Speed Read:
♦ Value investors regularly challenge conventional wisdom but short of questioning their own. In particular the value investing approach. The value investing approach is attractive because it works, and not because it is advocated by certain famous investors.
♦ Our maiden post looks at a 1994 study by LSV which examines the performance of value stocks against glamour stocks. Their result showed that value stocks consistently outperform glamour stocks over the period 1963 to 1990.
♦ Numerous literature have suggested that the outperformance is due to value stocks being fundamentally riskier. LSV have found no conclusive evidence that value stocks are riskier. Instead, the study has shown that value stocks exhibit extremely high reward-to-risk ratio.
♦ Beyond the results, LSV’s study provided lessons as to why “value investing is simple but not easy”. For the astute value investors, these lessons should be be seen as windows of opportunity.
Its fair to say that most of us come to know the Value Investing concept through certain successful value investors. Myself included. We began with an initial understanding that value investing approach entails purchasing companies at a price below their intrinsic value. This sounds readily intuitive – who doesn’t want to buy something on a bargain? Yet, only a handful of us questions the validity of this approach. After-all, how many value investors are truly successful than they are famous?
As value investors, we are required to constantly challenge the conventional wisdom. First and foremost, however, is always to question our own.
In our maiden post, we’ll examine the value investing approach through a 1994 study, “Contrarian Investment, Extrapolation, and Risk” by Josef Lakonishok, Andrei Shleifer and Robert W. Vishny (LSV). For seasoned value investors and budding investors alike, this review serves as an anchor to the bumpy, but ultimately rewarding road of value investing.
Value vs. Glamour
In this study, LSV attempt to provide insights into two key questions surrounding the value investing strategy. First, why value strategy works, and second, is value strategy fundamentally riskier?
Using accounting data from April 1963 to April 1990, LSV formed 10 portfolios (at the end of each April) from the NYSE and AMEX stock universe. These 10 portfolios are then rank based on the following 4 fundamental variables and classified accordingly as Value or Glamour portfolios. Value is defined as stocks with low price multiples / low sales growth, and Glamour as stocks with high price multiples / high sales growth.
- B/M = Book to Market ratio. This is simply the inverse of P/B ratio
- C/P = Cash flow to Market Price ratio. This is the inverse of P/CFO ratio
- E/P = TTM Earnings to Market Price ratio. This is the inverse of P/E ratio
- GS = Past 5-years average Sales growth rate
The stocks in each portfolio are equal weighted (i.e. same amount invested in each stock), with a buy-and-hold period of 1 to 5 years.
Hands down, Value beats Glamour …
Value portfolio outperformed Glamour portfolio in every fundamental variable. Outperformance persisted even after adjusting for size effect (this is to account for the fact that smaller firms generally have higher business risk than bigger and more established firms).
On a 5-year compounded basis, the outperformance is pretty significant:
- B/M : Value = 146% vs. Glamour = 56%
- C/P : Value = 149% vs. Glamour = 54%
- E/P : Value = 139% vs. Glamour = 72%
- GS : Value = 143% vs. Glamour = 82%
Table 1
Table 2
… at No Significantly Higher Risk
In measuring risk, LSV made the assumption that value stocks are fundamentally riskier if they underperform glamour stocks in some states (e.g. economic boom, recession, down markets, up markets) of the world. Those states should also be “bad” states, in which the marginal utility of wealth is the highest (what this means is that in a recession, a dollar gain is “worth” more than a dollar gain in an economic boom), in which values stocks are unattractive to risk averse investors.
To put this in layman’s term, value stocks if riskier, should underperform glamour stocks in a time where investors are most risk averse.
The below table shows returns of Value portfolios minus Glamour portfolios from 1968 to 1989 (22 years). Each panel represents usage of different fundamental variables, similar to the above process. Negative numbers indicate the year where value underperform glamour (Red boxes). The Blue box categorizes the holding periods.
Table 3
A couple of key observations here. First, the occurrence of value underperforming glamour is quite low. Of the 22 years sample period, value underperformed glamour only on 5 occasions. Second, value is a clear winner as the time horizon increases. There were zero underpeformance for a 5-year holding period.
Could these periods of underperformance coincides with “bad” states?
As it turns out, value outperformed glamour in all identified “bad” states.
The below table shows the yearly Value minus Glamour returns during the 22 years period. The Red box indicates the “bad” states. R = Recession and D = Market declines.
Chart 1
Moving on to conventional risk measurements, the study found that value exhibited higher standard deviations than glamour. The difference however, is largely due to size effect and the standard deviations were greatly reduced after adjusting for size. To isolate large cap stocks, LSV went on to perform the same test on the largest 50% of the stock universe and found that investors could still get the extra return from value stocks without this higher standard deviation.
Table 4
Consider also this: over the period 1929 to 1988, the S&P 500’s extra return over the Treasury bills is 8% while the extra standard deviation is 18%. In comparison, value stocks outperformed glamour stocks by 10%, with extra standard deviation of only 3%, the reward to risk ratio is extremely high investing in value stocks.
What can we Learn from this Study?
Using Warren Buffett’s words, “Investing is simple but not easy“. Beyond proving that value strategy works, LSV has demonstrated with a simple method why only a handful of value investors truly beat the market.
What can we learn?
- Doing nothing is difficult. If you recall, LSV employed a quantitative method that mathematically re-balances the portfolios annually. It requires no analysis of annual reports or financial statements and certainly no DCF. Often, we fell prey to the notion that effort equals result. This is largely true in life. In value investing however, less is often more.
- Patience is virtue. In Table 3, we observe that as the holding period increases from 1-year to 5-year, value strategy greatly increases its winning rate. This apparently simple strategy is not easy – those who have been in the market would agree that 1 year isn’t that short a time. Let alone 5 years. To make things worse, a period of underperforming the market would likely shaken the will of the investors. Causing them to sell or buy stocks at a time where they should be doing otherwise. In chart 1, the periods where value underperformed glamour coincides with a rising stock market. Investors who jumped the value-ship would have missed out on the subsequent outperformance.
- Growth (often) disappoints. Growth disappoints in both glamour and value stocks. As LSV so eloquently put it, “Investor expectations of future growth appear to have been excessively tied to past growth despite the fact that future growth rates are highly mean reverting. In particular, investor expect glamour firms to continue to grow faster than value firms, but they were systematically disappointed.” We have a very good article on growth which we’ll share in future post.
For the astute readers, you must be in silent rapture at this pessimism. So are we. For value strategy to work, the above must continue to hold true.
Do we expect this to change? We quote our answer from Reinhart and Rogoff (authors of “This Time is Different, Eight centuries of Financial Folly”), “… financial crisis follow a rhythm of boom and bus through the ages. Countries, institutions, and financial instruments may change across time, but human nature does not“.
Opportunities are in abundance for the intelligent investor.
hsquare capital 