Value investing is a mistake

[Guest]

Here's more evidence against "value" investing.

 

According to morningstar, $10,000 invested on 08/31/1976 (inception of vanguard 500) would turn into $634,628.99 for the S&P 500 index (less for fund), $623,622.98 for large growth morningstar category and... $577,203.43 for large value.

[yadayada]

Buying companies at 20-30x earnings can be risky at the tail end of a supercycle, with mountains of debt. If goverment spending is drastically reduced (because they run out of willing borrowers and can no longer run huge deficits as a % of GDP), GDP will shrink significantly (multiplier effect), especially if they cannot spend themselves out of a recession. So then shit can really hit the fan, and earnings from just about every company around (moat or not) will contract. Same with valuations. This only happens about once a century. So that is probably why few are prepared for it. Im looking more and more for protection by book value as well.

 

There is a reason why graham was so scared to invest in anything other then net nets...

 

Also interesting that buffett started his buy and hold great companies at somewhat expensive valuations right around the time that debt and productivity started to shoot up a huge amount over 20-30 years. He basically rode that massive bullmarket from the bottom to right at the top.

 

 

[Rainforesthiker]

It is helpful to start with a definition of value investing, so everyone is on the same page.  I would define it broadly - attempting to assess the value of a business or asset and only purchasing the business/asset when there is a sufficient difference between price and value (MOS).  Different flavors of value investing can work in different scenarios.

 

The biggest stumbling block that I see in value investing is failure of some to appreciate that markets are mostly efficient, and in general certain conditions must be present for value opportunities to exist.  Efficient markets are largely based on a wisdom of the crowd concept.  Certain criteria are necessary however for this crowd wisdom to manifest in the stock market.  Knowing what these criteria are, and how to reliably identify when they are missing, are IMHO extremely important to being a successful value investor.  In other words, value investors should be able to articulate WHY a stock is mispriced - why the crowd is getting it wrong. If you can't, you are essentially saying you are smarter than the crowd (smarter than a likely efficient market).  I see too many purported investors do their back of the envelope value calculation, determine this calculated value is greater than the stock price, and then stop their thinking.  It would be much better to give an equal amount of thought as to what is causing the mispricing - why is the crowd getting it wrong.

 

http://www.amazon.com/Inefficient-Market-Theory-Investment-Foolishness/dp/0692273948/ref=sr_1_1_twi_1?s=books&ie=UTF8&qid=1414171231&sr=1-1&keywords=inefficient+market+theory

 

[muscleman]

I think the biggest problem with classic value investors is that they claim market price and fundamental value are two completely different things and over the long run, fundamental value can influence market price and market price should converge with fundamental value.

 

This understanding is missing the second part of the reality, which is that market price CAN also influence fundamental value.

 

For example, an over valued stock, if under the helm of a great CEO, can start an acquisition spree and after each acquisition of FAIR valued deals, the fundamental value of this company goes up, therefore confirming the Wall Street's bias that the stock is good, therefore further pushing up the stock price.

 

Another example, all value investors like AMZN's business fundamentals, except that people say, oh shit, this stock is way overvalued. I'd love to buy at $40 per share instead of $400. Let me tell you this, if AMZN opens at $40 tomorrow, 90% of the star software engineers will leave within one month. Do you believe that? Then AMZN will immediately get into deep trouble. Therefore it is exactly the Wall Street's negative bias that destroy the fundamentals.

 

I think if people in the classic deep value investing clubs understand the above, then their performance would be better.

[jawn619]

Value investing doesn't always work in the short term, and you are indistinguishable from being wrong if you under perform. If you have investors who see you under perform and don't understand how it works, you will have to answer a lot of questions. I've found that if you have investors that don't understand how it works, they almost never will no matter how much explaining you do. It's tough especially in bull markets when clients say the S&P is up X% in this short time frame, why is the portfolio not at least matching it?

[muscleman]

Value investing doesn't always work in the short term, and you are indistinguishable from being wrong if you under perform. If you have investors who see you under perform and don't understand how it works, you will have to answer a lot of questions. I've found that if you have investors that don't understand how it works, they almost never will no matter how much explaining you do. It's tough especially in bull markets when clients say the S&P is up X% in this short time frame, why is the portfolio not at least matching it?

 

You have to define "short term" though. Is that one day? One month? One year?

Let's look at SHLD for example. Would you say that people who blame ESL or Fairholem because it hasn't been working for the past 10 years are all "short term" oriented people? Seriously, how many more 10 years do we have in our life span?

 

Of course, if people ask you "the S&P is up X% in this short time frame, why is the portfolio not at least matching it?", these clients should be kicked out. I definitely agree.

[Fowci]

In an effort to combat confirmation bias, please let me know how, where, and why value investors are wrong. 

 

I'm most interested in themes and patterns rather than specific examples of the form "company XYZ is a bad bet due to ABC".  What is the best evidence against the efficacy of value investing in general?

 

This isn't specific to value investing, but there's a lot of overlap between value investors and diversification = diWORSIFCATION LOL!

 

Many value investors are woefully undiversified and have massive overconfidence bias. "Why would I choose a worse idea than my top 10?" Maybe because you're quite often wrong, and even when you're right, company specific risk is a risk that you really are not getting paid for.

[Packer16]

You bring up an interesting question about being rewarded for company specific risk.  I think you can be rewarded if you can identify the cases where the potential upside more than compensate for this risk.  On average you are correct but as value investors we are suppose to differentiate when the price is reflecting this risk versus not.

 

Packer

[Guest longinvestor]

You bring up an interesting question about being rewarded for company specific risk.  I think you can be rewarded if you can identify the cases where the potential upside more than compensate for this risk.  On average you are correct but as value investors we are suppose to differentiate when the price is reflecting this risk versus not.

 

Packer

 

By "Risk", do we mean,

1) company could go to zero?

2) we didn't know 1)

 

Or something else, like,

3) the security may not reach my price objective?

4) in my targeted holding period?

 

[Fowci]

You bring up an interesting question about being rewarded for company specific risk.  I think you can be rewarded if you can identify the cases where the potential upside more than compensate for this risk.  On average you are correct but as value investors we are suppose to differentiate when the price is reflecting this risk versus not.

 

Packer

 

By "Risk", do we mean,

1) company could go to zero?

2) we didn't know 1)

 

Or something else, like,

3) the security may not reach my price objective?

4) in my targeted holding period?

 

I mean that you're not being compensated for the risk that the company's factory could explode, an earthquake could wipe out some stores, etc. These are real risks you take on when you buy a company, and there is no compensation for this risk (because it is completely diversifiable, and thus unpriced). By not diversifying, you take on that risk and it is not compensated. But most value investors ignore this risk.

 

[Packer16]

It is diversifiable if the stock is efficiently priced.  If it is not then you can get excess returns by investing in it.  I think some posters focus on those securities that are in dark corners of the market where there are pricing inefficiencies.  The Kelly formula can provide a benchmark of how much you can invest in one of these to reduce the risk of ruin.

 

Packer

[Guest Schwab711]

You bring up an interesting question about being rewarded for company specific risk.  I think you can be rewarded if you can identify the cases where the potential upside more than compensate for this risk.  On average you are correct but as value investors we are suppose to differentiate when the price is reflecting this risk versus not.

 

Packer

 

By "Risk", do we mean,

1) company could go to zero?

2) we didn't know 1)

 

Or something else, like,

3) the security may not reach my price objective?

4) in my targeted holding period?

 

I mean that you're not being compensated for the risk that the company's factory could explode, an earthquake could wipe out some stores, etc. These are real risks you take on when you buy a company, and there is no compensation for this risk (because it is completely diversifiable, and thus unpriced). By not diversifying, you take on that risk and it is not compensated. But most value investors ignore this risk.

 

The vast majority of quotes for all stocks are efficient and in those cases you are not being compensated for "black swan" events (non-zero, low probability, severe loss scenarios). I think you are only rewarded for the risk of these rare events occurring when inefficiency exists. Diversifying only decreases the expected loss frequency and magnitude, but not the overall amount (similar to MBS risk diversification).

 

As to the threads question of is value investing a mistake? Carter Capps of the Marlins (MLB) has recently changed the way people have thought about pitching in baseball. It has made the league review rules that are over 100 years old that they possibly have not read or, at least thought about, in their lifetimes (http://m.mlb.com/video/topic/21753540/v73287783/miaatl-capps-hopstep-delivery-analyzed). How can we evaluate whether current pitching techniques are efficient or not when such radically unique mechanics prove to offer such improved results (from an expected journeymen no less!). He seems to provide a reasonable example of why it is difficult to know if VI will ever be proven "correct", regardless of the mountain of evidence. How do we know we as an industry are not missing the more direct relationship for determining the "value" of something (If I had to make an uneducated guess I would bet the "true" definition of "value investing" is dynamic and that of "value" is static)? The fact that Ben Graham was able to improve valuation techniques so drastically and after such a significant period following the first "deep" markets seems like the best evidence to me that further efficiencies in modeling value exist but are yet unknown. Just the phrase "modeling value" suggests that an accurate view is currently unavailable.

 

In my opinion, VI may indeed be correct but not for the reasons assumed to be correct currently. It seems impossible to me that any attempt to assert inefficiency can be made without at least some consideration for the underlying business or source of revenue for a security. I would guess current knowledge of VI is closer to Newton's gravity then Einstein's. The Gettier Problem comes to mind (https://en.wikipedia.org/wiki/Gettier_problem).

 

With all that said, as Warren Buffett once pointed out, if everyone in the country flipped coins until they landed on "tails" and the all of the last flippers were from Rochester, NY, it would be more reasonable to assume something is going on in the Flour City then to assume a coincidence. Packer is exceedingly more likely to be in that last flipping group than what a random walk would lead you to believe. There must be some true knowledge known about VI since we can improve our ability to predict who will be in the last group of flippers.

[Fowci]

It is diversifiable if the stock is efficiently priced.  If it is not then you can get excess returns by investing in it.  I think some posters focus on those securities that are in dark corners of the market where there are pricing inefficiencies.  The Kelly formula can provide a benchmark of how much you can invest in one of these to reduce the risk of ruin.

 

Packer

 

If you use your insights and hard work to identify mispriced securities, then that's all well and good. But that does NOT mean you're getting paid for diversifiable risk. You're getting paid for your insights, and you have made the implicit judgment that that compensates for the company specific risk. My contention is many value investors underestimate how significant company specific risk is (and of course overestimate the value of their insights and hard work, but that's a universal human mistake)

[Packer16]

I do not how to divide risk into diversifiable and non-diversifiable portions to assess what type of risk I am getting compensated for or if the mispricing is not considered a risk (however with the new multi-factor models value and size are considered risks so the thinking on this may be in flux).  I think the key is the difference between the stock price versus the firm value.  For most large firms trading in more efficient markets, this difference is small.  You can also see this in the mutual fund performance of value funds that widely diversify, they underperform index funds that have lower costs. 

 

One effect diversification can have is to dilute the effect of the mispricings identified.  I think in many cases the number of mispriced securities is small so if you find one and diversify into fairly priced securities, I think you reducing the edge you have versus the market.  So a rationale strategy would be to have a default of index funds and invest in identified mispricings when found.

 

Packer     

[Uccmal]

I often hear VIs comment on being too early into a situation.  Maybe that is the wrong way of thinking about it.  Maybe VIs are early because they see opportunities for a turn around or reversion to the mean more easily than others - due to practice or obstinance?  I dont think diversification is important either way.  Graham and Schloss were successful and diversified.  Bruce B. is concentrated.  All three had a high threshold for pain.  Buffett is... different - his biggest hits have been in the "influence" category. 

[frommi]

Funny how this topic of diversification vs. concentration pops up again and again. And still everybody has other definitions of this, for some concentration means 1-5 securities and for others its 1-15.

For me it seems like in larger cap companies >500 million $ float the market is pretty efficient, but it has a tendency to undervalue companies with higher leverage be it operating leverage or leverage via debt (but not always). And this is because people are scared of leverage and underestimate the effect of operating leverage. ( Or is it just getting compensated for the risk of leverage in good times? :) )

 

The other is in micro cap companies where 1 seller can influence the price so much, that it is temporarily depressed. But this is the area where the most work is involved, because you can`t rely on the work of others. And there probably will never be a working hedge fund in this area, because investing in microcaps is not scalable.

 

On the other side momentum is a strong phenomenom in the investing world which creates the value situation on its own (but only when stocks go down long enough). So for me these are the yin and yang of investing, you can`t have one alone. So as long as there is momentum, value will be working as well.

[Guest longinvestor]

You bring up an interesting question about being rewarded for company specific risk.  I think you can be rewarded if you can identify the cases where the potential upside more than compensate for this risk.  On average you are correct but as value investors we are suppose to differentiate when the price is reflecting this risk versus not.

 

Packer

 

By "Risk", do we mean,

1) company could go to zero?

2) we didn't know 1)

 

Or something else, like,

3) the security may not reach my price objective?

4) in my targeted holding period?

 

I mean that you're not being compensated for the risk that the company's factory could explode, an earthquake could wipe out some stores, etc. These are real risks you take on when you buy a company, and there is no compensation for this risk (because it is completely diversifiable, and thus unpriced). By not diversifying, you take on that risk and it is not compensated. But most value investors ignore this risk.

If the business blows up, isn't that the same as not possessing a durable competitive advantage? The alternative to diversification is placing it in the "too hard" pile and moving on to something else.

 

I don't know how many value investors act this way but there are two!

 

Anyway, it is more about what you know about the durability of the business, in probability terms, than the black swan event itself.

 

Most investors invest in businesses that they don't really understand with this kind of rigor. They are kind of like the bee which dances incoherently and messes up the hive (Munger in Poor C's Almanack) when the nectar is found in an unusual way. It would've been better for the bee to not dance at all.

 

 

[ERICOPOLY]

Buffett and Munger learned that in order to confidently buy a company for less than intrinsic value, they must first predict the future path of the business (it's future earnings).

 

Therefore they decided to purchase businesses that have a far more predictable future.  That's where all the talk about "moats" and "boring businesses" and "high quality" comes into play.

 

They realized that they have an advantage in predicting the future if they focus their efforts on finding predictable situations.  Otherwise they won't invest ("too hard" pile).