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Five reasons why value investing may never regain its appeal

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Five reasons why value investing may never regain its appeal

In the Globe and Mail last month

https://www.theglobeandmail.com/investi ... -approach/
There has been a lot of talk about the death of value investing.

The strategy, embraced by Benjamin Graham and Warren Buffett and many followers, has beaten the market over decades going back to the 1930s, but it's hard to ignore how badly it has fallen behind in this recent 10-year period, eclipsed by the high-growth technology sector.

Still, value investors persist. They undoubtedly find support from like-minded investors. It’s human nature to have a set of core beliefs, flock to others who also believe them and to embrace information that supports those beliefs.

For investors, though, there's a danger of succumbing to confirmation bias. It's important to be able to step back and judge an investment strategy objectively, and see the other side of the argument. Here are five arguments why the value strategy might not work as well in the future as it has in the past.
I found points 4 and 5 to be rather interesting. Basically, the author is saying that the strategy is becoming a victim of its own success - the more investors who follow the strategy and the better they follow it, the less effective it becomes.
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CheapScotch wrote:
Sep 8th, 2019 12:14 pm
In the Globe and Mail last month

https://www.theglobeandmail.com/investi ... -approach/



I found points 4 and 5 to be rather interesting. Basically, the author is saying that the strategy is becoming a victim of its own success - the more investors who follow the strategy and the better they follow it, the less effective it becomes.
The article is behind a paywall so I couldn't read the reasons - would you mind copy / pasting them?

Just when investors en masse feel something will no longer work and start to abandon it is exactly when it starts to work.
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Repost of the same article from the Graham trading thread. Reposting my answer, tailored to investing:

I disagree with that author. Value investing works and will always work because its approach is the rational perspective of taking a long-term view. This is critically important, because it is all too common that undervalued common stock investments do not tend to perform well over the short run.

Common sense dictates that stocks only tend to become undervalued when they are simultaneously unpopular, at least temporarily. It is generally this unpopularity that creates the short-term discrepancy between fundamental value and stock price. However, the greatest success derived from value investing happens when the company's stock price is dropping even when the fundamentals of the company continue to remain strong. Therefore, the key to implementing a profitable value investing transaction is to learn to focus on and trust the fundamentals supporting the business. In the same context, this further means adopting the conviction to not trust, and even the willingness to ignore poor short-term price action. Accomplished value investors understand that stock prices can lie, at least over the short run. But more importantly, accomplished value investors also understand that in the long run, fundamentals matter most. I will elaborate how a value model uses that approach mathematically speaking later below. But first, a few clarifications regarding value.

Price is what you pay, value is what you get. This is true for any financial asset. Would you pay $10.5 for a $10 bill? No, because you know how much $10 is worth. A $10 bill is a financial asset, just like commercial paper, debentures, preferred stock, common stocks, etc. We never want to pay more than we think the asset we’re buying is worth. On the case of stocks, fair valuation (to match the intrinsic value of the business) allows us to pigback on the operating performance of the business. Buy it fairly valued, and that stock price will follow the business operating results. Buy it undervalued, and that stock price will do BETTER than the business operating results. Buy it overvalued, and that stock price will do WORSE Than the business operating results. So it’s all about employing the proper methods to calculate fair valuation. A $10 bill is easy to value. It’s a lot harder to value a share of common stock. But by no means it has stopped working.

Value investors need a sensible way to put valuations on stocks, and P/E (or P/S or B/B etc.) is not it. Saying a low P/E is inherently better than a high P/E makes as much sense as saying a run-down 1-bedroom house in a bad neighborhood listed for $75,000 is better than a beautiful well-built 4-bedroom house in a great neighborhood listed for $1.05 million. Indeed, when we think of all the factors that are important to home buyers, the $1.05 million house might turn out to be a bargain while the $75,000 listing turns out to be overpriced. That’s where value trap comes in. Many stocks are trading at a lower multiples because they deserve to do so. Accomplished value investors understand that long-term investment results are functionally related to the success of the business behind the stock. Therefore, they focus more on fundamentals such as earnings, cash flows and dividends (if the company pays one). As long as fundamentals are strong, they are confident that this strength will eventually be reflected in higher future stock values.

For me to consider a company a value trap, I have to believe that there is a permanent long-term deterioration in the future fundamental strength and health of the company. To me, a company becomes a value trap when either it's on the verge of going out of business, or poised for a long protracted period of collapsing or even disappearing earnings, cash flows, and inevitably dividend cuts or elimination. The best value opportunity manifests when earnings, cash flows and dividends continue to grow or improve in spite of current price weakness. It is for these reasons that I believe in focusing on fundamentals first and foremost, with the primary objective of evaluating a company's intrinsic value. Once this is accomplished, and only when it is accomplished, will I even consider bringing price into the analysis. When I am confident that the current stock price is lower than my assessment of intrinsic value, I see opportunity, not a trap.

Therefore, Investing based solely on the value factor makes no more sense than investing buying a home based solely on the price (and without looking at any characteristics of the home). Consequently, we cannot and should not say value investing doesn’t work. Instead, we have to say that Mr. Market has gone upscale, that he has favored company attributes normally associated with higher prices (i.e. higher valuation ratios), analogous to what might be the case if a greater number of homebuyers were to prefer well-located McMansions in lieu of handyman specials in blighted neighborhoods.

A big misconception is value factor mixed with value investing. Value factor is one of the components that this model uses, and one of the components considered for value investing. Examples include Price/Earnings, Price/Sales, Enterprise Value/Sales, Price/Free Cash Flow, Price/Book, etc., etc., etc. Lower is better. (Those who prefer higher-is-better sorting protocols can just turn the fractions upside down, so its Earning/Price, etc.). Personally, I prefer a multiple-criteria approach, to diversify against the risk that one or more individual ratios might be distorted by unusual items. However, one wants to articulate it, the idea is to compare some measure of the company’s market value with some measure of the fundamental wealth it generates.

Value investing is different. Many believe that value investing is the same thing as using the value factor to choose stocks with better (cheaper) valuation ratios. It’s the foundational assumption behind much literature and it’s the guiding principle behind the plethora of value-oriented ETFs out there. It’s also the presumed basis upon which commentators describing how bad value has been lately rely.

But it’s not so.

For convenience, let’s stick with P/E. We can then say a value investor looks to buy stocks whose P/Es are lower than they should be, and avoid those whose P/Es are higher than they ought to be. It sounds easy. But it’s not. It requires us to be able to state what a particular stocks’ P/E should be.

Here’s the formula for calculating a "correct" P/E:

P/E = 1/(R – G), where
R is the required rate of return for the stock, and
G is the expected future rate of earnings growth.
R is a combination of the required return on risk-free investments, the extra return investors should expect by choosing the inherently risky equities asset class, one more adjustment for the risk characteristics unique to the specific company in question.

As a matter of practice, we can assume companies that are high in terms of fundamental quality (margins, turnover, financial strength and return on capital) offer lower levels of company-specific risk (in quant terms, these are the factors that influence what Beta is likely to be in the future).

The math works out such that P/E rises along with increases in Growth and/or improvements in Quality.
This means that Value Investing isn’t simply a matter of picking favorable Value Factor scores. It is a matter of favorable Value combined with favorable Growth and/or Quality. Looking at one factor without the other is contrary to financial logic.

That's why the value investing approach uses several rules towards not only value, but also quality and estimated growth. If you think as an investor, a stock is only fairly valued if the business is estimated to grow and it's trading at typical multiples below they usually trade for such operating growth. It's the famous lower price with rising earnings / cash flow. So we don’t look at P/E alone. We don't look at historical data only. We take into account the estimated growth of the business to project the growth of that stock to determine if there’s value (and if it’s a value trap or opportunity).

So why value factor has not worked lately as it used to? When we say Value is working, we’re really saying low P/E stocks are outperforming and/or that high P/E stocks are underperforming. Low P/E will work (i.e. will lead to successful Value investing) when many low-P/E stocks incorrectly assess Quality and/or Growth when the market comes to realize that Growth and/or Quality are better than previously assumed. The Value factor works when Mr. Market is too pessimistic. Also, high P/E will falter (i.e. lead to unsuccessful value investing) when investors come to realize that the Growth and/or Quality considerations that motivated high P/Es were too optimistic and that expectations need to come down, so the Value Factor also works when Mr. Market is too optimistic. Putting all this together the Value factor works when Mr. Market’s assessment of the company turns out wrong and needs to be adjusted. Conversely, the Value factor, standing on its own, will fail as an investment criterion when expectations are accurate, when companies assumed by Mr. Market to be bad really are bad and when companies assumed by Mr. Market to be great really are great. And this, by the way, is why Value (the Value factor) has performed poorly of late (and why the situation may be starting to change).

There are 2 components to be observed: First, the market has stayed overvalued more often than before. That doesn’t mean value doesn’t work. But we all know what happens when overvaluation "corrects". The second component is that traditional valuation (via P/E) continues to work for the industries that it applies, but that’s not what makes the market anymore. The market is a basket of companies sorted by market cap. A big chunk of that sector is technology. Tech companies are evaluated in a complete different way, where top line is way more significant than bottom line. Therefore, tech companies always look expensive from a P/E perspective, but that’s the wrong metric to evaluate them. If you evaluate them by top line numbers, valuation concept applies, and value investing continues to work with those as well.

These companies don’t care if you bought them or not. Their fundamentals doesn’t change because you bought them or didn’t buy them. Operating results drive their price. So the arguments of the author regarding efficiency plays no role to each individual business, and the fact that a collection of businesses make a portfolio. The market is nothing but efficient, so suggesting that it’s getting more efficient is flawed because the market will continue to react emotionally to news and to have wild daily gyrations despite the fact that businesses report operating results 4 times a year only.

Momentum and Quality are both associated with higher P/E. This stems from the basic P/E formulation. As Quality rises, that reduces the R (Required Return) — given that R is a positive number in the denominator of the 1/(R-G) fraction, as it declines, P/E is pushed upward. Momentum is a proxy for the G (Growth) factor — given that G is a negative number in the denominator, as G rises, so, too, does P/E. The struggles we saw with the Value (price-tag only) factor don’t indicate that value investing was cold. It tells us instead, that the market chose to buy upscale in 2018; i.e. it paid what it perceived to have been fair prices for merchandise (stocks) that were, simply put, better (like a mansion compared to a dump). What’s interesting is how Mr. Market defined “better.” In 2017 and 2018, company quality was deemed important (something that wasn’t so in 1999 and as we see through the intervening years, can’t always be taken for granted). But the way the G factor was handled changed. In 2017, it was all about the classic Growth factor, reflecting a willingness to extrapolate from historical performance. That changed in 2018: Growth receded (i.e., investors became less willing to project past performance forward) and subjective judgment about the future became more important. Judgment is encompassed through Sentiment (the wisdom of professional analysts) and Momentum (the wisdom of the crowd). The latter is what dominated.

Value investing continues to work, specially for the investor building a company at the time, and for the trader that look for lower valuation that deserves higher multiples. The fact that the market has included companies that typically operate with higher multiples simply indicates that the basket of companies is different than before. But it says nothing about choosing a business at a time based on quality and valuation.


Rod
Last edited by rodbarc on Sep 26th, 2019 1:30 pm, edited 1 time in total.
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treva84 wrote:
Sep 8th, 2019 12:56 pm
The article is behind a paywall so I couldn't read the reasons - would you mind copy / pasting them?

Just when investors en masse feel something will no longer work and start to abandon it is exactly when it starts to work.
1. VALUE IS A BET AGAINST TECHNOLOGY
Unconstrained value strategies tend to gravitate to certain sectors over others. This can vary, but most strategies tend to underweight technology stocks. A sector-neutral approach could reduce some of this risk, but for unconstrained value models, this is a drag on performance.

Over the past decade, underplaying tech stocks has been costly. Value strategies have emphasized sectors that have done relatively poorly, such as financials. Technology stocks, meanwhile, have led the market and continue to do so.

Of course, this can work both ways. Value investors in 2000 were probably happy they were underweight technology stocks when the dust settled on the dot-com bust. But if a new normal has been created and more people believe tech stocks will drive the market going forward, that's a bad sign for value.

2. BIG DATA ARE LEADING TO MORE VALUE TRAPS
The more data that are available and the faster they can be processed, the more efficient the market should become. That could mean that more cheap stocks are cheap for a reason. It could also mean that using historical fundamental information to predict the future will be harder.

Let’s say a value investor picks Walmart Inc. shares because they trade at a discount to the market based on several traditional fundamental measures. But other investors have different data that could explain why Walmart shares are cheap and destined to remain that way. They might have access to satellite images of Walmart parking lots demonstrating low customer flow. Or they might have credit-card data that show sales are declining.

For the traditional value investor, information gaps could be masking value trap

3. THE WORLD IS DIFFERENT
It's not just access to additional data that has challenged the traditional concept of value investing. There is a different approach to risk taking.

The U.S. Federal Reserve and other central banks changed the rules a decade ago through a massive quantitative easing, including large-scale asset purchases and risk-taking without consideration for fundamentals.

In that type of world, things such as value and quality may not matter. At the very least, they may matter less and endure longer periods when they don’t work.

4. TOO MANY PEOPLE ARE DOING IT
Despite the strategy’s underperformance, there have been a proliferation of factor-based funds that use value measurements, and there are large investment firms such as Dimensional Fund Advisors that have put a lot of capital to work in value strategies. Perhaps these investors believe the markets will revert to the mean, as they have in the past.

But in investing, whenever there's a stampede into a strategy, the less effective the strategy becomes. It has the potential to degrade or eliminate the value premium.

5. THE CAPITAL FOLLOWING IT IS BECOMING MORE PERMANENT
A greater understanding of the role of behaviour in financial decisions is helping investors to develop stronger wills when it comes to their strategies.

It is counterintuitive in some ways to think like this, but followers of value strategies want other value investors to panic and sell during periods of underperformance. That bad behaviour is in part what makes the strategy work. Permanent followers of the strategy who won’t panic no matter how long it underperforms can reduce its effectiveness over time.

In presenting these five arguments, I’m not suggesting the value strategy will never work again. The case against value investing has just as many valid counterarguments. But it’s easy to get caught up in a feedback loop that only supports your case. Instead, consider the other side of your thesis and the arguments against yours. This process will make you a better investor over the long run.


Items 4 and 5 are flawed as the market is not efficient. Price does NOT equate to value. Details on my reply above.


Rod
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treva84 wrote:
Sep 8th, 2019 12:56 pm
The article is behind a paywall so I couldn't read the reasons
FYI, you can address this by browsing in private mode. Reposting entire articles is contrary to RFD forum rules.
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rodbarc wrote:
Sep 8th, 2019 1:04 pm
Items 4 and 5 are flawed as the market is not efficient. Price does NOT equate to value. Details on my reply above.
The author might agree with you to some extent, in light of the fact he runs an actively managed ETF. However, to his credit, he understands the danger of confirmation bias, and is willing to "see the other side of the argument". For example, summarily dismissing the Efficient-market hypothesis is not something a prudent investor should do, given the considerable academic support that exists for it.
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CheapScotch wrote:
Sep 8th, 2019 5:40 pm
The author might agree with you to some extent, in light of the fact he runs an actively managed ETF. However, to his credit, he understands the danger of confirmation bias, and is willing to "see the other side of the argument". For example, summarily dismissing the Efficient-market hypothesis is not something a prudent investor should do, given the considerable academic support that exists for it.
And that's where the disagreement lies. Academics are not investors. Real world investing done by well documented methods from Buffett, Munger, Klarman, Ackman, Greenblatt, all point to value investing and they all debunk the efficient market hypothesis because price doesn't equate to value. Read any of their book or letter or interview on the topic.

I explain extensively above why. Price will continue to follow earnings and cash flow. Real world investors don't ignore valuation. A prudent investor shouldn't either.

There are ALWAYS going to be market inefficiencies. The Efficient Market Hypothesis, which is what you're worried about, disregards all the investors who are making short-term and long-term trades for reasons that have little to do with company performance. Thousands of traders are buying and selling based on minute movements in prices. Some investors are wildly overreacting to market news while others have decided to keep buying stock in a company no matter what happens. In other words, there’s nothing efficient about the market. To keep one step ahead, to find the inefficiencies and take advantage of them, takes some work. But it's worth it.



Rod
Last edited by rodbarc on Sep 8th, 2019 7:09 pm, edited 1 time in total.
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rodbarc wrote:
Sep 8th, 2019 6:50 pm
And that's where the disagreement lies. Academics are not investors. Real world investing done by well documented methods from Buffett, Munger, Klarman, Ackman, Greenblatt, all point to value investing and they all debunk the efficient market hypothesis because price doesn't equate to value.
And in addition to academics, there are investors who agree with EMT in one form or another, so ignoring their point of view only demonstrates confirmation bias.

But getting back on topic, I thought it was interesting what the author said about successful value investors exploiting the weakness of unsuccessful value investors. If true, it occurs to me, in a more general sense, that it is not in the best interest of investors who are successful to teach other why they are successful.
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CheapScotch wrote:
Sep 8th, 2019 7:09 pm
And in addition to academics, there are investors who agree with EMT in one form or another, so ignoring their point of view only demonstrates confirmation bias.

But getting back on topic, I thought it was interesting what the author said about successful value investors exploiting the weakness of unsuccessful value investors. If true, it occurs to me, in a more general sense, that it is not in the best interest of investors who are successful to teach other why they are successful.
Valuation will be there regardless if you bought the stock or not. The companies don't care. What makes a successful investor is temperament and consistency. Apply that overtime, with a focus on quality and valuation, and you're set for superior returns. Like Buffett says, it's simple but difficult, because temperament and consistency are soft-skills that takes time to build up.

Lots of successful investors teaching everyone willing to listen. Buffett, Munger, Greenblatt, ONeil are just some of those names.


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rodbarc wrote:
Sep 8th, 2019 6:50 pm
Academics are not investors. Real world investing done by well documented methods from Buffett, Munger, Klarman, Ackman, Greenblatt, all point to value investing and they all debunk the efficient market hypothesis because price doesn't equate to value. Read any of their book or letter or interview on the topic.

I explain extensively above why. Price will continue to follow earnings and cash flow. Real world investors don't ignore valuation. A prudent investor shouldn't either.

There are ALWAYS going to be market inefficiencies. The Efficient Market Hypothesis, which is what you're worried about, disregards all the investors who are making short-term and long-term trades for reasons that have little to do with company performance. Thousands of traders are buying and selling based on minute movements in prices. Some investors are wildly overreacting to market news while others have decided to keep buying stock in a company no matter what happens. In other words, there’s nothing efficient about the market. To keep one step ahead, to find the inefficiencies and take advantage of them, takes some work. But it's worth it.



Rod
I agree!

"In theory there is no difference between theory and practice. In practice there is."

Also, @CheapScotch for what it's worth, when I buy individual stocks I take a value approach (basically what Rod has previously described, multiple times). My TTM percent performance for my stock picking account is more than 2X my broad based index accounts, in which I dollar cost average (either monthly or quarterly, depending on the account). For me, value investing continues to have a very strong appeal.
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treva84 wrote:
Sep 8th, 2019 7:37 pm
"In theory there is no difference between theory and practice. In practice there is."
Who are you quoting?
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rodbarc wrote:
Sep 8th, 2019 6:50 pm
there’s nothing efficient about the market. To keep one step ahead, to find the inefficiencies and take advantage of them,
Maybe you are the one who is investing inefficiently, and more enlightened investors are taking advantage of you? Are you the predator, or the prey? Smiling Face With Open Mouth

But again, getting back to the article I posted, what the author seems to be saying is that value investing (and perhaps other forms of investing?), if they genuinely are effective now, will be less effective in the future and more and more investors out there become more, um, efficient at implementing them.
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treva84 wrote:
Sep 8th, 2019 7:49 pm
Yogi Berra
Who, as we all know, was smarter than the average bear.
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CheapScotch wrote:
Sep 8th, 2019 8:00 pm
Maybe you are the one who is investing inefficiently, and more enlightened investors are taking advantage of you? Are you the predator, or the prey? Smiling Face With Open Mouth

But again, getting back to the article I posted, what the author seems to be saying is that value investing (and perhaps other forms of investing?), if they genuinely are effective now, will be less effective in the future and more and more investors out there become more, um, efficient at implementing them.
This point assumes investors are rational actors when they recognize and arbitrage out the inefficiencies. This is not always the case.

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