Joseph Calandro, Jr., is a Managing Director of a global consulting firm, Fellow of the Gabelli Center of Global Security Analysis at Fordham University, and the author of Creating Strategic Value (Columbia Business School Publishing, 2020).
Gates Capital Management's ECF Value Funds have a fantastic track record. The funds (full-name Excess Cash Flow Value Funds), which invest in an event-driven equity and credit strategy, have produced a 12.6% annualised return over the past 26 years. The funds added 7.7% overall in the second half of 2022, outperforming the 3.4% return for Read More
Value investing is often simply described as the process of investing in undervalued securities as practiced by highly successful investors such as Warren Buffett, Mario Gabelli and Seth Klarman. This is not wrong, but it does obscure the fact that the school of thought Graham and Dodd founded is much more than a method of evaluating stocks and bonds. And it is also far from simple.
Value investing is a comprehensive method of analysis that is built on a careful and conservative study of an investment’s (or initiative’s) fundamentals to inform the allocation of capital. The “careful and conservative” nature of the analysis is necessary because of the inherent uncertainty of the future. Due to this inescapable fact, analysts must be cautious about the assumptions they make regarding future values. But even when cautious, mistakes can still be made due to, “miscalculations or worse than average luck.” This is why value investors demand a “margin of safety,” which is a modest estimate of value that is (appreciably) larger than an investment’s asking price.
Despite the popularity of Graham and Dodd amongst value investors, their teachings have received remarkably little attention in the areas of corporate strategy and management. In fact, if you exclude Warren Buffett-related material, and vignettes about corporate managers who allocated capital in a value investing-consistent manner, scarcely anything has been written about value investing and corporate management. This rather odd state of affairs provided an opportunity to publish applied research in this area, and to enhance my corporate advisory practice.
Creating Strategic Value: Investments In Stocks And Private Equity
To understand how, first consider the number of corporations that have investment portfolios, some of which that have large equity (stocks) and equity-like (private equity) allocations. In mid-to-late 2017, I spoke with executives who oversee portfolios like this, as described in the first chapter of my recently published book, Creating Strategic Value. At the time, the stock market was booming, and therefore the equity/equity-like holdings in these portfolios were significantly increasing in value.
One consequence of the “boom” was a decline in the price of equity risk to remarkably low levels. For example, the volatility index (VIX) effectively traded between 9-to-12 on May 26, 2017. By way of background, the VIX is a popular measure of S&P 500 option volatility.
Based on value investing analyses conducted at the time, I recommended that certain executives, with significant S&P 500-correlated equities in their portfolios, should consider a VIX-based hedge. This was a very contrarian position at the time, and as a result few took advantage of it.
In February of 2018, volatility struck the S&P 500 causing the VIX to spike to slightly over 50 (and close at slightly over 29). Afterwards, I received a number of calls asking how I foresaw the market volatility. Significantly, I did not foresee anything; rather, I recognized sizeable balance sheet concentrations along with a highly economical way to hedge or “insure” those concentrations.
Market Volatility Following The Covid-19 Pandemic
After the February spike, equity volatility began to contract. As I observed in a footnote of my book, “As of the date of this writing (late-2018), volatility has dissipated in the VIX, and thus I am once again speaking to it as a possible economical hedge to select executives; however, many struggle to see the benefits of such ‘insurance’ in a capital markets context.” I continued these discussions up to March of 2020, which was when volatility returned to the equity markets following the Covid-19 pandemic.
Many executives and investors had not hedged their portfolios going into March of 2020, but some value investors did. In one case, six-month call options on the VIX were purchased for $1.00 each, which for one fund appreciated to a high of $50.00 each on March 16, 2020. Hedges like this significantly mitigated the impact of stock market volatility, even when the hedge covered only a small portion of the portfolio. The relatively stronger balance sheets were then able to be deployed to margin of safety-rich investments that arose out of the stock market volatility.
This type of strategy is obviously not new. For example, financial services executive Prem Watsa was well-hedged going into the infamous “Big Short” of 2007-2008 (as profiled in my book), as were several other professional value investors. What is new, however, is the direct application of value investing theory to corporate strategy and management to inform such strategies in an institutional setting. The above hedging example is just one, albeit timely, application of the kinds of insights that can be gained by doing this. There are many other examples beyond risk management including strategy formulation, general management approaches, corporate development (of course), turnaround management, and value realization.
In closing, corporate strategists and managers can only benefit from studying and applying the lessons of Graham and Dodd. It is hoped that books like Creating Strategic Value will help to facilitate this amongst executives, future executives and researchers alike. In the interim, at the time of this writing (August, 2020), equity volatility is once again contracting in the VIX. While it hasn’t (yet) contracted to margin of safety-consistent levels for hedging purposes, it is getting close. If this trend continues, it could once again prove to be strategically advantageous to select executives, and value investing-based analyses could be used to help understand why.