Value, Contrarian and Turnaround Investing - where to draw the line?

2012-07-23 07:40 -  , Value Investing

Value Investor, Contrarian Investor and Turnaround Investor

A Reader of my german blog posted a comment some time ago.

Where do you draw the line between Value, Contrarian and Turnaround Investing?

Contrarian, and in particular Turnaround Investors, are imo much more speculative.

While Value Investors try to find stocks, that retain their value under all conceivable scenarios, Contrarian and Turnaround Investors take more risk.

They also pay attention to the fundametals, but they also accept scenarios, where they risk to face a total loss. As long as the mean value of the expected return is big enough. There are of course much more of such not 100% secure stocks.

What is your opinion on this approach?

I will try to answer this question. Let’s start with a brief definition of the terms Value Investor, Contrarian Investor and Turnaround Investor. I don’t know, if the following definitions are the commonly accepted ones (if such a thing exists at all). The following definitions only describe, what this three terms mean to me personally.

A Value Investor is someone, who values investments, based on the benefits they will produce for him during a long-term holding of this investment. He buys investments, he can buy for a price below his estimated value.

A Contrarian Investor is someone, who buys investments that are unpopular. His thought is, that investors are driven by fear and greed, and that investments unpopular at present will not be unpopular forever.

A Turnaround Investor is someone, who invests in companies, that face difficult times at the moment. He tries to indentify those of them, who will overcome this difficult times and recover in the future.

There is no such thing as a 100% secure investment

Let’s think about the Value Investor first. You mentioned in your comment, that you regard someone as a Value Investor, who limits himself to investments, that are 100% secure. Meaning they are worth at least the amount you paid under all possible future developments.

I don’t think, there is such a thing as a 100% secure investment. Every investment can turn out to be worth zero. Only time will tell. It is not 100% secure, that one year US government bonds will be repaid in 2013. And it is not impossible, that Coca Cola goes bust soon without paying any dividend or liquidation proceed to shareholders ever again.

I think you know this. You certainly meant very secure instead of 100% secure. So is a Value Investor someone, who limits himself to investments, that retain their value with a very high degree of certainty?

I don’t think that is the case. Think of Benjamin Graham. One of his most loved kind of investments where net nets. Most individual net nets are very insecure investments. Many companies that trade below their net current asset value do this for good reasons. They are in danger to suffer losses in the future and that would reduce net current asset value. Net nets proofed to be profitable investments only as a group. Graham knew that and diversified his investments in net nets much. That poduced good results for the whole portfolio, although some individual stocks produced catastrophic results.

How to value a company…

But there is a fact, that makes your assumption about Value Investors not completely wrong: There are in fact many Value Investors, who prefer investments, that have a very low risk to turn out to be worth less than you paid. What are the reasons for that wide spread preference under value investors?

I think the reason is the following.

You can’t calculate the value of an investment. You can only calculate the value of an investment under certain assumptions on the future. The thing you have to do in theory is, find all possible future developments. Then calculate the value of the investment for all scenarios you identified. Then assign a likelyhood of occurence to every scenario. Multiply every calculated value with the assigned likelyhood of occurence. Then add up all those numbers and divide the results by 100%. With that approach you get the expected value of an investment. That does not mean that you are certain to profit, if you buy for a price below that calculated value. It depends on which of the possible scenarios will come true in the future. But one thing is sure: if you calculate this expected value correctly for many investments and manage to buy a large number of investments below your calculated value, you will profit (At least with a high degree of certainty. To make it 100% certain, you have to buy an infinite number of those investments. But let’s stop with that math stuff for now).

…and a useful simplification

The bad thing is, it is impossible to follow the approach decribed above. How large is the number of possible developments you have to assign a value to? The number is infinite. So you have to simplify. You could limit yourself to a small number of scenarios. Or more specifically to a number of groups of scenarios, that consist of scenarios, you can assign a similar value to. If you have three scenario groups, with a likelyhood of occurence of 50, 30 and 10 percent, there are only 10% probability left for all other scenarios. It could be acceptable, to leave these remaining scenarios out of your calculation and still come to a useful conclusion.

If you simplify further, you could do the following: try to estimate the minimum value of an investment, that should mark the lower limit of the value with a very high degree of certainty. I am so convinced of the beauty of simplicity, that I named my blog Simple Value Investing. And I apply this approach very often. I think it is a good thing to do that. If you pay less than that estimated very certain minimum value and have a reasonable upside, you don’t have to be right about much more things to make a good profit over time.

So my conclusion about Value Investors: many of them concentrate on investments, that have a very low probability to produce losses. That is a quite recommendable approach. But I don’t think that is the thing that makes them Value Investors. There are Value Investors who follow another approach. And some of them are successful.

The Contrarian Investor is not an Investor at all. Unless he is a Value Investor

Let’s proceed with the Contrarian Investor. He buys investments, because they are unloved by the public. He knows or thinks, that the public overreacts often, and that many unloved investments may prove to be not that bad in reality. He speculates that the public opinion will change in the future, and that he can sell his investments for a higher price then. I hope you noticed that italic word there: speculate. I think the Contrarian Investor meeting my definition is no investor at all. He is a speculator. That does not mean it is a dumb thing. The assumptions of the Contrarian Speculator may be right often enough, to make a good profit.

There is a thing, that makes that issue a bit complicated. You won’t find that form of a Contrarian “Investor” all too often. What many people do, who are called Contrarian Investors or call themselves Contrarian Investors, is the following: They search for investments, that are really unloved. Then they try to value them, to form their own opinion and see, if the public is right. They do that, because they know that the public often overreacts and they have a good chance to find undervalued investments by that approach. But what they do in fact is, they value companies. They do the same thing as a Value Investor does, and they are Value Investors. The Contrarian part is only for idea generation.

It is very common, that undervalued investments are unloved or contrarian investments. Probably because of the human tendency to see everything in black and white.

So are Contrarian Investors Value Investors? Or Value Investors Contrarian Investors? Or are Contrarian Investors in reality speculators and have nothing in common with an investor? It depends on your definition of this terms…

The Turnaround Investor

What does a Turnaround Investor do? He tries to identify companies, that are in bad economic condition at the moment, but have a probability to overcome these difficulties, that is higher, than the current price of the shares indicates. That means, the shares are traded at a price below what they are worth. So what differentiates a Turnaround Investor from a Value Investor? Nothing. A Turnaround Investor is a Value Investor. But a Value Investor is not necessarily a Turnaround Investor. So Turnaround Investing must be a subgroup of Value Investing.

It is true, that a Turnaround Investor takes more risk in a single investment he mades, than the kind of Value Investor, who focuses on investments with a low probability of permanent loss. But like Graham did with his net nets, he can compensate for that weaknesses by diversifying his investments. As long as his judgement about the expected value of his investments is good enough, he will profit over time.

Conclusion

Who is a Value Investor, a Contrarian Investor and who a Turnaround Investor? I hope this article helped to clarify this a bit. But you should keep in mind, that the answer to this question highly depends on your definition of these three kinds of investors. The definitions given in this article are only one possibility. They are not necessarily the best ones.

Please share your thoughts on that topic, by writing a comment!


Comments

Commenting is closed for this article.