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Montier on net nets: A simple quantitative value strategy

Posted in About, Liquidation Value, Net Current Asset Value, Net Quick Stocks, Net Quick Value, Stocks, tagged , , , , on January 21, 2010| 10 Comments »

Continuing the quantitative value investment theme I’ve been trying to develop over the last week or so, I present my definition of a simple quantitative value strategy: net nets. James Montier, author of the essay Painting By Numbers: An Ode To Quant, which I use as the justification for simple quantitative investing, authored an article in September 2008 specifically dealing with net nets as a global investment strategy: Graham’’s net-nets: outdated or outstanding? (Edit: It seems this link no longer works as SG obliterates any article ever written by Montier). Quelle surprise, Montier found that buying net-nets is a viable and profitable strategy:

Testing such a deep value approach reveals that it would have been a highly profitable strategy. Over the period 1985-2007, buying a global basket of net-nets would have generated a return of over 35% p.a. versus an equally weighted universe return of 17% p.a.

An annual return of 35% over 23 years would put you in elite company indeed, so Montier’s methodology is worthy of closer inspection. Unfortunately he doesn’t discuss his methodology in any detail, other than to say as follows:

I decided to test the performance of buying net-nets on a global basis. I used a sample of developed markets over the period 1985 onwards, all returns were in dollar terms.

It may have been a strategy similar to the annual rebalancing methodology discussed in Oppenheimer’s Ben Graham’s Net Current Asset Values: A Performance Update. That paper demonstrates a purely mechanical annual rebalancing of stocks meeting 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.” It doesn’t really matter exactly how Montier generated his return. Whether he bought each net net as it became a net net or simply purchased a basket on a regular basis (monthly, quarterly, annually, whatever), it’s sufficient to know that he was testing the holding of a basket of net nets throughout the period 1985 to 2007.

Montier’s findings are as follows:

  • The net-nets portfolio contains a median universe of 65 stocks per year.
  • There is a small cap bias to the portfolio. The median market cap of a net-net is US$21m.
  • At the time of writing (September 2008), Montier found around 175 net-nets globally. Over half were in Japan.
  • If we define total business failure as stocks that drop more than 90% in a year, then the net-nets portfolio sees about 5% of its constituents witnessing such an event. In the broad market only around 2% of stocks suffer such an outcome.
  • The overall portfolio suffered only three down years in our sample, compared to six for the overall market.

Several of Montier’s findings are particularly interesting to me. At an individual company level, a net net is more likely to suffer a permanent loss of capital than the average stock:

If we define a permanent loss of capital as a decline of 90% or more in a single year, then we see 5% of the net-nets selections suffering such a fate, compared with 2% in the broader market.

Here’s the chart:

This is interesting given that NCAV is often used as a proxy for liquidation value.

Very few companies turn out to have an ultimate value less than the working capital alone, although scattered instances may be found.

Montier believes this may provide a clue as to why the net net strategy continues to work:

This relatively poor performance may hint at an explanation as to why investors shy away from net-nets. If investors look at the performance of the individual stocks in their portfolio rather than the portfolio itself (known as ‘narrow-framing’), then they will see big losses more often than if they follow a broad market strategy. We know that people are generally loss averse, so they tend to feel losses far more than gains. This asymmetric response coupled with narrow framing means that investors in the net-nets strategy need to overcome several behavioural biases.

Paradoxically, it seems that what is true at the individual company level is not true at an aggregate level. The net net strategy has fewer down years than the market:

If one were to frame more broadly and look at the portfolio performance overall, the picture is much brighter. The net-net strategy only generated losses in three years in the entire sample we backtested. In contrast, the overall market witnessed some six years of negative returns.

Here’s the chart:

And it seems that the net net strategy is a reasonable contrary indicator. When the market is up, fewer can be found, and when the market is down, they seem to be available in abundance:

The main drawback to the net net strategy is its limited application. Stocks tend to be small and illiquid, which puts a limit on the amount of capital that can be safely run using it. That aside, it seems like a good way to get started in a small fund or with a individual account. Montier concludes:

…In various ways practically all these bargain issues turned out to be profitable and the average annual return proved much more remunerative than most other investments.

Good old Benjamin Graham. What a guy.

Buy my book The Acquirer’s Multiple: How the Billionaire Contrarians of Deep Value Beat the Market from on Kindle, paperback, and Audible.

Here’s your book for the fall if you’re on global Wall Street. Tobias Carlisle has hit a home run deep over left field. It’s an incredibly smart, dense, 213 pages on how to not lose money in the market. It’s your Autumn smart read. –Tom Keene, Bloomberg’s Editor-At-Large, Bloomberg Surveillance, September 9, 2014.

Click here if you’d like to read more on The Acquirer’s Multiple, or connect with me on Twitter, LinkedIn or Facebook. Check out the best deep value stocks in the largest 1000 names for free on the deep value stock screener at The Acquirer’s Multiple®.

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Intuition and the quantitative value investor

Posted in About, Quantitative investment, Stocks, Value Investment, tagged , on January 14, 2010| 11 Comments »

The rationale for a quantitative approach to investing was first described by James Montier in his 2006 research report Painting By Numbers: An Ode To Quant:

  1. Simple statistical models outperform the judgements of the best experts
  2. Simple statistical models outperform the judgements of the best experts, even when those experts are given access to the simple statistical model.

In my experience, the immediate response to this statement in the investing context is always two-fold:

  1. What am I paying you for if I can build the model portfolio myself?
  2. Isn’t this what Long-Term Capital Management did?

Or, as Montier has it:

We find it ‘easy’ to understand the idea of analysts searching for value, and fund managers rooting out hidden opportunities. However, selling a quant model will be much harder. The term ‘black box’ will be bandied around in a highly pejorative way. Consultants may question why they are employing you at all, if ‘all’ you do is turn up and run the model and then walk away again.

It is for reasons like these that quant investing is likely to remain a fringe activity, no matter how successful it may be.

The response to these questions is as follows:

  1. It takes some discipline and faith in the model not to meddle with it. You’re paying the manager to keep his grubbly little paws off the portfolio. This is no small feat for a human being filled with powerful limbic system drives, testosterone (significant in ~50% of cases), dopamine and dopamine receptors and various other indicators interesting to someone possessing the DSM-IV-TR, all of which potentially lead to overconfidence and then to interference. You’re paying for the absence of interference, or the suppression of instinct. More on this in a moment.
  2. I’m talking about a simple model with a known error rate (momentarily leaving aside the Talebian argument about the limits of knowledge). My understanding is that LTCM’s problems were a combination of an excessively complicated, but insufficiently robust (in the Talebian sense) model, and, in any case, an inability to faithfully follow that model, which is failure of the first point above.

Suppressing intuition

We humans are clearly possessed of a powerful drive to allow our instincts to override our models. Andrew McAfee at Harvard Business Review has a recent post, The Future of Decision Making: Less Intuition, More Evidence, which essentially recapitulates Montier’s findings in relation to expertise, but McAfee frames it in the context of human intuition. McAfee discusses many examples demonstrating that intuition is flawed, and then asks how we can improve on intuition. His response? Statistical models, with a nod to the limits of the models.

Do we have an alternative to relying on human intuition, especially in complicated situations where there are a lot of factors at play? Sure. We have a large toolkit of statistical techniques designed to find patterns in masses of data (even big masses of messy data), and to deliver best guesses about cause-and-effect relationships. No responsible statistician would say that these techniques are perfect or guaranteed to work, but they’re pretty good.

And I love this story, which neatly captures the point at issue:

The arsenal of statistical techniques can be applied to almost any setting, including wine evaluation. Princeton economist Orley Ashenfleter predicts Bordeaux wine quality (and hence eventual price) using a model he developed that takes into account winter and harvest rainfall and growing season temperature. Massively influential wine critic Robert Parker has called Ashenfleter an “absolute total sham” and his approach “so absurd as to be laughable.” But as Ian Ayres recounts in his great book Supercrunchers, Ashenfelter was right and Parker wrong about the ’86 vintage, and the way-out-on-a-limb predictions Ashenfelter made about the sublime quality of the ’89 and ’90 wines turned out to be spot on.

…

Overall, we get inferior decisions and outcomes in crucial situations when we rely on human judgment and intuition instead of on hard, cold, boring data and math. This may be an uncomfortable conclusion, especially for today’s intuitive experts, but so what? I can’t think of a good reason for putting their interests over the interests of patients, customers, shareholders, and others affected by their judgments.

How do we proceed? McAfee has some thoughts:

So do we just dispense with the human experts altogether, or take away all their discretion and tell them to do whatever the computer says? In a few situations, this is exactly what’s been done. For most of us, our credit scores are an excellent predictor of whether we’ll pay back a loan, and banks have long relied on them to make automated yes/no decisions about offering credit. (The sub-prime mortgage meltdown stemmed in part from the fact that lenders started ignoring or downplaying credit scores in their desire to keep the money flowing. This wasn’t intuition as much as rank greed, but it shows another important aspect of relying on algorithms: They’re not greedy, either).

In most cases, though, it’s not feasible or smart to take people out of the decision-making loop entirely. When this is the case, a wise move is to follow the trail being blazed by practitioners of evidence-based medicine , and to place human decision makers in the middle of a computer-mediated process that presents an initial answer or decision generated from the best available data and knowledge. In many cases, this answer will be computer generated and statistically based. It gives the expert involved the opportunity to override the default decision. It monitors how often overrides occur, and why. it feeds back data on override frequency to both the experts and their bosses. It monitors outcomes/results of the decision (if possible) so that both algorithms and intuition can be improved.

Over time, we’ll get more data, more powerful computers, and better predictive algorithms. We’ll also do better at helping group-level (as opposed to individual) decision making, since many organizations require consensus for important decisions. This means that the ‘market share’ of computer automated or mediated decisions should go up, and intuition’s market share should go down. We can feel sorry for the human experts whose roles will be diminished as this happens. I’m more inclined, however, to feel sorry for the people on the receiving end of today’s intuitive decisions and judgments.

The quantitative value investor

To apply this quantitative approach to value investing, we would need to find simple quantitative value-based models that have outperformed the market. That is not a difficult process. We need go no further than the methodologies outlined in Oppenheimer’s Ben Graham’s Net Current Asset Values: A Performance Update or Lakonishok, Shleifer, and Vishny’s Contrarian Investment, Extrapolation and Risk. I believe that a quantitative application of either of those methodologies can lead to exceptional long-term investment returns in a fund. The challenge is making the sample mean (the portfolio return) match the population mean (the screen). As we will see, the real world application of the quantitative approach is not as straight-forward as we might initially expect because the act of buying (selling) interferes with the model.

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Contrarian investing or value investing disguised?

Posted in About, Contrarian investment, Stocks, Value Investment, tagged , on January 13, 2010| 5 Comments »

One of the themes that I want to explore in some depth is “pure” contrarian investing, which is investing relying solely on the phenomenon of reversion to the mean. I’m calling it “pure” contrarian investing to distinguish it from the contrarian investing that is value investing disguised as contrarian investing. The reason for making this distinction is that I believe Lakonishok, Shleifer, and Vishny’s characterization of the returns to value as contrarian returns is a small flaw in Contrarian Investment, Extrapolation and Risk. I argue that it is a problem of LSV’s definition of “value.” I believe that LSV’s results contained the effects of both pure contrarianism (mean reversion) and value. While mean reversion and value were both observable in the results, I don’t believe that they are the same strategy, and I don’t believe that the returns to value are solely due to mean reversion. The returns to value stand alone and the returns to a mean reverting strategy also stand alone. In support of this contention I set out the returns to a simple pure contrarian strategy that does not rely on any calculation of value.

Contrarianism relies on mean reversion

The grundnorm of contrarianism is mean reversion, which is the idea that stocks that have performed poorly in the past will perform better in the future and stocks that have performed well in the past will not perform as well. Graham, quoting Horace’s Ars Poetica, described it thus:

Many shall be restored that now are fallen and many shall fall that are now in honor.

LSV argue that most investors don’t fully appreciate the phenomenon, which leads them to extrapolate past performance too far into the future. In practical terms it means the contrarian investor profits from other investors’ 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.

LSV’s definition of value is a problem

LSV’s contrarian model argues that value strategies produce superior returns because of mean reversion. Value investors would argue that value strategies produce superior returns because they are exchanging of one store of value (say, 67c) for a greater store of value (say, a stock worth say $1). The problem is one of definition.

In Contrarian Investment, Extrapolation and Risk LSV categorized the stocks on simple one-variable classifications as either “glamour” or “value.” Two of those variables were price-to-earnings and price-to-book (there were three others). Here is the definitional problem: A low price-to-earnings multiple or a low price-to-book multiple does not necessarily connote value and the converse is also true, a high price-to-earnings multiple or a high price-to-book multiple does not necessarily indicate the absence of value.

John Burr Williams 1938 treatise The Theory of Investment Value is still the definitive word on value. Here is Buffett’s explication of Williams’s theory in his 1992 letter to shareholders, which I use because he puts his finger right on the problem with LSV’s methodology:

In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset. Note that the formula is the same for stocks as for bonds. Even so, there is an important, and difficult to deal with, difference between the two: A bond has a coupon and maturity date that define future cash flows; but in the case of equities, the investment analyst must himself estimate the future “coupons.” Furthermore, the quality of management affects the bond coupon only rarely – chiefly when management is so inept or dishonest that payment of interest is suspended. In contrast, the ability of management can dramatically affect the equity “coupons.”

The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase – irrespective of whether the business grows or doesn’t, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value. Moreover, though the value equation has usually shown equities to be cheaper than bonds, that result is not inevitable: When bonds are calculated to be the more attractive investment, they should be bought.

What LSV observed in their paper may be attributable to contrarianism (mean reversion), but it is not necessarily attributable to value. While I think LSV’s selection of price-to-earnings and price-to-book as indicia of value in the aggregate probably means that value had some influence on the results, I don’t think they can definitively say that the cheapest stocks were in the “value” decile and the most expensive stocks were in the “glamour” decile. It’s easy to understand why they chose the indicia they did: It’s impractical to consider thousands of stocks and, in any case, impossible to reach a definitive value for each of those stocks (we would all assess the value of each stock in a different way). This leads me to conclude that the influence of value was somewhat weak, and what they were in fact observing was the influence of mean reversion. It doesn’t therefore seem valid to say that the superior returns to value are due to mean reversion when they haven’t tested for value. It does, however, raise an interesting question for investors. Can you invest solely relying on reversion to the mean? It seems you might be able to do so.

Pure contrarianism

Pure contrarian investing is investing relying solely on the phenomenon of reversion to the mean without making an assessment of value. Is it possible to observe the effects of mean reversion by constructing a portfolio on a basis other than some indicia of value? It is, and the Bespoke Investment Group has done all the heavy lifting for us. Bespoke constructed from the S&P500 ten portfolios with 50 stocks in each on the basis of stock performance in 2008. They then tracked the performance of those stocks in 2009. The result?

Many of the stocks that got hit the hardest last year came roaring back this year, and the numbers below help quantify this.  As shown, the 50 stocks in the S&P 500 that did the worst in 2008 are up an average of 101% in 2009!  The 50 stocks that did the best in 2008 are up an average of just 9% in 2009.  2009 was definitely a year when buying the losers worked.

It’s a stunning outcome, and it seems that the portfolios (almost) performed in rank order. While there may be a value effect in these results, the deciles were constructed on price performance alone. This would seem to indicate that, at an aggregate level at least, mean reversion is a powerful phenomenon and a pure contrarian investment strategy relying on mean reversion should work.

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Greenbackd Readers: Save $1750 off 2010 Value Investing Congress West

Posted in About, Value Investment, tagged on December 8, 2009| Leave a Comment »

Greenbackd is a proud sponsor of the 2010 5th Annual Value Investing Congress West and I’ve been able to secure a special discount for you to attend.

Though the Congress is more than 6 months away, over 40% of the seats have already been reserved. Register by midnight next Tuesday, December 15, 2009 with discount code P10GB1 and you’ll save $1,750 off the regular price of admission.

Every year hundreds of people from around the world converge at this not-to-be-missed event to network with other savvy, sophisticated investors and learn from some of world’s most successful money managers. At the upcoming event, all-star investors will share their thoughts on today’s tumultuous markets and present their best, actionable investment ideas. Just one idea could earn you outstanding returns.

Here are Jon Heller’s notes on Lloyd Khaner of Khaner Capital’s talk at this year’s event:

The Key to Turnarounds

First time presenter at the Value Investing Congress, Khaner, who has compounded 445.4% since 1991 (versus 295.2% for the S&P 500), looks for the following attributes in potential investments:

  • Unique management
  • Strong decision making ability
  • Avoid value traps
  • Debt/Equity less than 70%
  • Avoid dying industries
  • Franchise companies with manageable debt

Khaner is a big believer in the concept of “CEO family trees,”placing value on those that have been trained or worked under other successful CEO’s.

Khaner listed the signs of a successful turnaround, including:

  • Cutting unprofitable sales
  • Cutting headcount
  • New senior managers
  • Fix customer relationships
  • CEO sets plan within 3 months
  • Gross Margin up
  • SG&A down
  • Focus on Return on Capital
  • Restructure Debt-Push out maturities.

One of Khaner’s favorite ideas is Starbucks (SBUX):

  • Slowing new store openings
  • Improving service
  • Expects positive comps fiscal 2010
  • ROIC growth 100-200 bps next 3+ years
  • FCF $500-$750 million 3+ years

See a slide show of the last Value Investing Congress in New York.

Don’t miss your opportunity to learn from these financial luminaries. The insights you gain could guide your investment decisions for years to come. Remember, you must register by midnight December 15, 2009 with discount code P10GB1 to take advantage of this special offer and SAVE $1,750 off the regular price to attend. Avoid disappointment – reserve your seat today.

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Greenbackd Portfolio Q4 2009 Performance and Update

Posted in About, Activist Investors, Greenbackd, Liquidation Value, Net Current Asset Value, Stocks, tagged , on December 1, 2009| 3 Comments »

November 30, 2009 marked the end of Greenbackd’s fourth quarter and first year, and so it’s time again to report on the performance of the Greenbackd Portfolio and the positions in the portfolio, and outline the future direction of Greenbackd.com.

Fourth quarter 2009 performance of the Greenbackd Portfolio

The fourth quarter was another satisfactory quarter for the Greenbackd Portfolio, up 14.3% on an absolute basis, which was 9.8% higher than the return on the S&P500 return over the same period. A large positive return for the period is great, but my celebration is tempered once again by the fact that the broader market also had a pretty solid quarter, up 7.4%. The total return for Greenbackd’s first year (assuming equal weighting in all quarters) is 136.8% against a return on the S&P500 of 34.2%, or an outperformance of 102.6% over the return in the S&P500.

It is still too early to determine how well Greenbackd’s strategy of investing in undervalued asset situations with a catalyst is performing, but I believe Greenbackd is heading in the right direction. Set out below is a list of all the stocks in the Greenbackd Portfolio and the absolute and relative performance of each from the close of the last trading day of the third quarter, September 1, 2009, to the close on the last trading day in the fourth quarter, November 30, 2009:

*Note the returns for SOAP and NSTR include special dividends paid. See below for further detail.

You may have noticed something odd about my presentation of performance. The S&P500 index rose by 7.4% in the fourth quarter (from 1020.62 to 1,095.63). Greenbackd’s +14.3% performance might suggest an outperformance over the S&P500 index of 6.9%, while I report outperformance of 9.8%. I calculate Greenbackd’s performance on a slightly different basis, recording the level of the S&P500 Index on the day each stock is added to the portfolio and then comparing the performance of each stock against the index for the same holding period. The Total Relative performance, therefore, is the average performance of each stock against the performance of the S&P500 index for the same periods. As we discussed above, the holding period for Greenbackd’s positions has been too short to provide any meaningful information about the likely performance of the strategy over the long term (2 to 5 years), but I believe that the strategy should outperform the market by a small margin.

Update on the holdings in the Greenbackd Portfolio

There are currently ten stocks in the Greenbackd Portfolio:

  1. TSRI (added November 12, 2009 @ $2.10)
  2. CNVR (added November 11, 2009 @ $0.221)
  3. NYER (added November 3, 2009 @ $1.75)
  4. ASPN (added October 1, 2009 @ $0.985)
  5. KDUS (added September 29, 2009 @ $1.51)
  6. COSN (added August 6, 2009 @ $1.75)
  7. FORD (added July 20, 2009 @ $1.44)
  8. DRAD (added March 9, 2009 @ $0.88)
  9. SOAP (added February 2, 2009 @ $2.50. Initial $3.75 dividend paid July 30)
  10. NSTR (added January 16, 2009 @ $1.91. Initial $2.06 dividend paid July 15)

Greenbackd’s investment philosophy and process

I started Greenbackd in an effort to extend my understanding of asset-based valuation described by Benjamin Graham in the 1934 Edition of Security Analysis. (You can see a summary of Graham’s approach here). Through some great discussion with Greenbackd’s readers, many of who work in the fund management industry as experienced analysts or even managing members of hedge funds, and by incorporating the observations of Marty Whitman (see Marty Whitman’s adjustments to Graham’s net net formula here) and Seth Klarman (the Seth Klarman series starts here), I have refined Greenbackd’s process. I believe that the analyses are now pretty robust and that has manifest itself in satisfactory performance.

Tweedy Browne provides compelling evidence for the asset-based valuation approach. In conjunction with a reader of Greenbackd I have now conducted my own study into the performance of sub-liquidation value stocks over the last 25 years. The paper has been submitted to a practitioner journal and will also appear on Greenbackd in the future.

The future of Greenbackd.com

Greenbackd is a labor of love. I try to create new content every weekday, and to get the stock analyses up just after midnight Eastern Standard Time, so that they’re available before the markets open the following day. Most of the stocks that are currently trading at a premium to the price at which I originally identified them traded for a period at a discount to the price at which I identified them. This means that there are plenty of opportunities to trade on the ideas (not that I suggest you do that without reading the disclosures and doing your own research). If you find the ideas here compelling and you get some value from them, you can support my efforts by making a donation via PayPal.

If you’re looking for net nets in the meantime, here are two good screens:

  1. GuruFocus has a Graham net net screen, with some great functionality ($249 per year)
  2. Graham Investor NCAV screen (Free)

I look forward to bringing you the best undervalued asset situations I can dig up in the next quarter and the next year.

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The Reformed Broker’s Periodic Table

Posted in About, Greenbackd, tagged on November 6, 2009| Leave a Comment »

I am absolutely thrilled that Greenbackd made The Reformed Broker’s superb Period Table of Finance Bloggers. I slept through most of my high school chemistry classes, but I think Greenbackd occupies the same esteemed place accorded to carbon on the periodic table of elements. Carbon’s got a bad rep at the moment, but that doesn’t bother me. Being a value investor, I know that “Many shall be restored that now are fallen and many shall fall that are now in honor.”

Disclosure: Long Carbon (C).

Click to see a readable version (via The Reformed Broker):

Reformed Broker Periodic Table

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Stockmarket overvalued by 40%

Posted in About, Value Investment, tagged , on October 26, 2009| 3 Comments »

The FT Alphaville blog has a post, The US stock market is overvalued by 40%, based on a recent research report, The US Stock Market: Value and Nonsense About It, from Andrew Smithers of London-based research house Smithers & Co.

According to the FT Alphaville blog, Smithers says there are only two ‘valid’ ways to value the market. One is by using a cyclically adjusted PE ratio and the other by using the Q ratio, which compares the market capitalisation of companies with their net worth, adjusted to current prices. Both techniques yield the same answer: the stockmarket is overvalued by around 40%.

Smithers explains:

As the valid measures of the US market show that it is currently around 40% overvalued, some ingenuity is needed to claim otherwise. The EPS for the past 12 months on the S&P 500 is $7.51 so, with the index at 1071, it is selling at a trailing PE of 142. This is far higher than it has ever been before, as the previous end month record is a PE of 47. But current multiples are no guide to value; when depressed, or elevated, they need to be adjusted to their cyclical norm.

This is how the cyclically adjusted PE (”CAPE”) is calculated and when its current value is compared with long-term average, using the geometric means of EPS and cyclically adjusted PEs,6 it shows that the market is 37.7% overpriced using 10 years of earnings’ data and 45% if 20 years are used. This method is therefore of no use to those who sell shares, or have made faulty claims about value in the past. The following are among the most common approaches to circumventing the problem this presents. Some produce relatively small distortions, but these can amount to a substantial degree of misinformation when combined.

Go to the The FT Alphaville blog post, The US stock market is overvalued by 40%.

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Iconic Value vs Glamour research receives an update

Posted in About, Greenbackd, Stocks, Value Investment, tagged , , , on October 23, 2009| 12 Comments »

In a new paper Value vs Glamour: A Global Phenomenon (via SSRN)  The Brandes Institute updates the landmark 1994 study by Josef Lakonishok, Andrei Shleifer, and Robert Vishny investigating the performance of value stocks relative to that of glamour securities in the United States over a 26-year period. Lakonishok, Shleifer, and Vishny found that value stocks tended to outperform glamour stocks by wide margins, but their earlier research did not include the glamour-driven markets of the late 1990s and early 2000s. The paper asks, “What effect might this period have on their conclusions?” To answer that question, The Brandes Institute updated the research through to June 2008, examining the comparative performance of value and glamour over a 40-year period, and extending the scope of the initial study to include non-U.S. markets, to determine whether the value premium is evident worldwide.

The research focuses on our favorite indicator, price-to-book value, but also includes price-to-cash flow, price-to-earnings, sales growth over the preceding five years and combinations of the foregoing. Here is The Brandes Institute’s discussion on price-to-book:

Lakonishok, Shleifer, and Vishny on price-to-book

The Brandes Institute  hewed closely to Lakonishok, Shleifer, and Vishny’s methods, described on page 3 of the paper:

First, the sample of companies as of April 30, 1968 was divided into deciles based on one of the criteria above. Second, the aggregate performance of each decile was tracked for each of the next five years on each April 30. Finally, the first and second steps were repeated for each April 30 from 1969 to 1989.

We start with the price-to-book criterion as an example. First, all stocks traded on the NYSE and AMEX as of April 30, 1968 were sorted into deciles based on their price-to-book ratios on that date. Stocks with the highers P/B ratios were grouped in decile 1. For each consecutive decile, P/B ratios decreased; this cuilminated in stocks with the lowest P/B values forming decile 10.

In essence, this process created 10 separate portfolios, each with an inception date of April 30, 1968. The lower deciles, which consisted of higher-P/B stocks, represented glamour portfolios. In contrast, the higher deciles – those filled with lower-P/B stocks – represented value portfolios.

From there, annual performance of deciles 1 through 10 was tracked over the subsequent five years. Additionally, new 10-decile sets were constructed based on the combined NYSE/AMEX sample as of April 30, 1969, and every subsequent April 30 through 1989. For each of these new sets, decile-by-decile performance was recorded for the five yeras after the inception date. After completing this process, the researchers had created 22 sets of P/B deciles, and tracked five years of decile-by-decile performance for each one. Next, [Lakonishok, Shleifer, and Vishny] averaged the performance data across these 22 decile-sets to compare value and glamour.

As the chart below indicates, [Lakonishok, Shleifer, and Vishny] found that performance for glamour stocks was outpaced by performance for their value counterparts. For instance, 5-year returns for decile 1 – those stocks with the highest P/B ratios – averaged an annualized 9.3%, while returns for the low-P/B decile 10 averaged 19.8%. These annualized figures are equivalent to cumulative rates of return of 56.0% and 146.2%, respectively.

Value Glamour 1

[Lakonishok, Shleifer, and Vishny] repeated this analysis for deciles based on price-to-cash flow, price-to-earnings, and sales growth. The trio found that, for each of these value/glamour criteria, value stocks outperformed glamour stocks by wide margins. Additionally, value bested glamour in experiments with groups sorted by select pairings of P/B, P/CF, P/E, and sales growth.

The Brandes Institute update

The Brandes Institute sought to extend and update Lakonishok, Shleifer, and Vishny’s findings. They replicated the results of the Lakonishok, Shleifer, and Vishny study to validate their methodology. When they were satisfied that there was sufficient parity between their results and Lakonishok, Shleifer, and Vishny’s findings “to validate our methodology as a functional approximation of the [Lakonishok, Shleifer, and Vishny] framework,” they adjusted the sample in three ways: First, they included stocks listed on the NASDAQ domiciled in the US. Second, they excluded the smalles 50% of all companies in the sample. Finally, they divided the remaining companies into small capitalization (70% of the group by number) and large capitalization (30% of the group by number):

To expand upon [Lakonishok, Shleifer, and Vishny’s] findings we begin with our adjusted sample, which now includes data through 2008. Specifically, we added decile-sets formed on April 30, 1990 through April 30, 2003 and incorporated their performance into our analysis. This increased our sample size from 22 sets of deciles to 36. In addition, the end of the period covered by our performance calculations extended from April 30, 1994 to April 30, 2008.

Exhibit 3 compares average annualized performance for U.S. stocks from the 1968 to 2008 period for deciles based on price-to-book. Returns for deciles across the spectrum changed only slightly in the extended time frame from our replicated [Lakonishok, Shleifer, and Vishny’s] results. Most notably, the overall pattern of substantial value stock outperformance persisted. During the 1968 to 2008 period, performance for decile 1 glamour stocks averaged an annualized 6.9% vs. an average of 16.2% for the value stocks in decile 10. Respective cumulative performance equaled 39.6% and 111.9%.

Value Glamour 2

Set out below is the comparison of large cap and small cap performance:

Value Glamour 3The paper concludes that the value premium persists for the world’s developed markets in aggregate, and on an individual coutry basis. We believe it is more compelling evidence for value based investment, and, in particular, asset based value investment.

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Brains or a bull market?

Posted in About, Greenbackd, Value Investment, tagged on October 20, 2009| 1 Comment »

The old Wall Street saw, variously attributed to Warren Buffett or Humphrey B. Neill, author of the Art of Contrary Thinking, goes, “Never confuse genius with a bull market.” With that in mind, we present to you the performance of the Wilshire 5000 Equal Weight Index, which is one of the broadest measures of the stock market.

For the month of September the Wilshire 5000 Equal Weight Index was up 15.8% and for the last quarter to September 30 it was up 36.0%.  You can see for yourself at the Wilshire Index Calculator (it’s a little clunky – you’ll need to select “Wilshire 5000 Equal Weight” in the “Broad/Style” box and set the date to September 30 2009). Year to date the index is up a whopping 83.02%. From March through September, the average stock is up 113.1%. If we take the Wilshire 4500 Equal Weight Index, which excludes the top 500 stocks by market capitalization of the 5000 Equal Weight Index, the return is +120% from March to September 2009. Sobering.

Hat tip Bo.

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Grahamites, meet Ludwig von Mises

Posted in About, Greenbackd, Stocks, Value Investment, tagged , on October 2, 2009| 5 Comments »

Dr. Chris Leithner has prepared a paper for the von Mises Institute, Ludwig von Mises, Meet Benjamin Graham: Value Investing from an Austrian Point of View, in which he argues that Grahamite value investors and economists from the Austrian School hold “compatible views about a range of fundamental economic and financial phenomena” and Austrian economics should therefore be compelling to value investors “because it subsumes real economic and financial events within justifiable laws of human action.”

This paper shows that value investors and Austrians hold compatible views not only about the price and value, but also about other vital economic and financial phenomena. These include risk and arbitrage; capital and entrepreneurship; and time-preference and interest. Indeed, with respect to these matters each group may have more in common with the other than each has with the mainstream of its respective field.

While we’ve never explicitly said so on this site, many of you will have guessed that we subscribe to the Austrian School of economics. We know that view is unpopular with some of our readers, but we ask that you read Leithner’s paper before inveighing in the comments or the mail bag. Leithner is the principal of Leithner & Company, a private investment company based in Brisbane, Australia, and a strict adherent to the “traditional “value” approach to investment pioneered by Benjamin Graham and adapted by his colleagues Warren Buffett, Thomas Knapp and Walter Schloss.” His paper is a tour de force on both Grahamite value investment and Austrian economics, and describes our views with a clarity that escapes us.

Set out below are some important excerpts from Leithner’s paper. The first describes the Austrian view of the operation of markets and its rejection of Efficient Market Theory, which is relevant given the discussion in the comments on Jim Hodge’s guest post several weeks ago:

A deep chasm separates the theory of entrepreneurial discovery from the mainstream model of perfect competition. To mainstream economists, the decisions to buy and sell in the market are mere mathematical derivations. A decision, in other words, is “made” by a “given” model, probability distribution and data. The mainstream model thus eliminates the real-life, flesh-and-blood decision-maker – the heart of the Austrian economics and value investing – from the market. Market automatons do not err; accordingly, it is unthinkable that an opportunity for pure profit is not instantly noticed and grasped. The mainstream economist, goes the revealing joke, does not take the $10 banknote lying on the floor because he believes that if it were really there then somebody would already have grabbed it.

In sharp contrast, Austrians recognise that decisions are taken by real people whose plans are imperfectly clear, indistinctly ranked, often internally-inconsistent and always subject to change. Further, at any given moment a market participant will be largely unaware of other market participants’ present and future plans. It is participation in the market that makes buyers and sellers a bit more knowledgeable about their own plans and slightly less unaware of others’ plans. Market participants will inevitably make mistakes; further, it is probable that they will not automatically notice them. Accordingly, it is not just possible – it is typical – that opportunities for gain (“pure profit”) appear but are not instantly detected. Recognising the obvious – namely that he has possibly been the first to notice it – the Austrian will therefore take the $10 note inadvertently dropped on the floor and ignored by his mainstream colleague. An “Austrian” act of entrepreneurial discovery, then, occurs when a market participant seeks and finds what others have overlooked.

…

It is important to emphasise that this discovery, like Buffett’s and Graham’s many others, did not derive from information that other buyers and sellers could not possess. These acts of entrepreneurial discovery stemmed from the alert analysis of publicly available information and the superior detection of opportunities that others had simply overlooked. On numerous occasions, Graham and his students and followers have found promising places to look and have been the first, in effect, to detect the piles of notes that others have disregarded and left lying on the floor. Anybody, for example, could have bought parts of American Express, The Washington Post, GEICO (whose enormous potential Graham was the first to find) and Coca-Cola when Mr Buffett did; but few saw what he saw, ignored the irrelevancies and reasoned so clearly. Instead, most were distracted by myriad worries – and economic and financial fallacies – and so very few followed Buffett’s lead.

In this second excerpt, Leithner discusses the Grahamite approach to investment in an uncertain world (as it ever is), and why Grahamites pay no heed to mainstream economists’ forecasts about macroeconomic aggregates such as inflation, exchange rates, joblessness, trade and budget deficits and the like:

Grahamites recognise that the future is inherently uncertain. That is to say, there is no probability distribution and there are no data that can “model” it. The future is not radically uncertain, in the sense that Ludwig Lachmann maintained, but it is largely so. Like many Austrians, Grahamites accept that one can know some things (such as historical data, relationships of cause and effect and hence the laws of economics), and therefore that to some extent the past does project into the future. Grahamites do not agree, in other words, that anything can happen; but they are acutely aware – because they have learnt from unpleasant personal experience – that the unexpected can and often does happen. They also acknowledge that forecasting the future is the job of entrepreneurs, not economists or bureaucrats, and therefore that the entrepreneur-investor-forecaster must be cautious and humble.

…

Market timers, commentators and mainstream economists, then, cannot foresee economic events and developments with any useful degree of accuracy. And even if they could, the aggregate phenomena upon which they fixate are typically of little interest to Grahamites. Hence value investors ignore analysts, economists and others who claim that they possess clear crystal balls. But Grahamite investors do not ignore the future per se. Quite the contrary: they plan not by making particular predictions about what will happen but by considering general scenarios – particularly pessimistic scenarios – of what might conceivably happen. They then structure their actions and investments in order to reduce the risk of permanent loss of capital in the event that undesirable eventsand developments actually occur.

Grahamites also recognise that if markets tend towards but never attain a state of equilibrium, and if profit-seeking entrepreneurs constitute the “oil” that enables the market mechanism to operate and adapt so smoothly, then over time particularly talented and shrewd and lucky entrepreneurs will tend, more often than not and relatively consistently, to accumulate capital. Less successful entrepreneurs, on the other hand, will consistently lose some – and eventually all – of their capital. It is for this reason that Grahamites search incessantly for businesses that possess consistently solid and relatively stable track records, and the demonstrated ability to surmount a variety of unexpected changes and vicissitudes.

In this final excerpt, Leithner discusses the calculation of desired rates of return, and the relationship to firm value:

On what bases, then, do Grahamites reason towards an assessment of a given security’s value? First, they assess the structure of the underlying firm’s capital and the stability of its earnings. Second, they ascertain their time preference (i.e., the extent to which they are prepared forego consumption today in order to consume more in the future) and thus their desired rate of return. Although value investors have never used the term “time preference,” embedded within the Grahamite approach to the valuation of securities is a notion of time preference and interest that is compatible with Austrian understandings of these concepts.

…

What is an appropriate payback period? The answer depends upon one’s time preference; and that, in turn, will vary from one investor to another. But a few general points can be made. First, a shorter payback period (i.e., a higher rate of return) is preferable to a longer one (i.e., lower rate of return). This is because the longer the time required in order to recoup an investment, the riskier that investment becomes. The longer the payback period, the more a decision to invest depends upon the veracity of its underlying assumptions, i.e., the more imperative it becomes that those assumptions correspond to reality. With each additional year of waiting, the chances increase that unforseen or uncontrollable factors – a recession, a decrease of the purchasing power of the currency, new competition, the loss of key contracts, employees and other innumerable and perhaps unimaginable factors – will decrease (or halt the rate of increase of) the size of the yearly coupon and hence prolong further the payback period.

…

Second, a high natural rate of interest implies a large required rate of return and a more stringent hurdle for potential investments to surmount. For example, a natural rate of 12-15% (which Leithner & Co. uses to conduct its investment operations) and a constant stream of coupons imply a payback period of 6-8 years. By that criterion, both the Telstra stock’s and the Commonwealth bond’s payback period is unacceptably long; and by this absolute, more challenging – and, to mainstream investors, virtually unknown – yardstick, neither of these securities are compelling. Since the late 1990s, in other words, wide swaths of the investment universe (i.e., most equities, bonds and real estate) have been unacceptably dear; and the five-year investment results of most mainstream investors confirm the sad consequences of buying securities at inflated prices.

Leithner’s paper is superb,and well worth reading. His explication of the concept of “capital goods” and capital, and the relationship to firm value should not be missed.

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