EXCERPT:
Remember the days when you could count on value investing as a solid defensive strategy. It worked that way as recently as the downturn we experienced earlier this decade. Lately, though, value has not been fulfilling this role. And there are reasons to wonder if this is more than a temporary oddity and whether the entire approach needs to be overhauled. FULL ARTICLE.
BY: Marc Gerstein
CATEGORY: What’s Working
Marc:
Your articles are a great addition to Portfolio123.
I have a couple comments to get a discussion started on the topic of your blog “What’s Wrong With Value Investing?”
Before offering a practical suggestion for improving results, let me begin with a key point which some might think is philosophical, but which I find to be very helpful for sticking with proven strategies that are temporarily under performing.
I think Value stocks are currently doing what they MUST do from time to time. A key reason why value has worked for decades is that it occasionally fails to “work” for a year or two. Think of this this way. If Value investing ALWAYS produced profits superior to the market during bull periods and ALWAYS produced smaller losses than the general market during bear period, soon everybody would be value investors. In such a world, value investing would just give average market returns. So it is a good thing that market randomness causes value investing to under perform for a year or two. When enough “weak hands” have abandoned value strategies, then value investing will start working again.
OK, enough philosophy. Now for something more practical for improving the value example you gave in the blog.
May I suggest you add a price momentum factor to the value method. Value purists may argue that one should not put price appreciation into a value strategy. But if this is just given minor weight (say 20% to 33% in a ranking system), I still see the strategy as a value strategy. Why is it still a “value” strategy? Because the purpose of the price momentum factor is to keep the value metrics “honest”. A value strategy that has no price momentum factor is, in my mind, better called a “Value and Junk” strategy. Why? Sometimes value metrics are wrong. When a company is experiencing a down turn, that down turn will not show up in the value metrics until the next quarter statement is released (or until a busy analyst gets around to double checking his figures and updating his estimates for earnings and growth numbers). All value metrics will lag to some degree, even the forward looking analyst projections lag. But the market does not need to wait for the analyst’s update or for the next quarterly report. The market will start to push down the price of stocks that have false value metrics.
Furthermore, consider this. In the short term, that initial price decline started by the smart money in the market will make the value metrics look even better. Think about that. As the price goes down, the value stock looks like a greater value. But this is fool’s gold. It is a value trap. But we can avoid many of these value traps by including price momentum as a minor factor (say 20% to 33%). This will turn a “Value and Junk” strategy into a true “value” strategy.
Oh, widely differing forms of price momentum factors “work” (ie, keep the value metrics honest). For example, close(0)/close(60) helps, lose(0)/close(120) or lose(0)/close(00). So does SMA(close,50)/SMA(close,200), etc, etc. You can pick almost any medium length price momentum factor and it will significantly improve value strategies.
If that was all that price momentum had to offer to a value strategy it would be enough. However, there is a second reason for including price momentum as a minor factor. It is to avoid dead money time. There are cases where a great value metric is correct. Such a stock is truly undervalued, often significantly so. However, such value stocks may stay undervalued for months and months and months. Why park one’s money in value value stocks that have yet to start rising in price? It makes more sense to put one’s money into those select few value stocks that have already started to increase in price. Rising price shows the market is starting to notice the stock and good value metrics show that the stock still has a considerable distance to go before it is fully valued. A great time to get on board a Value train is just as it is starting to pull out of the station. Price momentum helps to find the value stocks that are On-The-Move.
Marc, I look forward to reading your articles. Keep up the great work.
Brian (o806)
Right on!
At Reuters, I pursued the same approaches based on the same reasons you articulated. For example, my Relative Values screen, for instance, included Pr4W%Chg>Pr4W%ChgInd. That’s not by any means the best way to address price momentum, but given the variable set available in Reuters PowerScreener, it was the best I could do. Now, with portfolio123, there’s a much richer palette and I am going to experiment with all the factors you list.
Using the same logic, I also worked with the estimates data-set. There, I used such factors as estimate revision and recommendation upgrade to tune into smart-money activity. The rank I created for these articles is not the first time I worked that way. The Reuters Select Favored Value plays screen has been a good one for many years.
As to the inevitability of bad periods, I half agree. I think value investors are ok with them during hot market periods. In my opinion, the reason why the whole world doesn’t do value is because so many investors don’t want to lag bullish phases (which have tended to be more numerous). Value fans can handle it, if there’s an offsetting benefit, less downward pressure during bad times. That’s what has been faltering recently among the models I’ve seen.
But for the most part, those have been based on profit streams. I need to do more with balance-sheet-based models to see how those have been faring. Has anybody been having success with these lately?
It is interesting, I have often wondered, “is value investing dead”, or even “will value investing ever be dead”. If we are talking about a “Warren Buffet” type of value investing, namely, buy a company at a discount to its intrinsic worth, then I doubt that method of value investing will ever die. In fact, it is almost an axiom that it will always work over the long term.
However, value investing based on single simple metrics is much more vulnerable. I have read a study by Bob Haugen showing that low P/E stocks tend to have inferior EPS growth than high P/E stocks. This is hardly surprising, but it does show that the market does correctly discount those stocks with inferior prospects. However, historically this discount has been too high, and that is why “value” has outperformed “growth” - at least measured by a relative P/E basis. It seems to me that there is a risk that if the gap between value and growth narrows too much (as we have seen) that simply buying low P/E stocks is no longer a way to gain alpha- the low ratio simply reflects the inferior prospects.
However, despite the fact that a lot of the value indicies have been trailing the growth indicies of late, my own studies tend to indicate value continuing to outperform. It is just that the rather crude methods used in the indicies are insufficient. I have to main objections:
-Only using either trailing or projected earnings. Obviously, trailing earnings are always “out of date”, and may not reflect the current situation. I am sure we have all been caught by a value trap. Using projected earnings may get around this, but on the other hand, projected earnings may be too optimistic and subject to innacuracies because they are only guesstimates. Therefore, I always like to use both trailing and projected numbers.
-Taking no account of the balance sheet. This is a problem with traditional metrics like P/E ratios. However, more modern metrics such as EV/EBITDA get around this by including balance sheet items, such as debt and cash. This makes sense to me, if a company has $2 cash per stock, then you should effectively imagine that the stock price is trading for $2 less than it currently is. Debt is also a major issue. Quite apart from the risks associated with high debt, a company that has a lot of debt may be less willing to distribute free cash to shareholders, instead using it to pay off debt first. A debt-free company has no such issues, the shareholders can geniunely “eat” all the cash that comes in. Buffett is known for prefering low or no debt companies. Perhaps simply adding the debt to the market capitalisation is too simple, but it does also have the elegance that if the company were to be takenover, it does represent the total scope of all the liabilities.
GIven these factors, I have been observing a port running on pure value, (it is 200 stocks because people know my opinion on small portfolios )
http://www.portfolio123.com/port_summary.jsp?portid=351559
Anyway, so far it has been pulling ahead of the market, that leads me to think: rumours of the death of value have been greatly exaggerated!
Over the years, investors have come up with a lot of different factors they describe as “value”. Similarly, there are different common notions of “defensive”, including 1) robust to market downturns, 2) robust to economic downturns, and 3) robust to estimation and/or financial reporting noise. Even if we are happy to focus on the first of the categories as the type of defensiveness we really care about, it is likely the case that in any particular downturn, the set of value factors that contribute to defensiveness and their degree of contribution would vary depending on the reasons for the downturn. For example, I’d expect a low price to sales ratio (typically associated with lower operating margins and higher leverage) to be helpful in market downturns that are driven by downward growth estimate revisions, valuation compression, and a withdrawal of venture capital, but I wouldn’t expect that factor to be helpful in a downturn driven by rising input costs and tightening credit. I’d expect (current assets - debt) to be defensive in most environments, and the non-value factor liquidity to be helpful in most sharp market downturns. In the current market downturn, any value factor that has the side effect of tending to keep one out of financials (e.g. high ROA) and into energy (e.g. improving operating margin) will be helpful.