Contrarian investing
What is value investing? “The most realistic distinction between the investor and the speculator is found in their attitude toward stockmarket movements. The speculator's primary interest lies in anticipating and profiting from market fluctuations. The investor's primary interest lies in acquiring and holding suitable securities at suitable prices. Market movements are important to him in a practical sense, because they alternately create low price levels at which he would be wise to buy and high price levels at which he certainly should refrain from buying and probably would be wise to sell.�
“Assume that a run-of-the-mill common stock is not particularly well suited to a formal valuation because there are too many uncertainties about its future to permit the analyst to estimate its earning power with any degree of confidence. Should analysts reject the valuation technique in such cases and form their opinions about the issue by some other approach? ‌ The soundness of a common stock investment, in a single issue or a group of issues, may well depend on the ability of the investor or the analyst-advisor to justify the purchase by a process of formal valuation. In plainer language, a common-stock purchase may not be regarded as a proper constituent of a true investment program unless some rational calculation will show that it is worth at least as much as the price paid for it."
Margin of safety "[To] have a true investment, there must be a true margin of safety. And a true margin of safety is one that can be demonstrated by figures, by persuasive reasoning, and by reference to a body of actual experience." – Ben Graham
A portrait of failure: the performance of every US large cap fund with a 15 year history vs the S&P500 and CRSP 1-10 indexes. 15 Years ending 31 December 2001 (285 Funds)
Picture credit: Dimensional Fund Advisors
Efficient markets hypothesis • Weak form: all past market prices and data are fully reflected in securities prices. (Technical analysis is of no use.) • Semi-strong form: all publicly available information is fully reflected in securities prices. (Fundamental analysis is of no use.) • Strong form: all information is fully reflected in securities prices. (Even insider information is of no use – market is omniscient.)
The implications of EMH: There are only two ways to outperform the market: 1.Getting lucky 2.Taking on higher risk
Traditional EMH: • Stock prices move in “random walks”. • Prices always reflect best estimate of value based on all available data. • Dart board as good as any analyst. • Best approach is passive or indexed investing.
Warren Buffett: “The Superinvestors of Graham and Doddsville”, 1984 Name
Index Return
Period
WJS Partnership
8.4% 21.3%
1956 – 1984
Tweedy, Brown and Co.
7.0% 20.0%
1968 – 1983
Buffett Partnership
7.4% 29.5%
1957 – 1969
Sequoia Fund, Inc.
10.0% 17.0%
1970 - 1984
Warren Buffett: “The Superinvestors of Graham and Doddsville”, 1984 Name
Index Return
Period
Charlie Munger
5.0% 19.8%
1962 – 1975
Pacific Partners Ltd
7.8% 32.9%
1965 – 1983
Perlmeter Investments
7.0% 23.0%
1965 – 1983
Fama and French’s “Three factor” model Your returns mostly come down to asset allocation: • The mix of stocks vs bonds • The average company size • The value characteristics of the stocks - how “cheap” stocks are compared to book value.
Picture credit: Dimensional Fund Advisors
“Modern finance today resembles a MesoAmerican religion, one in which the high priest not only sacrifices the followers - but even the church itself. The field has been so indoctrinated and dogmatised that only those who promoted the leading model from the start are allowed to destroy it." - Comment on Fama/French value findings
Academic definition of “value” • Fama and French sorted stocks by “book to market” or BtM, which is the inverse of the measure most investors use, price to book ratio. • Using BtM rather than PBR avoids divide by zero (infinite) values. “Value” stocks are stocks with a high book to market. • Other parameters have been tried out, like sorting by earnings, sales, cash flow, dividend yield etc, but many researchers find that BtM gives better results, partly due to the fact that book values are less volatile than other measures.
Dreman major findings: • Analysts tended to be bad at forecasting with low precision on all time frames in all industries in all market capitalisations. • Overall, analysts tend to be too bullish and overestimate future earnings growth. • When a stock “surprises” the market with earnings higher or lower than expectations, significant price movements can result. • Stocks tend to react differently depending on their price and market expectations.
Growth stock earnings surprises • Dreman found that “growth” stocks tend to have very bullish expectations built into them. (Hence the high prices of course). As a result, when growth companies have earnings surprises, they more commonly surprise on the downside. • Interestingly, he found that when growth stocks tended to surprise on the upside, little price action resulted. It seems that investors sometimes can be so bullish about a company that even good news doesn’t surprise them. • When growth stocks surprised on the downside though, the result was often a sharp selloff.
Value stock earnings surprises • Dreman found that “value” stocks tend to have very poor expectations built into them. (Hence the low prices of course). As a result, when value companies have earnings surprises, they more commonly surprise on the upside. • Interestingly, he found that when value stocks tended to surprise on the downside, little price action resulted. It seems that investors sometimes can be so bearish about a company that even bad news doesn’t surprise them. • When growth stocks surprised on the upside though, the result was often a sharp rally.
Net effect of all earnings surprises Great things are expected from growth stocks so when they deliver great things the market can be hard to impress (more), but if the worst is feared from a value stock the result can often be pleasing. The earnings surprises tended to result in value stocks having higher returns and lower risks than growth stocks.
Lakonishok, Josef, Andrei Shleifer, and Robert Vishny, 1994, Contrarian investment, extrapolation, and risk, Journal of Finance 49, 1541–1578.
“For momentum investors, who pin their expectations to high growth rates, any slip in quarterly performance can cause grievous results. There is little solace in missing targets by tiny amounts, even though accounting practices leave ample wiggle room. Most companies that are close to earnings targets should meet those targets - particularly when the stock price hangs in the balance. In high p/e territory, if lofty growth expectations are missed by an inch, it may mean that a company has really missed by a mile. Whatever the actual amount of the miss, uncertainty alone can mete out tough punishment, and creative accounting practices ultimately catch up to offenders.� - John Neff, John Neff on Investing
Value or growth? “The whole concept of dividing it up into "value" and "growth" strikes me as twaddle. It's convenient for a bunch of pension fund consultants to get fees prattling about and a way for one advisor to distinguish himself from another. But, to me, all intelligent investing is value investing. That's a very simple concept. And I don't see how anybody could really argue with it. Buffett says, In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.” – Charlie Munger, 2000 Berkshire Hathaway AGM
Two very different forms of value investing • Active (Graham and Dodd) investors look at stocks as shares in a business, try to understand that business and buy them when they are cheap relative to their intrinsic value, usually using some form of discount cash flow valuation. • Passive or quantitative investors simply sort stocks via some measure like price to book ratio and divide them up into “value”, “neutral” and “growth”. This is not value investing the way any active investor would recognise it. This causes much confusion, so perhaps “unglamour” and “glamour” would be better.
Variations on a theme • • • •
“Deep value” active “Deep value” passive “Growth at a Reasonable Price” active Stock pickers
Disclaimer: This article contains the opinions of the author but do not represent a personal recommendation of any particular security, strategy or investment product. The author's opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. Investors should seek the advice of their own qualified advisor before investing in any securities.