Thursday, November 24, 2011

Diary: Netflix, growth versus value


I'm generally not interested in US shares, but Netflix has so much publicity, what with Whitney (or as some unkind soul is calling him, Whitless) Tilson going short and then long. Slashdot is having an interesting discussion about Netflix. Check out the cartoon. There's a lot of scepticism around Netflix, and my bet is that Tilson is gonna get burned on his long position. It's not all bad news for Tilson, though, as someone said: 2 and 20 baby, 2 and 20.

Growth versus value

I said I was going to talk about growth and value yesterday. So here goes ...

Why isn't everybody doing it

I came across an article in the excellent Valuewalk website, which launched my whole interest. Some notes ...

There are structural return patterns relying on certain factors. These factors come down to buying cheap instead of expensive (value factor), stocks on the rise (momentum factor), avoiding stocks that have recently issued new shares (equity offerings factor) and several others. [This feeds into my increasing convictions about choosing the correct structural pattern, rather than being especially savvy on individual securities].

Lakonishok et al looked at the idea risk not as beta, but the underperformance of an asset class in times of economic stress as good indicator of embedded risk. They discovered, though,  that there were only few instances where value stocks underperformed at all.

So, doesn't that mean that in order to generate above-average returns, we just need to stick to value strategies? There's some equivocation here. Grantham April 2010 argued that the value effect is related to a special risk if you look closely enough (top quality paper - read it!). The problems occur when the economy goes down a lot (e.g. Depression of post-1929 and recession of post-2007). The crux of the analysis is that the outperformance of value stocks is a compensation for the near-wipeout investors suffer in a value portfolio when very hard times hit. Grantham also points that high-quality stocks out-perform the market. Quality is important, especially in times of deep economic trouble but value stocks rarely possess quality attributes.

The upshot should be to buy value stocks to capture institutional mispricing, and avoid the large declines during deep recessions (in Ken Fisher's book, The Only Three Questions That Count, he says the same thing: if you can simply the capitulation phase of a bear market, you'll automatically come out ahead). You should be able to achieve that by combining "good" and "cheap" - for example the Greenblatt Magic Formula or the Piostroski F-score. I think that even here it's not quite so cut-and-dried, as I think Greenblatt found his formula very disappointing in 2007, IIRC.

Grantham April 2010

I want to cover some additional points on the Grantham quarterly letter (same link as above). Sketch notes follow.

page 1: on our data [the market is] likely to have a second consecutive very poor decade. speculation is rewarded because Bernanke creates an asymetry by bailing out burst bubbles.

page 4: UK house prices expected to decline 40% to get back to trend . if they don't do this, then it will be the first time in history that a bubble has not behaved that way.

page 6: now for the really good stuff: "On the potential disadvantages of Graham and Dodd-type investing".

page 7: Grantham likes chapter 12 of Keynes' General Theory of Employment, Interest and Money, and is non-plussed by its remainder. Grantham calles Graham irrational, because they are just as much prisoners of the future as anybody else. [It's interesting that Munger takes the same view: Graham is throwing out highly pertinent information]. Grantham thinks Grahamites have too narrow a focus. When you buy a stock, because it has surplus assets or a good yield or a great safety margin, you are really making a bet on regression to the mean. Statistical fact: industries are more dependably mean-reverting than stocks. Individual stocks can on rare occasion permanently change their stripes. Sectors, like small caps, are more provably mean-reverting than industries. Stock markets of a country are more mean-reverting than sectors. Asset classes are more mean-reverting that individual countries. Asset classes are the most predictable of all: when a bubble occurs in a major asset class, it is a near certainty that it will go away. He defines a bubble as a 2-sigma event, so it would be expected to occur every 40 years under normal conditions. He defines "near certainty" as over 90%.

page 8: We are up to 34 bubbles. Every one of them has broken all the way back to the trend. All the data errors that frighten us all at the individual stock level are washed away at these great aggregations. It's simply more reliable, higher-quality data.

page 9: a potential weakness of the Graham and Dodd approach, as it is usually practiced, is in its reliance on low price-to–book (P/B) ratios as one of its cornerstones. Low P/B ratios are, after all, the market’s way of saying “these are the assets in which I have the least trust.” It should not be surprising, therefore, that when you have a depression, or nearly have one, that more of these “cheap” companies go bust than is the case for the “expensive” Coca-Colas. In late 2006, many cheap companies failed. There were several that were blatantly bankrupt, but were fortunately bailed out by the government. So, despite the pain suffered by value investors, they were lucky in being saved by the Great Bailout [I think there's even a letter floating around that Buffett wrote to the effect that Berkshire would have been bankrupted had the government not done its bailout. Bonus points to anyone who can provide a link!].

To put it in my own words, value stocks are more subject to black swan events, causing Grantham to say that Fama and French were right, but for the wrong reason. What Grantham showed in his "exhibit 1" was that post 1933 the low PBV stocks would take 41 years (!) to catch up with high PBV stocks.

Page 10: in other words, the 1932 drop chewed up what amounts to 41 years worth of reasonable risk premium. The rest of the time until 2007 you made extra money by buying low PBV stocks, of course.  Graham lost 70% in the Crash of 1929 - he was in a leveraged position, though. Leynes got wiped out in the early 1920's currency speculating, and was bailed out by a rich friend.

Now Grantham really gets cooking ... The “cheapest” P/B ratios have another potential weakness. Sometimes they are not usefully cheap at all. In 2000, the range between the P/B of the market favorites and the market pariahs was very, very wide. As wide as it had ever been. When the range is wide, the top end – the high P/E favorites – are very vulnerable, and the cheap, contrarian stocks at the other extreme can make you a fortune.

Page 10: In 1983, he pronounced the "Death of Value". Everybody wanted to be a value manager by 1983 becasue it had done so dazzlingly well since 1974. It had beaten the market by 100 percentage points. The growth managers were hiding under the table. Yet from 1984, because value investing became so trendy, you made no extra money in the cheapest PBV stocks for 19.5 years. AND you weren't being compensated for the fundamentally lower quality of these stocks.

Sidenote: Having read Cundill's book - who was very interested in net-net stocks - people touted what a great performance that the fund has had. The fund was formed in late 1970's, and the performance was until 2010. People who crow about him explain that his fund worked even better since 2000 - presumably implying that his investment acumen had increased during that period. BUT. BUT ... and this is something nobody seems to have picked up on ... IIRC correctly he had an initial outperformance, which helped him stay ahead of the indices for a long time. IIRC the indices caught up with him in 1987, but then he outperformed for awhile, and then lagged. Significantly, though, it was in about 2000 that again the indices matched his performance. Think about this.You could have invested in his fund for 20 years, and still only matched the index. It's true that he outperformed from 2000 onwards, but as the above notes state, that was at a time that value was poised to outperform. So we can reach a rather frightening conclusion. Even though the fund had been operating for 30 years and outperformed the index, this outperformance was due to a relatively short period, and is probably merely due to style preference (i.e. "luck") than great investment acumen. As Richard Beddard at Interactive Investor speculated - Peter Lynch has only operated a fund for a relatively short period, a period in which a growth style was coincidentally favourable. I used to be skeptical when naysayers said that there was insuffiicient statistical evidence of the outperformance of managers - but it's clear from the above that they might really have a point! (which brings me back to my original assertion: it's style, not stockpicking, that's important. And: you're a macroeconomist, even if you don't know it). You can outperform an index for a decade - and it still proves nothing!

OK, back to Grantham ... Grantham defines quality/growth companies his own way: principally level and stability of profitability and secondly on debt. He doesn't give specifics, but it seems sound enough. Now here he makes an interesting observation: Grahamites wouldn't buy the quality companies because they would not be considered cheap. But they must have been, because they outperformed - which is the only thing that counts. So fundamentally, PBV (or PE or yield) does not represent intinsic value [something that Buffett says, too]. To prove his point, he says that given a choice, everyone would buy Coca-cola at 1.2 times book instead of General Motors at 1.0 times book. Ergo, PBV is not value.

Page 12: OK, now be prepared to have your mind blown. These factors [value stocks 1973-1983] in the past had delivered the goods because the "spreads" - the range between large and small cap and between high and low PBVs - had been wide. As the value strategies became popular, the spreads narrowed, and then failed to deliver an excess return. Low PBV stocks or small cap stocks only outperform when priced to do so [this guy must be channeling Howard Marks, or something]. This was the problem by mid-2006.

Now we move on to exhibit 4, where he plot the relative value of the cheapest 25% on price to book to the market. I consider this THE MOST IMPORTANT PART OF THE PAPER. He draws a heavy line at 0.5 - which I presume to be the "average". He has circled three peaks (about 1987, 1994,  2005), which are around or above 0.6. This represented when value stocks were unattractive. I think it is a very very important graph, because it allows you to guage when value investing it like to work, and when it isn't. My only gripe is that I don't quite understand what he means by "the cheapest 25% - is it the PBV at the 25th percentile, or the average PBV of the stocks in the lowest 25 th percentile? I assume the former.

I highly recommend that you read page 12 in its entirety.

Page 13: He makes a similar argument for small cap stocks. They may well outperform, but tend to get slaughtered disproportianately in black swam events like the Great Depression [Graham noted this problem, too]. Using high ROE as a proxy for quality, they lost 25% of their value during the crash. The value ones lost 95%. Quality stocks have outperformed the market since 1965 (when their quality data began). Interestingly, this also echoes a poster on TMF whom I respect highly. His basic assertion is that the value stocks are too erratic to be useful, and it's the quality ones that have produced the superior returns over the long haul. Granhtam says: Warren Buffett doesn't really talk much about the fact that he is playing in a superior universe. PBV, despite its low beta, is a risk factor because of its low fundamental quality and its vulnerability to failure in a depression. Ditto for small cap. Quality has outperformed "forever".

Whare are we now?

Well, I did some number-crunching (buyer beware!) on some data that I have on PBVs for over 400 shares (excluding investment trusts) with the highest market caps. I ranked them in quartiles. Here's what I found:

Q1 0.99
Q2 1.68
Q3 3.13

So the median is 1.68 (doesn't look that bad, actually), and at the 25th percentile, the PBV is 0.99. This gives the ratio of Q1:Q3 of 0.59 (0.99/1.68). If I have interpreted Grantham's chart exhibit 4 correctly, this means that value stocks are at their "high" end of relative valuation, and are therefore priced unattractively. A portfolio of value shares are likely to underperform, whilst quality and growing companies are likely to out-perform. This is consistent with my post from yesterday, where I mentioned that high volatility coupled with a high put/call ratio is likely to favour growth. In low-growth environments, growth companies are likely to outperform. Then there's the whole macro picture, which is bleak. I'm not confident that the market is pricing in the ultimate cost of the fallout.

My analysis could be wrong, of course. Whilst formerly I would have said that the drop in share prices coupled with high volatility is bullish for value, now I'm more reticent to conclude that. Given the cheapness of quality companies, it may make more sense to invest in them. I'll leave you with snippets from a recent post by "F958B" on TMF, an investor whom I greatly respect:
We're approaching a point where the ECB will soon start their printing press. France is on the brink of a credit downgrade and even the German government now appears to be struggling to find people willing to lend it money (half of their bonds at auction today were, apparently, not able to be sold). The Fed, BOE and ECB seem likely to very soon supply their economies with possibly the biggest synchronised monetary-adrenaline shot ever seen. In such a stimulatory situation, commodities would probably launch into a huge speculative bubble - similar to the late 1970's ... Like Buffett, I believe that now is a good time to accumulate high-quality companies if the price is sensible. Don't buy bombed-out junk; buy quality which you would be prepared to sit on for several years. Prices are so attractive for many companies that there is no need to buy what appears to be the cheapest; even the relatively more expensive shares are mostly at sensible prices nowadays and look perfectly capable of delivering good long-term returns for brave and patient investors. Even ignoring share price moves, the 4-6% dividend on some of the most solid of defensive blue chips would not be bad at all, for an annual average return.


Alan Shouls said...

Hi Mark,

With reference to the housing in this county it is my feeling that the situation is skewed by demand & supply issues (shortage of housing stock) and low interest rates. My feeling is that if interest rates rise significantly then people will simply be able to afford less.


Richard Beddard said...

I really want to come back on growth v value but you wrote a mountain and then pointed us to another in the Grantham report! I've read it before and I think my reaction was he's kind of set up a straw man in assuming value = low price to book. This is what academics do, because they have to test something simple, but in practice most value investors I know recognise quality is a factor too. Then they work out how much they are prepared to pay for it. I gather from your blog he kind of says value works until it really blows up in a crash, but I've got a paper from JP Morgan ( ) that shows concentrating on financial strength during bear markets is an effective strategy, which is why I use the F_Score in combination with value metrics.

That's not to say value will always outperform, as Greenblatt says, if that were to happen everybody would do it, the market would be efficient, and there'd be no value left!

Anyway sorry for the stream of consciousness. I plan to pen a response to your blog and Grantham's but I've got to find time to read them properly first!