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Charles Brandes and the Orthodoxy of Value Investing

Charles Brandes has applied the value investing principles of Benjamin Graham on a global stage to create great wealth, but his investors haven’t always shared in it.

  • Julie Segal

Charles Brandes has squeezed a lot out of a chance meeting more than 40 years ago. Emerging from the Benjamin Graham conference room in the headquarters of his San Diego money management firm, Brandes walks to the lobby to show off a letter he received from the father of value investing in 1974, when he opened the business that would become Brandes Investment Partners. The slightly yellowed letter on Graham’s personal stationery is displayed under glass, next to a first edition of Security Analysis,which Graham cowrote with David Dodd in 1934 and has since become the bible for those who buy stocks priced below their real worth.

In his own book on investing, Brandes on Value: The Independent Investor, Brandes chronicles his fortuitous first meeting with Graham and how their subsequent conversations changed his life. Brandes’s adulation doesn’t stop there. He funds a think tank that researches Graham’s theories of investing and other topics, such as countering behavioral biases, and his marketing material includes a biography of Graham and handouts on the role the famous investor played in the founding of Brandes Investment Partners, which focuses exclusively on value and now has $30 billion in assets. A three-minute video on the Brandes Investment Partners’ website, When Charles Met Benjamin Graham, extols “the monumental twist of fate” that brought the two together. The dramatic voice-over showers Brandes with praise for having the courage to reject Wall Street, “free himself from the constraints of short term–ism” and open his own shop in free-thinking California.

Using the Graham and Dodd approach to investing, sticking with the discipline of buying stocks on sale through the many booms and global financial crises of the past four decades, Brandes became the richest man in San Diego County. Even after an expensive divorce settlement, his net worth is an estimated $1.2 billion, qualifying him for the Forbes 400 list of the richest Americans. He tries not to spend too much on stocks, but he is willing to fund a lavish lifestyle. As owner of the most expensive residence in the county, Brandes has room for a lot of toys: Ten Ferraris, worth more than $4 million, according to his 2011 divorce papers, stock his garage.

Academics have repeatedly shown that over the long term the strategy of buying value stocks has delivered better results than investing in so-called glamour stocks. Graham outlined a framework for value investments in the U.S.; Brandes took the strategy global, believing a wider net would yield more potential opportunities. And although value stocks can suffer long periods of underperformance, prompting many investors to drift from the strategy, Brandes has spent his entire career following Graham’s sacred text to the letter. “I have never seen him flinch, waver for one second, about value investing,” says Brent Woods, who joined Brandes Investment Partners in 1995 and took over as CEO in 2012.

Brandes has been richly rewarded by his orthodox approach to deep-value investing: His firm has been profitable every year. Investors, however, haven’t always benefited from his stubbornness. His largest international fund has delivered benchmarklike results for the past ten years, while his global fund has trailed its bogey, mostly because of bad decisions made around the financial crisis. Brandes’s investors only see significant excess returns after 15 or 20 years.

Brandes’s track record illustrates the challenges facing active managers, whose funds have been losing out for years to cheap index products that promise nothing more than to mirror the returns of their benchmarks. Investors are increasingly skeptical of stock pickers, who promise not only to provide excess returns but to protect clients from the full brunt of market downturns. Although investors love managers who stick to their philosophy and resist the crowd, Brandes’s decision to load up on financial stocks in 2008 and 2009 shows that he may have carried his convictions too far.

Brandes, who personally made $16 million a month as recently as 2011, demonstrates why index funds have become so popular: Investors in active funds might profit some of the time, but managers of active funds win all the time. Brandes Investment Partners charges as much as 95 basis points in fees, whether its funds’ values go up or down. Though index funds, which charge as little as 6 basis points, offer no downside protection, institutional investors know exactly what to expect from them, don’t have to research and question their managers’ thinking and don’t have to defend how much they are spending on fees to their boards of trustees.

Firms with mixed track records, like Brandes Investment Partners, show how difficult it is to find managers that will consistently outperform or be able to educate people enough about their process that they will stay with the funds during prolonged periods of underperformance. “It seems like they’re down, they recover, they lose, they come back, and when you put it all together, they basically match the benchmark over most periods of time,” says Michael Rosen, chief investment officer of Angeles Investment Advisors, commenting on Brandes’s main strategies. Santa Monica, California–based Angeles, which advises on $47 billion in assets for institutional investors, still invests with Brandes, but far less than it did in the past. Rosen confirms how hard it is to assess active managers, their records and how they will likely perform in the future. Brandes’s returns may look mediocre, but many firms are in the vast middle of performance at one time or another, and other factors need to be analyzed, he says. “How to separate the truly superior organizations from the okay organizations is not something that can be bottled or written into some algorithm in a neat little formula,” Rosen adds.

Independently owned Brandes Investment Partners has 23 partners, including Brandes, and 337 employees. The amount of money it manages has fluctuated dramatically. At the end of 1995, after more than 20 years in business, the firm had just $6 billion in assets. In the late 1990s, when its flagship global and international equity funds started posting stellar results, the firm took off. Brandes ended 1998 with $25 billion, even though it had begun to close funds to new clients, believing growth would hurt performance. In the 2000s assets continued to climb from market appreciation and new money from existing clients; Brandes had hit $112 billion by the end of 2007. But poor performance during the financial crisis scared off investors. The firm’s assets have declined every year since 2008, falling to a low of $26.4 billion at the end of 2014.

In addition to its flagship funds, Brandes offers 20 value-style investments, including U.S. and global small-cap equity and global and international midcap equity. The firm has investments focused on European equities, Asia-Pacific ex-Japan equities and even fixed income. Ten of these smaller strategies have outperformed their benchmarks by 1 to 4 percentage points annually over three years. Oliver Murray, who joined the firm in 2002 to set up a mutual fund company in Canada and is now head of client services, says that as an independent firm Brandes can remain true to value no matter what: “To do that, you need to be free of outside influences like corporate owners, where asset-gathering targets and profitability targets are front and center.”

Like all investing styles, value goes in and out of favor. By some measures, value stocks have been underperforming for seven years. Joseph Huber, who founded El Segundo, California–based Huber Capital Management in 2007 after overseeing $40 billion in value assets at Hotchkis & Wiley, says investors’ move from active to passive funds has made it more difficult for stock pickers, particularly value investors. He explains that passive strategies are price-momentum strategies: The higher the stock gets, the more the index fund needs to own. It’s a buy-high, sell-low approach. “What happens is that active managers underperform because they are trying to do the opposite — buy low and sell high,” Huber says. “Those stocks are being taken away from them as clients shift money to passive.” In 2014, he points out, the least expensive stocks based on price-to-book, a common value statistic, underperformed the most expensive stocks by a whopping 10 percentage points.

Brandes makes no apologies for his 2008 decisions except to say the firm should think through more possibilities about what could happen to its holdings under certain scenarios. He says the bigger danger for any investor is thinking the markets have permanently changed or doubting the efficacy of the value philosophy and taking on too few risks. “I suppose you could think about imagining black swans more than we had imagined black swans before,” says Brandes, 72, who is chairman of the firm and a member of its investment oversight committee but is no longer involved in the day-to-day stock picking. “I do think we imagine more about black swans. However, you have to be very careful because the chances of that happening are slim. They’re saying in the industry now that there’s a lot more likelihood of something like the credit crisis happening than the bell curve would suggest. But I’m not too convinced.”

He could be right. At the peak of the technology bubble in the late 1990s, many value money managers famously threw in the towel. A few years later the markets shifted, value stocks went on a tear, and growth stocks fell out of favor.

Brandes brags that he’s been through more market cycles than the vast majority of professional investors and has the patience to sit through this one as well. His global equity fund is one of just seven such funds that have been around for more than 40 years.

Though academics have proved there is a value premium — that unpopular value stocks outperform growth stocks — investors can practice the strategy very differently. Graham only provided the general framework for the style. Many value investors look for higher-quality businesses that they believe will protect them during tough periods. Others shun banks and companies whose complicated structures make it too difficult to project future earnings.

Brandes says he, too, implements a quality measure, but he adds that quality and other factors can dilute the effectiveness of a true value strategy. “Everyone thinks they might be able to take the edge off, but instead they need patience,” he explains. He says the current environment reminds him of the early days of his career, when he wasn’t very good at convincing people that value was the best way to pick stocks — or at persuading them to give him money.

Brandes is intent on proving his outsider status. In the introduction to the fourth edition of his book, he writes, “Value investing also requires a natural, or strongly willed, propensity to take a different path than most.” He notes that he is a southpaw and that extensive research has shown that left-handed people think differently.

He grew up in Gibsonia, Pennsylvania, a small town less than 20 miles north of Pittsburgh. His father, who had a Ph.D. in chemistry, worked in the research group of Gulf Oil. His mother, with a master’s degree from Oberlin Conservatory of Music, taught piano. Brandes studied at Bucknell University in nearby Lewisburg and graduated with a BA in economics in 1968. Chalking up his big life decisions to his independent streak, he says he headed to sunny California after graduation not only to escape the cold but to be part of the fast-growing state. He chose San Diego because it was less crowded than Los Angeles or San Francisco.

Brandes’s attraction to value investing was informed by the market booms and busts that dotted his early career in finance. He worked as a broker trainee during the end of the go-go era of stocks, while attending San Diego State University for his MBA (he never got a degree). By 1971, Brandes had abandoned his graduate studies and taken a job in La Jolla as a broker-analyst at Hayden, Stone & Co., now part of Morgan Stanley Wealth Management. There he learned fundamental stock analysis and discovered securities that were selling for less than he thought they were worth. But at the time, value investing was considered old-school; Nifty 50 big-company growth stocks like IBM Corp. were soaring. At Hayden Stone, Brandes met Graham, who walked into the brokerage firm to find information on a troubled appliance maker he was interested in buying.

Three years out of college, Brandes was fearless in pursuing a man who even then was revered by the financial industry. “Graham was very formal,” he recalls. “I would meet him in his apartment, and he would be in a coat and tie behind his desk.” The two talked about growth investors who convinced themselves to pay 50 to 60 times a company’s earnings, and weaknesses of the then-popular Value Line Investment Survey.

Graham convinced his young disciple that he wouldn’t be able to pursue value investing at his current employer. Brandes decided to open his own firm, originally called Branco Investors, during the depths of the 1973–’74 bear market. Graham wrote Brandes on March 1, 1974, that he regretfully wouldn’t make the opening because of his declining health. He died two years later.

Brandes launched a global fund and began managing money for a handful of individual clients. Although his mentor never wrote about international investing, Brandes believed a broader scope would give him more opportunities. “From day one I wanted to take his principles and apply them worldwide,” he says.

In 1975 the markets recovered and Brandes’s fund was up 75 percent. From 1976 to 1982, Brandes produced returns that weren’t much better than the benchmark. During those six years, as the markets bounced up and down, he became increasingly convinced that value investing would work in the long term. Investors would buy and sell stocks based on irrelevant information, and Brandes would swoop in to snatch up companies he liked at discounted prices.

A long bull market began in 1982, but Brandes didn’t start growing his firm until he’d brought in people to help with management and marketing. In the mid-1980s he hired Robert Wood; Glenn Carlson, who later became CEO; and Jeffrey Busby, who would become de facto chief operating officer and build computer systems to support the firm’s global investing. Part of Brandes’s edge was his willingness to invest abroad at a time when information was scarce and the rules governing many overseas markets were nascent at best. These men would help Brandes, who liked investing more than managing, turn the firm into a professional organization.

Like all value managers, Brandes believes stocks need to be purchased with a margin of safety — the difference between a company’s stock price and its underlying value. He seeks to buy companies at substantial discounts to their intrinsic value, aims to hold stocks for five years or more and believes the longer the time frame, the better the chances of excess returns. He limits the number of stocks that he’ll own in a portfolio, sometimes purchasing a large percentage of a company’s outstanding shares and working behind the scenes as an activist. “When you’re trying to build portfolios with the largest margin of safety, you can’t do that with 200 or 300 names,” he says.

Brandes sells his holdings when investors discover his once-out-of-favor stocks and their prices get closer to what he believes the companies are actually worth. He’s a big believer in behavioral finance and thinks he can take advantage of mistakes investors make in the market. He uses teams rather than individuals to run funds. Brandes Investment Partners executives believe the firm’s success results from its investment process and philosophy rather than from any one person. “By everybody on the team having to explain how they think about value in that particular business, that country, that sector, we think we get to a better estimate of what the actual value is,” adds client services head Murray.

Though he had been investing globally from the beginning, Brandes in 1990 launched a fund that excluded the U.S.: the Brandes International Equity Fund. At the time, as the cold war ended, consultants advised U.S. institutions to diversify outside their home country and investors were finally starting to shift money overseas. Brokers began to add the Brandes international fund. In 1994, Brandes used the new fund to start marketing to institutions. That same year he launched an emerging-markets fund; three years later he opened a group of small-cap equity funds. International Equity’s performance was strong, beating its benchmark by 2.5 percentage points in 1995, 10.3 percentage points in 1996 and 18.3 percentage points in 1997. By the beginning of 1998, the firm had almost $16 billion, up $10 billion in two years.

In the late 1990s a number of value managers retired as their funds lagged amid the technology-stock boom. Brandes kept to his philosophy. Instead of buying Internet stocks, which he thought were ridiculously priced, he loaded up on out-of-favor auto manufacturing, construction materials and utility companies. Clients stuck with him and sent the firm $10 billion in new money, prompting Brandes to partly close the international fund in 1998. It was the first of many fund closings for the firm.

When the technology bubble burst in 2000, Brandes’s strategy looked brilliant. The global and international equity funds outperformed their benchmarks by 36 and 17 percentage points, respectively, and assets continued to rise, reaching $62 billion by the end of 2001. The firm closed the global fund to new clients in 2001; two years later it closed both funds completely — a rare move for an asset manager — in an attempt to prevent their size from hurting existing shareholders. Other funds were either partly or fully closed, including the small-cap, emerging-markets, European equity and Japanese equity strategies. Between 2003 and mid-2006, Brandes went from $75.8 billion to $117 billion, with most of the increase coming from rising prices of the funds’ holdings.

The financial crisis was a disaster for Brandes. For most of the decade up until 2007, the firm had held few financial stocks. It had bought and sold insurance giant American International Group but generally believed banks and other financials were overvalued despite generating significant profits. But in late 2006 and early ’07, as cracks appeared in the market, the firm began to think banks would soon be in value territory.

In the summer of 2007, Brandes started to look at commercial and investment banks, consumer finance companies, thrifts, insurers and U.S. auto companies. The firm had profited from buying these kinds of companies in past recessions; using that experience, as well as new analysis, it began to load up on stocks in these sectors. It assumed a worst-case housing correction of 10 percent, which had never occurred nationally, and purchased stocks like Countrywide Financial Corp. and Freddie Mac. As Brandes’s funds experienced huge losses, the firm was also hurt because it had essentially shut down its marketing apparatus when it closed its funds. “We had lost our edge in client acquisition,” Murray says. “Coming out of the crisis, we had to rebuild all of that pretty much from scratch.”

Brandes loves to emphasize his independence, except when it comes to 2008. In his book he writes about the purchases he made leading up to the financial crisis: “I still believe that this was a smart value disposition, and it would have worked well for many of the holdings we applied it to, had it not been for forces and developments that we, like many others, unfortunately did not foresee.”

The committed value investor may have believed in his firm’s decisions, but clients started fleeing. At the time, Brandes saw many opportunities, but he couldn’t persuade anyone to pony up more money. Between exiting clients and market losses, the firm had shrunk by half by year-end 2008, to $53 billion. In 2009, as equity funds in general snapped back, Brandes’s largest portfolios failed to rebound. The global equity fund underperformed by almost 11 percentage points, and the international fund trailed its benchmark by almost 10 percentage points. By the end of 2010, the firm had $48 billion in assets; two years later it had $7 billion. Kenneth Little, who heads Brandes’s research and oversees its investment teams, says clients who had been with the firm for decades and made good returns during that time nonetheless chose to leave. “Performance in the near term wasn’t up to their expectations, even though performance since inception was pretty good,” he explains. “A lot of clients became more short-term themselves.” Adds Zev Frishman, CIO of Canadian investment management firm Open Access and an advisory board member of the Brandes Institute, which researches market behavior and portfolio management: “Many investment committees will fire a manager after two years of underperformance. Intuitively, that sounds good, but that’s why the value premium exists. Most investors can’t stand the pain.”

The copy of Security Analysis displayed in the lobby of Brandes Investment Partners was bought in October 2000 for $5,500, a little more than half what a rare-books website was charging at the time. Even at the higher price, though, Brandes thought the finance bible was a steal. After all, value stocks were just beginning to recover from one of their worst periods of underperformance, and he believed that Mr. Market — the character Graham invented to help students understand the irrationality behind security prices — was incorrectly valuing a copy of the iconic guide. Now the book is being sold for as much as $16,000 by antiquarian booksellers.

Brandes has done a number of things since founding his firm that institutional investors typically love. He’s remained independent, allowing the firm to ride out periods of underperformance without having to answer to owners with different objectives from his. He’s stuck to his philosophy, building a firm consisting of experienced investment teams, and he hasn’t expanded beyond what he knows best: value investing. He’s even closed funds.

Despite all Brandes’s efforts, his specialized boutique firm got too big a decade ago. “When your assets get that big, your universe of investable ideas and ability to get an edge on those names dissipates dramatically,” says Mark Yusko, CEO and CIO of Morgan Creek Capital Management, a Chapel Hill, North Carolina–based investment adviser for institutions and wealthy families.

Brandes, and the firm that bears his name, also may have lost focus. While the investor was in the local papers fighting an ex-wife in court, hiring Christina Aguilera for $1 million to sing at his annual Halloween party and paying an additional $1.5 million for Elton John to entertain at his wedding to his third wife, Tanya, the seeds of the subprime crisis were being sowed. “There is a pattern of behavior in the investment business that when firms get wildly successful, they stumble,” says one consultant, who asked not to be named. “It’s natural human nature to give in to some of the trappings of wealth.” (See a brief story about Brandes's California estate, Suncatch, here.)

Since Brandes’s serendipitous first meeting with Ben Graham, alpha — risk-adjusted returns over the benchmark — has become more elusive. “Everybody has gotten smarter in money management over 30 or 40 years,” says Angeles’s Rosen. “It’s a lot harder to stand out. The information advantage that a firm like Brandes had at the beginning just isn’t there anymore.”

Many value investors, however, say Brandes’s problem is simple: He’s rooted in the past. Though the fathers of value investing taught their disciples to focus only on a company’s fundamental characteristics, believing no one could predict the future, many value investors say the financial world has changed in the past 40 years and it’s perilous to ignore the macroeconomic picture. Company fundamentals, not the macro view, are Brandes’s primary focus. Debt issuance to both individuals and corporations has soared, prompting many value investors to think about where credit bubbles are forming. When there are excesses in credit, stocks might look cheap but earnings aren’t sustainable. Currencies, too, have changed. Brandes has never hedged currencies, believing that it’s difficult to do well and that value investors can manage risk by spreading their investments around.

Some accuse Brandes of not abiding by the maxim, articulated by Martin Whitman, founder of Third Avenue Management and another original thinker, that you should buy stocks that are both cheap and safe — meaning they have strong balance sheets. As banks and other companies, especially the Europeans, were borrowing increasing amounts of money in the 2000s, Brandes continued to buy these stocks. Although he wasn’t the only value manager to do this, some investors say he ignored blatant warning signs.

The biggest shift for value investors, still ongoing, is toward quality companies. Many investors have conceded it is difficult to assess whether an industry is permanently changing for the worse. That makes companies in some sectors hard to understand. “If we had become more relative-value, our performance might be better, but after the crisis we made it clear we weren’t going to change our style,” says client services chief Murray. Adds CEO Woods: “We like quality companies; we’re just price-sensitive. And we don’t have a bias against secondary businesses, as Graham called them, if we get them at an outstanding price.”

Brandes, though, is out of step with many investors. He believes volatility presents opportunities for value investors. Some critics say he’s wrong, that investors want protection on the downside even if that hurts long-term performance.

Brandes may be right. Not everybody is cut out to be a value investor. Open Access’s Frishman says a former colleague of his believed that pension plans should think 20 to 40 years in the future. “But that’s hard,” he notes. “Few investment committees will like you when you say, ‘The past ten years haven’t been great, but in 40 years we’ll outperform.’” •