Wednesday, December 7, 2011

Diary: Value investing - it's no panacea

Three buckets

There's a couple of interesting posts I want to touch upon. Valuhunteruk wrote:
To state it simply, it isn’t about just buying stocks with low P/Es or P/Bs. We have to keep an eye on risk and the fundamental quality of the business we are buying into.
My response was generally along the lines that it's a contradiction in terms.  Aswath Damodaran sums it up perfectly: the PE ratio is a combination of the risk-free rate, the expected growth rate, and the risk. In other words, TCG (Thomas Cook) isn't on a PER of just over 1 because the market somehow forgot the ticker symbol, it's on a PER of 1 because the economy is going into the tank, it's making losses, business is expected to decline, and it has being trying to prevent breaches in its banking covenants. So the question isn't so much "is it a business with a good fundamental quality", but "is it underpriced". The first question is easy to answer: no, it's a rubbish business with deluded rubbish managers. The second question is harder to answer. For all I know, the intrinsic value of TCG is zilch nada, making the share overpriced rather than underpriced.

Expecting Value also did a review of his value portfolio in December, and found underperformance. He sums up:
The fact I think the market is mispricing these companies is evident by me purchasing them; I wouldn't do it otherwise. Since it mispriced them then, there's no reason to think that me buying them will magically reconcile the price with the true value; that could take years.
 Value investor Richard Beddard also expressed his frustration recently. His T30 (Thrifty 30) invests in micro-caps. In the period from 09-Sep-2009 to 01-Dec-2011, his performance is a whisker ahead of the All-share. I hope Richard doesn't take it the wrong way when I say that, so far, his theory that micro-caps are under-researched and hence should produce a higher return hasn't been a convincing one so far. I'm also worried that he hasn't properly adjusted for the high spreads that are inherent in micros.

More bad news for value investors comes in the form of Stephen Bland (aka Pyad) over at The Motley Fool. I can't find the link, but at the latest update, he was underperforming the indices. I used to think that Stephen was an excellent investor, but he has decreased in my estimation considerably.

"OK Mr. Smartypants, how are you doing so far this year?", I hear you ask. My response is "Stay tuned". I'll write about it in another post.

I'm now tending more and more to think of the stock market as consisting of 3 buckets: a "value bucket", a "defensive bucket", and a "growth bucket" (my experiences with insurers and banks is particularly solidifying my view - but like I say, it's for another post). Out of mathematical necessity, one bucket has to underperform the averages, whilst another has to outperfrom. So far this year, we've certainly seem that the defensives have outperformed value, with growth being amongst the outperformers, too.

My view now is that in order to outperform, you either need to own the right bucket, or you need to pick the right companies within your chosen bucket. There are advantages and disadvantages with both approaches. "The right bucket" requires two things: that the bucket is wildly mispriced, and you can know it is mispriced. If you can settle that question, then you merely have to choose the contents of the bucket at more-or-less at random. It doesn't matter what you choose (within reason, of course), you just need to choose a selection of them. This is the easy approach. It requires little imagination, and the worst that will happen is that you'll underperform the market somewhat. If in doubt, just choose the value bucket, or possibly the defensive bucket. The other approach is to choose the right companies in whatever bucket is your preferred one. The problem here is that you'll need to be a genius-level Mike Burry insight with Aspergers to do that (don't leave out the Aspergers, that's your structural advantage!). Very, very, difficult, as the people I've mentioned above have discovered.

We've still got a question to answer: which bucket should I choose now? Well, it's tricky! Value has taken a pounding lately, so it's plausible to answer that they'll be a dash for trash, and you should choose the value bucket. I see that Barclays and Lloyds are up nearly 2% today (did you guys buy those banks?)  despite all the doom and gloom surrounding the financial situation in the Eurozone. Some of the really beaten-up stuff is making a strong recovery (Pace is up 30% over the last week or so, and it's up over 5% today).

But I don't think value is the right way to bet at the moment, despite this. I'm thinking of two factors here. For starters, take a look at AAPL (Apple). It is trading on a PER of 14. It has cash of £26bn against a market cap of £363bn, a forward PE of 10, massive returns on equity of 41%, and net income margins of 23%. That such a large, strong, profitable growing company is trading at these kinds of multiples suggests to me that growth is very cheap, and that we should buy growth. There actually seems to be some gross mispricings in the US markets, more obvious even than in the UK markets. MSFT (Microsoft) is on a PER of 9, yet it too has massive returns on equity, and even better margins than AAPL. I'm not saying that MSFT is a better growth company; but I seriously doubt investors will do badly buying into these kinds of companies. BRK (Berkshire Hathaway) is on a PBV of about 1, the lowest its been in way over a decade.

The second factor (all of the above was just the first factor, believe it or not), is simply an elaboration of the point above. In a previous post, I concluded that the relative PBVs of value and growth shares put the odds in favour of growth - with the caveat that I might have misinterpreted Grantham's method of measuring the values. In another post, I also said that the combination of VIX and the CBOE Put/Call ratio indicated that growth would be the more successful strategy - again subject to the caveat that I had misinterpreted information.

I'm also mindful of the fact that if economic conditions deteriorate, as is looking increasingly likely, then value is going to be the worst place to be. It's not all a one-way bet, of course, because the problems are well-understood, and if the Euro manages to magic away the problem "until next time", it's likely that all the junk will rise to the top.

Good luck one and all. I hope no-one has taken offense. If it's any consolation, it's been no picnic for me either. Happy investing, and let's hope Santa brings us a nice rally.


John McElligott said...

Very interesting post. I am firmly in the value camp when it comes to investing. But value is not that simple, as you point out. Value to me, means that the asset must be undervalued against a set of what is the most likely returns that asset generates.
So yes, it is absolutely conceivable that MSFT on a PE of 9 could be significantly more undervalued than say Thomas Cook on a PE of 1.
Value is not the price, nor is it the present multiple - it is the difference between where an asset is trading and where one believes that it should trade based on its returns profile.

All of the my investing successes and failures stem from this. It is the difference between cheap and value.

Many investing blogs focus on small and micro cap. While I can find very many cheap assets in that opportunity set, I think that many of them are simply speculative and poorly run businesses - hence cheap but no value. They are a play on the cost of risk as opposed to a play in themselves.
One way I try to think about this is by comparing the present CAPE with the P/B. I am looking for stocks where the implied RoE are significantly less than those that have historically been achieved.

If you diaggregate the PE (or PB) you will see that ROE is the key determinant of where valuation should lie.
(One should consider just how much leverage has been used to prduce the RoE of course). My tuppence worth.

Richard Beddard said...

Hi Mark, I just want to correct some misconceptions about the Thrifty 30.

1. Microcaps. I have no rules about size, and while there are many small companies, there are many companies in it with market caps > £100m. I came very close to putting £5bn Smith and Nephew in.

2. Spread. This is what I do when I add a share, I get an actual quote from my broker. So the price is the price I would pay if I were actually buying the stock not the mid price. I charge a £10 fee, and 0.5% stamp duty. When I sell I take mid price and deduct a quarter of the spread on the assumption that I won't get the mid price.

I think that's pretty close to reality, and certainly it's more accommodating of the spread than any of the academic studies I've seen or any portfolio I've followed in the media. Also, there has always been significant cash in the portfolio and I don't pay any interest. Admittedly that wouldn't add much to performance at current rates, but it all counts and I mention it to demonstrate that I make every effort not to rig the performance of the portfolio.

3. Performance. I'm only just ahead of my benchmark, which is very carefully chosen. Most people benchmark against an index that takes no account of dividend income that might be earned from investing in that index. I take the dividend and reinvest it in the index.

For a large part of the portfolio's first year, a bull market, most of the portfolio was in cash as I selected the investments for it. The benchmark etf was fully invested from the beginning and my performance would look better now had I trickled money into the benchmark at the rate I invested in the portfolio.

I don't think two years is enough to judge a portfolio. I set it up as a five year experiment, precisely because value often underperforms over any given period of a year or two. I think if you set yourself the goal of never underperforming, you're setting yourself up to fail. However if, after five years I have failed to beat a FTSE All-Share index tracking ETF with dividends reinvested, I will be disappointed.

I don't follow Stephen Bland, but I know he's been running value portfolios for a long time. If his performance over the last decade has been lacklustre he probably deserves to have lost your confidence, but if you're basing your judgement on one year I think that's a very harsh verdict.

However it's a common one, which is why value investing is so hard to do, and why so few fund managers do it (and consequently, in my opinion, why almost of all of them fail to beat the market in the long-run).

Regarding your post. Of course, you're right, sometimes growth (glamour) outperforms value, and sometimes value outperforms growth. Study after study has shown that over the long-term value beats growth though.

If you chose to play the clever game, switching from one to the other, then good luck. It's very competitive! All those scaredy-cat fund managers are playing it too :-)

Nate Tobik said...

Interesting post and two great comments.

I have one thing to add, Mark you are discovering on your own something written up in a book called Style Investing. Basically the idea is that the market moves in cycles such as Value, Growth, Small, Large and there are inflection points. By understanding the market movement one can shift and continue to outperform in all environments.

While this all sounds nice on paper I don't have any confidence I can do this myself except for after the fact. My main safety net is trying to buy businesses with a margin of safety. Even if I underperform I can sleep well at night. To me being a value, and true value is more investment and not speculation.

John, good points on cheap vs value. Many investors are lured by cheap because they have a hard time determining value. I feel right now is unique in that there seem to be a lot of quality European companies selling cheaply, to me this is value.

Professor Professorson said...

Nice debate. Just a couple of points to add. If you are looking at defensive/growth/value buckets with defensives currently the best performing and value the worst, from a countercyclical/contrarian perspective, isn't value or growth where you should be looking now/next?

I think the issue investors (value or not) have been facing recently is that the market looks inexpensive but, as John points out and Richard has been writing recently on his blog, a lot of the companies are just cheap rather than value.

You need to be a lot sharper about what you add and what you leave alone because individual industries are changing so much - in a lot of cases you can throw the earnings record out of the window, particularly among the small caps.

So the fact the T30 is outperforming its benchmark in an environment that has not been favourable for small cap value investment is pretty impressive. Particularly as it's something only about 1/3 of professional fund managers achieve themselves!

My bet is that it would have substantially outperformed the FTSE250, which is probably a truer benchmark for a small/microcap fund.

Which, in a roundabout way, is an example of how value investing can still display some, err, value.

Wexboy said...

Hi Mark,

First, I've been reading your blog for a couple of months now, but haven't commented before - many thanks, plenty of good posts, esp. recently! Second, I launched a value investing blog recently - I hope you'll take a look when you have a chance:

I'm kinda on the same page as you. I think of investing as being in 3 bands:

At one extreme of the Investing spectrum, we have pure Growth Investing, which is Equity analysis and investment based on growth and earnings. At the other extreme, we have pure Distressed Investing, which is basically Credit analysis and investment based on assets and cashflows. And I believe pure Value Investing falls somewhere in the middle band of the spectrum.

Obviously, depending on the multitude of market circumstances, one band of the spectrum may benefit at the expense of the others. I also think any asset normally belongs to a particular band of the spectrum, but that can of course change over time. Investors also generally have a natural affinity for a particular band of the spectrum, probably because they demand very different skills and approach - this is how somebody becomes a Value Investor over time, while somebody else ends up being a Distressed Debt Investor...hmmm, maybe it all comes down to personality?!

It is usually pretty difficult for people to switch from one style of Investing to another, and I think this is where a lot of problems and under-performance arise. For example, using Value Investing to determine that buying at a P/E of 10, 5, 3, 2, 1, 0.5 is cheap suddenly becomes fatal when the company collapses. A simplistic example, but you get the idea, and there are plenty of equally horrible examples for all Investing styles. All told, this style bias can prompt bad investments, and equally can cause an investor to miss compelling 'value' (in the broadest sense of the word) investments.

Personally, I think the best/most mispriced investments are to be found right on the borders of these different bands of the Investing spectrum. The old cliche is perhaps the best example: It is sometimes possible to buy a Growth investment at a Value price. Or a Value investment that has a specific catalyst to turn into a Growth investment. Or we have Greencore (GNC:ID or LN), for example - just writing about it, looks like a lovely cheap Value investment, but it's just crossing over into a Distressed investment - analyze/value on this basis, and you see a v different underlying value - a possible short if you have the stomach for that sort of thing.

This style overlap is however a tough proposition in terms of Investing style, it causes a lot of cognitive dissonance, and I'm sure I'll be much much better at it in 5, 10, 15 years time than today. But it is definitely the most rewarding approach, in my belief.

Hmm, I'm pretty tired, so I can prob expand on this better another day - that's enough for now! - hope the above makes some kind of sense!?!

Richard Beddard said...

Re: Prof Prof's comment

Hi Prof. I think it's too early to say whether I'm doing badly or well.

I'm mostly in small caps now because they're cheap (after considering the risks i.e. good value). If I put the portfolio in large cap shares because that's the trend I wouldn't be a value investor - I'd be following the herd! However, if I'm channelling the portfolio into unfashionable shares with a long-term view, it's a bit harsh to say I'm doing badly if they don't beat the market in the short term. I'd argue it's almost inevitable they'll struggle in the short-term because they're out of fashion!

I think Mark misinterpreted my 'frustration'. I'm frustrated, as you say, that despite looking at a number of cheap shares I couldn't find any that were good value. I'd done a lot of work, and for nothing, at least for now (I learned a lot). I'm not frustrated that the portfolio has underperformed the benchmark etf this year fractionally - that would be wasted energy!