Risk := ON

Quantitative Squeezing

As the immediate fears of market immolation have faded the switch in investors’ heads marked “Risk” has moved to the OFF position. All those little signs of uncertainty, the mass synchronisation of share price movements, the endless twittering and wittering about the imminent end of the known world have faded, to replaced by the normal measures of complacency in the face of unimagined dangers.

It’s likely that the relief generated by the Eurozone’s ability to stitch together a patchwork quilt of compromise to keep Greece from defaulting and the general resilience of corporate profits is only temporary. A reckoning must come when quantitative squeezing replaces quantitative easing. Getting this right requires finessing on a grand scale by the lords of finance; not impossible, merely very, very difficult.

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Losing Momentum: Is It Time to Exploit Mean Reversion?

One Last Free Lunch

There are a range of so-called anomalies that have preoccupied investors for many years, largely because they seem to offer a free lunch, which is a rare thing in investment markets. So the momentum effect and various value-related effects have spawned a whole host of exciting but not entirely convincing ventures.

A range of recent research now threatens to actually shed some light onto these anomalies suggesting that the momentum effect has vanished and that value effects are real but caused by idiosyncratic factors. It also suggests that mean reversion, upon which many investing careers is based, generally works but sometimes only if you have an investing lifetime to wait. On a positive note, NOW might be a really good time to try and exploit it.

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Deep Time and the Fallacy of Frequency

Ice Age 6?

There was a time when geologists reckoned that we’d never see another Ice Age. This was when our understanding stretched back only as far as the last one. Then they discovered that there’d been not one Ice Age, but five, stretching away back into countless hundreds of millions of years.

One-off events, even ones as apocalyptic as the general freezing of the world, tend to be ignored: but repetitive ones are viewed very differently. Things that have happened multiple times before may happen again: frequency changes perspectives. Unfortunately the geological view of Deep Time isn’t shared by investors, whose event horizons rarely reach beyond the next quarter.

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Mayhem with M&A;

Insane Acquisitions

Most company acquisitions generate significant benefits. Unfortunately these accrue almost exclusively to the shareholders of the companies being bought, rather than the owners of the acquiring corporation. Time and again major mergers and acquisitions fail to work yet this doesn’t seem to stop the cycle of value destruction. Yet again, something in the corporate world seems to be a bit broken.

The problem is that generally companies overpay for their acquisitions, diluting the value of their equity and, thus, damage the interests of their shareholders. Yet this is no secret, so company executives are persisting with their problematic purchases in the face of almost certain failure. Being insanely overoptimistic seems to be part of the human condition but being dementedly stupid isn’t an obvious precondition for managing major corporations. So what gives?

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Buffett and Munger on the BBC

The BBC’s Evan Davis talks to an avuncular Warren Buffett and a waspish Charlie Munger.

A few snippets below with links to the interviews.

Interview with Munger

Q: How worried are you by the declines of the share price of Berkshire Hathway?

CM: Zero. This is the third time Warren and I have seen our holdings in Berkshire Hathway go down, top tick to bottom tick, by 50%. I think it’s in the nature of long term shareholding of the normal vicissitudes, of worldly outcomes, of markets that the long-term holder has his quoted value of his stocks go down by say 50%. In fact you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.

Q: Munger and Buffett’s checklist for picking a company to invest in.

CM: We have to deal with things that we’re capable of understanding and then, once we’re over that filter we need to have a business with some characteristics that give us a durable competitive advantage and them, of course, we would vastly prefer management in place with a lot of integrity and talent and finally, no matter how wonderful it is, it’s not worth an infinite price. We have to have a price that makes sense and gives a margin of safety considering the normal vicissitudes of life It’s a very simple set of ideas and the reason that our ideas have not spread faster is they’re too simple. The professional classes can’t justify their existence if that’s all they have to say. It’s all so obvious and so simple what would they have to do with the rest of the semester?

Interview with Buffett

Q: Buffett on the trouble with stockmarkets.

WB: The very liquidity of stockmarkets causes people to focus on price action. If you buy an apartment house, if you buy a farm, if you buy a MacDonald’s franchise you don’t think about what it’s going sell for tomorrow or next week, or next month, you think about how is this business going to do. But stocks with this huge liquidity suck people in and they turn what should be an advantage into a disadvantage … You are focusing on the right thing if you look at the stream of income that an asset is going to produce over time.


Related Articles: The Buffett-Munger Paradox, Investing Like Berkshire Hathaway, Is Intrinsic Value Real?

Don’t Overpay For Growth

Why’s Value Better?

A moment’s serious thought should tell us that investing in growth stocks ought to be a better stockmarket strategy than any other. Growth stocks, by their very nature, grow their earnings faster than other stocks so – obviously – they ought to be better investments. But investing’s not a zero sum game and the obvious often isn’t what it appears to be.

Investing in growth stocks all too often turns out to be a less than optimal stock allocation strategy but the simplistic argument that companies on lower ratings perform better than companies on higher ones simply won’t do. Value type companies are on lower ratings because their ability to grow their earnings is lower. All things being equal this shouldn’t translate into better share price performance. It does – so what’s going on?

Bubbling Growth

One simple answer, frequently given, is that growth stocks are the stuff of bubbles. There’s never been a bubble in lowly rated, moth-eaten, downtrodden, ex-growth value companies and, offering a rare prediction, I don’t think there ever will be. So when bubbles pop it’ll be the exciting growth pedigree stories that are bursting, not the mangy mutts that no one wants to re-home.

Recent research by the Brandes Institute confirms the long standing evidence of the superior performance of value over growth. Value vs. Glamour: A Global Phenomenon extends existing US based research across the globe to come to the following conclusions:

“Between 1968 and 2008, we found U.S. large-cap value stocks … outperformed U.S. large-cap glamour stocks … by 6.8% on an average annualized basis across 5-year periods. In the small-cap arena, U.S. value stocks returned an average annualized 9.7% more than their glamour counterparts across 5-year periods.

In non-U.S. developed markets, the premium for large-cap value stocks was 8.6% greater than large-cap glamour stocks between 1980 and 2008. Again, returns were annualized on 5-year periods. The difference was even greater for non-US small-cap stocks, where value stocks outperformed glamour stocks by 9.0% annualized. Note that this was not the absolute return for non-U.S. small-cap value stocks – this was the excess return over the small-cap value stocks.”

To paraphrase: everywhere and at all times growth stocks suck.

Clairvoyant Investing

Although the Brandes research brings up to date and confirms what we already knew it doesn’t offer any explanation for why this is so. It’s like Newton’s Laws of Gravity – providing laws that are always applicable without offering the slightest explanation of why this should be so. Many of Newton’s contemporaries regarded the concept of invisible forces acting at a distance as magic, not science. For humans it’s not enough to accept that something is so, we need to understand why it is so. So why do value stocks outperform?

Let’s face it – all the great companies of the world today were once growth stocks, they didn’t get to be big by being low-growth, grungy value mongrels. There’s something counterintuitively weird going on. As usual it’s nothing to do with the intrinsic merits of the companies and everything to do with the warped sense of values in the heads of the people who invest in them.

As previously reported here, recent research by Research Affiliates has come up with an interesting new way of examining past performance of various types of stocks. The so-called Clairvoyant Value analysis goes back to 1956 and assesses future performance of stocks against whether they were then rated as value or growth through a combination of various valuation ratios – price-to-sales ratio, price-to-earnings ratio and price-to-dividend ratio – all relative to the market at the time. These are fairly typical investment ratios, low values of which are often used to define value stocks, high ones to weed out growth.

Given the Brandes research we should be pretty confident in predicting that the research shows that value stocks will outperform growth stocks and we wouldn’t be disappointed. They do, significantly. However, what is interesting and different about this study is that it gives us a window why this is so, rather than simply reaffirming the facts.

Growth Stocks Are Best, But …

The first, notable point is that it turns out that our intuition about growth stocks being superior companies is, by and large, right on the money. Higher rated stocks justify their ratings by growing earnings significantly more than lower rated stocks. Investors correctly identify the growth stocks which will provide superior performance yet lower rated value stocks turn out to be better investments. What’s going on?

The simple answer is that we get excited about growth stories and overpay for them. Generally by about double what it turned out they were worth when we look at the discounted future cashflows of the companies at the various valuation points. The premium paid for growth stocks over value stocks has varied significantly over the period from a multiple of 1.6 times in 1977 – as the Nifty Fifty bubble burst – to 3.3 times in 1999 as dotcom mania exploded. Rarely has the premium turned out to be justified in terms of future, clairvoyant, growth. Here’s what Research Affiliates had to say about this:

“Perfect foresight through 2007 provides an even more powerful result—for spans of 20 or more years, the market never failed to overpay for the long-term realized successes of the growth companies, even though the market chose which companies deserved the premium multiples with remarkable accuracy.”

It’s perfectly obvious that it’s not anything about the intrinsic nature of the stocks that’s causing these effects, it’s human psychology in its purest form. Even when the markets are on their uppers, blood running in the streets, we still manage to push our money into the wrong stocks, incorrectly assuming that a good growth story equals a good investment. Unfortunately the opposite seems to be the truth of it and that’s highly unfortunate for us because we generally operate on stories and not numbers.

And It’s Getting Worse

The research also indicates that the premium that we’re prepared to pay for growth over value is actually increasing, contrary to any expectations about our ability to learn from our mistakes. This increase in “Value Dispersion” could be explained by a number of factors but most likely it means that investors are increasingly overconfident in their abilities to project forward future growth rates, despite all the evidence to the contrary.

One other factor that needs to be considered and doesn’t seem to be is the effect of survivorship on the statistics. You might suspect that higher risk growth stocks would be more likely to go bust than value stocks which ought to offer a margin of safety, but the studies don’t address this point. Intuition tends not to be a good guide to these things, but if it’s correct then growth stocks are even less attractive than they appear.

In general it’s interesting that it’s not our intuitions that let us down when it comes to growth stocks, it’s our number crunching. As ever, price is what you pay, value’s what you get. Invest with the head and not with the heart.


Related Posts: Clairvoyant Value, Overconfidence and Over Optimism, Fairy Tales for Investors

The Rediscovered Ben Graham

Occasionally this interwebnet thingy throws up a bit of a gem. So I’m delighted to have found The Rediscovered Ben Graham, hidden in the bowels of John Wiley & Sons website. A link has been added to the Links section.

These are a series of lectures given by Graham at the Columbia Business School in 1946. There’s a fair amount in here that’s not relevant any more – like the appropriate treatment of war profits (although you never know) – but much that is. Here are a few samples …

Ben Graham lived in not entirely politically correct times (his firm was, even in the fifties, just about the only one on Wall Street that employed Jews – its first non-Jewish employee was some bloke called Warren Buffett). His metaphor for how to regard the stockmarket is both spot on and condescending:

The correct attitude of the security analyst toward the stock market might well be that of a man toward his wife. He shouldn’t pay too much attention to what the lady says, but he can’t afford to ignore it entirely. That is pretty much the position that most of us find ourselves vis-à-vis the stock market.

He was sound on short-term investor psychology, where nothing much changes:
 

… it is interesting to see how unpopular companies can become, merely because their immediate prospects are clouded in the speculative mind.

Prescient on index tracking, thirty years ahead of the launch of Vanguard:

Furthermore, there is nothing to prevent the investor from dealing with his own investment problems on a group basis. There is nothing to prevent the investor from actually buying the Dow-Jones Industrial Average, though I never heard of anybody doing it. It seems to me it would make a great deal of sense if he did.

Wryly amusing on the virtues and otherwise of security analysts:

It seems to me that Wall Street analysts show an extraordinary combination of sophistication and naiveté in their attitude toward speculation. They recognize, and properly so, that speculation is an important part of their environment. We all know that if we follow the speculative crowd we are going to lose money in the long run. Yet, somehow or other, we find ourselves very often doing just that. It is extraordinary how frequently security analysts and the crowd are doing the same thing. In fact, I must say I can’t remember any case in which they weren’t. (Laughter.)

And acutely accurate on human nature:

In one important respect we have made practically no progress at all, and that is in human nature. Regardless of all the apparatus and all the improvements in techniques, people still want to make money very fast. They still want to be on the right side of the market. And what is most important and most dangerous, we all want to get more out of Wall Street than we deserve for the work we put in.

Worth a browse.

David Stevenson FT Interviews

Over at the Financial Times David Stevenson has conducted a couple of set of interviews with a bunch of the more value oriented investment professionals around. They’re well worth listening to, especially if you have doubts about a buy and hold strategy. If there’s a single theme it’s about buying cheap, but there’s far more here than that. Thought provoking.

Podcast 1: James Montier, Albert Edwards and Tim Bond

Podcast 2: Paul Marsh, Elroy Dimson and Rob Arnott

David’s regular Adventerous Investor FT column is well worth reading as well.