Value investing shown to work consistently

Serious Money/Chris Johns: Of all the investment topics covered in this column in recent months, none has elicited a more extreme reaction that my thoughts on investment style.

Some fund managers are obviously touchy about criticisms of their particular style, while one or two stockbrokers have seen an opportunity to advertise their own preferred methodology via a dig at the contents of Serious Money. But the ways in which our money is managed should be a critical input into manager selection.

These days, investment style falls under one of four headings. The old value and growth categories have now been joined by quality and momentum.

The emerging industry consensus is that if any style works at all it is only likely to do so over the long haul - and the only style to have been shown to work consistently is value (although it has to be said that not everybody is convinced).

Just how we define value or growth is one of those esoteric discussions that we can safely ignore for now: suffice to say that value simply means "cheap".

Warren Buffett is the world's most well-known and successful value investor. He often pays homage to the "inventors" of value investing, Graham & Dodd.

While every investor will have heard of Mr Buffet, relatively few will have heard of another phenomenally successful value-based fund manager, the Californian company, Brandes Investment Partners. Brandes is unusual in a number of regards, not least the upfront ways in which it says its style is simply an implementation of the 70-year-old ideas of Graham & Dodd.

Indeed, Brandes' marketing materials often read as if Mr Ben Graham could have written them: "For value investors a stock's price and its intrinsic value often detach from one another in the short term.

"Because of the manic-depressive nature of the overall market - where sentiment can shift between sweeping, carefree optimism and overwhelming fear and uncertainty seemingly overnight - prices of stocks tend to fluctuate much more than the true worth of the companies they represent.

"This irrationality can materialise on the upside, lifting prices to dangerously lofty heights. It can also appear on the downside, dragging prices for select stocks to bargain levels."

Brandes' investment performance since the establishment of the firm in 1974 has been nothing short of astonishing. Its global equity portfolio, for example, has outperformed the benchmark (MSCI world) by just over 4 per cent a year for the past two decades.

The consistency of the outperformance is such that it has beaten the benchmark over 20, 15, 10, seven, five, three and one years. But out of the past 20 years, there have been nine years when the firm underperformed. But when this firm does well it really shoots the light out.

One of the pet hates of many investors is the fund manager who exhibits "style drift"; one who fails to adhere to the promised investment philosophy.

On the face of it, this accusation cannot be levelled at Brandes: its global portfolio had two relatively bad (although positive) years in 1998 and 1999 when the technology bubble was in full swing (and growth investing was all the rage); value investors the world over were either being fired or looking for places to hide.

In 2000, the year the bubble burst and markets began a three-year slide, Brandes beat its benchmark by around 45 per cent.

I would guess that Brandes' approach is far more complex than simple appeals to the philosophy of Graham & Dodd would suggest. Actually, although it underperformed in 1998 and 1999, it should, arguably, have not done as well as the near 35 per cent positive returns they did generate. Other value investors did much worse.

Another unusual feature of the Brandes approach is that most of its funds are now closed. Disappointingly, for those of us who would like to give our money (assuming that we could, given cross-border impediments to investing) to it to be managed, it has decided that it is in the best interests of its business to stop taking on new clients.

A remarkable decision - I can't really work out why it has taken it but I would guess that it believes that further growth would involve some kind of diseconomies of scale.

I've no idea about the bells and whistles that Brandes might have tacked on to orthodox value investing.

Other smart managers are recognising that while their investment process might work over the longer term, the volatility of style performance over the shorter term means that other investment tactics have to be adopted if they are not to go belly up during the periods when their chosen style goes out of fashion.

In particular, this is where "momentum" comes in: tools that recognise that stock prices can go off on trends, up or down, for long periods of time, for no good reason.

Additionally, some of us look at measures of "quality": it can be a help to buy a company that is both cheap and, according to a number of well-defined criteria, of high quality.

Personal investors can learn something from these increasingly sophisticated habits of successful institutional investors. But it has to be acknowledged that most of the morals of this story revolve around the need to select the right manager.

Of course, it is a great shame when one of those managers is closed to new business, but even a cursory glance at the methods employed by Brandes will pay huge dividends: we should ask all our prospective managers what they think of the Brandes investment philosophy.

Always check whether your manager actually sticks to his knitting: failure to adhere to the advertised style can be an indicator of either sloppiness or a failure of nerve.

Value should always be at the heart of any long-term strategy but it is always important to ask how the prospective fund manager copes with shorter-term market vagaries.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal