Despite overwhelming successes by value investors such as Warren Buffett and, Ivey MBA graduate, Prem Watsa (Chairman and CEO of Fairfax Financial Holdings), why haven’t we seen mainstream portfolio investors and advisors follow the value investing style when they offer investment advice? A reason for this may be that what value investors do is not well known or understood. This stems from universities accepting the notion that markets are efficient and, as a result, a mainstream focus on teaching and applying modern portfolio theory, which cannot be more different than value investing.
Value investing is a style of investing developed in the early 1930’s by Ben Graham at Columbia University and involves a three step process – even though most people believe the process is limited to only the first step. First, identify possibly undervalued stocks by choosing stocks with low price-to-earnings (P/E), price-to-book (P/B) or other valuation related metrics, second, value in depth the stocks that pass the screening process to estimate their intrinsic value and third, make an investment decision to buy only if the stock price is below the intrinsic value by a predetermined margin of safety – value investors are very careful of valuation risk, which is paying too much. Value investors are contrarian (bottom up) stock pickers with long term perspective.
DOES IT WORK
Does value investing work? Are Buffett and Watsa the exception rather than the rule? In answering this question, academic research focused primarily on the first step of screening as academics do not know what stocks value investors actually buy, but they do know that they tend to buy from the low P/E or P/B group of stocks. Such research showed that thus defined value investing works. Value stocks (low P/E or P/B) outperform growth stocks (high P/E, P/ B) in Global markets. They outperform when the markets go down and when they go up, and in good and bad times and when news is good and when it is bad. And they do all this without having higher risk, as measured by beta or standard deviation or adverse states of the world. This flies in the face of market efficiency which advocates that risk and return go together. An initial run of Indian stocks purely on P/Bratios brought up companies such as Coromandel Agro (0.0188 P/B), Zenith Infotech (0.0173 P/B) and Pantaloons Fashi(0.0055 P/B). These stocks are potentially undervalued and could further be taken through steps two and three, as explained above,to explore whether they pass all steps of the value investing process, making them worthwhile investments.
Other academic research, better focused on the process value investors follow, also showed that value investing works. Kacperczyk, Sialm and Zheng and Kaperczyk and Seru, in two papers published in the prestigious Journal of Finance, examined whether skilled managers exist. The researchers studied about 1,700 actively managed U.S. funds from 1984-99 and 1993-2002, respectively. They found that the more concentrated a fund was – in other words, the less diversified – the better it did. The outperformance resulted from selecting the right sectors or stocks, not from market timing. Additionally, the studies found that the lower the reliance on public information and the greater the reliance on portfolio manager’s own skill, the greater the outperformance. Value investing is all about concentrating a portfolio to a few selected truly undervalued stocks. Diversification does not play an important role in value investing; the margin of safety,which helps identify that the stock is infact truly undervalued,protects the downside and controls for risk in a way that is distinct from diversification. And as Keynes once said “once you attain competence, diversification is undesirable”. Buffett echoes this view. Moreover, as noted investor Sir John Templeton said, “It is impossible to produce a superior performance unless you do something different from the majority”. Being contrarian and doing something different from the majority is precisely what value investors do. Again, this goes against the teachings of modern portfolio theory, whose main tenets are that everyone holds a well-diversifiedportfolio and in this setting the only risk that matters is beta. Value investors do notbelieve thatbeta or standarddeviation or volatility, the cornerstones of modern portfoliotheory, are true measuresof risk. Risk for value investors is thepossibility of losingcapital – nothing to do with market volatility or standard deviation or beta. In fact,volatilityis good and desired by value investors.
Anchor ADDING VALUE
Finally, in a study I carried out, the first direct study of value investors, I examined whether value investors add value over and above a simple rule that dictates they invest only in stocks with low P/E and low P/B ratios. I found that value investors do add value, in the sense that their three-step process of selecting truly undervalued stocks produced significantly positive excess returns over and above the naive approach of simply selecting stocks with low P/E and low P/B ratios.
This brings us back to the original question: If the evidence in favour of value investing is so overwhelming, why isn’t everyone a value investor? Why does a value premium (i.e., that value, on average, beats growth investing) still exist? Shouldn’t it be eliminated? Not necessarily, because the driving forces behind the value premium are human psychology and institutional biases – forces again that fly in the face of market efficiency.
Human and institutional behaviour bias stock prices in such a way that give rise to the value premium. Individuals are subject to irrational behaviour. They extrapolate, they are overly optimistic, they overreact and most importantly they herd. They herd to protect their jobs. If the group loses and a portfolio manager is in the losing group, his job is protected as he lost as everyone else – but if he is wrong and others win while he loses, then his job and reputation are at stake. As John Keynes had indicated “It is better to fail conventionally than succeed unconventionally”.
At the same time, individuals working for institutions have their own agendas that may conflict with those of their clients or investors. They act on these agendas to benefit themselves, rather than those who hired them. They rebalance their portfolios throughout the year to earn their annual bonus, they window dress to spruce up their portfolio to look better than they are to their clients and herd to protect their jobs. While portfolio managers intrinsically work on regularly rebalancing their stock portfolios based on their own short term objectives, value investing requires a long term investment view.
Weaknesses of human nature and institutional biases are not going to go away – just as portfolio managers do poorly not due to lack of stock picking abilities, but rather due to institutional factors that encourage them to over-diversify to protect their jobs and assets under management, investors will also continue to believe the promises that growth (glamorous) stocks make, overbidding them, and giving rise to the value premium.
By George Athanassako
About George Athanassakos
George Athanassakos is a Professor of Finance and holds the Ben Graham Chair in Value Investing at Ivey Business School, Canada. Ivey is one of two schools globally with a rigorous and comprehensive academic Value Investing program with dedicated focus. Prem Watsa, recently in news for Fairfax backed Thomas Cook’s acquisition of Chennai based Sterling Holiday and Resorts and an ardent supporter of Ivey’s Ben Graham Center of Value Investing, regularly invites Dr. Athanassakos and a group of his Value Investing MBA and HBA students from Ivey Business School to attend Fairfax annual meeting of shareholders. After the annual meeting, students have an opportunity to meet Mr. Watsa and his team. Speaking on the Value Investing program at Ivey Business School, Watsa said “The value investing program that George established and teaches at the Ivey School of Business for the last 7 years is #1 in Canada and at par with Columbia’s program which has been in operation for over 70 years. It took us and Ivey some time to fill this position as we wanted to find the right professor with a value perspective, a professor like George, and boy did we luck out with George. He is a fabulous professor and has done an outstanding job teaching and developing value investing, which we are now thinking of expanding globally”. Dr Athanassakos also takes a group of his Value Investing students from Ivey annually to Berkshire Capital to meet with Warren Buffet in Omaha, Nebraska at Buffett’s invitation.