value investing in theory and in practice travis morien compass financial planners pty ltd

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 stock-market 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

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

Warren Buffett: “The Superinvestors of Graham and Doddsville”, 1984

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 Meso-American 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.

$-

$500,000.00

$1,000,000.00

$1,500,000.00

$2,000,000.00

$2,500,000.00

Jul-2

6

Jul-2

7

Jul-2

8

Jul-2

9

Jul-3

0

Jul-3

1

Jul-3

2

Jul-3

3

Jul-3

4

Jul-3

5

Jul-3

6

Jul-3

7

Jul-3

8

Jul-3

9

F/F Lrg Val F/F Lrg Ntl F/F Lrg Gro F/F Sml Val F/F Sml Ntl F/F Sml Gro

$-

$200,000.00

$400,000.00

$600,000.00

$800,000.00

$1,000,000.00

$1,200,000.00

$1,400,000.00

Jan-

40

Jan-

41

Jan-

42

Jan-

43

Jan-

44

Jan-

45

Jan-

46

Jan-

47

Jan-

48

Jan-

49


$-

$200,000.00

$400,000.00

$600,000.00

$800,000.00

$1,000,000.00

$1,200,000.00

Jan-

50

Jan-

51

Jan-

52

Jan-

53

Jan-

54

Jan-

55

Jan-

56

Jan-

57

Jan-

58

Jan-

59


$-

$200,000.00

$400,000.00

$600,000.00$800,000.00

$1,000,000.00

$1,200,000.00

$1,400,000.00

$1,600,000.00

Jan-

60

Jan-

61

Jan-

62

Jan-

63

Jan-

64

Jan-

65

Jan-

66

Jan-

67

Jan-

68

Jan-

69


$-

$200,000.00

$400,000.00

$600,000.00

$800,000.00

$1,000,000.00

$1,200,000.00

Jan-

70

Jan-

71

Jan-

72

Jan-

73

Jan-

74

Jan-

75

Jan-

76

Jan-

77

Jan-

78

Jan-

79


$-

$200,000.00

$400,000.00

$600,000.00

$800,000.00

$1,000,000.00

$1,200,000.00

Jan-

80

Jan-

81

Jan-

82

Jan-

83

Jan-

84

Jan-

85

Jan-

86

Jan-

87

Jan-

88

Jan-

89


$-$200,000.00$400,000.00$600,000.00$800,000.00

$1,000,000.00$1,200,000.00$1,400,000.00$1,600,000.00$1,800,000.00

Jan-

90Ja

n-91

Jan-

92Ja

n-93

Jan-

94Ja

n-95

Jan-

96Ja

n-97

Jan-

98Ja

n-99

Jan-

00Ja

n-01

Jan-

02Ja

n-03

Jan-

04


$1.00

$10.00

$100.00

$1,000.00

$10,000.00

$100,000.00

$1,000,000.00

$10,000,000.00

Jul-2

6

Jul-3

2

Jul-3

8

Jul-4

4

Jul-5

0

Jul-5

6

Jul-6

2

Jul-6

8

Jul-7

4

Jul-8

0

Jul-8

6

Jul-9

2

Jul-9

8

Jul-0

4

F/F Lrg Val F/F Lrg Ntl F/F Lrg Gro

F/F Sml Val F/F Sml Ntl F/F Sml Gro

5 year rolling returns US large cap value, neutral and growth, July 1926 to August 2004

-40.00%

-30.00%

-20.00%

-10.00%

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

Jun

-31

Jun

-37

Jun

-43

Jun

-49

Jun

-55

Jun

-61

Jun

-67

Jun

-73

Jun

-79

Jun

-85

Jun

-91

Jun

-97

Jun

-03


5 year rolling returns US small cap value, neutral and growth, July 1926 to August 2004

-40.00%

-20.00%

0.00%

20.00%

40.00%

60.00%

80.00%Ju

n-3

1

Jun

-37

Jun

-43

Jun

-49

Jun

-55

Jun

-61

Jun

-67

Jun

-73

Jun

-79

Jun

-85

Jun

-91

Jun

-97

Jun

-03


10 year rolling returns US large cap value, neutral and growth, July 1926 to August 2004

-15.00%

-10.00%

-5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

Jul-3

6

Jul-4

2

Jul-4

8

Jul-5

4

Jul-6

0

Jul-6

6

Jul-7

2

Jul-7

8

Jul-8

4

Jul-9

0

Jul-9

6

Jul-0

2


10 year rolling returns US small cap value, neutral and growth, July 1926 to August 2004

-10.00%

-5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%Ju

l-36

Jul-4

2

Jul-4

8

Jul-5

4

Jul-6

0

Jul-6

6

Jul-7

2

Jul-7

8

Jul-8

4

Jul-9

0

Jul-9

6

Jul-0

2


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?

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%

Jul-2

6

Jul-3

2

Jul-3

8

Jul-4

4

Jul-5

0

Jul-5

6

Jul-6

2

Jul-6

8

Jul-7

4

Jul-8

0

Jul-8

6

Jul-9

2

Jul-9

8

Jul-0

4


Historical drawdown US small caps

0.00%10.00%20.00%30.00%40.00%50.00%60.00%70.00%80.00%90.00%

100.00%

Jul-2

6

Jul-3

3

Jul-4

0

Jul-4

7

Jul-5

4

Jul-6

1

Jul-6

8

Jul-7

5

Jul-8

2

Jul-8

9

Jul-9

6

Jul-0

3


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 1996Before Costs

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Percent Return

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Index Fund Return

Figure 1b: Distribution of Simulated Portfolio Returns for 1996After Costs

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Figure 2a: Distribution of Simulated Portfolio Returns for 1994Before Cost

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Figure 2b: Distribution of Simulated Portfolio Returns for 1994After Cost

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"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, andrisk, 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.

value investing in theory and in practice travis morien compass financial planners pty ltd

Documents

longterm earnings growth

growth companies

big growth stocks

value stocks

future earnings growth

investing slide

persistence of growth

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