VALUEINVESTING:WHEREISTHEBEEF?

AswathDamodaran

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Thepayofftoinstitutional“active”valueinvestingisweak..

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If value investing is the “best way to invest”, how do we explain the fact that active growth investors beat a passive growth index fund far more frequently and by far more than active value investors do, relative to a passive value fund?

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Andonlyslightlystrongerforactiveindividualinvestors¨ Averageunderperformance:Inastudyofindividualbrokerageaccounts

between1991-96,theaverageindividualinvestorunderperformedtheS&P500byabout1%andthatthedegreeofunderperformanceincreasedwithtradingactivity.

¨ Heavilyskewed:Thetop-performingquartileinthestudyreferencedaboveoutperformedthemarketbyabout6%.Anotherstudyof16,668individualtraderaccountsatalargediscountbrokeragehousefindsthatthetop10percentoftradersinthisgroupoutperformthebottom10percentbyabout8percentperyearoveralongperiod.

¨ Homebiasandconcentration?Studiesofindividualinvestorsfindthattheygeneraterelativelyhighreturnswhentheyinvestincompaniesclosetotheirhomescomparedtothestocksofdistantcompanies,andthatinvestorswithmoreconcentratedportfoliosoutperformthosewithmorediversifiedportfolios.

¨ Less(trading)ismore(return):Whilenoneofthesestudiesofindividualinvestorsclassifythesuperiorinvestorsbyinvestmentphilosophy,thecollectivefindingthattheseinvestorstendnottotrademuchandhaveconcentratedportfolioscanbeviewedasevidence(albeitweak)thattheyaremorelikelytobevalueinvestors.

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Someactivistsdowell,butactivismisoftenazerosumgame…¨ Overallreturns:Activistmutualfundsseemtohavehadthelowestpayoff

totheiractivism,withlittlechangeaccruingtothecorporategovernance,performanceorstockpricesoftargetedfirms.Activisthedgefunds,ontheotherhand,seemtoearnsubstantialexcessreturns,rangingfrom7-8%onanannualizedbasisatthelowendto20%ormoreatthehighend.Individualactivistsseemtofallsomewhereinthemiddle,earninghigherreturnsthaninstitutionsbutlowerreturnsthanhedgefunds.

¨ Volatilityinreturns:Whiletheaverageexcessreturnsearnedbyhedgefundsandindividualactivistsispositive,thereissubstantialvolatilityinthesereturnsandthemagnitudeoftheexcessreturnissensitivetothebenchmarkusedandtheriskadjustmentprocess.

¨ Skeweddistributions:Theaveragereturnsacrossactivistinvestorsobscuresakeycomponent,whichisthatthedistributionisskewedwiththemostpositivereturnsbeingdeliveredbytheactivistinvestorsinthetopquartile;themedianactivistinvestormayverywelljustbreakeven,especiallyafteraccountingforthecostofactivism.

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ThethreebiggestRsofvalueinvesting

¨ Rigid:Thestrategiesthathavecometocharacterizeagreatdealofvalueinvestingrevealanastonishingfaithinaccountingnumbersandanequallystunninglackoffaithinmarketsgettinganythingright.Valueinvestorsmaybethelastbelieversinbookvalue.Therigidityextendstothetypesofcompaniesthatyoubuy(avoidingentiresectors…)

¨ Righteous:Valueinvestorshaveconvincedthemselvesthattheyarebetterpeoplethanotherinvestors.Indexfundinvestorsareviewedas“academicstooges”,growthinvestorsareconsideredtobe“dilettantes”andmomentuminvestorsare“lemmings”.Valueinvestorsconsiderthemselvestobethegrownupsintheinvestinggame.

¨ Ritualistic:Moderndayvalueinvestinghasawholemenuofritualsthatinvestorshavetoperformtomeetbe“valueinvestors”.Theritualsrangefromthebenign(claimtohaveread“SecurityAnalysis”byBenGrahamandeveryBerkshireHathawayannualreport)tothenot-so-benign…

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Myth 1: DCF valuation is an academic exercise…The value of an asset is the present value of the expected cash flows on

that asset, over its expected life:

Proposition 1: If “it” does not affect the cash flows or alter risk (thus changing discount rates), “it” cannot affect value.

Proposition 2: For an asset to have value, the expected cash flows have to be positive some time over the life of the asset.

Proposition 3: Assets that generate cash flows early in their life will be worth more than assets that generate cash flows later; the latter may however have greater growth and higher cash flows to compensate.

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Myth2:Betaisgreekfromgeeks…andessentialtoDCFvaluation¨ Dispensingwithallofthenoise,herearetheunderpinningsforusingbeta

asameasureofrisk:¤ Riskismeasuredinvolatilityinassetprices¤ Theriskinanindividualinvestmentistheriskthatitaddstotheinvestor’s

portfolio¤ Thatriskcanbemeasuredwithabeta(CAPM)orwithmultiplebetas(inthe

APMorMulti-factormodels)1. Betaisameasureofrelativerisk:Betaisawayofscaledrisk,withthe

scalingaroundone.Thus,abetaof1.50isanindicationthatastockis1.50timesasriskyastheaveragestock,withriskmeasuredasriskaddedtoaportfolio.

2. Betameasuresexposuretomacroeconomicrisk:Riskthatisspecifictoindividualcompanieswillgetaveragedout(somecompaniesdobetterthanexpectedandothersdworse).Theonlyriskthatyoucannotdiversifyawayisexposuretomacroeconomicrisk,whichcutsacrossmostorallinvestments.

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Myth3:The“MarginofSafety”isanalternativetobetaandworks.¨ Themarginofsafetyisabufferthatyoubuildintoyourinvestment

decisionstoprotectyourselffrominvestmentmistakes.Thus,ifyourmarginofsafetyis30%,youwillbuyastockonlyifthepriceismorethan30%belowits“intrinsic”value.Thereisnothingwrongwithusingthemarginofsafetyasanadditionalriskmeasure,aslongasthefollowingarekeptinmind:

¨ Proposition1:MOScomesintoplayattheendoftheinvestmentprocess,notatthebeginning.

¨ Proposition2:MOSdoesnotsubstituteforriskassessment andintrinsicvaluation,butaugmentsthem.

¨ Proposition3:TheMOScannotandshouldnotbeafixednumber,butshouldbereflectiveoftheuncertaintyintheassessmentofintrinsicvalue.

¨ Proposition4:Beingtooconservativecanbedamagingtoyourlongterminvestmentprospects.ToohighaMOScanhurtyouasaninvestor.

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Myth4:Goodmanagement=LowRisk

¨ Riskisabouthowcompaniesdo,relativetoexpectations.Totheextentthatexpectationsaresettoohighforgoodmanagers,firmsthatarewellmanagedmaybemoreriskythanbadlymanagedfirms,wherelittleisexpectedofthecompany.

¨ Thus,ratherthanthinkaboutriskinabsoluteterms,weshouldbethinkinginrelativeterms,i.e.,whataretheresultslikelytoberelativetoexpectations?

¨ Infact,giventhefuzzydefinitionsthatmanyvalueinvestorsattachto“good”management,itislikelythatscreeningforitismorelikelytocreateharmthangood.

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Myth5:Widemoats=Goodinvestments

¨ Moatsarethecompetitiveadvantagesthatallowcompaniestogeneratekeepthecompetitionout.Intheprocess,theycankeeptheirmarginsandreturnshighandimprovethequalityoftheirgrowth.

¨ Intrinsicvaluepeopleandvalueinvestorsdoagreethatmoatsmattertovalue:thewiderthemoat,thehigherthevalueaddedbygrowth.Buttherearetwoplaceswheretheymightdisagree:¤ Moatsmattermoreforgrowthcompaniesthanmaturecompanies:

Widemoatsincreasethevalueofcompaniesandthevalueincreaseisproportionaltothegrowthatthesecompanies.

¤ Thereturnsonstocksarenotafunctionofthewidth,buttherateofchangeinthatwidth.So,companieswithwidemoatscanbebadinvestmentsifthewidthshrinksandcompanieswithnomoatscanbegoodinvestmentsifthewidthopenstoasliver.

¤ Itiseasiertotalkaboutmoatsthanitistomeasuretheirwidth…

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Myth6:Intrinsicvalueisstableandunchangeable..¨ Thereisawidelyheldbeliefthattheintrinsicvalueofan

investment,ifcomputedcorrectly,shouldbestableovertime.Itisthemarketthatisviewedasthevolatilecomponentintheequation.Asaconsequence,hereiswhatwetendtodo:¤ Wemakeadecisiononwhethertobuyorsellthestockandnever

revisittheintrinsicvaluation.¤ Weviewmarketpricechangesasrandom,arbitraryandcompletely

unjustifiedandignorehefactthateventhereisinformationinmarketpricechangesineventhemostunstablemarket.

¨ Theintrinsicvalueofacompanyisviewedasagiven,withinvestorshavinglittleimpactonvalue(thoughtheyaffectprice)¤ Wedonotconsiderthefeedbackeffectsonintrinsicvalue,from

changingstockholderbasesandmanagementteams.¤ Weignorethefactthatthe“intrinsicvalue”ofacompanycanbe

differenttodifferentinvestors.

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Thevalueinvestors’finaldefense..

• Somevalueinvestorswillfallbackonthatoldstandby,whichisthatweshoulddrawourcuesfromthemostsuccessfulofthevalueinvestors,nottheaverage.

• ArguingthatvalueinvestingworksbecauseWarrenBuffettandSethKlarman havebeatenthemarketisasignofweakness,notstrength.Afterall,everyinvestmentphilosophy(includingtechnicalanalysis)hasitswinnersanditslosers.

• Amoretellingtestwouldbetotakethesubsetofvalueinvestors,whocomeclosesttopurity,atleastasdefinedbytheoraclesinvalueinvesting,andseeiftheycollectivelybeatthemarket– .HavethoseinvestorswhohavereadGrahamandDoddgeneratedhigher

returns,relativetothemarket,thanthosewhojustlistentoCNBC?– DothetruebelieverswhotrektoOmahafortheBerkshireHathaway

annualmeetingeveryyearhavesuperiortrackrecordstothosewhobuyindexfunds?

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Conclusion

¨ Valueinvestingcomesinmanystripes.¤ Therearescreenssuchasprice-bookvalue,priceearningsandprice

salesratiosthatseemtoyieldexcessreturnsoverlongperiods.Itisnotclearwhethertheseexcessreturnsaretrulyabnormalreturns,rewardsforhavingalongtimehorizonorjusttheappropriaterewardsforriskthatwehavenotadequatelymeasured.

¤ Therearealso“contrarian” valueinvestors,whotakepositionsincompaniesthathavedonebadlyintermsofstockpricesand/orhaveacquiredreputationsas“bad” companies.

¤ Thereareactivistinvestorswhotakepositionsinundervaluedand/orbadlymanagedcompaniesandbyvirtueoftheirholdingsareabletoforcechangesthatunlockthisvalue.

¨ Inspiteoftheimpeccableacademicevidenceinitsfavor,thereislittlebackingforthegeneralclaimthatbeinganactivevalueinvestorgeneratesexcessreturns(relativetoinvestingavalueindexfund).