Be brave, and patient, to make a fortune in value investing

March 26, 2014 8:23 am

Be brave, and patient, to make a fortune in value investing

By John Authers

Combining two popular approaches will reward stockpickers

Fortune favours the brave. And everything comes to he who waits. In these two well-worn phrases lie differing justifications for two different approaches to value investing. Both have merit, but the trick is to combine them.

Value investing has been popular ever since it was promulgated by US academic Benjamin Graham in the 1930s. His idea was that many companies had grown so cheap in the wake of the Great Crash and the subsequent economic depression that it was possible to buy them for less than their intrinsic value.

It received a separate and very different impetus in the 1970s, when a vast research project by two more academics, Eugene Fama and Kenneth French, showed that over time, cheap stocks – which they measured by price-to-book ratio – did indeed outperform. They labelled this the “value” effect.

These approaches are different. But there is also an academic debate over how to explain the Fama and French findings which leads, in turn, to two different kinds of “value” investing. Mr Fama himself, who was made a Nobel economics laureate last year, explains the value premium in terms of risk. Cheap stocks are generally cheap because they are in bad shape and face big risks. Therefore a value effect over time is just what would be expected in an efficient market – higher risk is related to higher long-term returns.

A second explanation comes from behavioural finance, and suggests that markets are inefficient. As humans we get excited about stocks with a great story to tell, and tend to ignore the more humdrum boring stocks that plug away producing predictable profits and dividends. Buying such stocks is a way of taking advantage of inefficiency and in the long run it will pay off. Both approaches are about “value”, but they are different.

Brave and patient approach

The effort is now on to systematise both strategies. Société Générale’s Andrew Lapthorne labels the approaches “brave” and “patient” value, and has a strategy for each. The patient approach involves buying stocks with strong balance sheets and regular dividend yields. This strategy is also called “quality income” and will work well in the long run. The disadvantage is that stolid dividend-payers tend to underperform in a strong bull market, as we have had for five years.

The “brave” approach involves buying the 200 cheapest stocks, relative to their own sectors, in the developed world. This compensates for the fact that some sectors will naturally look “cheaper” on basic metrics than others, and uses a weighted combination of five value measures – price/earnings, forward price/earnings and price/book multiples as well as, for non-financial companies only, free cash flow to price, and earnings before interest, tax, depreciation and amortisation to enterprise value. These companies are reshuffled every quarter, so the index will not ride for long with its “winners” whose share price takes off. It is now available as the SG Value Beta index.

Tying to it might make it a little easier psychologically to do the things that deep value investors need to do, such as buy shares in BP while its oil was still pumping into the Gulf of Mexico.

As Mr Lapthorne points out, the two strategies prove to be remarkably complementary. The “brave” value index has a high “beta”, meaning that its fate is linked to the market. It outperforms in good times, and will suffer far greater falls in a downturn. Its ultimate gains come from a rising share price. Meanwhile, “patient” value is less correlated to the market, and delivers its returns by compounding dividends in the long term.

Over the last 20 years, patient value returned 11.9 per cent per year, while brave value gained 14.3 per cent per year, with far higher volatility. In combination they returned 13.4 per cent per year, with lower volatility than that achieved by an equal-weighted market index, which returned a compound 8.4 per cent per year. Wherever the returns from value come from, they mount up in the long run.

Shortage of value stocks

This is far removed from the original Graham approach of buying stocks so cheap that they virtually pay for themselves. But sometimes there are few such stocks. By Mr Lapthorne’s own screen, using Graham criteria, barely more than 20 stocks in the MSCI World index now qualify. These do include intriguing names like Intel, BHP Billiton and Vodafone, along with a raft of large Japanese groups, and there is always the option of staying in cash if stocks look too expensive – but it does suggest limitations to the original Graham approach.

And maybe the later Graham would approve. In the 1950s, in retirement, he said he was “no longer an advocate of elaborate techniques of security analysis to find superior value opportunities.” He proposed a screen based only on historic p/e, the AAA-rated corporate bond yield, and a test of balance sheet strength.

This, he said, “seems to be practically a foolproof way of getting good results out of common stock investment with a minimum of work”. That could be a good description for the value screens of today.