The modern hedge fund guru faces two separate but distinct problems. First, asset prices continue to rise, irrespective of economic or business fundamentals. If everything is going up, why pay high hedge fund fees? Second, markets have become increasingly “efficient”. The explosion of information and analytics along with a massive, global asset management industry, has made abnormal returns difficult to sustain. The first phenomenon will presumably reach its natural conclusion, though the timing is uncertain. The second is even more uncertain.
Billionaires Howard Marks and Seth Klarman have written lengthy memos sharing their thoughts on the apparent collapse of value-investing. Mr Klarman laments the way in which central bank policies of low interest rates perversely inflate the values of speculative companies. Distant cash flows have become more valuable in present terms. The slow deterioration of the premium that shareholders typically demand to own stocks over risk-free securities was comparable, he wrote, to a frog being slowly boiled while blissfully unaware of its fate.
Mr Marks points to changes in the investing subculture over the past half century. Financial and corporate data was not easily accessible and an understanding of concepts such as return on capital and free cash flow “were not widely appreciated” when he began his career. Not only has there been an explosion in data and analytical techniques, but investors like Warren Buffett and Mr Marks himself are now celebrities.
Mr Klarman explicitly rejects the idea that markets have become “fully efficient”, believing mass investor sentiment will one day become his friend. “The fluctuating emotions and irrational behaviours governing human activity ensure that markets will always be inefficient and mispricings will always exist.” But for value buyers, that environment simply has not materialised. Those who have bet short or stayed out of the market have looked foolish. In his memo, Mr Marks went as far as to say that “value investing doesn’t have to be about low valuation metrics”.
The best hope for these humbled titans is that financial markets reassert their habit of ebb and flow. This can happen quickly. In the brief window of tumult last March and April, several investors were able to strike quickly. The key question is whether any particular set of firms will be able to consistently profit when financial markets are as deep, well-capitalised and efficient as ever.
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