Why gaining from value investing is hard

March 16, 2014 2:34 pm

Why gaining from value investing is hard

By John Authers

In the financial context, the word ‘value’ sets off emotions

Values in common parlance elude definition. Equally decent people can hold contrasting values with deep fervour. In the financial context, the word “value” sets off emotions that are almost as deep.

“Value” is a style of investing that offers the chance of beating the market. It is widely understood in the US, where it is common for mutual funds and other products to be marketed as being “value”.

The case for value springs from two sources. The first is the work of Benjamin Graham, an investor and academic who published his magnum opus, Security Analysis, during the Great Depression.

He argued that investors should treat any stock as a share of a bigger company, and work out the exact intrinsic value of the assets they were buying with that company. The important concept was “margin of safety”. If a company could be bought for less than its intrinsic value, then the downside risk was minimal.

Mr Graham taught his theory for many decades at Columbia Business School. His many successful alumni include Warren Buffett, who describes Graham as the second most influential man in his life, coming only after his father.

The second case for value also stems from academia. Eugene Fama (made a Nobel economics laureate last year) and Kenneth French studied equity returns over the years to find out if there were any predictable inefficiencies. This revealed a “value effect”. Put simply, stocks that are cheap when bought, as measured by their price-to-book ratio, tend to beat other stocks over the long run.

Mr Fama also spawned a dynasty of successful investors. Using quantitative screens, investors buy stocks that are cheaper than average, and can expect to reap outperformance in the longer term. Dimensional Fund Advisors is the most famous exponent. Its founder, David Booth, honoured his intellectual debt to Mr Fama with a donation to his alma mater, which was renamed the Chicago Booth School of Business in his honour.

This approach has also spawned “factor” investing. Fund managers use quantitative methods to screen many stocks, and chase particular factors. For example, there was a period recently when dividend yield was in demand. In a downturn “quality” stocks – with consistent earnings and strong balance sheets – tend to outperform.

The two approaches have something in common. They involve comparing the current market price to some kind of intrinsic measure of a company’s value. But there are big differences. The Graham approach involves minute examination of balance sheets to find a true margin of safety. Only a few stocks will make the cut. A Fama/French approach involves buying stocks that are cheaper than others and relying on the anomaly to shine through. It is about looking for relative rather than absolute value.

Tren Griffin of Microsoft, an expert in Graham-style value investing, suggests a basketball analogy. He says: “The Fama/ French approach would be to recruit 100 of tallest males in town. This team would do better than average since there is a correlation between height and ability.” Graham would “hold tryouts and evaluate everyone’s basketball skills. Someone using this style would pick the top 15 players”. He suggests that the Graham team would win “by a large margin”.

There is a further issue. Both value approaches have evolved over time. Far fewer stocks meet Graham’s original criteria now, with the market in a bull run, than when he wrote. That has led to new takes on Graham’s ideas. Mr Buffett looks for stocks with a strong franchise, or a reason to believe that they will maintain or increase earnings into the future.

Further, value is often offered as an alternative to “growth” investing. Growth lacks a Ben Graham figure, and no academic research has yet demonstrated a “growth” anomaly. In general a “growth” stock needs to show that its earnings are growing. There are periods when such stocks will outperform “value” stocks.

Fund groups will offer separate “value” and “growth” funds, and maintain style discipline between them. This gives investment advisers the chance to show their worth by switching between them.

The main index-providers now offer separate “growth” and “value” indices. The danger here is that all the concepts become so stretched as to be meaningless.

Beating the market is difficult. The Graham and Fama approaches both yield strategies that have a decent chance to do so. But the former requires exhaustive research. When markets are particularly strong, as now, few stocks will offer the margin of safety that Graham required. The latter requires some great algorithms. Both require iron discipline.

It is hard to believe that most of the funds now marketed under the “value” label truly follow a value approach, or that they are giving their investors much chance to outperform in the long term.