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Saturday, May 02, 2015

Value investing fact and fiction

Email not displaying correctly? View it in your browser. (http://us4.campaign-archive1.com/?u=bd62eb752b5b6a832968161ea&id=068694a883&e=b698de5ae8 Value investing fact and fiction 1st May 2015, Ed Croft - CEO, Stockopedia Another superb piece has been published by the team at AQR Capital Management under the title “Fact, Fiction and Value Investing (https://www.google.com/url?q=https%3A%2F%2Fwww.aqr.com%2Flibrary%2Fworking-papers%2Ffact-fiction-and-value-investing&sa=D&sntz=1&usg=AFQjCNFWlS2gRHGwRvDpSFMh3WYAQhKZ6A ". It is designed as a complement to their excellent 2014 publication “Fact, Fiction and Momentum Investing" and does exactly what it says on the tin. Sadly, most academic finance papers are so dry even a cactus couldn't grow on them but, to their credit, AQR have a style that even a lay investor could (just about) get their head around. The paper holds a lot of reinforcing lessons for Stockopedia subscribers… so I'll summarise a few key findings that are of most relevance. ------------------------------------------------------------ Click here (https://www.youtube.com/watch?v=VtHgyW18dP0 to check out our StockRank Portal Webinar (https://www.youtube.com/watch?v=VtHgyW18dP0 . If you're interested in learning more, feel free to take a free trial (http://www.stockopedia.com/plans/ by clicking here (http://www.stockopedia.com/plans/ . ------------------------------------------------------------ ** 1. Buying 'cheap' works ------------------------------------------------------------ Investing successfully is really quite simple... though often not easy. We've long pushed the mantra that investors should focus on buying ' good, cheap, improving' companies - a philosophy based on the long term outperformance of quality, value and momentum as factors in stock selection. AQR are probably the most vocal institutional proponents of these three factors and in their paper they reiterate that 'cheap beats expensive' loud and clear. Paraphrasing… “The existence of the value premium is a well established empirical fact: it is evident in 87 years of US equity data, in 40 other countries and even dating back to Victorian age England... The returns of a diversified portfolio of value stocks over their more expensive counterparts are available to any who choose to pursue them." The authors make the clear distinction between 'pure' value investing (just buying the cheapest stocks in the market according to simple price ratios) and 'normal' value investing (which aims to find the best stocks within the cheap basket). While value investing returns can be improved by weeding out all the worst stocks in the cheap basket, 'pure value investing' works just fine. “A good strategy can survive a little noise" the authors say. Of course how should you measure 'cheap'? ** 2. Value is best measured by a blend of ratios ------------------------------------------------------------ A lot of investors stick to a single preferred valuation ratio to measure 'cheapness'. For private investors, it's often the Price to Earnings ratio, but in academic circles the lion's share of the studies have used the Price to Book ratio. But going to war with a single weapon has often proven foolhardy, and so it is with value investing. The paper shows that different valuation methods perform better or worse during different market cycles, with 4 different valuation ratios performing best in each of the last 4 decades. Of the 5 ratios the authors test, the Price to Earnings ratio performed best during the 60s and 70s, the Dividend Yield in the eighties, while the Price to Cash Flow dominated in the seventies and 'noughties'. Counter intuitively in the nineties the best valuation measure in their set was the biggest previous five year losers ! Clearly becoming pig-headed about a preferred valuation tool of choice could be expensive if it fell out of vogue. There's a lot of current buzz about the Earnings Yield (EBIT/EV) and I've noticed a range of ETFs being launched based on its backtested success. This seems to me a bit like driving forwards using the rear view mirror. I'm skeptical that a single measure of value will work better than others persistently and the above data backs that skepticism up with more hard data. As you can see in the table, a composite of all the other ratios performs the most reliably and steadily across the full time periods. The authors say: “No single measure of value is demonstrably better than another. But an average of multiple measures is typically best." Those that use the Stockopedia Value Rank (http://www.google.com/url?q=http%3A%2F%2Fhelp.stockopedia.com%2Fknowledgebase%2Farticles%2F182732-what-is-the-valuerank&sa=D&sntz=1&usg=AFQjCNHHedpsqEs7G5KpwF_TFc1CIanqIQ will gain comfort from reading this section of the paper. The Value Rank employs six blended measures of valuation to rank the entire market for ' cheapness' - the P/E, P/S, P/B, EBIT/EV, Yield & P/CF - and our tracking to date has shown its effectiveness (http://www.stockopedia.com/stockranks/performance/?marketId=gb&field=_ValueScore_∩=10.=4&buckets=deciles) . Certainly cheap has beaten expensive in the last couple of years in UK & European markets quite dramatically. One common misunderstanding amongst Stockopedia members who use our Value Rank (http://www.google.com/url?q=http%3A%2F%2Fhelp.stockopedia.com%2Fknowledgebase%2Farticles%2F182732-what-is-the-valuerank&sa=D&sntz=1&usg=AFQjCNHHedpsqEs7G5KpwF_TFc1CIanqIQ) is that it's an 'all in one' value investing metric. It is, but only from this 'pure value' perspective - all it measures is cheapness … it doesn't adjust for quality at all. When hunting amongst high Value Rank stocks it's wise to either adjust for quality/momentum (see point 4) or broadly diversify (see point 6 below). ** 4. Value works best with Quality and/or Momentum ------------------------------------------------------------ Of course buying cheap comes with a lot of attendant risks as you'll be exposing yourself to plenty of Value Traps (http://www.google.com/url?q=http%3A%2F%2Fwww.stockopedia.com%2Fcontent%2F10-worrying-signs-that-your-stock-may-be-a-value-trap-63930%2F&sa=D&sntz=1&usg=AFQjCNFn2ruxzg6B87zIVZD3VBNtu0ibmQ) if you do: “Because [the pure value] strategy systematically buys all cheap companies, it also buys some firms that are cheap for a reason and will continue to underperform." In order to lessen these risks, the authors use the publicly available data on Kenneth French (http://www.google.com/url?q=http%3A%2F%2Fmba.tuck.dartmouth.edu%2Fpages%2Ffaculty%2Fken.french%2Fdata_library.html&sa=D&sntz=1&usg=AFQjCNFyKh1YF3CdpjI95eAblYy1I6_rVg) 's website to try to improve on 'pure value' returns through adjusting for combinations of momentum and profitability. The following chart shows that an equal weighted combination of all three provides the highest risk-adjusted-return according to the Sharpe ratio. The data shows that momentum is a hugely powerful factor when used in combination with value, even more powerful than profitability/quality. I know that so many value investors just can't abide the idea of buying stocks that are trading at new highs, but I do wish they'd get over their biases and start putting the empirical evidence to work in their portfolios. Of all strategies tested, an equal weighted blend of Value, Momentum and Profitability worked best, mirroring the construction of Stockopedia's own QVM StockRank (http://www.google.com/url?q=http%3A%2F%2Fhelp.stockopedia.com%2Fknowledgebase%2Farticles%2F184381-how-do-you-calculate-the-stockopedia-stockranks&sa=D&sntz=1&usg=AFQjCNEQXHLcT26aNuNHt37JSqAVSlnkig) . “Clearly, value does not work best alone. Combining it with other intuitive and empirically strong factors such as profitability and momentum builds the best portfolio. The diversification benefits of combining value with momentum and profitability also extend to trading costs and tax considerations." Anyone looking to put these ideas to work should consider using the the Value Rank in combination with the Quality Rank or the Momentum Rank. We provide various 'crossover' (http://www.google.com/url?q=http%3A%2F%2Fwww.stockopedia.com%2Fcontent%2Fintroducing-the-stockrank-crossovers-79035%2F&sa=D&sntz=1&usg=AFQjCNHxSpM4SrqP3aSmJvUmQTLy3bSQhQ) ranks (http://www.google.com/url?q=http%3A%2F%2Fwww.stockopedia.com%2Fcontent%2Fintroducing-the-stockrank-crossovers-79035%2F&sa=D&sntz=1&usg=AFQjCNHxSpM4SrqP3aSmJvUmQTLy3bSQhQ) which can be extremely helpful shortcuts… the QV Rank (quality + value) , the VM Rank (value and momentum) and of course the QVM StockRank (quality+value+momentum). All are especially useful to value investors seeking safety from value traps and easily browsed in the StockRanks portal (http://www.google.com/url?q=http%3A%2F%2Fwww.stockopedia.com%2Fstockranks%2F&sa=D&sntz=1&usg=AFQjCNE1JOpi2HiSNjB1r9tydKT5-SvstQ) . ** 5. Value works best in small caps ------------------------------------------------------------ Private investors are small-cap crazy and so they should be. Not only have there been historically higher returns available amongst smaller companies but it's an area of the market that institutional investors find hard to play in due to parched liquidity. Private investors have no such restrictions and can find it much easier to build meaningful stakes in small caps. The good news is that the value premium is strongest amongst this part of the market. The authors don't go so far as to say that value doesn't work amongst large caps but it's effectiveness is significantly reduced. “Over the entire sample period, the market-adjusted return to value within small cap stocks is a significant 5.5% per annum, but within large cap it is an insignificant 1.7% per annum." Of course, while value less insignificant amongst large caps, value in combination with momentum remains highly effective amongst large caps. “Once again momentum rides to value's rescue!" ** 6. There's no need to over-concentrate your portfolio ------------------------------------------------------------ We had a fun debate at David Stredder's excellent “Mello Workshop (http://www.google.com/url?q=http%3A%2F%2Fmelloevents.com%2Fmello-workshop%2F&sa=D&sntz=1&usg=AFQjCNETKqjI6ZoZb6bWtmGGt0Tvka-KZw " in Peterborough about having 'commitment' in position sizing your portfolio. Among the 5 investors on the panel, Richard Beddard and I probably stood alone in advocating broad diversification and equal weighting of position sizes. I've long thought there's too strong a tendency for value investors to buy into the Warren Buffett myth that 'diversification is a hedge for ignorance'. This kind of thinking often leads too many to oversize their positions, over-concentrate their portfolios and leave themselves highly exposed to tail risks. AQR state that the value premium (cheap beats expensive) is available to all investors, especially those that diversify broadly: “Being Warren Buffett is nice work if you can get it, especially after the fact. But the legion of academic and practitioner evidence is that diversified portfolios of 'cheap' securities healthily outperform their more expensive brethren, all without the necessity and danger of picking the handful of best ones." Again this backs up the Stockopedia house philosophy that we should align with the QVM payoffs and diversify to capture them. I strongly believe that picking the right rules is far more important than picking the right stocks … though saying this publicly normally gets my head bitten off by the other panelists at these events. I defer, as do AQR, to the father of value investing Ben Graham: “In the investor's list of common stocks there are bound to be some that prove disappointing… but the diversified list itself, based on the above principles of selection… should perform well enough across the years." ------------------------------------------------------------ Check out our free ebooks (http://www.stockopedia.com/books/ to learn more about value investing, as well as making money in dividend stocks. ------------------------------------------------------------ ** 7. Two reasons why value investing will keep working ------------------------------------------------------------ At the Mello Peterborough Workshop (http://www.google.com/url?q=http%3A%2F%2Fmelloevents.com%2Fmello-workshop%2F&sa=D&sntz=1&usg=AFQjCNETKqjI6ZoZb6bWtmGGt0Tvka-KZw I ran several seminars, one of which was called “What Pays Off and Why?". In this session I discussed both the risk-based behavioural reasons why the payoffs to quality, value and momentum may be likely to persist. There's a great final section in this AQR paper that goes into depth on this topic for value investing. Essentially, if you are going to keep value investing, you've got to be sure that there's a mechanism for value to out. * Risk based reasons suggest that value investors get paid a premium as compensation for higher credit risk and the risk of underperformance. There have been long periods where value investing hasn't worked (e.g. the 1990s in the tech bubble and in 2008 in the global financial crisis) so we can think of value investors as being paid an insurance premium for holding risky cheap stocks. Our own Value Rank shows that cheaper stocks are certainly more highly levered & less liquid. * Behavioural based reasons suggest that the value premium is due to mispricings due to investor over-reaction. Investors just can't stand buying cheap stocks as they are unpopular and have seemingly unfixable 'problems', so they get over-sold and as a result outperform over time. At Stockopedia we've long preferred the behavioural story to the risk based story as we have a behavioural bias (sic), but interestingly AQR sit on the fence. They note that “ the jury is still out on which of these explanations better fit the data. Both explanations have important elements of truth, nothing says that the mix is constant through time ." Whatever the truth, there are plenty reasons to believe that investors will continue to misprice shares and the value premium will persist. If I've stopped saying the mantra 'cheap beats expensive' in 20 years, then either the investing world will be being run by robots or aliens. It certainly won't be being run by primates as it is today. ** Conclusions ------------------------------------------------------------ There's a lot of other commentary in this paper that is part of what I consider the academic 'echo chamber'. These conversations are like slow motion Test Matches between academic luminaries, entertaining to those who've tuned in for a while but completely lost on others. These parts may best be skimmed by private investor readers that don't follow the threads but essentially there's some hostile criticism of the proponents of Fundamental Indexing and a good beating up of Fama & French's 5 factor model. Hopefully the above summary puts their AQR's thoughts ... into a good context for Stockopedia subscribers. If you want to read the original paper you can find it at the AQR website or at the social science research network (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2595747 which is an awesome source for these kinds of publications. I'll continue to look out for new publications from their team. Safe investing, Ed Croft CEO, Stockopedia Twitter: @edcroft (https://twitter.com/edcroft Stockopedia is a financial data & analysis portal which should be used for informational & educational purposes only. We do not provide investment advice or recommendations as to whether an investment or strategy is suited to the investment needs of a specific individual. You should always make your own decisions and seek independent professional advice before doing so.

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