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The Art And Science Of Value Investing

UNCERTAINTY IS THE NORM

2023-04-28, Steven Kim



Volatility as measured by the VIX has settled to two year lows this past month. It’s unclear if wider expectations of the economy or market are settling down, or if it’s simply the calm before the storm.

Despite the lull, there remains a great deal of uncertainty and unknowns. With growing concern over the stability of North American banks, wage inflation, geopolitical tensions, and the impression that ‘inflation’ is still persistent as the energy transition and food costs continue to put a strain on consumers, it’s no wonder so many are stressing over what the future may hold.

With all the circulating unknowns, it’s important to note that when it comes to investing, uncertainty is the norm. Capital is continuously allocated with incomplete information and an unpredictable future. In these especially uncertain times, a value investing approach (one that acknowledges the future is unknown and unpredictable) can provide clarity and conviction to remain steadfast.

UNLIKELY TWINS OF NAVIGATING THE UNKNOWN

The renowned Canadian medical doctor William Osler once described the field of medicine as “a science of uncertainty and an art of probability”.

Medicine is often perceived as a ‘hard science’. Despite this, you may find when chatting with a doctor that they will describe the profession as both an art and science. In a conversation with a friend who is a doctor by trade, they provided me with a healthy dose of reality. Our discussion made me note that the field of medicine and investing have more in common than many realize.

Similar to investors, medical professionals rarely have 100% certainty in making their decisions. Often, they make assessments based on probabilities and incomplete information.

As we consider Dr. Osler’s quote and apply it to the world of investing, we get an interesting picture. “Value investing is a science of uncertainty and an art of probability”. Making this minor tweak to Osler’s quote, we can see just how similar our professions are in our navigation of the unknown.

SOUND PROCESS & BEST EFFORTS OUTWEIGH NEGATIVE OUTCOMES

In the healthcare industry, it’s understood that negative outcomes aren’t always avoidable. Uncertainty and risk are an everyday fact of life. Thankfully, many press on with their knowledge and best efforts to help patients.

Similarly, investors use their expertise and best efforts to improve the return-to-risk ratio of their portfolios. The goal is that these efforts will lead to asymmetric results, ideally with frequent positive outcomes that outweigh the inevitable negative outcomes. While perfection is impossible, we can learn from the past, our peers, and competitors in our due diligence to methodically improve the craft of investing.

INVESTING IS AN UNCERTAIN SCIENCE

Oftentimes, experienced medical professionals will have widely varying recommendations on the best course of action for a patient. Their field is no exception as investment analysts from multi-billion dollar corporations, with vast resources, experience, and brain power can have polar opposite views on the economy or a particular stock. Our value investing mindset for example, emphasizes the need to have an appropriate margin of safety, often in the relative price paid or through a sound growing franchise and healthy balance sheet to create room for uncertainty and being wrong.

In practice, a highly cyclical company with financial leverage would likely require a much greater margin of safety than a utility with highly visible and regulated cashflows. From a portfolio perspective, the uncertainty is further addressed in different ways. Despite a cyclical business with much lower valuation risk at 5x P/E or 20% earnings yield versus a utility at 16x P/E or 6.3% earnings yield, the cyclical could also have a much lower allocation with regard to the uncertainty in outcomes.

Another portfolio management tool used as a ‘best course of action’ is diversification. Investor Ray Dalio has been quoted saying “knowing how to deal with what you don’t know is much more important than anything you know”. This is a principle we at QV also take to heart. We consistently stress how crucial it is to have diversity in portfolios in order to reduce risk and the challenge of “what you don’t know”.

THE ART OF PROBABILITY

As mentioned prior, William Osler characterized the practice of medicine as the ‘art of probability’, which can apply to the investing field in various ways. The first is to focus on this art of probability, and not psychology.

Our experience suggests that markets can tend to be herdlike, usually more psychologically influenced than one would assume. Nobel prize winning Robert Shiller may concur, as he too has stated that markets may not be as rational as finance theory would suggest, with asset prices impacted by “psychological, social, epidemiological factors”. As a result, investors shouldn’t allow psychology to guide them, but rather use probability assessments to inform and direct decisions.

The art of probability is inexact, but continuously updating views in light of new information is essential to quality assessments. For example, a physician will likely have assessed the nature of an illness but will order a test to rule out or confirm a patient’s diagnosis. As the seriousness or consequence of the issue builds, more information and subsequent testing are typically required. The ‘art of probability’ is similarly applied to improve investment outcomes and return to risk assessments for value-focused firms like QV.

PROBABILITY IN ACTION

The small cap technology industry can be a notoriously dangerous sector for investors. This is in big part due to rapid innovation, changes within the field, and the high risk of failure for both technology and early stage firms. While this is a reasonable and logical baseline, further updating evaluations of risks based on balance sheet strength, management acumen, financial track record, and price paid can guide to company specific opportunities in a difficult space. As a result, investments in the technology space, such as Enghouse (ENGH), can be made given the net cash balance sheet, cash generative nature of the business, and management’s track record.

Another example of using additional information to increase the accuracy of assessments may be the investment in consumer discretionary holding Pet Valu (PET) in the QV small cap strategies. While there was modest information available as a newer company, based on further analysis we updated our assessment of the business to a more consumer staple despite it being categorized as a consumer discretionary business. Evaluating the pet spending cycle in past downturns, the cash generative nature of the current business, and market share rivalling Walmart, informed our view that this is a durable, growing franchise and cashflow stream to invest in.

USING ART AND SCIENCE TO IMPROVE END RESULTS

Recently, famed investor Stanley Druckenmiller described the current environment as the most uncertain for markets and the global economy in his over 40 year career. While it’s unclear if this is an accurate assessment, we can say that we operate (very similarly to medical professionals) in a highly uncertain field.
In our view, it’s important to acknowledge the market and economy as they are. Be mindful and make decisions based on investing as a science of uncertainty and an art of probability. It will likely improve outcomes for all stakeholders.

All views and projections are the expressed opinion of QV Investors Inc. and are subject to change without notice. This Update is provided for informational purposes only. QV Investors takes no legal responsibility from any losses resulting from investment decisions based on the content of this Update.

ABOUT THE AUTHOR

Steven Kim | Portfolio Manager, Canadian Equities

Steve oversees QV’s investment process and makes portfolio decisions for the Canadian small and mid cap strategies.