Historically, the term ‘absolute value’ has been associated with various methodologies for measuring the pure, or intrinsic, value of a security. Today, however, Absolute Value Investing has evolved into a distinct portfolio management approach that occupies a unique niche between the more recognized Deep Value and Relative Value investment styles.
Distinguishing between Deep and Relative Value
Value managers are commonly placed into one of two categories, ‘Deep Value’ or ‘Relative Value’, based upon how they assess securities. Relative Value managers measure the estimated value of a security based upon its price relationship to other securities at that moment. Relative Value investors do not mind paying a high multiple for a security, as long as that security is cheap relative to its peers. Since Relative Value managers are often focused on sector trends and benchmark performance, their style is best described as top-down and index sensitive. Relative Value managers typically have higher portfolio turnover than other value strategies, often exceeding 100% or more annually.
Value managers are commonly placed into one of two categories, ‘Deep Value’ or ‘Relative Value’, based upon how they assess securities. Relative Value managers measure the estimated value of a security based upon its price relationship to other securities at that moment. Relative Value investors do not mind paying a high multiple for a security, as long as that security is cheap relative to its peers. Since Relative Value managers are often focused on sector trends and benchmark performance, their style is best described as top-down and index sensitive. Relative Value managers typically have higher portfolio turnover than other value strategies, often exceeding 100% or more annually.
At the other end of the spectrum is Deep Value. Deep Value investors are bottom-up, focusing exclusively on a security’s intrinsic value. Intrinsic value can be calculated in numerous ways, but for Deep Value managers the focus is often liquidation, or break-up, value. As the name implies, Deep Value managers target companies trading at substantial discounts; typically 60% or less of their estimated intrinsic value. Since finding attractive companies at these valuation levels is difficult, Deep Value investors typically manage concentrated portfolios. This style is not typically index sensitive, as the realization of such value may require long periods of time. As a result, portfolio turnover is low; often in the 25 – 50% range.
Absolute Value – River Road’s Niche
Situated between these two strategies lies Absolute Value. The objective of Absolute Value investing is to provide attractive, sustainable returns over the longer-term. While similar to Deep Value in several aspects, Absolute Value managers typically place more emphasis on positive return consistency and, correspondingly, minimizing downside portfolio risk.
Situated between these two strategies lies Absolute Value. The objective of Absolute Value investing is to provide attractive, sustainable returns over the longer-term. While similar to Deep Value in several aspects, Absolute Value managers typically place more emphasis on positive return consistency and, correspondingly, minimizing downside portfolio risk.
Another key distinction from Deep Value is the target discount for investments. While both Absolute and Deep Value styles seek to invest in companies trading at a discount to their implicit value, many Absolute Value managers target a more modest discount. At River Road, for example, our Small Cap Value Portfolio targets a minimum 75% of estimated value, versus the 60% or less sought by most Deep Value investors. At River Road, we believe this strategy of seeking a more moderate discount has two key benefits: 1) a higher quality investment portfolio; and, 2) broader diversification potential. In this regard, River Road’s Absolute Value approach embraces the philosophy of legendary value investor Warren Buffet, who wrote in his 1987 annual report to Berkshire Hathaway shareholders, “Our goal is to find an outstanding business at a sensible price, not a mediocre business at a bargain price.”
In order to control downside volatility, Absolute Value investors typically employ structured risk management guidelines. At River Road, this includes a discipline of selling stocks not only when they reach their target value, but when they trade against the portfolio manager. This is an important distinction from Deep Value managers, whose strategy is commonly to average down on declining positions. As such, the turnover for Absolute Value managers is typically higher than a Deep Value strategy, but significantly less than the typical Relative Value manager.
The Absolute Value Advantage
There are several advantages to an Absolute Value strategy. The first is its focus on generating consistent, low risk returns. While such a strategy is enviable in any equity class, it is particularly attractive in more volatile asset classes such as small cap, where such a strategy may allow a manager to capture greater returns without accepting additional risk.
There are several advantages to an Absolute Value strategy. The first is its focus on generating consistent, low risk returns. While such a strategy is enviable in any equity class, it is particularly attractive in more volatile asset classes such as small cap, where such a strategy may allow a manager to capture greater returns without accepting additional risk.
A second advantage is that an Absolute Value strategy is inherently alpha-driven. By focusing on alpha, rather than beta, Absolute Value managers are not dependent on broad market volatility, or being able to capture the latest market trend, in order to generate attractive returns. Additionally, Absolute Value managers are not dependent upon a deeply discounted market in order to find and capture value; a particular advantage in the current market environment. Lastly, Absolute Value managers that incorporate a structured sell discipline are better able to preserve capital in difficult markets and avoid ‘value traps’, the classic pitfall of Deep Value investing.
