Transcript Contrarianism and value investment

Value investing in theory and in
practice
Travis Morien
Compass Financial Planners Pty Ltd
http://www.travismorien.com
In the beginning…
What is value investing?
“The most realistic distinction between the investor and
the speculator is found in their attitude toward stockmarket movements. The speculator's primary interest lies
in anticipating and profiting from market fluctuations. The
investor's primary interest lies in acquiring and holding
suitable securities at suitable prices. Market movements
are important to him in a practical sense, because they
alternately create low price levels at which he would be
wise to buy and high price levels at which he certainly
should refrain from buying and probably would be wise to
sell.”
– Ben Graham, The Intelligent Investor.
“Assume that a run-of-the-mill common stock is not particularly
well suited to a formal valuation because there are too many
uncertainties about its future to permit the analyst to estimate its
earning power with any degree of confidence. Should analysts reject
the valuation technique in such cases and form their opinions about
the issue by some other approach?
…
The soundness of a common stock investment, in a single issue or a
group of issues, may well depend on the ability of the investor or the
analyst-advisor to justify the purchase by a process of formal
valuation. In plainer language, a common-stock purchase may not
be regarded as a proper constituent of a true investment program
unless some rational calculation will show that it is worth at least as
much as the price paid for it."
– Security Analysis, 5th Ed.
Margin of safety
"[To] have a true investment, there must be a
true margin of safety. And a true margin of
safety is one that can be demonstrated by
figures, by persuasive reasoning, and by
reference to a body of actual experience."
– Ben Graham
A portrait of failure: the performance of every US large cap fund with a 15
year history vs the S&P500 and CRSP 1-10 indexes. 15 Years ending 31
December 2001 (285 Funds)
Picture credit: Dimensional Fund Advisors
Efficient markets hypothesis
• Weak form: all past market prices and data are
fully reflected in securities prices. (Technical
analysis is of no use.)
• Semi-strong form: all publicly available
information is fully reflected in securities
prices. (Fundamental analysis is of no use.)
• Strong form: all information is fully reflected
in securities prices. (Even insider information is
of no use – market is omniscient.)
The implications of EMH:
There are only two ways to outperform the
market:
1.Getting lucky
2.Taking on higher risk
Traditional EMH:
• Stock prices move in “random walks”.
• Prices always reflect best estimate of value
based on all available data.
• Dart board as good as any analyst.
• Best approach is passive or indexed
investing.
Warren Buffett: “The Superinvestors
of Graham and Doddsville”, 1984
Name
Index Return
Period
WJS Partnership
8.4% 21.3%
1956 – 1984
Tweedy, Brown and Co.
7.0% 20.0%
1968 – 1983
Buffett Partnership
7.4% 29.5%
1957 – 1969
Sequoia Fund, Inc.
10.0% 17.0%
1970 - 1984
Warren Buffett: “The Superinvestors
of Graham and Doddsville”, 1984
Name
Index Return
Period
Charlie Munger
5.0% 19.8%
1962 – 1975
Pacific Partners Ltd
7.8% 32.9%
1965 – 1983
Perlmeter Investments
7.0% 23.0%
1965 – 1983
Fama and French’s “Three factor” model
Your returns mostly come
down to asset allocation:
• The mix of stocks vs bonds
• The average company size
• The value characteristics of
the stocks - how “cheap”
stocks are compared to book
value.
Picture credit: Dimensional Fund Advisors
“Modern finance today resembles a MesoAmerican religion, one in which the high priest
not only sacrifices the followers - but even the
church itself. The field has been so indoctrinated
and dogmatised that only those who promoted the
leading model from the start are allowed to
destroy it."
- Comment on Fama/French value findings
Academic definition of “value”
• Fama and French sorted stocks by “book to
market” or BtM, which is the inverse of the
measure most investors use, price to book ratio.
• Using BtM rather than PBR avoids divide by
zero (infinite) values. “Value” stocks are stocks
with a high book to market.
• Other parameters have been tried out, like sorting
by earnings, sales, cash flow, dividend yield etc,
but many researchers find that BtM gives better
results, partly due to the fact that book values are
less volatile than other measures.
$2,500,000.00
$2,000,000.00
$1,500,000.00
$1,000,000.00
$500,000.00
F/F Lrg Val
F/F Sml Val
F/F Lrg Ntl
F/F Sml Ntl
F/F Lrg Gro
F/F Sml Gro
Jul-39
Jul-38
Jul-37
Jul-36
Jul-35
Jul-34
Jul-33
Jul-32
Jul-31
Jul-30
Jul-29
Jul-28
Jul-27
Jul-26
$-
$1,400,000.00
$1,200,000.00
$1,000,000.00
$800,000.00
$600,000.00
$400,000.00
$200,000.00
F/F Lrg Val
F/F Sml Val
F/F Lrg Ntl
F/F Sml Ntl
Jan-49
Jan-48
Jan-47
Jan-46
Jan-45
Jan-44
Jan-43
Jan-42
Jan-41
Jan-40
$-
F/F Lrg Gro
F/F Sml Gro
$1,200,000.00
$1,000,000.00
$800,000.00
$600,000.00
$400,000.00
$200,000.00
F/F Lrg Val
F/F Sml Val
F/F Lrg Ntl
F/F Sml Ntl
Jan-59
Jan-58
Jan-57
Jan-56
Jan-55
Jan-54
Jan-53
Jan-52
Jan-51
Jan-50
$-
F/F Lrg Gro
F/F Sml Gro
F/F Lrg Val
F/F Sml Val
F/F Lrg Ntl
F/F Sml Ntl
Jan-69
Jan-68
Jan-67
Jan-66
Jan-65
Jan-64
Jan-63
Jan-62
Jan-61
Jan-60
$1,600,000.00
$1,400,000.00
$1,200,000.00
$1,000,000.00
$800,000.00
$600,000.00
$400,000.00
$200,000.00
$-
F/F Lrg Gro
F/F Sml Gro
$1,200,000.00
$1,000,000.00
$800,000.00
$600,000.00
$400,000.00
$200,000.00
F/F Lrg Val
F/F Sml Val
F/F Lrg Ntl
F/F Sml Ntl
Jan-79
Jan-78
Jan-77
Jan-76
Jan-75
Jan-74
Jan-73
Jan-72
Jan-71
Jan-70
$-
F/F Lrg Gro
F/F Sml Gro
$1,200,000.00
$1,000,000.00
$800,000.00
$600,000.00
$400,000.00
$200,000.00
F/F Lrg Val
F/F Sml Val
F/F Lrg Ntl
F/F Sml Ntl
Jan-89
Jan-88
Jan-87
Jan-86
Jan-85
Jan-84
Jan-83
Jan-82
Jan-81
Jan-80
$-
F/F Lrg Gro
F/F Sml Gro
F/F Lrg Val
F/F Sml Val
F/F Lrg Ntl
F/F Sml Ntl
F/F Lrg Gro
F/F Sml Gro
Jan-04
Jan-03
Jan-02
Jan-01
Jan-00
Jan-99
Jan-98
Jan-97
Jan-96
Jan-95
Jan-94
Jan-93
Jan-92
Jan-91
Jan-90
$1,800,000.00
$1,600,000.00
$1,400,000.00
$1,200,000.00
$1,000,000.00
$800,000.00
$600,000.00
$400,000.00
$200,000.00
$-
$10,000,000.00
$1,000,000.00
$100,000.00
$10,000.00
$1,000.00
$100.00
$10.00
F/F Lrg Val
F/F Sml Val
F/F Lrg Ntl
F/F Sml Ntl
F/F Lrg Gro
F/F Sml Gro
Jul-04
Jul-98
Jul-92
Jul-86
Jul-80
Jul-74
Jul-68
Jul-62
Jul-56
Jul-50
Jul-44
Jul-38
Jul-32
Jul-26
$1.00
5 year rolling returns US large cap value, neutral and
growth, July 1926 to August 2004
60.00%
50.00%
40.00%
30.00%
20.00%
-40.00%
F/F Lrg Val
F/F Lrg Ntl
F/F Lrg Gro
Jun-03
Jun-97
Jun-91
Jun-85
Jun-79
Jun-73
Jun-67
Jun-61
Jun-55
Jun-49
Jun-43
-20.00%
-30.00%
Jun-37
0.00%
-10.00%
Jun-31
10.00%
5 year rolling returns US small cap value, neutral and
growth, July 1926 to August 2004
80.00%
60.00%
40.00%
20.00%
-40.00%
F/F Sml Val
F/F Sml Ntl
F/F Sml Gro
Jun-03
Jun-97
Jun-91
Jun-85
Jun-79
Jun-73
Jun-67
Jun-61
Jun-55
Jun-49
Jun-43
Jun-37
-20.00%
Jun-31
0.00%
10 year rolling returns US large cap value, neutral and
growth, July 1926 to August 2004
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
-15.00%
F/F Lrg Val
F/F Lrg Ntl
F/F Lrg Gro
Jul-02
Jul-96
Jul-90
Jul-84
Jul-78
Jul-72
Jul-66
Jul-60
Jul-54
Jul-48
-10.00%
Jul-42
-5.00%
Jul-36
0.00%
F/F Sml Val
F/F Sml Ntl
F/F Sml Gro
Jul-02
Jul-96
Jul-90
Jul-84
Jul-78
Jul-72
Jul-66
Jul-60
Jul-54
Jul-48
Jul-42
40.00%
35.00%
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
-5.00%
-10.00%
Jul-36
10 year rolling returns US small cap value, neutral and
growth, July 1926 to August 2004
Source: Brandes Institute, The Value Premium in non US markets, Oct 2003
To preserve the EMH:
• The higher performance of value and small
cap stocks must be due to their higher risk.
• But… value stocks are notoriously less
volatile than growth stocks.
• Academics now admit that there may be
some forms of risk which do not result in
greater volatility. Fundamental risk?
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
70.00%
80.00%
90.00%
100.00%
F/F Lrg Val
F/F Lrg Ntl
F/F Lrg Gro
Jul-04
Jul-98
Jul-92
Jul-86
Jul-80
Jul-74
Jul-68
Jul-62
Jul-56
Jul-50
Jul-44
Jul-38
Jul-32
Jul-26
Historical drawdown US large caps
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
70.00%
80.00%
90.00%
100.00%
F/F Sml Val
F/F Sml Ntl
F/F Sml Gro
Jul-03
Jul-96
Jul-89
Jul-82
Jul-75
Jul-68
Jul-61
Jul-54
Jul-47
Jul-40
Jul-33
Jul-26
Historical drawdown US small caps
Two competing theories
• Market is efficient, value is just more risky.
(Fama/French Three Factor Model)
• Market is inefficient, investor errors create
the value premium. (Behavioural finance)
"These large return differentials cannot be explained by risk
as captured by the Fama and French three-factor model, nor
differences in economic fundamentals, such as profitability
or the likelihood of delisting. In contrast, predictions of the
overreaction hypothesis are borne out. Distressed firms
exhibit the largest return reversals around earnings
announcements, and the book-to-market return premium is
largest in small firms with low analyst coverage."
- Griffin, J.M. and M.L. Lemmon. “Book-to-Market Equity,
Distress Risk, and Stock Returns.” The Journal of Finance,
Vol 57 No. 5 (2002): 2317 - 2336
"On the basis of the risk argument, it would follow
that Internet stocks which had virtually no book value
but stellar market values were much less risky than
traditional utility stocks which typically have high
book values of equity relative to market. It is also
noteworthy that the idea that value stocks have higher
risk surfaced only after their higher returns became
apparent. Data snooping is considered to be a sin, and
coming up with ad hoc risk measures to explain
returns should be regarded as no less of a sin."
-Josef Lakonishok,
“Value and Growth Investing, A Review and Update”
"I believe a third view of market efficiency, which holds
that the securities market will not always be either quick
or accurate in processing new information. On the other
hand, it is not easy to transform the resulting opportunities
to trade profitably against the market consensus into
superior portfolio performance. Unless the active investor
understands what really goes on in the trading game, he
can easily convert even superior research information into
the kind of performance that will drive his clients to the
poorhouse . . . why aren't more active investors
consistently successful? The answer lies in the cost of
trading."
Jack Treynor, "What Does It Take to Win the Trading
Game?" Financial Analysts Journal, January/February
1981
Whether the market is up or down, low cost diversified investors will still outperform the
majority of investors after costs, even if some investors still manage to outperform. Source: “The
Inefficient Market Argument For Passive Investing”, Professor Steven Thorley, the Marriot
School at BYU. Used with permission.
Figure 1a: Distribution of Simulated Portfolio Returns for 1996
Before Costs
1000
1000
Index Fund Return
900
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700
Portfolio Count
Portfolio Count
Figure 2a: Distribution of Simulated Portfolio Returns for 1994
Before Cost
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100
0
Index Fund Return
0
-20 -15 -10
-5
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Percent Return
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Portfolio Count
Portfolio Count
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Figure 2b: Distribution of Simulated Portfolio Returns for 1994
After Cost
Index Fund Return
900
15
Percent Return
Figure 1b: Distribution of Simulated Portfolio Returns for 1996
After Costs
1000
10
600
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400
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0
Index Fund Return
0
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Percent Return
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35
"It is crucial to understand, and very few people do, that attaining
superior investment performance has nothing at all in common with
succeeding in 99% of other occupations. If you were building bridges
and a dozen consulting engineers experienced in bridge building all gave
you the same advice, you'd be stupid not to build your bridge their way.
In all probability, if the experts all agree, their way is the right way to do
it. You'd build a better bridge at lower cost if you followed their advice.
But the very nature of the investment-selection process turns that
scenario topsy-turvy. Let's assume that every securities analyst you see
says, 'that's the stock to buy!' You might think that if all the experts are
saying "buy", you should. But you couldn't be more wrong. To begin
with, if they all want it, they'll probably all buy it and the price will build
up enormously, probably to unrealistic levels. By the same token, if all
the experts say, 'it's not the stock to buy,', they won't buy it and the price
will go down. It's then, if your research and common sense tell you the
stock does have potential, that you might pick up a bargain.
That's the very nature of the operation. It's quite simple; if everybody
else is buying, you ought to be thinking of selling. But that type of
thinking is so peculiar to this field that hardly anybody realises how valid
it is. They say: 'I know you're supposed to look where other people aren't
looking,' but very few actually understand what that means."
- John Marks Templeton
“The truth of our corporate venture is quite
otherwise [than investors think]. Extremely few
companies have been able to show a high rate of
uninterrupted growth for long periods of time.
Remarkably few also of the large companies suffer
ultimate extinction. For most, this history is one of
vicissitudes, of ups and downs, with changes in
their relative standing.”
- Benjamin Graham, Security Analysis
While some firms have grown at high rates
historically, they are relatively rare instances.
There is no persistence in long-term earnings
growth beyond chance, and low predictability
even with a wide variety of predictor variables.
Specifically, IBES growth forecasts are overly
optimistic and add little predictive power.
- Chan, L.K.C., J. Karceski, and J. Lakonishok.
“The Level and Persistence of Growth Rates."
Journal of Finance, Vol. 58 No. 2 (April 2003):
643-684
"Brand-name growth stocks ordinarily command
the highest p/e ratios. Rising prices beget
attention, and vice versa - but only to a point.
Eventually their growth rate can diminish as
results revert towards normal. Maybe not in all
cases, but often enough to make a long-term bet.
Bottom line: I wouldn't want to get caught in a
rush for the exit, much less get left behind. Only
when big growth stocks fall into the dumper
from time to time am I inclined to pick them up and even then, only in moderation.“
– John Neff, John Neff on Investing
Dreman major findings:
• Analysts tended to be bad at forecasting with
low precision on all time frames in all industries
in all market capitalisations.
• Overall, analysts tend to be too bullish and
overestimate future earnings growth.
• When a stock “surprises” the market with
earnings higher or lower than expectations,
significant price movements can result.
• Stocks tend to react differently depending on
their price and market expectations.
Growth stock earnings surprises
• Dreman found that “growth” stocks tend to have very
bullish expectations built into them. (Hence the high
prices of course). As a result, when growth companies
have earnings surprises, they more commonly surprise
on the downside.
• Interestingly, he found that when growth stocks tended
to surprise on the upside, little price action resulted. It
seems that investors sometimes can be so bullish about
a company that even good news doesn’t surprise them.
• When growth stocks surprised on the downside though,
the result was often a sharp selloff.
Value stock earnings surprises
• Dreman found that “value” stocks tend to have very
poor expectations built into them. (Hence the low
prices of course). As a result, when value companies
have earnings surprises, they more commonly surprise
on the upside.
• Interestingly, he found that when value stocks tended to
surprise on the downside, little price action resulted. It
seems that investors sometimes can be so bearish about
a company that even bad news doesn’t surprise them.
• When growth stocks surprised on the upside though, the
result was often a sharp rally.
Net effect of all earnings surprises
Great things are expected from growth stocks so
when they deliver great things the market can be
hard to impress (more), but if the worst is feared
from a value stock the result can often be pleasing.
The earnings surprises tended to result in value
stocks having higher returns and lower risks than
growth stocks.
Lakonishok, Josef, Andrei Shleifer, and Robert Vishny, 1994,
Contrarian investment, extrapolation, and
risk, Journal of Finance 49, 1541–1578.
“For momentum investors, who pin their expectations to
high growth rates, any slip in quarterly performance can
cause grievous results. There is little solace in missing
targets by tiny amounts, even though accounting practices
leave ample wiggle room. Most companies that are close to
earnings targets should meet those targets - particularly
when the stock price hangs in the balance. In high p/e
territory, if lofty growth expectations are missed by an inch,
it may mean that a company has really missed by a mile.
Whatever the actual amount of the miss, uncertainty alone
can mete out tough punishment, and creative accounting
practices ultimately catch up to offenders.”
- John Neff, John Neff on Investing
Value or growth?
“The whole concept of dividing it up into "value" and
"growth" strikes me as twaddle. It's convenient for a bunch of
pension fund consultants to get fees prattling about and a way
for one advisor to distinguish himself from another. But, to
me, all intelligent investing is value investing. That's a very
simple concept. And I don't see how anybody could really
argue with it. Buffett says, In our opinion, the two
approaches are joined at the hip: Growth is always a
component in the calculation of value, constituting a variable
whose importance can range from negligible to enormous
and whose impact can be negative as well as positive.”
– Charlie Munger, 2000 Berkshire Hathaway AGM
Two very different forms of value investing
• Active (Graham and Dodd) investors look at stocks as
shares in a business, try to understand that business and
buy them when they are cheap relative to their intrinsic
value, usually using some form of discount cash flow
valuation.
• Passive or quantitative investors simply sort stocks via
some measure like price to book ratio and divide them
up into “value”, “neutral” and “growth”. This is not
value investing the way any active investor would
recognise it. This causes much confusion, so perhaps
“unglamour” and “glamour” would be better.
Variations on a theme
•
•
•
•
“Deep value” active
“Deep value” passive
“Growth at a Reasonable Price” active
Stock pickers
Disclaimer:
This article contains the opinions of the author but do not represent a
personal recommendation of any particular security, strategy or
investment product. The author's opinions are subject to change
without notice.
Information contained herein has been obtained from sources believed
to be reliable, but is not guaranteed.
This article is distributed for educational purposes and should not be
considered investment advice or an offer of any security for sale.
Investors should seek the advice of their own qualified advisor before
investing in any securities.