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Charlie and I would much rather earn a lumpy 15% over time than a smooth 12%.

–Buffett, Chairman’s Letter (1996)

Can an investor concerned about a big crash use a systematic timing tool to exit the market before the crash without giving up too much return? One possible method for doing so is to use the Shiller PE as a valuation tool, and to move the portfolio into cash at some given level of overvaluation. The backtests below show the returns and drawdowns for exiting at four different levels of the Shiller PE ratio, from aggressive to conservative.

The first option is to simply always remain fully invested in the value decile (measured by price-to-book value). For our present purposes, this is the most aggressive. The three other timed strategies kick out of the value decile when the Shiller PE gets increasingly expensive. Mean, the most conservative kicks into cash when the Shiller PE gets just above its mean (17.6 for the data set). Slightly more aggressive is a strategy that kicks into cash at one standard deviation above the mean (a Shiller PE of 24.8) called 1 Std. Dev., and the next most aggressive kicks out at two standard deviations above the long-run average (a Shiller PE of 32.0) called 2 Std. Dev..

Edit: The backtests use 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.

Performance of Value Decile (Price-to-Book Value), Cash and 3 Shiller PE Timed Strategies

Shiller and Value Performance 1926 to 2014

Over the period examined, the market (the equally weighted universe from which the portfolios were drawn) generated a compound average growth rate (CAGR) of 13.94 percent. Cash generated an average return of 5.17 percent over the same period. The fully invested value decile generated the best CAGR over the full period at 20.01 percent. The other strategies underperformed to the extent that they remained out of the market: The strategy that kicked into cash at the mean returned 13.4 percent yearly, the strategy that kicked into cash at one standard deviation above the mean returned 18.15 percent yearly, and the strategy that kicked into cash at two standard deviations above the mean returned 19.36 percent compound over the full period.

We expect underperformance for remaining out of the market. This is the tradeoff we make to avoid drawdowns. Is it worth it? Below we examine how much drawdown we avoid by getting out of the market at the different ratios.

Drawdowns to Value Decile (Price-to-Book Value), and 3 Shiller PE Timed Strategies

Shiller and Value Drawdown 1926 to 2014

The market had a maximum drawdown in 1929 of 86 percent, and has a Sharpe ratio over the full period of of 0.13. The fully invested strategy had a maximum drawdown of 85 percent, and generated a Sharpe ratio of 0.15. The other strategies generate lower maximum drawdowns, but do so for lower Sharpe ratios: The strategy that kicked into cash at the mean had a maximum drawdown of 69 percent, and the worst Sharpe ratio at 0.11;  the strategy that kicked into cash at one standard deviation above the mean had a maximum drawdown of 80 percent, and a Sharpe ratio of 0.14, and the strategy that kicked into cash at two standard deviations above the mean had a maximum drawdown of 84 percent, and a Sharpe ratio of 0.15.

Drawdowns Relative to the Market for Value Decile (Price-to-Book Value), and 3 Shiller PE Timed Strategies

Shiller and Value Drawdown Relative 1926 to 2014

This chart examines the drawdown to each strategy relative to the market. Where it is below the midline, the strategy has drawn down further than the market, and above the midline it is outperforming.

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.

Performance of Value Decile (Price-to-Book Value), Cash and 3 Shiller PE Timed Strategies (Graham Rule)

Shiller and Value Performance Graham Rule 1926 to 2014

The additional exposure to the market improves the returns for the three timed strategies. The strategy that kicked into cash at the mean now returns 15.23 percent yearly, the strategy that kicked into cash at one standard deviation above the mean returned 18.67 percent yearly, and the strategy that kicked into cash at two standard deviations above the mean returned 19.55 percent compound over the full period. All still underperform the fully invested strategy at 20.01 percent.

Drawdowns to Value Decile (Price-to-Book Value), Cash and 3 Shiller PE Timed Strategies

Shiller and Value Drawdown Graham Rule 1926 to 2014

The tradeoff for slightly improved returns is greater drawdowns and volatility. The strategy that kicked into cash at the mean had lower a maximum drawdown of 73 percent, but an improved Sharpe ratio at 0.12;  the strategy that kicked into cash at one standard deviation above the mean remained unchanged with a maximum drawdown of 80 percent, and a Sharpe ratio of 0.14, and the strategy that kicked into cash at two standard deviations above the mean had a maximum drawdown of 85 percent, and a Sharpe ratio of 0.15.

Drawdowns Relative to the Market for Value Decile (Price-to-Book Value), and 3 Shiller PE Timed Strategies

Shiller and Value Drawdown Relative Graham Rule 1926 to 2014

The Shiller PE is not a particularly useful timing mechanism. This is because valuation is not good at timing the market (really, nothing works–timing the market is a fool’s or genius’s game). Carrying cash does serve to reduce drawdowns. It also reduces returns. The more conservative the Shiller PE ratio used, the lower the drawdown, but returns suffer, and Sharpe ratios reduce. 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 toby@eyquem.net 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 TwitterLinkedIn or Facebook.

 

 

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The 10th Annual New York Value Investing Congress is just weeks away (Sept. 8-9), ​but there’s still time to ​get your seat and enjoy the many benefits of attending the Congress in-person:

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Confirmed Speakers include:

  • Leon Cooperman, Omega Advisors
  • Sahm AdrangiKerrisdale Capital Management
  • Carson BlockMuddy Waters Research
  • Andrew LeftCitron Research
  • Alexander RoepersAtlantic Investment Management
  • Jeffrey SmithStarboard Value
  • Amitabh SinghiSurefin Investments
  • Guy SpierAquamarine Fund
  • David HurwitzSC Fundamental
  • Michael KaoAkanthos Capital
  • Guy GottfriedRational Capital Management
  • Adam CrockerMetropolitan Capital Advisors
  • Whitney TilsonKase Capital
  • John LewisOsmium Partners
  • Tim EriksenEriksen Capital Management
  • Cliff RemilyNorthwest Priority Capital
  • With more to come!

I’ve been digging back through some very old historical data to understand how unusual the 1929 crash was and found the site Measuring Worth, which has the interesting mission “to make available to the public the highest quality and most reliable historical data on important economic aggregates.” Measuring Worth has a data series combining the Dow Jones Industrial Average and its precursor, the Dow Jones Average, all the way back to May 1885. Measuring Worth provides this fascinating history of the index:

On July 3, 1884, Charles Henry Dow began publishing his Dow Jones Average. By the time it was published daily eight months later, the index was composed of 12 stocks, 10 of which were railroads. This index appeared in the Customer’s Afternoon Letter up until July 8, 1889 when the first issue of The Wall Street Journal was published. On October 7, 1896, Dow started publishing two “Daily Moving Averages,” 12 industrials and 20 railroads (that would later become the transportation index.) This first Dow Jones Industrial Average (DJIA) was published through September 29, 1916. This first DJIA closed at 71.42 on July 30, 1914 and so did the New York Stock Market for the next four months. Some historians believe the reason for this was worry that markets would plunge because of panic over the onset of the World War. An interesting book by William L. Silber titled When Washington Shut down Wall Street: The Great Financial Crisis of 1914 and the Origins of America’s Monetary Supremacy (2007) has a different explanation. He thinks that Secretary of the Treasury, William McAdoo closed the exchange because he wanted to conserve the US gold stock in order to launch the Federal Reserve System later that year with enough gold to keep the US on the gold standard. Whatever the reason, the first day it reopened on December 12, 1914, the index closed at 74.56, thus the War had not had the predicted impact. On October 4, 1916, the WSJ starts publishing a (new) DJIA of 20 stocks, 8 stocks from the old index and 12 new stocks. It was traced the index back to December 12, 1914 at that time. It is important to know that data for the first DJIA of 12 stocks and the second DJIA of 20 stocks are BOTH available for the 21 months and the first index was about 36% higher than the second and the data here are adjusted to make them a consistent time series. On October 1, 1928 the DJIA of 30 stocks was first quoted in the WSJ. It contained 14 stocks from the second list of 20 and 16 new stocks. Its level was consistent with the second list, so no adjustment was necessary.

In the chart below I’ve plotted the daily closing price for the series from May 1885 to Friday’s close (the blue line, log, right-hand side), along with the drawdowns (the red line, left-hand side).

DJIA Closing Price and Drawdowns 1885 to 2014

Source: Samuel H. Williamson, ‘Daily Closing Value of the Dow Jones Average, 1885 to Present,’ MeasuringWorth, 2012.

For me there are two striking features on the chart. First, the 1929 crash is on a different scale to any other crash, dwarfing even the second biggest crash, which was the most recent one beginning in 2007. The 1929 crash began on September 4, 1929, and bottomed on July 8, 1932, down 89.2 percent. The market wouldn’t achieve its 1929 high again until November 23, 1954, more than 25 years from its last peak, and more than 22 years from the bottom. By way of contrast, the second deepest drawdown at -53.8 percent, the 2007 Credit Crisis began October 1, 2007, and ended March 4, 2013, a mere 5 years and 5 months later. The second longest drawdown began November 1905, bottomed down -48.5 percent, and ended almost 10 years later in July 1915.

The second striking feature of the chart is how much time the market spends in a drawdown. The market hits a new high about 3.8 percent of days, which means it’s in drawdown 96.2 percent of the time. In addition to the 1905 and 1929 crashes, there have been two other busts that lasted longer than 8 years, including one that ran from May 1890 and ended almost 9 years later in January 1899, and another that began January 1973, and ended November 2, 1982. And there were six more that lasted longer than four years. It makes me think we really should break out the Dow X,000 hats every time the market crosses a round number that’s a new all-time high.

It’s not all bad news. Since 1885, the Dow Jones is up 552 times, which equates to a compound annual growth rate of about 5 percent (this excludes the impact of dividends, which have been material, to the tune of around 4 percent more on average, and 1.9 percent today). From the 1932 bottom to the next all-time high in November 1954, the market returned more than double that rate at 10.6 percent. Drawdowns are the usual condition of investing, but, over the very long term, the market has continued to grow. 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 toby@eyquem.net 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 LinkedIn.

I’ve been reading John F. Wasik’s Keynes’s Way to Wealth: Timeless Investment Lessons from The Great Economist, a book about British economist John Maynard Keynes’s life as an investor. Keynes started out as a foreign currency and commodity speculator in 1919, was wiped out twice in 1922, and 1929, and went on to become a Buffett-style concentrated value investor by around 1932. In 1991, Buffett, who noted in an earlier Chairman’s letter that Keynes had “began as a market-timer (leaning on business and credit-cycle theory) and converted, after much thought, to value investing,” described Keynes’s end-point as an investor thus:

John Maynard Keynes, whose brilliance as a practicing investor matched his brilliance in thought, wrote a letter to a business associate, F. C. Scott, on August 15, 1934 that says it all: “As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence. . . .

One’s knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence.”

Wasik reports that Keynes died in 1946 with a net worth of about £500,000, equivalent to about $36 million today, not including his extensive collection of artwork and rare manuscripts.

What is most remarkable about Keynes is that he was a self-taught Buffett-style concentrated value investor before Buffett. He wrote the letter to Scott around the time that Benjamin Graham published Security Analysis, but there is little evidence that he read it. Like Graham, Keynes had to contend with perhaps the most difficult period in modern history to be an investor, one that encompassed the second World War, the 1929 stock market crash, and the Great Depression. Throughout that 18-year period, while the UK stock market fell 15 percent, and the US market fell 21 percent, the discretionary portfolio he managed on behalf of King’s College, Cambridge grew fivefold.

The charts below, which begin in 1926 and continue through to April 2014, show how unusually difficult the period was. The charts use Fama and French backtests of the book value-to-market equity (the inverse of the PB ratio) data from 1926 to 2014. As at April 2014, 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 approximately $400 million, which is smaller than the average, but still investable for most investors). Portfolios are formed on June 30 and rebalanced annually.

Compound Returns 1926 to April 2014 (Market Capitalization Weight)

PB VW Returns 1926 to 2013

The 1938 crash also hit Keynes hard. At the end of the year, his King’s College discretionary portfolio was down 40.1 percent.

10-Year Rolling Returns (Market Capitalization Weight)


PB VW 10-yr Rolling Returns 1926 to 2013

Drawdowns (Market Capitalization Weight)

PB VW Drawdowns 1926 to 2013

Compound Returns 1926 to April 2014 (Equal Weight)

PB EW Returns 1926 to 2013
10-Year Rolling Returns (Equal Weight)

PB EW 10-yr Rolling Returns 1926 to 2013

Drawdowns (Equal Weight)

PB EW Drawdowns 1926 to 2013

As these charts demonstrate, volatility and drawdowns are part and parcel of investing, but, over the long term, value has comprehensively beaten out the market and glamour stocks. To generate the extraordinary returns of the value deciles, 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 toby@eyquem.net 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 LinkedIn.

Imagine that, back in January, you were given an ironclad forecast of how the world and economy would shape up in the first half of 2014.

You would have known in advance that the U.S. GDP would have a negative print for the first quarter, that Ukraine would explode into violence with Russian involvement — and that the much-touted housing recovery would begin to show signs of slowing down.

You would have known that Iraq would see sectarian violence, and that Islamists separatists would successfully attack major cities and seriously destabilize the region. You would have had information showing you that the prices of important food items like coffee, hogs and cattle would experience double-digit price surges.

You would have foreseen the strict, new environmental regulations imposed on industry and utilities. The slowdown in retail profits and decline in consumer confidence would have been no surprise to you, because you would already be in the know about these things.

Good Information Isn’t Always Enough

Now, given the fact that the economy never really picks up any steam, the global geopolitical situation is worsening dramatically, food and energy prices are up and the jobs situation is still lukewarm at best, how would you have placed your bets on the direction of the stock market?

A rational person would have bet against higher prices and sold the market short. And they would have been wrong, as stock prices have hit new highs so far this year. Unless you had the foresight to realize that zero rates really do trump all in today’s world, the combination of factors would have made you very skeptical of any likelihood of a stock market advance.

Even with perfect information you could not have predicted how the stock market would react to various events, and most of us would have bet on the wrong side of the trade.

Predicting the stock market is a futile exercise for most investors. If the markets were rational it might be possible, but the simple truth is that they are not. Human psychology plays as big a role in market behavior, as economic numbers and corporate profits do in the short to intermediate term. The stock market tends to overshoot on the side of both fear and greed, and is rarely priced to accurately reflect current conditions.

Look at What Is Undervalued

Guessing what will happen and them how the market will react is a waste of time, and more importantly a waste of money the vast majority of the time.

Research and reality has shown that investors can gain a huge edge on the market by focusing their attention on corporate valuations and adopting a longer time frame. Rather than worrying about and betting on what the market might do in the future, most investor’s time would be better spent looking for stocks and even sectors that are undervalued and have the potential for enormous long term price recovery.

Ironically, adopting this approach would force investors to be buying after large declines and selling rallies, rather than the well-documented tendency to buy exciting markets as they approach the top and selling scary ones as they begin the bottoming process.

Get Rich Quick Doesn’t Happen

It seems that everyone wants to be the next George Soros or Ray Dalio; making grand, spectacular bets on equities bonds and currencies. They want to be in the center of the action, trading in and out of the market and racking up spectacular profits. Everyone is selling some “get rich and quit your job, day-trading from home” program — and they sell pretty well, apparently.

The sad truth is most people who try these trading programs are not going to get rich and will probably lose a good deal of money. The reality is that, like great baseball players, for every one that goes on to hit those game-winning home runs and make spectacular catches, there are 99 who didn’t make it. We can hope and dream all we want, but most people who try to make a living by guessing market direction will fail.

Instead of trying to emulate Jesse Livermore and Paul Tudor Jones investors should aspire to be the next Leon Black or David Rubenstein. These two private equity investors have made a fortune buying undervalued companies and assets, holding them for an extended period of time and then selling them at a profit. Rather than search for penny stock profits they should try to act like Seth Klarman, who has compiled a fortune by acting as the buyer of last resort in falling markets, and insisting that every dollar invested has a large margin of safety.

There is an enormous amount of money to be made in the market. However, it is probably not going to come from guessing market direction and furious trading. The real money, especially for individuals, is in reacting to what the market does and buying when stocks are cheap and selling them when they are not.

Cheap assets and long time frames are a much more reliable path to big profits than the seemingly more exciting trading and guessing approach to investing. The industry continues to present opportunities for value-investors who can weed through the daily noise of the market. Learn about Banking’s Top “Insider Secret,” known as the Great Bank Reduction.

As we’ve seen over the last few weeks, value has comprehensively outperformed glamour stocks since 1951. Value also outperforms the market. Whether we examine the simple fundamental metrics like the price-to-earnings (PE) ratio, the price-to-book value (PB) ratio, and the price-to-cashflow (PCF) ratio, the dividend yield or a compound model of all excluding the dividend yield, all outperform.

Set out below are the results of Fama and French backtests of the equal weight portfolios of each metric’s value decile using data from June 1951 to December 2013 and the market. As at December 2013, there were 2,406 firms in the sample. Stocks with negative earnings, cashflow, or book value were excluded. Portfolios are formed on June 30 and rebalanced annually.

The “market” here is an equal weight, and total return average of all deciles, and includes stocks with negative earnings, cashflow, or book value.

Value Deciles and Market Compound Returns (June 1951 to December 2013)

Combo EW Mthly Returns 1951 to 2013

Value Deciles and Market Drawdowns (June 1951 to December 2013)

Most of this outperformance is to the upside. When the market turns down, value tends to drawdown along with the market. The following chart shows the drawdowns to each of the value deciles and the market.

Combo EW Drawdowns 1951 to 2013

The chart really shows the enormity of the 2007 to 2009 credit crisis. Outside the 1929 crash, which I’ll examine at a later date, every other drawdown pales beside the credit crisis.

Value Decile Drawdowns Relative to the Market (Portfolio Constituents Equally Weighted) June 1951 to December 2013

This chart shows the performance in a drawdown of each of the value deciles relative to the market. Market drawdowns greater than 10 percent are indicated by the grey bars on the chart. Where the lines for each value metric are below the 0 percent midline, the value metric has drawn down further than the market, and where the lines are above the 0 percent midline, value has outperformed in the drawdown.

Combo EW Relative Drawdowns 1951 to 2013

We can see in the chart that, when the market is in a drawdown, the value deciles tend to drawdown faster, and further, and then recover earlier. We can observe this in the  late 1990s-from 1998 until 2000–when value struggled, and then from the early 2000s when value outperformed. We can also see it in the last big drawdown from 2007 to late 2008 when value fell further than the market, and then recovered faster from early 2009.

In a drawdown, value is below the line about twice as often as it is above the line.

Value has comprehensively outperformed the market over a very long period of time. Most of this outperformance seems to the upside. Despite the received wisdom that value has protected portfolios in a drawdown, it seems that value has fallen along with the market. When it does enter a drawdown, value stocks seem to fall first, and at a faster rate than the market, but they also tend to recover earlier, and faster.

Volatility and drawdowns are part and parcel of investing. To generate the extraordinary returns of the value deciles, 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 toby@eyquem.net 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 LinkedIn.

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We’ve added 3 New Speakers to the 10th Annual New York Value Investing Congress!

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We are now offering  a special discount – over 50% off! — on registrations for the NY Congress taking place September 8 & 9, 2014.  This year, seating will be strictly limited to 275, so we would encourage Greenbackd readers to register now, before we sell out.

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Below please find information about the event:

10th Annual New York Value Investing Congress

  • Date:  September 8 – 9, 2014

Confirmed speakers include:

  • Leon Cooperman, Omega Advisors
  • Alexander Roepers, Atlantic Investment Management
  • Carson Block, Muddy Waters Research
  • Whitney Tilson, Kase Capital
  • Sahm Adrangi, Kerrisdale Capital Management
  • David Hurwitz, SC Fundamental
  • Jeffrey Smith, Starboard Value
  • Michael Kao, Akanthos Capital Management
  • Guy Gottfried, Rational Investment Group
  • John Lewis, Osmium Partners
  • Tim Eriksen, Eriksen Capital Management
  • Cliff Remily, Northwest Priority Capital
  • With many more to come!
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