It is easy to get lost amidst a sea of ambiguous definitions when considering different investment styles and approaches. Not only can it be difficult to discern the true rationale of another investor, it might also be unclear what our own underlying motivations are for a particular decision. If we step away from the jargon however, we can see that it doesn’t need to be this complex. Virtually all active investment decisions are made for one of two reasons. Either we believe the valuation of a security is wrong or we think that the price will go up*. These are not the same thing and this distinction matters for investors.
Investors can be valuation-led or price-led.
Valuation-led investors are focused on the features of the underlying asset in which they are invested. They believe that it is mispriced relative to its fundamental attributes. They are not concerned about the behaviour of other investors.
Price-led investors do not care about the valuation of the underlying asset, they are focused on the behaviour of other investors. This is akin to a Keynesian beauty contest.
Berkshire Hathaway is a prime example of the valuation-led approach. Here the focus is on the robustness of the business in which they are invested, not how other investors might move the price.
It is critical to grasp the distinction between valuation-led and value investing. They are not synonymous. A value approach is just a subset of the broader church of valuation-led investing. If we invest in a security because we believe it is fundamentally mispriced, then we care about valuation.
A company might be considered undervalued because its market price doesn’t reflect its stellar earnings growth prospects, or its ability to earn and reinvest high returns on capital, or the fact that its earnings are temporarily depressed. These are all broad and distinct investment styles (growth / quality / value) that can be defined as valuation-led, but they are not all value approaches as we might broadly define it.
At the other end of the spectrum is a simple price-based trend following strategy. Here, there is no consideration of the valuation of the underlying security, it is merely seeking to exploit price patterns driven by investor behaviour.
Price-led strategies can be more of an ambiguous area. Not many investors like to say that they are investing because of what they think other investors will do or have done (apart from trend following where it is explicit). Obvious areas where price movements or the actions of other investors are paramount include thematic equities and macro strategies.
Thematic equity funds rarely launch without strong historic price momentum and the investment case often resides more on how compelling investors find the story rather than a robust fundamental case. Macro investing is often much more explicit about its intentions in attempting to decipher how other market participants will react to new developments.
Approaches which are price-led are typically incremental in nature. They are focused on how investors are currently positioned and their expected behavioural response to new information.
Few things in investment are binary and most investment approaches will sit somewhere on the spectrum between valuation-led and price-led. A valuation-led investor might, for example, seek to identify a catalyst that will realise the mispricing they have identified. The foundation of the investment rationale is about the valuation of the business, but they are also attempting to understand when other investors might understand this and bring about a revaluation. Many price-led investors are interested in valuations insofar as they can draw inferences about prevailing market expectations.
Where investors sit on the spectrum is not only critical because it provides a clear insight as to why a decision is being made, but it can have significant implications for other vital aspects – most notably time horizon and risk.
The shorter our investment time horizon the more likely we are to be a price-led investor. If we are basing our trades on the anticipated behaviour of other investors, then we are worried about what is happening now and tomorrow. We cannot make predictions about how investors will react in a year’s time. The purer our valuation-led approach the further our time horizon stretches into the future – we have no view on how other investors will behave, just the fundamental attributes of an asset.
The most dangerous scenario is where our environment defines what type of investor we are. We might think that we are biased towards a long-term, valuation-led approach, but if we face significant short-term pressure about results then, by default, we become a price-led investor. A disconnect between what type of investor we think we are and what our environment allows us to be is toxic.
The risks faced by investors at opposite ends of the spectrum are also distinct. Price-led investors not only have the challenge of anticipating the behaviour of others, but the stark danger of a reversal of sentiment. Market dynamics can change swiftly and sharply, and without any valuation discipline the floor can be a long way down.
The central challenge for valuation-led investors is being accurate about the fundamental mispricing in a business or asset. To make matters worse even if the analysis is correct they might be on the wrong side of investor opinion for years.
As with time horizons, a major problem arises when investors misclassify the approach they are adopting. An investor in a thematic fund who believes that they are exploiting a valuation-led opportunity could be in for a nasty surprise if the prevailing narrative shifts.
Understanding what type of investor we are (and are able to be) is absolutely paramount to making prudent and behaviourally consistent choices. If we don’t know or are mistaken, then we really have no chance of making good decisions.
* Or down, if we are short / underweight etc…