Monday, January 3, 2011

The Value Bias

I am perpetually mystified by the pervasive insistence by investment professionals that 'value' dominates 'momentum'. This debate really comes down to the age-old question of whether any one person (or team of analysts) can consistently identify 'cheap' companies which the market, in its collective wisdom, has neglected. More broadly, this debate is about whether any one expert, or team of experts, can consistently forecast the future better than 'the crowd' can through its collective actions. This is a key plank of adherents to Behavioural Economcs; lots more on this subject here, here and here.

Value investors rely on [their own perceived] keen powers of observation and analysis, or a unique understanding of the industry or company of interest, to identify inexpensive companies which the market will eventually reward by raising their prices to some perceived 'fair value'. These investors would then [in theory] sell the company at their calculated 'fair value' and move on to invest in other [theoretically] 'cheap' companies.

Momentum investors, on the other hand, implicitly believe that markets are smarter than they are. They are on the lookout for companies in which the market has already demonstrated an interest by raising the price of their stocks. They reason that, if the 'market' likes the stock, then so should they. Who are they to argue with the collective wisdom of thousands of investors who are actively committing their hard-earned capital to these very stocks?

This article aims to make three important points:
  1. Active investing works: I present 2 different screens which add significant value over time relative to buy and hold.
  2. Investors are biased to systematically overemphasize the importance of a 'value' approach while under-emphasizing the power price momentum.
  3. Outstanding investment results have been achieved by combining two very different, but independently effective approaches.
Value investors apply the traditional stock market wisdom of 'Buy low, sell high'. Or at least that is their ambition. Far more often, their experience is 'Buy low, and then wait a very, very long time for the company to prove its merit.' The very best value investors, like Warren Buffet or Peter Lynch, have the patience to wait for companies to become very cheap before purchasing them, and then they have the patience to wait many years for the market to recognize the value of the companies they purchased. Warren Buffet, for example, held treasury bonds in his personal account from the early 1990s through to later 2008 while markets were in a euphoric state of overvaluation. How else would he have personal funds available to purchase large quantities of stocks in late 2008 during the market meltdown? Of course Berkshire Hathaway, his corporate investment vehicle, is first-and-foremost an insurance company, and therefore must be invested at all times, but also has a very long investment horizon given the duration of its liabilities.

The vast majority of investors (you and I included), are not able to wait for markets to become cheap before investing. Most people have a limited investment horizon, bounded by spending or retirement objectives, and can't sit in cash for 15 years waiting for markets to become cheap enough to purchase. Further, most people do not have enough patience to wait the many years it often takes to realize the 'value' in their 'value stocks'.

Momentum investors embrace the wisdom of 'Buy high, sell higher'. They buy stocks which are already in a positive trend, and expect the trend to continue. There is very strong evidence suggesting that this approach is highly effective, even using very simple measures of momentum, such as performance over the prior 12-month period, or the number of new 52-week highs experienced over the past 52 weeks. Further, this approach works for every asset class, including commodities which are impossible to value according to traditional 'value' measures.

I was reminded of this value bias when I read a recent article by the Applied Finance Group. Let me stipulate that I am a big fan of this group, which applies a unique quantitative strategy for finding attractive stocks. We are beginning to include their stock screens in our weekly scans, in which we identify stocks that appear in lists by many of the world's greatest screens, such as IBD, HighGrowthStockInvestor, FusionIQRank, CPMS, and others.

The article was primarily concerned with how momentum factors can add to the performance of a traditional value screen. We enthusiastically concur with this assertion, and apply it in our own portfolios. However, the first paragraph of the article states, 'Typically, long-term valuation is the main driver of stock performance, as shares of companies that are trading at a discount to their intrinsic values tend to go up over time [sic.]. If we were to attempt to quantify this, it appears that aggregate stock movement can be explained by long-term valuation adjustements roughly 75% of the time. The remaining 25% are best identified as momentum markets, which simply implies that a short-term event has created an environment that makes investors less concerned with long-term value and more focused on short-term issues [sic.]."

Then in the second paragraph the article makes an outrageous claim: 
"Due to its significant overall outperformance, we believe utilizing a trust-worthy valuation metric is of utmost importance in stock screening."
 What makes this claim outrageous is that the article then goes on to present two tables, which I have attached below for discussion:

Source: The Applied Finance Group

Source: The Applied Finance Group

Please attend to the numbers in the top red boxes in both tables. Table 1. shows the relative performance of stocks which screen in the top half (TH) of AFG's valuation metrics (i.e. cheap stocks) versus stocks which screen in the bottom half (BH). Note that high ranking value stocks (TH) outperform low ranking stocks (BH) by 7.9% per year from 2001 through 2009, using AFG's proprietary ranking methodology. Note also that this screen did a pretty good job on a 'per trade' basis: in terms of 'Batting Average", 67% of TH stocks outperformed, and 68% of their BH stocks underperformed in each selection period. This is pretty good stuff!

Now look at the top red box in Table 2., which shows the relative performance of stocks which screen in the top half (TH) of all stocks according to a simple momentum screen versus stocks that screen in the bottom half. You can see that high ranking momentum stocks (TH) outperformed low ranking stocks by 11.1% per year from 2001 through 2009.  The batting average is also fantastic, with 80% of top ranked stocks outperforming and 79% of low ranked stocks underperforming in each selection period.

What gives? The authors assert that, "...long-term valuation is the main driver of stock performance". However we can plainly see that, with 18 years of data on almost 7000 global stocks, momentum substantially dominates value as a selection criteria, with 11% returns versus 8% respectively.

This is not uncommon. The dominant investment theories of our time are Modern Portfolio Theory and the Capital Asset Pricing Model. These models rely on a value-based framework to identify securities for investment, and to allocate efficiently among those securities. Substantially all of the capital that is invested by major institutions worldwide is allocated by according to these theories. Unfortunately, these theories assume that momentum effects can not exist, despite hundreds of years of evidence to the contrary. Fortunately, this leaves those of us who follow momentum-based strategies with a dramatic advantage. We largely ignore the basic tenets of CAPM, while we use MPT for efficient capital allocation, but with greatly modified parameters.

I promised to show you how two independently effective, but very different, approaches to investing can combine to deliver outstanding investment results. Courtesy of The Applied Finance Group, Table 3 shows the performance of stocks that have met both criteria: TH of value screen AND TH of momentum screen. By buying the TH of this combination screen and selling short the BH, and investor would have realized 20% returns from 1991 through 2009.

Now that is really powerful stuff.

Source: The Applied Finance Group