U.S. Markets closed
  • S&P 500

    +32.40 (+0.88%)
  • Dow 30

    +248.74 (+0.83%)
  • Nasdaq

    +87.05 (+0.70%)
  • Russell 2000

    +43.75 (+2.37%)
  • Crude Oil

    +0.45 (+0.99%)
  • Gold

    +0.90 (+0.05%)
  • Silver

    +0.13 (+0.55%)

    -0.0022 (-0.1819%)
  • 10-Yr Bond

    +0.0490 (+5.33%)
  • Vix

    -0.49 (-2.30%)

    -0.0015 (-0.1088%)

    +0.2800 (+0.2696%)

    +68.41 (+0.36%)
  • CMC Crypto 200

    -14.05 (-3.71%)
  • FTSE 100

    +59.96 (+0.92%)
  • Nikkei 225

    -58.13 (-0.22%)

Seth Klarman on 'Value Pretenders'

·3 min read

Value investing is, without a doubt, the most followed investment style in the world. Every year, tens of thousands of people flock to Ohama, Nebraska to hear Warren Buffett (Trades, Portfolio) speak about the topic (though they won't get the chance this year). There are hundreds of thousands of websites, groups and publications devoted to value investing online.

This presents a real problem for every investor. With so many people trying to find value in the market, the number of opportunities has dwindled to a tiny stream. As soon as an opportunity appears, it is quickly swept up.

That means most of the stocks that look to be traditional value investments on the market today are cheap because they deserve to be. Not only do actual value investors have to grapple with the problem of competition, but they also have to deal with the issue of "value pretenders" as well.

Value pretenders

This isn't a new phenomenon. Seth Klarman (Trades, Portfolio) wrote about these pretenders in his now out of print book, "Margin of Safety," which was published in the 1990s:

"These value pretenders are not true value investors, disciplined craftspeople who understand and accept the wisdom of the value approach. Rather they are charlatans who violate the conservative dictates of value investing, using inflated business valuations, overpaying for securities, and failing to achieve a margin of safety for their clients. These investors, despite (or perhaps as a direct result of) their imprudence, are able to achieve good investment results in times of rising markets."

However, as Klarman went on to explain, most of the "pretenders" suffer substantial losses when the rising tide no longer protects them:

"To some extent value, like beauty, is in the eye of the beholder; virtually any security may appear to be a bargain to someone. It is hard to prove an overly optimistic investor wrong in the short run since value is not precisely measurable, and since stocks can remain overvalued for

a long time. Accordingly, the buyer of virtually any security can claim to be a value investor at least for a while."

How do you distinguish a "value pretender" from a real value investor? As the above quote suggests, it is not easy. Anyone can justify why their investment idea is a good one when the markets are rising. It's hard to prove them wrong if the stock price continues to increase.

For example, some Wall Street analysts have been arguing that Tesla (NASDAQ:TSLA) is a value stock for the past few years based on their growth projections. The company is still losing money and doesn't look cheap on any traditional value metrics. However, investors who were unlucky enough to buy the Russell 2000 Value Index ETF (IWN) five years ago have seen a loss of nearly 20%, excluding dividends, while Tesla has returned 234% over the same time frame.

Using these figures alone, value "pretenders" who've been touting Tesla as a value stock look very clever. Investors who thought they were clever by buying a value ETF don't look so smart.

A solution to the problem?

So, what's the solution? How can investors distinguish between real value investors and value pretenders?

There's no easy answer to this question, like so many parts of investing, but one thing is clear: it is difficult to tell the difference between these two styles if you don't understand value investing to begin with.

Disclosure: The author owns no share mentioned.

Read more here:

  • Seth Klarman and George Soros: Reflexivity and Stock Prices

  • Seth Klarman: The Importance of Liquidity

  • Seth Klarman: You Need to Have an Edge

Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.

This article first appeared on GuruFocus.