My journey in the financial world started at age 17 when, for the first time, I read Benjamin Graham’s The Intelligent Investor (edition 1949). It took approximately ten years of readings in finance and economics, research and experience to truly understand and appreciate the enormous added value of the book for equity investors.
By far the best book on investing ever written.
Warren Buffett
In Security Analysis (1934) but even more so in The Intelligent Investor Benjamin Graham lays both the technical and psychological foundations of what has become known as value investing. From the book the reader comes to understand that Grahamite value investing involves buying financially sound companies at significantly below average valuations.
In the following paragraphs, from numerous perspectives, I will briefly explain why a businesslike quantitative value investing approach is one of the soundest approaches to long-term wealth accumulation.
2. The Business-Economic Perspective
In The Intelligent Investor Graham sets forth two dangers related to investing in growth stocks. Growth companies that have realized high earnings growth rates over the past years and/or companies with good earnings prospects usually quote at correspondingly high valuations. In the most optimistic scenario the growth firm succeeds in meeting the high hopes, but even in this condition chances are high that the growth stock will realize an inferior stock return, due to the fact that the growth investor has paid in full (and perhaps overpaid) for the expected prosperity. When the scenario is less rosy the growth firm is confronted with an earnings growth rate showing a significant slackening. High earnings growth rates attract competition, which results in systematically lower sales growth and lower profit margins. Very few companies truly live on an economic island. High ex ante valuations combined with slackening and disappointing earnings growth rates usually result in decimating the share price of the growth stock and consequently inferior stock returns (see also “The Behavioral Perspective”).
This second warning against growth investing is supported by the research paper “The Level and Persistence of Growth Rates” by Chan, Karceski and Lakonishok (2003) published in The Journal of Finance. The authors document that past earnings growth rates cannot be considered to be a reliable guide to future earnings growth; past above median earnings growth rates are no guarantee for consistent future above median earnings growth. Their findings are consistent with the economic intuition where above average earnings growth rates are skimmed off due to competitive forces. The researchers consequently caution against extrapolating past success in earnings growth into the future and paying high valuation multiples, in accordance with Benjamin Graham’s warnings in his discussion on the adoption of a growth stock program.
In 2000 when the Internet period reached its peak, the same authors published the study “New Paradigm or Same Old Hype in Equity Investing” in the Financial Analysts Journal. At the time they correctly warned that the valuations of many technology- and/or internet-related companies could not be supported by underlying business fundamentals, i.e. as reflected in their sales and earnings growth rates. In November 1999 Chan, Lakonishok and Karceski document that 25 percent of the 100 stocks with the highest market capitalizations traded at price-to-sales multiples above 7! From the March 2000 high, the Nasdaq subsequently tumbled more than 75 percent to a low of approximately 1,175 points. Even today the technology-related index is almost 30 percent in nominal terms below its 2000 all-time high. The episode was again a perfect example on how dangerously high price levels translate into permanent losses for investors.
Consequently, from a business-economic perspective I conclude that it is advisable not to overpay for future growth expectations as reflected in traditional valuation measures such as price-to-book, price-to-sales and/or price-to-earnings ratios. By adopting a quantitative value approach, investors automatically avoid companies with lofty valuations.
3. The Empirical Perspective
Many studies have documented the attractive returns to value stocks. In the academic literature value stocks are defined as stocks with low price-to-book, price-to-sales, price-to-earnings, and/or price-to-cashflow ratios without, it should be noted, taking into account the financial strength or fundamental health of the company (see also “The A Priori Perspective”).
Recently I have updated the study titled “Value and Growth Investing: Review and Update” by Chan and Lakonishok (2004) from the Financial Analysts Journal. The graph below shows the ten-year real total returns to value stocks and growth stocks over the 1980-2012 period using the following methodology: at the end of May non-financial, large-cap US stocks are annually sorted based on the aforementioned four valuation measures. Subsequently stocks are divided into equally-weighted decile portfolios and portfolio returns are computed over a one-year period. The final bar in the graph below shows the average ten-year real total return for both value stocks and growth stocks over the 1980-2012 period. The first bar indicates that over the May 1970 – May 1980 period value stocks realized a real total return of 122 percent. Growth stocks lagged with a real total return of 25 percent over that same ten-year time period.
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Value stocks (decile 1) outperform growth stocks (decile 10) in 32 out of 33 ten-year periods. Please note that even in the one ten-year period of underperformance, concentrated around the Internet period, the ten-year real total returns to value stocks still can be considered to be very attractive (see also “The Agency Perspective”).
4. The Behavioral Perspective
A number of studies try to explain the long-term outperformance of value stocks vis-à-vis growth stocks. According to Benjamin Graham in The Intelligent Investor the inferior returns to many growth stocks can be explained by overoptimistic growth expectations as reflect by their dangerously high price levels. A research paper by Skinner and Sloan (2002) published in the Review of Accounting Studies with the subtitle “Don’t let an earnings torpedo sink your stock portfolio” provides very compelling evidence that the inferior returns to growth stocks are indeed directly linked to expectational errors about their future earnings performance. Publication of below expected earnings results in an average stock price drop of 7.32 percent for growth companies over the 1984-1996 period; for value stocks Skinner and Sloan document a drop of 3.57 percent. After taking into account this asymmetric price response, the researchers document no remaining evidence of a return differential between value stocks and growth stocks. Their findings are consistent with the aforementioned warnings by Benjamin Graham with respect to the implementation of a growth stock program. More recent evidence in this regard is provided by, for example, Arnott, Li and Sherrerd (2009) in The Journal of Portfolio Management and by Piotroski and So (2012) in The Review of Financial Studies.
5. The A Priori Perspective
As part of the empirical perspective I emphasized that the academic literature does not take into account the financial strength or the fundamental health of a company as part of the definition of a value stock or growth stock. A lot of academic studies initially assumed that within a value or growth portfolio companies are substantially uniform in terms of business fundamentals and consequently also with respect to the underlying risk profile. Important examples of these can be found in Lakonishok, Shleifer and Vishny (1994) and Fama and French (1995). However, looking at an academic value portfolio, for example established based on the price-to-book ratio, shows that within such a portfolio there is a substantial heterogeneity with respect to corporate solvency, liquidity and profitability.
It does not matter how frequently something succeeds if failure is too costly to bear.
Nassim Nicholas Taleb, Fooled by Randomness
Based on a priori reasoning we cannot exclude that at some point in time an academic value portfolio will uniquely contain companies having very precarious business fundamentals, business fundamentals which in extreme circumstances such as The Great Depression will cause that the majority of these fundamentally weak value companies will go down, causing a permanent loss of capital for the corresponding alleged value investors. Since the exact timing of the onset of such an economic dislocation is not ex ante predictable, a businesslike value investor will definitely want to avoid those companies with significantly below average business fundamentals. By avoiding these fundamental risky companies I can guarantee that both as an investor and as a fiduciary your nights will be much more comfortable in times of financial and economic distress.
A quantitative value investing approach is the only form of safety first investing and one of the very few investment approaches that puts risk management at the heart of the strategy.
James Montier, The Tao of Investing
6. The Agency Perspective
As part of “The Empirical Perspective” it was shown that of the 33 ten-year periods value stocks underperform growth stocks during only one ten-year period. Even in that one ten-year period of underperformance, the ten-year real total return to value stocks was still very impressive. In the following graph I consider the real total returns to value stocks and growth stocks over two-year periods. The final bar in the graph below shows the average two-year real total return for both value stocks and growth stocks over the 1972-2012 period. The first bar indicates that over the May 1970 – May 1972 period value stocks realized a real total return of 46 percent. Growth stocks outperformed with a real total return of 79 percent over that same time period. Now I find that value stocks underperform growth stocks in twelve (!) of the 41 two-year periods, the highest underperformance being more than 60 percent in the Internet period.
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The fiduciaries of institutional investors (pension funds, insurance companies, trust and endowment funds) are traditionally subject to severe penalties for short-term underperformance relative to a broad stock index such as for example the S&P500. Being a market-cap weighted index the S&P500 is dominated by (expensive) growth stocks. Considering the possibility of short-term underperformance of value strategies, as illustrated in the graph above, professional investors consequently are sorely afraid to take advantage of the long-term outperformance of value stocks. If the institutional investors stay put and do not change their obsession with short-term performance relative to a benchmark index, the long-term outperformance of value stocks will remain available to businesslike investors who deal in value rather than in short-term (random) price movements.
Moreover my experience as fiduciary has indicated that a transparent communication vis-à-vis investors substantially helps to prevent them to concentrate on short-term performance. Both the stock selection criteria (see “The Empirical Perspective”) need to be communicated transparently and the underlying reasons for selecting the criteria clearly need to be motivated (see “The Behavioral Perspective” and “The A Priori Perspective”). In addition, the fiduciary needs to guarantee that the investment strategy meticulously will be implemented.
7. Conclusions
In this document I explained, from numerous perspectives, the rationale for adopting a businesslike quantitative value investing approach. From a business-economic perspective investors avoid overpaying for unrealistic, over-optimistic growth expectations. As part of the empirical perspective many studies have documented the attractive long-term returns to value stocks. From a behavioral perspective we are able to explain the long-term outperformance of value stocks vis-à-vis growth stocks due to over-optimistic errors about the future earnings performance of growth stocks. In the a priori perspective I highlighted the deficiency of the initial studies on value investing in the academic literature. The majority of investors definitely want to avoid a permanent loss of capital and, as a consequence, require minimal safety margins with respect to corporate financial strength. Finally I discussed the agency perspective. I showed that over short time horizons value investing strategies can suffer from underperformance. Professional investors usually are judged based on short-term results vis-à-vis a benchmark index, which prevents them to implement (opportunisitic) value investing strategies. By focusing on value and safety rather than short-term price movements relative to a benchmark index, businesslike investors avoid the perverse psychological pressures related to the practice of benchmarking.
Overall I conclude that a businesslike quantitative value investing approach is one of the soundest approaches to long-term wealth accumulation.
8. References
Arnott, R.D., F. Li, and K.F. Sherrerd. (2009a). “Clairvoyant Value and the Value Effect.” The Journal of Portfolio Management.
Arnott, R.D., F. Li, and K.F. Sherrerd. (2009b). “Clairvoyant Value II: The Growth/Value Cycle.” The Journal of Portfolio Management.
Chan, L.K.C., J. Karceski, and J. Lakonishok. (2000). “New Paradigm or Same Old Hype in Equity Investing?” Financial Analysts Journal, 23-36.
Chan, L.K.C., J. Karceski, and J. Lakonishok. (2003). “The Level and Persistence of Growth Rates.” The Journal of Finance, Vol. LVIII, No. 2, 643-684.
Chan, L.K.C., and J. Lakonishok. (2004). “Value and Growth Investing: Review and Update.” Financial Analyst Journal, 71-86.
Fama, E.F., and R.F. Kenneth. (1995). “Size and Book-to-Market Factors in Earnings and Returns.” The Journal of Finance, Vol. L, No. 1, 131-155.
Graham, B. (1949). The Intelligent Investor. New York, NY: HarperCollins Publishers, Inc.
Graham, B., and D.L. Dodd. (1934). Security Analysis. New York, NY: McGraw-Hill Book Company, Inc.
Lakonishok, J., A. Shleifer, and R.W. Vishny. (1994). “Contrarian Investment, Extrapolation, and Risk.” The Journal of Finance, Vol. XLIX, No. 5, 1541-1578.
Piotroski, J.D., and E.C. So. (2012). “Identifying expectation errors in value/glamour strategies : a fundamental analysis approach.” Review of Financial Studies, Vol. 25, 2841-2875.
Skinner, D.J., and R.G. Sloan. (2002). “Earnings Surprises, Growth Expectations, and Stock Returns or Don’t Let an Earnings Torpedo Sink Your Portfolio.” Review of Accounting Studies, 7, 289-312.
