Buy the book the subject of the interview, Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations (hardcover or Kindle, 240 pages, Wiley Finance) from Wiley Finance, Amazon, or Barnes and Noble.
Buy the book the subject of the interview, Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations (hardcover or Kindle, 240 pages, Wiley Finance) from Wiley Finance, Amazon, or Barnes and Noble.
David Ogilvy as he appears in Ogilvy on Advertising
In my first year of law school I worked as a junior copywriter in an advertising agency. The two founders of the agency were famous for a series of iconic beer commercials that ran in the 1980s featuring sports stars, bikini-clad women, sun, surf and sand. All standard fare for beer ads in the ’80s. What made these advertisements iconic was the jingle, the writing and singing of which was the specialty of the founders. Legend had it that they produced the jingles under the influence of the product, which of course only helped their myth grow.
This had all passed into folklore by the time I got there. In the late 1990s it was a mostly corporate environment. Mostly. There were still a few refugees from the ’80s, and a few young guys who wished that the ’80s lived on. Grinding out copy 9-to-5, Monday-to-Friday is a great way to become a solid writer while getting paid. All the guys I sat with were smart, and funny and very good writers. What makes a good writer? As Bo says in Get Shorty:
There’s nothin’ to know. You have an idea, you write down what you wanna say. Then you get somebody to add in the commas and shit where they belong, if you aren’t positive yourself. Maybe fix up the spelling where you have some tricky words . . . although I’ve seen scripts where I know words weren’t spelled right and there was hardly any commas in it at all. So I don’t think it’s too important. Anyway, you come to the last page you write in ‘Fade out’ and that’s the end, you’re done.
In response, John Travolta’s Chili Palmer deadpans, “That’s all there is to it? Then what do I need you for?”
It’s deceptively simple, but good writing is really hard. I didn’t know much when I got to the agency, but I knew that I didn’t know how to write copy. I asked around for a good book to read. Someone told me Ogilvy on Advertising was the bible. (It still is. Everyone should read it. It’s the copywriter’s Intelligent Investor.) I bought it and read it. And it intimidated me. Ogilvy is an extraordinarily good writer. You’d expect nothing less from a man who made his living writing words that persuaded other people to pay him lots of money to write words for them.
I still have my original copy of Ogilvy on Advertising, ripped and soaked through with coffee. It begins in the Overture:
I do not regard advertising as entertainment or an art form, but as a medium of information. When I write an advertisement, I don’t want you to tell me that you find it ‘creative’. I want you to find it so interesting that you buy the product. When Aeschines spoke, they said, ‘How well he speaks’. But when Demosthenes spoke, they said, ‘Let us march against Philip.’
The call out on the first page reads, “I run the risk of being denounced by the idiots who hold that any advertising technique which has been in use for more than two years is ipso facto obsolete.” The photo above appears on the facing page: Ogilvy in suit-and-tie leaning over his desk, pipe clenched between his teeth, all aggressive mien under perfectly coiffed hair. It was heady stuff for a kid. I lapped it up. In my mind, Ogilvy was a Hemingway-esque character, writing, drinking and fighting his way around the world. (That’s no great stretch. His autobiography is called Blood, Brains and Beer.) I wanted to be Ogilvy. If I’m honest, I still want to age into Ogilvy.
What does this have to do with investing?
Ogilvy was a pioneer in the use of research about advertising and behavioral psychology to make ads that persuade people to buy.
Back to the Overture. Ogilvy writes:
I am sometimes attacked for imposing ‘rules’. Nothing could be further from the truth. I hate rules. All I do is report on how consumers react to different stimuli. I may say to a copywriter, ‘Research shows that commercials with celebrities are below average in persuading people to buy products. Are you sure you want to use a celebrity?’ Call that a rule? Or I may say to an art director, ‘Research suggests that if you set the copy in black type on a white background, more people will read it than if you set it in white type on a black background.’ A hint, perhaps, but scarcely a rule.
Though I eventually abandoned advertising for law school exams, I’ve never abandoned Ogilvy. I believe that that research about investing and simple rules to combat behavioral errors are essential to good fundamental investment.
Research lets you know, for example, that using forward earnings estimates is a bad idea. Research also shows that screening for good five-year earnings growth leads to below average returns. And it also hints that return on equity is a misleading metric.
And simple rules combat behavioral errors. David Ogilvy passed away in 1999, but the Ogilvy Group, the firm he founded, adheres to his philosophy. Rory Sutherland, the vice-chairman of Ogilvy Group UK is a self-described “champion of the application of behavioral economics in advertising.” Sutherland believes that we are more likely to follow simple, absolute rules—“if X, then Y”—that work with our nature than others that are subtle, and require a “continuous exercise of self-restraint:”
Let’s consider the old rule of restricting yourself to a maximum number of units of alcohol a week. It demands constant vigilance. It often requires you to stop drinking while drunk. And it is fiendishly easy to cheat: you simply convince yourself that a 25cl glass of 14.7 per cent Chilean Merlot is one unit when it is really three. Better men than us have deceived themselves this way: Immanuel Kant rationed himself to one pipe of tobacco after breakfast; he stuck to his rule, but friends noticed that by the end of his life, all his pipes were enormous.
Sutherland’s observation applies equally to investing. Value investors follow a simple algorithm that states something like the following: Buy if market price is equal to or less than some fixed discount from intrinsic value. Sell if market price is equal to or exceeds intrinsic value. Graham’s net current asset value rule for acquiring sub-liquidation stocks is an example of such a simple, unambiguous investment strategy; simple to calculate, with concrete rules for its application. Graham recommended it as a “foolproof method of systematic investment—once again, not on the basis of individual results but in terms of the expectable group outcome.”
The net current asset value calculation couldn’t be simpler: Net current asset value equals current assets less all liabilities. And the rules couldn’t be more concrete: Buy if market price is two-thirds of net current asset value or less. Sell if market price has risen 50 percent, or two years have elapsed since acquisition, whichever occurs first. The returns to the net current asset value rule are astronomical. The problem with it is that it is very limited in its application. Few stocks pass its “buy” criteria in an ordinary market. It is possible, however, to apply the underlying philosophy without employing the actual rule. We can calculate intrinsic value in any number of ways, and apply the same directive.
This is all that is meant by a rule. At root, it is simply an exhortation to adhere strictly to the philosophy of value investment: Buy only if market price is some fixed discount from intrinsic value or less, pass otherwise. Sell only if market price is equal to or greater than intrinsic value, or a better opportunity can be found, hold otherwise.
I discuss these ideas–the use of research to identify counterintuitive, but predictive value investment principles, and the application of simple, unambiguous rules to combat behavioral errors–and many more in my new book Deep Value: Why Activist Investors and Other Contrarians Battle for Control ofLosing Corporations (hardcover, 240 pages, Wiley Finance).
I am very pleased to announce that my new book Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations (hardcover, 240 pages, Wiley Finance) is now available.
Deep Value is an exploration of the philosophy of deep value investment. It describes the evolution of the various theories of intrinsic value and activist investment from Benjamin Graham to Warren Buffett and Carl Icahn and beyond.
Filled with engaging anecdotes, penetrating statistical analysis and meticulous research, the book illustrates the principles and strategies of deep value investing and examines the counterintuitive idea behind its extraordinary performance.
It is a simple, but counterintuitive idea: Under the right conditions, losing stocks—those in crisis, with apparently failing businesses, and uncertain futures—offer unusually favorable investment prospects.
This is a philosophy that runs counter to the received wisdom of the market. Many investors believe that a good business and a good investment are the same thing. Many value investors, inspired by Warren Buffett’s example, believe that a good, undervalued business is the best investment.
The research offers a contradictory view.
Deep Value is an investigation of the evidence, and the conditions under which those losing stocks become asymmetric opportunities, with limited downside, and enormous upside. In pursuit of this idea, it canvases the academic and industry research into theories of intrinsic value, management’s influence on that value, and the impact of attempts to unseat management on both market price and value.
The value investment philosophy first described and practiced by Benjamin Graham in 1934 identified targets by their discount to liquidation value. That approach has proven extremely effective; however, those opportunities have all but disappeared from the modern stock market. To succeed, today’s deep value investors have adapted Graham’s philosophy, embracing its spirit while pushing beyond its confines. In Deep Value, I examine Graham’s 80-year-old intellectual legacy using modern statistical techniques to offer a penetrating and highly original perspective: That losing stocks offer unusually favorable investment prospects. The evidence reveals an axiomatic truth about investing: Investors aren’t rewarded for picking winners; they’re rewarded for uncovering mispricings.
And Deep Value shows the place to look for mispricings—in calamity, among the unloved, the ignored, the neglected, the shunned, and the feared.
Each chapter tells a different story about a characteristic of deep value investing, seeking to demonstrate a genuinely counterintuitive insight.Through these stories, it explores several ideas demonstrating that deeply undervalued stocks provide an enormous tail wind to investors, generating outsized returns whether they are subject to attention from private equity, strategic buyers, activist investors or not.
The book begins with former arbitrageur, and option trader Carl Icahn. An avowed Graham-and-Dodd investor, Icahn understood early the advantage of owning equities as apparently appetizing as poison. He took Benjamin Graham’s investment philosophy and used it to pursue deeply undervalued positions where he could supply his own catalyst, and control his own destiny.
As a portfolio, deeply undervalued companies with the conditions in place for activism or private equity attention offer asymmetric, market-beating returns. Modern activists exploit this property by taking large minority stakes in these stocks and then agitating for change. What better platform than a well-publicized proxy fight and tender offer to highlight mismanagement and underexploited intrinsic value? How better to induce either a voluntary restructuring or takeover by a bigger player in the same industry?
We’ll also see how activist investing can be understood as a form of arbitrage. Activists invest in poorly performing, undervalued firms with underexploited intrinsic value. By remedying the deficiency, or moving the company’s intrinsic value closer to its full potential, and eliminating the market price discount in the process, they capture a premium that represents both the improvement in the intrinsic value, and the removal of the market price discount. We scrutinize the returns to activism to determine the extent to which they are due to an improvement in intrinsic value, or simply the returns to picking deeply undervalued stocks.
Deep Value is also a practical guide that reveals little-known valuation metrics that activist investors, corporate raiders, private equity firms, and other contrarians use to identify attractive, asymmetric investment opportunities with limited downside and enormous upside—undervaluation, large cash holdings, and low payout ratios. These metrics favor companies with so-called lazy balance sheets and hidden or unfulfilled potential due to improper capitalization. Activists target these undervalued, cash-rich companies, seeking to improve the intrinsic value and close the market price discount by reducing excess cash through increased payout ratios. We analyze the returns to these metrics, and apply them to two recent, real world examples of activism. The power of these metrics is that they identify good candidates for activist attention, and if no activist emerges to improve the unexploited intrinsic value, other corrective forces act on the market price to generate excellent returns in the meantime.
I am incredibly excited about the calibre of endorsers for Deep Value, all of whom are extraordinarily talented practitioners:
I highly recommend Deep Value. It takes a lively look at a variety of value investing strategies starting with the father of security analysis, Ben Graham. It outlines how individual investors can vastly outperform simple index strategies. For these value strategies to work, investors must be patient and brave, as it requires looking at stocks that the herd ignores. It will be a useful addition to any value investor’s library.
Value investing is the most intuitive form of investing ever devised—the attempt to buy one dollar’s worth of assets for sixty cents. In his new book, Carlisle provides a thoroughly contemporary guide to the discipline, informed by killer anecdotes. Deep Value is part historical saga, part treasure map—a must-read for all investors.
Deep Value is a smart, modern take on classic Benjamin Graham-style value investment. It’s half history book and half quant stock screen guidebook. Learn both the history of value investing as well as a practical way to put it to work.
Deep Value is a refreshing, and highly entertaining work that makes a persuasive case for traditional value investment and a revival of Graham-style ‘ownership consciousness’. It is a compelling addition to the value investing canon.
In Deep Value Carlisle provides a qualitative and quantitative view of why value investing has worked since the time of its conception. The book is a unique combination of careful description of the value styles and players, backed up by data that supports the conclusions reached. I strongly recommend this book to the value aficionado.
Carlisle has written an engaging history of the market, and its influence on the evolving theory of value investment. He has produced a valuable addition to any value investor’s library. I’m glad I read it.
Carlisle’s work succeeds on two levels: It is both a gripping account of some of the most notable episodes in the history of shareholder activism as well as an instructive guide to profiting from mean reversion and activist opportunities in today’s market. Highly recommended!
From accounts of bold corporate raiders, behavioral psychology, to hard quantitative research, Deep Value leaves no stone unturned in a passionate exploration of what makes value investing and activism work.
Carlisle weaves together a rich tapestry of multi-disciplinary academic research, investment theory, and historical anecdotes to produce the must-read investment book of 2014.
Carlisle rigorously shows why value investing will continue to work. Deep Value is a MUST-READ for value investors.
Carlisle has persuasively rendered a thought-provoking examination of a counterintuitive investment theory. The book is as engrossing as it is useful.
Carlisle’s book provides a wonderful combination of entertaining case studies, synthesized with results from academic research and statistical backtesting, to arrive at sometimes surprising conclusions about what works in investing, and why.
The 10th Annual New York Value Investing Congress returns to Manhattan September 8 and 9. The two-day event will feature 18 brilliant speakers, high-quality stock ideas, and superb networking. Here are just a few of the world-class money managers who’ll be appearing, and their presentation topics:
See the full list of speakers here.
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Don’t miss out on the profitable ideas you’ll learn at the Congress and the great networking — Register Now with discount code GREENBACKD to guarantee your seat at our $2,995 Anniversary Rate – that’s $3,000 off the price others will pay later to attend, if any seats remain unsold.
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This week I’ve examined the course of bear markets from 1871 to date (really to March 2009, the end of the last bear market). This post is part 2 of last week’s post about the duration and magnitude of all bull market periods in U.S. stocks since 1871, which used the S&P 500 price series from Shiller’s publicly available database and the method adopted by Butler|Philbrick|Gordillo and Associates’ post What the Bull Giveth, the Bear Taketh Away. A bear market is defined as a drop in prices of at least 20 percent from any peak, and which lasted at least 3 months. A bull market was defined as a rise of at least 50 percent from the bear market low, over a period lasting at least 6 months.
Chart 1 and Table 1 describe every bear market since 1871 in the S&P, including duration and magnitude information.
The average bear market lasts 43 months–about 3 1/2 years–and wipes out 40 percent of the market’s gains. Butler et al. point out that a drop of this magnitude requires a gain of about 66 percent to break even. The average bull market since 1871 has gained 182 percent, so the first third of the bull is simply making back losses from the bear. If we could figure out a reliable means to avoid bear markets we could pocket all of that gain, but, as far as I am aware, none has every been found. Timing mechanisms based on valuation don’t work, and neither do timing mechanisms based on price action. Most timing mechanisms generate too many false positives–signals to exit when no bear eventuates–and so increase trading costs and tax events. Bear markets and volatility are simply the cost of doing business in the market.
Very good, long term gains are available for investors prepared to remain invested in value strategies through thick-and-thin. My firm, Eyquem, offers low cost, fee-only managed accounts that implement a systematic deep value investment strategy. Please contact me by email at email@example.com or call me by telephone on (646) 535 8629 to learn more. Click here if you’d like to read more on Quantitative Value, or connect with me on Twitter, LinkedIn or Facebook.
The little wobble in the market last week made me think of a post I ran in April last year on the duration and magnitude of all bull and bear market periods in U.S. stocks since 1871 using charts from Butler|Philbrick|Gordillo and Associates’ What the Bull Giveth, the Bear Taketh Away. I’ve used Butler et al.’s method to update the charts to July 2014.
The study uses the S&P 500 price series from Shiller’s publicly available database. I use Butler et al.’s method to define a bear market as a drop in prices of at least 20 percent from any peak, and which lasted at least 3 months. A bull market was defined as a rise of at least 50 percent from the bear market low, over a period lasting at least 6 months.
Chart 1 and Table 1 describe every bull market since 1871 in the S&P, including duration and magnitude information.
I don’t believe that there is anything predictive about the duration or magnitude of the average and median bull markets. I only include that information to contextualize the present market. In that sense, it is decidedly average, if a little long in the tooth. It has delivered about 9/10ths of the gains of the average, and lasted a few months less. It has run 11 months longer than the median, and generated 120 percent of the return. Only the bull markets ending in 1929, 1961, 1987, and 2000 returned more (in each case, much more), and lasted longer (in each case, much longer). Two other bull markets lasted longer–those ending in 1902 and 1968–but neither returned as much as the current one.
The two bull markets that really stand out are the January 1975 to August 1987 market, which delivered a return of 391 percent, and the January 1988 to August 2000 bull, which returned an incredible 516 percent. Each lasted 153 months. The two were separated by the 1987 bear market, which drew down only -26.4 percent peak to trough, and lasted just 5 months. Through the full period from January 1975 to August 2000, the market returned 2,140 percent, or 13 percent yearly (excluding dividends)–almost 3 times the yearly return of the long run average of 4.7 percent (also ex. dividends).
My firm, Eyquem, offers low cost, fee-only managed accounts that implement a systematic deep value investment strategy. Please contact me by email at firstname.lastname@example.org or call me by telephone on (646) 535 8629 to learn more. Click here if you’d like to read more on Quantitative Value, or connect with me on Twitter, LinkedIn or Facebook.
I received a number of emails asking me to revisit the backtests from last week’s post about using the Shiller PE to time the market (Worried about a Crash? Backtests Using Shiller PE to Time The Market (1926 to 2014)). The most common request was to separate the buy and sell rules such that if the strategy sold out at say one standard deviation above the mean, it didn’t buy back until the Shiller PE fell below its mean. The second most common request was to alter the strategy such that it hedged out the market rather than switching to cash.
Edit: Fama and French backtests of the book value-to-market equity (the inverse of the PB ratio) data from 1926 to 2013. As at December 2013, there were 3,175 firms in the sample. The value decile contained the 459 stocks with the highest earnings yield, and the glamour decile contained the 404 stocks with the lowest earnings yield. The average size of the glamour stocks is $7.48 billion and the value stocks $2.54 billion. (Note that the average is heavily skewed up by the biggest companies. For context, the 3,175th company has a market capitalization today of $404 million, which is smaller than the average, but still investable for most investors). Portfolios are formed on June 30 and rebalanced annually.
The following backtests use the market’s state of knowledge at the time about the average, and standard deviations of the Shiller PE. The chart below shows how the Shiller PE’s average and standard deviations have varied over time.
The mean now is 16.55, but was as low as 14.2 in the 1950s and, excluding the slightly higher reading at the start of the data, as high as 17.5 in the 1900s. The standard deviation has expanded over time. Until the 2000s two standard deviations above the average meant a Shiller PE of about 25, and now it means a Shiller PE of almost 30.
The following chart backtests three strategies. The first–“Sell at 1SD, Buy at -1SD”–buys the price-to-book value decile only if the Shiller PE is one standard deviation below its mean, sells into cash if the Shiller PE is more than one standard deviation above its mean, and holds cash until the market falls back below one standard deviation below the mean. The second–“Sell at 1SD, Buy at Mean”–buys the price-to-book value decile only if the Shiller PE is below its mean, sells into cash if the Shiller PE is more than one standard deviation above its mean, and holds cash until the market falls back below the mean. The third–“Sell at 2SD, Buy at Mean”–buys the value decile only if the Shiller PE is below its mean, sells into cash if the Shiller PE is more than two standard deviations above its mean, and holds cash until the market falls back below the mean.
All the strategies underperform the simple buy-and-hold strategy over the full period.
The market returned 13.94 percent compound and the fully invested PB value decile returned 20 percent compound over the full period. Sell at 1SD, Buy at -1SD returned 15.0 percent compound; Sell at 2SD, Buy at Mean returned 19.3 percent compound; and Sell at 1SD, Buy at Mean returned 15.9 percent compound.
Sell at 2SD, Buy at Mean had good lead until the 1990s, but has woefully underperformed since. Notably, it is still fully invested. Its sell rule won’t kick in until the Shiller PE hits 29.7.
The market has the worst maximum drawdown at 86 percent, and the fully invested PB value decile has a comparably bad maximum drawdown of 85 percent. Sell at 1SD, Buy at -1SD had the best maximum drawdown at 50 percent; Sell at 2SD, Buy at Mean had a maximum drawdown of 78 percent; and Sell at 1SD, Buy at Mean had a maximum drawdown of 60 percent.
Benjamin Graham recommended maintaining a minimum portfolio exposure to stocks of 25 percent. Below we re-run the tests, but this time instead of kicking all of the portfolio into cash, we put only 75 of the portfolio in cash, and maintain 25 percent exposure to the value decile.
All the returns are improved, but the strategies continue to underperform the simple buy-and-hold strategy over the full period.
Sell at 1SD, Buy at -1SD now returns 16.8 percent compound; Sell at 2SD, Buy at Mean returned 19.6 percent compound versus 19.3 percent above; and Sell at 1SD, Buy at Mean returned 17.2 percent compound.
The tradeoff for slightly improved returns is slightly worse drawdowns. Sell at 1SD, Buy at -1SD still has the lowest maximum drawdown, but now draws down 53 percent; Sell at 2SD, Buy at Mean has the same maximum drawdown of 78 percent; and Sell at 1SD, Buy at Mean had a maximum drawdown of 64 percent.
In this set of backtests the strategy is levered and hedged. The ratios change depending on the level of the market. When the strategy deems the market cheap, it is 130 percent long the value decile, and 30 short the market. When the market is expensive, it doesn’t sell into cash, but reduces the long to 100 percent, and hedges out 75 percent of the portfolio using the market.
The Hedge at 2SD, Lever at Mean strategy outperforms the buy-and-hold strategy over the full period, returning 21.9 percent compound, versus 20 percent for the value decile.
Hedge at 1SD, Lever at -1SD now returns 19 percent compound; and Hedge at 1SD, Buy at Mean returned 18.9 percent compound.
Hedge at 2SD, Lever at Mean strategy draws down 88 percent, worse than the market’s 85 percent; Hedge at 1SD, Lever at -1SD has a maximum draw down of 67 percent; and Hedge at 1SD, Buy at Mean has a maximum drawdown of 79 percent.
Changing the buy-and-sell rules, and hedging rather than running to cash alters the performance of the strategies. The levered and hedged strategy that maximizes exposure to the market–Hedge at 2SD, Lever at Mean–outperforms the simple buy-and-hold strategy, but does so with an enormous drawdown. Nothing else beats buy-and-hold. As we saw last week, the more conservative the Shiller PE ratio used, the lower the drawdown, but returns suffer. To generate the extraordinary returns of the value deciles I’ve examined over the last few weeks, it was necessary to remain fully invested in those value stocks through thick and thin. My firm, Eyquem, offers low cost, fee-only managed accounts that implement a systematic deep value investment strategy. Please contact me by email at email@example.com or call me by telephone on (646) 535 8629 to learn more. Click here if you’d like to read more on Quantitative Value, or connect with me on Twitter, LinkedIn or Facebook.