The Faustian Contract of Deep Value Investing by Wendl Financial
Imagine someone who is interested in pursuing a career as a money manager. Let’s assume he’s not a rich kid from Greenwich, Connecticut, and has no family or friends in the financial services industry to help him to establish his foot in the door. Assume further that our aspiring young money manager is passed over by all of the large investment houses for an entry-level position and, as a last resort, strikes a deal with the devil. So there’s no confusion, the devil in this tale of woe is not one of the major investment firms (an easy mistake to make). Who wouldn’t want to break into an industry that, up until now, has been blessed with the financialized wind always at its back through an endless sea of quantitative easing? The devil agrees to provide the fledgling fund manager not only startup capital for the money manager’s new financial enterprise but also an investment methodology that has historically proven effective in terms of generating above-market rates of return over the long term.
As in all stories involving the devil, this creature from hell is no fool and always makes conditions if one is in need of his assistance. In this case, the newly minted money manager must follow to the letter a stock selection criterion that the devil specifies for all assets gathered under management. Under no circumstances can this money manager deviate even in the slightest from the investment criterion the devil outlines. If the investment methodology is violated, the price is forfeiture of the money manager’s soul. With no other options available, the ambitious manager agrees to the devil’s conditions, and the Faustian contract is sealed.
The term Faustian contract comes from Johann Wolfgang von Goethe, a German-born playwright, statesman and scientist. One of Goethe’s most famous plays is Faust, a story about a man who makes a pact with the devil in order to gain infinite knowledge. At any point in time, if Faust becomes so enthralled with everything the devil has granted him that he wishes to remain in that perfect state perpetually, he instantly dies, and his soul suffers eternal damnation in hell.
In our updated Wall Street version of Faust, the devil’s superior investment criterion is substituted for the higher-order goal of infinite knowledge. We’ll use as the devil’s chosen investment filter a stock selection screen popularized by a Benjamin Grossbaum. Grossbaum is the birth surname of Benjamin Graham, the author of The Intelligent Investor. Given the anti-German sentiment that existed in America shortly after the Great War, the Grossbaums had changed their German-sounding last name to Graham upon immigration to this country. One of the methodologies outlined in Benjamin Graham’s investment book was to select stocks that were trading below working-capital value or liquidation value. Using data taken from a company’s balance sheet, determining the working-capital value of a company is a simple mathematical calculation. By mandating this stock selection criterion as part of the Faustian bargain, the devil’s job of monitoring the money manager for any contract violation becomes that much easier. The calculation is made by subtracting all liabilities including preferred stock from the current assets (the most liquid assets on a company’s balance sheet). This calculation is then converted to a per-share figure. As already mentioned, the price paid by this money manager for any stocks purchased above working-capital value results in the loss of his or her soul and eternal damnation. In the book A Guide to Purchasing Stocks Trading below Liquidation Value, the long term performance of the devil’s chosen stock selection criterion is reviewed in detail. As illustrated in the chart below, Graham’s value-investing criterion outperforms an index fund over the long term.
*All value stocks trade below 75% of working-capital value and are held for one year. No more than 10% was invested in any one stock, and during years where few stocks met the deep value investing criterion, the balance remained idle in U.S. Treasury bills.
The devil is a cunning creature. By mandating this stock selection requirement for all future purchases, the naïve money manager’s fulfillment of his or her side of the Faustian bargain is more difficult than what it appears to be on the surface. Someone new to the value-investing philosophy might find it easy to perform the simple mathematical calculation, but having the discipline to implement this approach over a long career is where the challenge comes in to play. Unbeknownst to the money manager, having the patience to follow the value-investing rule using the money of other people whose conviction in the investment criterion will fade at times is where the devil has the upper hand.
Excluding the changing of his German last name, Goethe, the original literary creator of the Faustian contract, would have enjoyed Graham’s company. Graham was born 62 years after Goethe’s death, and both men shared many interests, including language, philosophy and literature. It would be interesting to eavesdrop on these two Renaissance men deep in conversation. Imagine Goethe critiquing Graham’s play, Baby Pompadour, while returning the favor with free investment advice. It would have been a profitable relationship for both of these creative geniuses.
Would Goethe’s modern-day version of Faust applied to money management result in the devil getting the last laugh by adding a fresh soul to his inventory? Graham’s investment criterion used by enterprising money managers is easy to understand and shows excellent performance over the long term, but can a fund manager stay loyal to it over an entire career? Other successful money managers who followed a value-investing philosophy over their careers might put their money on the devil.
Over his long career, Jean Marie Eveillard believed in the value-investing philosophy and was recognized in 2003 with a lifetime achievement award from Morningstar. Eveillard’s stalwart conviction to purchase assets that were undervalued forced him on occasion to be out of sync with the opinion of the retail public. This resulted in temporary periods of significant asset withdrawals from impatient investors. Being disciplined enough to prefer losing clients rather than losing their money is not easy on a manager. Enduring those rough time periods where the value investment methodology is not personally favorable is not easy as you watch your peers benefit from buying overvalued stocks that move even higher.
Jeremy Grantham, one of the founders of the well-respected GMO money management firm, was recognized in 2011 by Bloomberg as one of the 50 most influential people in global finance. In 1999, before the dot.com bubble burst, he moved a good portion of his clients’ assets into cash. Over the following year as stocks continued trending lower, instead of getting a big “thank you” from clients for not losing their money, they abandoned his fund, forcing him to endure a temporary drawdown of more than half of his assets under management.
These great money managers had the conviction not to purchase overvalued assets, enduring time periods when they underperformed relative to their peers in the industry. It remains to be seen whether the protagonist in our Wall Street version of Faust can follow Graham’s original teachings by purchasing only stocks that are trading below working-capital value. Maybe the loss of management fee income during time periods when value investing is personally unfavorable might seem insignificant if you knew your soul was on the line.