Strategies Even Value Investing Go in Cycles

Market rents are typically fixed in size.  When a strategy to exploit a particular market inefficiency gets too big, returns to the rent disappear, or even go negative prospectively, even if they appear exceedingly productive retrospectively.

 

Strategies Even Value Investing Go in Cycles

If you have read me for any decent amount of time, you know I am big on economic and financial cycles, and how they can’t be eliminated.  There are two groups that think the cycles can be eliminated:

  • Politicians and Central Bankers who think they can create permanent prosperity, when all they really create is an increase in overall debt.
  • Efficient market theorists who think there are no strategies that beat the market.

It is the second group that I am dealing with this evening.  Market strategies trend.  If we have had outperformance from value investing this year,  the odds are good that we will have it next year, unless it has gone on for too many years (5+).

Ideas in investing tend to streak, get overinvested, then die.  This is one reason why I don’t believe articles about the death of various investment concepts.  We need to think about investment ecologically.  There are no permanently valid investment factors to beat the market.  There are many investment factors that beat the market over time, but not while many are pursuing them.  Imitation drives returns, and then over-imitation kills them.

That means we should be wary when a strategy has been working too well for too long.  It also means we should be skeptical when any strategy with a strong thesis behind it is declared “dead.”  That may be the very time to consider it, or maybe wait a year or two.  Many strategies are forgotten; after a time of failure it is time to remember them.

Part of this stems from the biases of institutional investors.  They think that their winnowing down of the investable universe through screening will always produce a good crop of candidates in which to invest.  But that’s not true.  Talented investors think more broadly, and are willing to consider investments that don’t fit within common screens.

The thing is: strategies go in cycles.  They are born at a time when no one loves them.  They gain currency from the good returns of those who adopt them, leading to a frenzy where many adopt the strategy, and returns are great, but now companies that fit the strategy are overvalued.  The process goes into the reverse gear where the strategy is garbage, until enough parties abandon it and the prices of stocks that would be a part of the strategy are attractive.

So when you hear:

  • Value is dead
  • Growth is dead
  • Large caps are dead
  • Small caps are dead (rare)
  • Momentum is dead
  • Low volatility is dead.
  • Quality is dead.
  • Low Quality is dead.
  • XXX industry or sector is dead.

Be skeptical, and begin edging into companies that you like in the “doomed” strategy.  Make sure they have strong balance sheets and competitive positions.  That will protect you if the trend persists.

One more note: this doesn’t work in reverse.  A strategy that has been working for a little while will likely streak.  Resist the trend when it is old, not when it is young.

Finally, remember: there are only tendencies, not laws: markets exist to surprise you.  There are theories that work in the market over time, but they do not work year after year, the results come in lumps, unlike the projections of the financial planners.

And I close by saying to all of my readers — is this not how the market works?  There is momentum, but it sometimes fails dramatically.  Ideas streak, and then collapse far faster.  I say be aware of what has been rewarded and what has not.  Sell stuff that has been rewarded too long, and that which has been recently trashed.  Buy the stuff that has come into favor, and strong companies that have been unduly trashed.

By David Merkel, CFA of Aleph Blog



About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.