive equity returns. Capital
preservation lost its importance at the very time valuations reached all-time
highs.
Nortel Networks illustrates the impact of this shift on plan
sponsors. As Nortel became a disproportionately large part of the TSE 300, active
managers began to lag the index and concerns about performance shortfalls arose.
Professional managers made fewer decisions based purely on investment merit and
more on their own business risks.
"We were approached by some managers when Nortel's weight
rose into double-digit territory," says John Cannell, treasurer of the Toronto
Transit Commission Pension Fund Society in Toronto. "They asked us to consider
increasing the maximum to a higher level. We weren't comfortable and maintained our
original limits."
Not all plan sponsors chose this route. Some believed it was
less risky to hold a large weighting in Nortel (trading at 100 times its estimated
forward earnings and all-time high valuations) than owning no stock in this company
at all. In retrospect, the 90% decline in Nortel's share price serves as a harsh
reminder that valuations matter and risk is absolute.
"My pet peeve is that the index creators drove investment
decisions rather than money managers," says Zainul Ali, Canadian director of
research at Towers Perrin in Toronto. "It was wrong. You can't let the TSE 300 or
Standard & Poor's 500 composite index drive how you manage money. While
benchmarks are important, flaws must be recognized early and dealt with.
Unfortunately, some managers worried about massive business risk and relegated
fundamental analysis to the backburner."
|
Fiduciary road-map
Don't let market volatility steer your pension fund off course. Stick
to your investment principles and with managers who adhere to their
style.
Over the past few years, volatile markets have presented distinct
problems for plan sponsors. Market gyrations have challenged trustees'
sense of what it means to be a fiduciary. With virtually every Canadian
equity manager underperforming their benchmark index during the
technology bubble, trustees were faced with hard decisions. Those who
ultimately changed managers in order to recapture lost ground were
whipsawed. In the future, what should plan sponsors look for in a money
manager?
Since markets fluctuate over the short term, investment styles move in
and out of favour. Successful money managers adhere to their style
nonetheless. Switching styles at the very moment it is most out of
favour compromises long-term performance.
Plan sponsors want to avoid money managers who don't have a highly
disciplined investment process that consists of a proven philosophy
that is consistently implemented and backed by solid, in-house
research.
Money managers must demonstrate unflinching resolve when faced with
external pressures to amend their style. Unyielding managers will
certainly be tested occasionally, but sponsors will be the
beneficiaries of this discipline.
Lastly, expect the unexpected. Low probability events, such as the
technology bubble and the biotechnology bubble, occur with surprising
regularity. When this happens, a mean-reverting event will occur at
some point.
Don't let unusual events dictate your reaction and don't panic. More
importantly, don't allow unusual but temporary events influence
decisions made during tranquil times.
|
|
Batting $1,000
A $1,000 investment in equities made by a value manager would have
grown to $11,320 between 1982 and June 2001. The same investment made
by a growth manager during this period has only risen $3,973.
|
VALUE VS. GROWTH
According to Barra Canada style equity indexes, value outperforms growth in most
years. Surprised? If so, you're probably not alone. Between 1982 and the second
quarter of this year, value strategies outperformed growth in 14 out of the 19
years. Growth strategies dominated only five years during this period (see
"Comparing styles").
Clearly 1999 was the best year for growth as it generated a 40.3% advantage over
value in Canada. End-date sensitivity combined with short time horizons produced
annualized charts that led some to conclude that growth was consistently the better
strategy. So what did each style really produce for investors? Referring to the
Barra Canada style equity indexes, a $1,000 investment in value would have grown to
$11,320 between 1982 and June 2001. The same investment in growth would have risen
to only $3,973 (see "Batting $1,000").
Despite the stellar record, the concept of buying undervalued equities to achieve a
margin of safety was almost universally abandoned last year. Articles trumpeting
the death of value and ridiculing traditional valuation techniques were prevalent.
Warren Buffet, arguably the most successful investor of the 20th century, was
called a dinosaur who was out of touch with modern day reality.
Value managers who kept their investment disciplines throughout the technology
euphoria experienced debilitating tracking error shortfalls, often dropping to the
fourth quartile. "Deep value managers remained true to form," observes Ahmad. "Core
managers, by definition, drifted according to the bias of the index, which by 1999
had a distinct growth orientation."
Naturally, trustees began questioning consultants about their value managers.
Fourth-quartile performers don't often get new mandates, and usually lose existing
ones. "In a few cases, plan sponsors made classic timing errors during the bubble
period," says Brian Goguen, senior consultant at Toronto-based Frank Russell Canada
Ltd. "Some terminated value managers, based largely on performance, switched to
either core or growth Canadian strategies. This decision has been costly."
So what has the investment industry learned from this experience? Canadian equity
markets are not efficient. Risk is absolute. Valuations matter. And we live in a
mean-reverting world, where there are no new eras.
In retrospect, sponsors may have unknowingly accepted riskier strategies based on
their belief that the index was unbeatable over time. However, if Canadian equity
markets are not efficient, the promises of the index may be oversold. Meanwhile,
value managers who buy equities far below their intrinsic worth have proven that
they can preserve their clients' capital, generate significant returns and reduce
absolute risk.
In the words of value guru Benjamin Graham: "An investment operation is one which,
upon thorough analysis, promises safety of principal and a satisfactory return.
Operations not meeting these requirements are speculative." BC
|
News
