Absolute Value

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Absolute Value

Some value fund managers follow an absolute-value strategy. They don’t compare a stock’s price ratios with something else, as the relative-value managers do. Rather, they try to figure out what a company is worth in absolute terms, and they want to pay less than that figure for the stock.

How they do it

Absolute-value managers determine a company’s worth using a variety of factors, including the company’s assets, balance sheet, and likely future earnings or cash flows. They may also study what private buyers have paid for similar companies.

A hypothetical example of such a fund

For example, the managers might look for companies that trade at discounts of 40% or more to the team’s estimates of their intrinsic value, using discounted cash-flow analysis, asset values, or sales of comparable firms to determine the latter. The managers would place much importance on the ability of a company’s management to run the business on an operational level and to effectively allocate capital. They’d often take sizable positions, and the fund typically would hold 20–25 names. The turnover rate would be typically very low.

Because of this approach, its portfolio isn’t broadly diversified, and its concentrated approach means that trouble in a few top holdings can have a significant negative impact on returns.

This example illustrates the patience required of investors in an absolute value fund. Because such a fund may look very different from the broad market, and its performance may deviate as a result, it can look very out of step over shorter time periods. Of course, some absolute value funds are better than others, but even the best absolute value funds can be misused by investors who can’t stomach the rougher ride.