Greenbackd

As I foreshadowed yesterday, there are several related themes that I wish to explore on Greenbackd. These three ideas are as follows:

1. Quantitative value investing
2. Pure contrarian investing
3. Problems with the received wisdom on value investment

Set out below is a brief overview of each.

A quantitative approach to value investment

I believe that James Montier’s 2006 research report Painting By Numbers: An Ode To Quant presents a compelling argument for a quantitative approach to value investing. Simple statistical or quantitative models have worked well in the context of value investing, and I think there is ample evidence that this is the case. (Note that simple is the operative word: I’m not advocating anything beyond basic arithmetic or the most elementary algebra.) Graham was said to know little about the businesses of the net current asset value stocks he bought. It seems that any further analysis beyond determining the net current asset value was unnecessary for him (although he does discuss in Security Analysis other considerations for the discerning security analyst). Perhaps that should be good enough for us.

As Oppenheimer’s Ben Graham’s Net Current Asset Values: A Performance Update paper demonstrates, a purely mechanical application of Graham’s net current asset value criterion generated a mean return between 1970 and 1983  of “29.4% per year versus 11.5% per year for the NYSE-AMEX Index.” Oppenheimer puts that return in context thus, “[one] million dollars invested in the net current asset portfolio on December 31, 1970 would have increased to $25,497,300 by December 31, 1983.” That’s a stunning return. It would have put you in elite company if you had been running a fund blindly following Oppenheimer’s methodology from the date of publication of the paper. Other papers examining the returns over different periods and in different markets written after Oppenheimer’s paper have found similar results (one of the papers is by Montier and I will be discussing it in some detail in the near future). The main criticism laid at the feet of the net net method is that it can only accommodate a small amount of capital. It is an individual investor or micro fund strategy. Simple strategies able to accommodate more capital are described in Lakonishok, Shleifer, and Vishny’s Contrarian Investment, Extrapolation and Risk. In that paper, the authors found substantial outperformance through the use of only one or two value-based variables, whether they be price-to-book, price-to earnings, price-to-cash flow or price-to-sales.

I believe these papers (and others I have discussed in the past) provide compelling evidence for quantitative value investing, but let me flip it around. Why not invest solely on the basis of some simple value-based variables? Because you think you can compound your portfolio faster by cherry-picking the better stocks on the screen? This despite what Montier says in Painting By Numbers about quant models representing “a ceiling in performance (from which we detract) rather than a floor (to which we can add)”? Bonne chance to you if that is the case, but you are one of the lucky few. The preponderance of data suggest that most investors will do better following a simple model.

Pure contrarian investing

By “pure” contrarian investing, I mean contrarian investing that is not value investing disguised as contrarian investing. LSV frame their Contrarian Investment, Extrapolation and Risk findings in the context of “contrarianism,” arguing that value strategies produce superior returns because most investors don’t fully appreciate the phenomenon of mean reversion, which leads them to extrapolate past performance too far into the future. LSV argues that investors can profit from the market’s (incorrect) assessment that stocks that have performed well in the past will perform well in the future and stocks that have performed poorly in the past will continue to perform poorly. If that is in fact the case, then contrarian strategies that don’t rely on value should also work. Can I simply buy some list of securities at a periodic low (52 weeks or whatever) and sell some list of securities at a periodic high (again, say 52 weeks) and expect to generate “good” (i.e. better than just hugging the index) returns? If not, it’s not contrarianism, but value that is the operative factor.

It is in this context that I want to explore Nassim Nicholas Taleb’s “naive empiricist.” If contrarianism appears to work as a stand alone strategy, how do I know that I’m not mining the data? I also want to consider whether the various papers written about value investment discussed on Greenbackd and the experiences of Buffett, Schloss, Klarman et al “prove” that value works. Taleb would say they don’t.  How, then, do I proceed if I don’t know whether the phenomenon we’re observing is real or a trick? We try to build a portfolio able to withstand stresses, or changes in circumstance. How do we do that? The answer is some combination of employing Graham’s margin of safety, diversifying, avoiding debt and holding an attitude like Montaigne’s “Que sais-je?”‘ (“What do I know?”). It’s hardly radical stuff, but, what I believe is interesting, is how well such a sceptical and un-confident approach marries with quantitative investing.

Problems with the received wisdom on value investment

Within the value investment community there are some topics that are verboten. It seems that some thoughts were proscribed some time ago, and we are now no longer even allowed to consider them. I don’t want delve into them now, other than to say that I believe they deserve some further consideration. Some principles are timeless, others are prisoners of the moment, and it is often impossible to distinguish between the two. How can we proceed if we don’t subject all received wisdom to further consideration to determine which rules are sound, and which we can safely ignore? I don’t believe we can. I’ll therefore be subjecting those topics to analysis in any attempt to find those worth following. If I’m going to make an embarrassing mistake, I’m betting it’s under this heading.

There are several other related topics that I wish to consider, but they are tangential to the foregoing three.