Yes, There Are Good Stockpickers (VIC)
Evidence suggests the professional investors in my sample have significant stock-picking skills. Interestingly, these skilled investors share their profitable ideas with their competition. I test various private information exchange theories in the context of my data and determine that the investors in my sample share ideas to receive constructive feedback, gain access to a broader set of profitable ideas, and attract additional arbitragers to their asset market. The proprietary data I study are from a confidential website where a select group of fundamentals-based hedge fund managers privately share investment ideas. The investors I analyze are not easily defined: they exploit traditional tangible asset valuation discrepancies, such as buying high book-to-market stocks, but spend more time analyzing intrinsic value and special situation investments.
Can Investors Pick Stocks On VIC — Wesley R. Gray
Using a proprietary dataset of investment recommendations shared on the private website Valueinvestorsclub.com (VIC), I find robust evidence of significant stock-picking skill for a select group of small fundamentals-based hedge fund managers. Abnormal returns, calculated with a variety of methods, are economically large and statistically significant across various holding periods for long recommendations. For example, using a benchmark-portfolio BHAR (buy-and-hold abnormal return) calculation technique I find one-, two-, and three-year average abnormal returns of 9.52%, 19.03%, and 23.60%, respectively. The evidence for stock-picking skill for short recommendations, while directionally correct, is mixed and inconclusive.
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To further test if the investors in my sample can identify profitable trades, I analyze the relationship between the average ratings VIC members assign to recommendations, which proxy for VIC members’ ex-ante expectation of future performance, and the recommendation’s ex-post abnormal returns. I find compelling evidence that the investors in my sample are able to decipher ex-ante which stocks will perform the best. This result holds for both long and short recommendations.
VIC is a new environment in which to test if there are professional managers with stockpicking skill; however, the unique context of VIC, which is a venue explicitly established so fund managers can share their private information, allows me to empirically address a fundamental question: Why does an organization such as VIC even exist? Stein (2008) questions why an arbitrageur would honestly tell another about an attractive trading opportunity when money managers are concerned with relative performance. In a market with efficient funds allocation, competing arbitrageurs should keep their valued information private so they can outperform their competition and thus attract more investor capital.
Three theories have emerged in response to Stein’s assertion. Stein proposes that fund managers may share private information because they gain valuable feedback from the person with whom they are sharing (“collaboration argument”). Gray (2009) proposes that another reason managers may share information is to promote their undervalued portfolio positions in order to get other arbitrageurs to bring additional arbitrage capital to a market overwhelmed by noise trader influence (“awareness argument”). Gray also argues that a resource-constrained arbitrageur will share profitable ideas with the competition because doing so allows the arbitrageur to diversify his portfolio among a group of arbitrage trades, as opposed to allocating all his capital into his limited set of good ideas (“diversification argument”). The empirical evidence cannot reject any of these theories and suggests that all three theories of information exchange play a role in fund managers’ decisions to share their private information.
Finally, with my data, I address a basic but important economic question: How do fundamentals-based, or “value” investors, make investment decisions? Value investors are presumably the agents driving asset prices to efficient levels. Studying the value investor’s thought process may help researchers better understand the price discovery process. To date, the common assumption in academic work is that value investors are those who focus on high book-to-market stocks (e.g., Piotroski 2000). And yet Martin and Puthenpurackal (2008) show that Warren Buffett, widely known as the greatest value investor of all time, is a “growth” investor according to the Fama and French size and book-to-market classification scheme.
My results addressing how value investors make decisions are specific to the sample of investors I analyze. With that caveat in mind, I find that the value investors in my sample overwhelmingly focus on measures of intrinsic value as opposed to book value. They examine valuation models based on discounted free cash flow, use various earnings multiple measures, and often search for growth-at-a-reasonable-price (GARP) investments. To a lesser extent, these investors favor the analysis of tangible asset undervaluation, open market repurchases, net operating losses, spin-offs, turnarounds, and activist involvement. In summary, the investors in my sample are focused on investigative analysis of business fundamentals, management signals, and complicated corporate situations.
The remainder of the paper is organized as follows. Section I discusses relevant research. Section II describes the data. Section III provides the main results on the characterization of value investor decisions in my sample. Section IV tests for stock-picking skill via abnormal return analysis. Section V examines the relation between ex-ante VIC idea ratings and ex-post abnormal returns. Section VI addresses why skilled fund managers may share profitable trading opportunities, and section VII concludes.
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