Executive Summary

  • This is the first of a multi-part series examining the use of valuation approaches to identify future outperforming asset classes.
  • I discuss why value investing is an essential and useful tool for asset class traders.
  • I briefly discuss the Warren Buffett approach as the purest form of discretionary value investing.
  • I clarify the distinction between fair value (a concept I’ve used to discuss short-term trading edges) and intrinsic value used by value investors.
  • I briefly review the vast academic literature on mechanically value-tilted portfolios. These portfolios are typically heavily weighted towards cheap and risky assets. These cheap securities are most often fairly priced to deliver long-term returns that are superior to a market cap weighted basket of similar securities.
  • Finally, I introduce Asset Class Value Investing as: identifying moments in time when an asset class appears to be irrationally mispriced based on an assessment of long-term intrinsic value.

Introduction

As asset class traders, we must understand the current thinking built into asset class prices. Prices are generally determined by the actions of a global set of large institutions, pension funds, endowments, sovereign wealth funds, banks, mutual fund managers and hedge fund managers considering future prospects and risks. Finding trading opportunities requires us to get into the heads of these large market players.

Many large firms specialize in one or a few asset classes, while other large institutions focus their attention at the asset class level. Most organizations are too big to actively buy and sell securities; they need to act on longer time frames.

The question of assessing an asset class’s relative value is particularly topical right now. U.S. growth stocks continue to outperform all other asset classes despite being “overvalued” for the past 5 or so years. Meanwhile, international and emerging market stocks continue to sink, despite trading at a fraction of U.S. equity multiples. Furthermore, across the global stock market, the value style has underperformed growth stocks for over a decade, despite strong evidence value stocks outperform over the long term. The current market seems a lot like the late 1990s all over again.

Many traders may logically decide to ignore value in their decision making. Short-term trading edges work independently of whether an asset class is overvalued or undervalued. A trader may also accept they have no edge is assessing intrinsic value, so they’re not going to use it. That’s decent self-assessment, but in practice it’s hard not to be influenced by the massive amount of market information bombarding us each day.

To do your best at asset class trading, paying attention to relative values is an important skill to have in the toolbox. Here are a few reasons why.

  • A mechanical value investing approach works in identifying future outperforming assets. The logic is very sound and there’s lots of academic evidence supporting the approach.
  • An assessment of value can determine how much upside there is in a price breakout. An undervalued asset will sustain a larger and longer price move. Such an assessment can dramatically enhance conviction and lead to large portfolio allocations when prices seem out of whack with intrinsic value.
  • The larger asset allocators rely almost exclusively on longer-term value judgements. Knowledge of their rationale for assessing value and risk is essential for understanding their motives and future asset allocation moves. Often, their allocation moves are well telegraphed and thus can be gamed and front-runned.
  • Developing skills in valuing asset classes can also help assess how much a price move was produced by investor overreaction versus an asset class that has efficiently repriced future risks. Value opportunities driven by investor behavioral effects provide much better rates of return than those indicated by mechanically value measures.
  • Sometimes it’s good for an asset class trader to mix up time frames to avoid the noise associated with a crowded time frame. If most traders and PMs are focused on the next three months, then that’s probably not a time frame to be searching for opportunities. Thinking on a long time scale can provide many benefits, such as enhancing creativity, avoiding whipsaws, achieving tax benefits and diversifying a portfolio over various time frames. The long-term phase space may provide ideas that would not have been seen if the focus was just on the short-to-intermediate time scale. For instance, moments in time when illiquid private investments are extremely attractive require a long-term view and a “buying right” mentality to achieve superior returns.

The Warren Buffett View of Value Investing

The very best value managers have a dharma-based affection for their investment approach. It just feels right in their souls to identify and hold a portfolio of the best values they can find. Warren Buffett is rightfully their sage and oracle.

Warren Buffett is arguably the best investor/wealth accumulator/asset class trader of all time. Buffett relies almost solely on value investing and takes a very long-term view. He likes to say his favorite holding period is forever.

Buffett’s approach is extremely patient and adaptable.1,2 Following Benjamin Graham’s teaching,3 he patiently waits for the market to present an opportunity to purchase assets below his assessment of long-term intrinsic value. Buying a dollar’s worth of assets at a 50-cent price provides a large margin of safety to weather unexpected negative events while waiting for value to be realized. When prices fall, just buy more because the margin of safety grows with a falling price and expected returns for each new purchase are higher.

Comparing prices with a sense of intrinsic value also allows Buffet to avoid overvalued and popular assets that are destined to underperform in the future. At times, Buffett gets it wrong and makes a bad investment. While he has great patience to wait out short-term stumbles, he will modify, trim and sell holdings when the story changes or the stock is no longer a good value.

To fully enhance this approach to managing investments, Buffett has arranged his personal affairs to be robust to any downturn and remain in business. He doesn’t want to be in a position where volatility can permanently destroy his wealth.

He’s always lived far below his means. He still lives in the same house in Omaha, Nebraska, that he purchased in 1958 for $31,500.4 He doesn’t use leverage, and the companies he purchases use leverage prudently. The more a person relies on their wealth to fund a lifestyle, or on leverage to enhance returns, the shorter the risk-aversion time frame. He’s rolled essentially his entire net worth into a single entity he controls – Berkshire Hathaway (Symbol: BRKA). This structure perfectly aligns his interests with his investors. He can’t be fired, or have money pulled from him at the wrong time. The more career risk a portfolio manager is exposed to, the shorter their risk-aversion time frame.

Structured this way, volatility creates opportunities to buy assets cheap. Contrast this with essentially all professional investment managers (including myself) who very appropriately use volatility as the risk measure – and thus something to be monitored, managed or minimized.

Finally, Buffett lets the cash pile up if there are no compelling investments. Most PMs can’t afford to do this because cash drag more often than not hurts performance versus a benchmark. Buffett is confident his skill in finding investments ultimately compensates for the opportunity cost associated with cash drag. On a side note, since excellent value opportunities tend to cluster around bear markets, each value investor must develop their own approach to portfolio design when there’s a lack of good value opportunities.

By establishing a fortress of stability, Buffett can invest with the ultra-long term in mind, which perhaps is an edge for him since most professionals don’t work on this time frame. Even most professional value managers in the mutual fund and hedge fund space are judged based on short-term performance and volatility-adjusted returns. Underperformance leads to outflows. For this reason, portfolio managers require a catalyst to be identified before making an investment. Buffett can make investments without any sort of catalyst on the horizon, although nowadays, any announcement of a new Buffett investment turns out to be its own catalyst.

What Is Intrinsic Value?

In past blog entries, I’ve been a little loose in my reference to terms such as fair value, equilibrium value and intrinsic value. It’s time to tighten up the definitions. First, the fair value of a security depends on the holding period. Portfolio managers and traders are always on the lookout for opportunities to achieve enhanced risk-adjusted returns over any time frame (seconds, days, weeks, months, years and even as long as a decade).

The fair value of a security FV(t) is the price that equates future risk-adjusted returns with all other fairly valued securities and combination of fairly valued securities over holding period t. Considering combinations of securities allow for applying this concept to asset classes and trading pairs as a means to enhance risk-adjusted returns.

The crux of the efficient markets argument is that the combined actions of market participants is to equate future risk-adjusted returns on all time frames. It doesn’t matter if the trading strategy holds individual stocks for an average of a couple days, buys the previous-month’s underperforming stocks and holds for a month or holds a pair trade for over a year.

It’s absolutely possible to have an asset priced above fair value on one time scale and trading below fair value on another time scale. For instance, on a weekly time frame, a security may be trading below FV due to forced selling by a levered hedge fund facing redemptions. On the other hand, the asset class associated with the security may be experiencing bubble-like phenomenon, such that the price is simultaneously way above fair value on a 5-10 year time scale.

The assessment of risk is very nuanced and varies over time and with time frame. For market makers, bid and ask prices must be weighed against potential losses due to sudden price shocks, multiday moves in one direction and asymmetric knowledge. For hedge funds, annual highwater markets can cause high sensitivity to risks associated with a 3-6 month time scale. For mutual fund managers operating on a 1-2 year time scale, volatility becomes the primary risk measure since risk-adjusted returns matter more to their clients than losses.

Following an excellent blog post at Philosophical Economics,5 intrinsic value (IV) is the price that equates risk-adjusted expected returns assuming we are holding all securities forever. In other words:

IV = FV (t → ∞)

This is consistent with Buffett’s view of intrinsic value.

My gut tells me it might be impossible for a price to be at fair value on all time scales. I don’t know how someone can prove or disprove this statement. Our job as asset class traders is to search for opportunities on any time frame. This post investigates using a value approach on a long time frame.

I highly recommend reading lots of books by expert value managers to get a sense for how they assess IV and the nuances involved. I can’t add any value to what’s been written on the subject. While some textbooks and CFA source materials establish intrinsic value as a simple calculation of the net present value of future expected cash flows, there is considerable leeway and art in choosing a discount rate that captures all the risks involved. I recommend anything by and about Buffett. Also see the References section at the end of the post for more books by respected value investors I like.6-13

Academic Evidence in Support of Value Investing

Academics have studied the value effect extensively.14-17 The most straightforward approach is to rank securities based on a price-to-value ratio among securities that are part of the same asset class, such as U.S. stocks. This is what I call mechanical value investing. It’s rules based, whereas value investing performed by a human relies on the manager’s creativity to discover bargains.

There’s plenty of academic evidence that systematically ranking stocks by various valuation measures (price to book, price to earnings, price to dividend, price to cash flows, etc.) leads to outperformance. Ken French’s website has many constructed indices going back about 100 years. Studies among other asset classes including bonds, commodities, currencies and foreign equities all show the value effect works there, too.14-17

There are unlimited ways to implement mechanical value, and each measure has its pros and cons. Just like with technical analysis, practitioners quibble over the superiority of one measure versus another. While I follow the space closely, I can’t possibly contribute anything new and original to the literature.

Mechanical value investing works over the long-term due to three factors. The first is simply that value stocks are fundamentally riskier, and thus should provide a return that is greater than the market. I like this view. A company that is fundamentally riskier (for example, a small oil drilling company) should have a higher cost of capital than a relatively safe company such as a massive consumer staples company or a regulated utility. This is also the efficient markets view.

Similarly, a stock with an extremely high dividend yield often signals that a company is distressed along with a high likelihood of a future dividend cut. In corporate bond space, two bonds with the same ratings agency grade can have very different yields. This is not a market inefficiency. The market is pricing the higher yielding bond to account for a greater risk of downgrade or default.

The second generally accepted reason is irrational investor behavior causing prices to overshoot to the downside in reaction to negative news and sour sentiment. The selling pressure causes prices to fall below IV in the sense of Mr. Market handing an opportunity to Mr. Buffett. Conveniently, when implementing mechanical value (via a value index fund, for example), the reason why a stock becomes a value doesn’t matter since the approach to capture the effect is the same.

To further confuse interpretations, ranking stocks by a valuation measure also segregates companies with high growth rates and low growth rates. For instance, ranking a bunch of utilities or energy MLPs based on dividend yield also reverse-ranks stocks based on reinvested capital and growth rates. This pricing effect is completely rational. The expected returns should be very similar (low yield plus higher growth in dividends = high yield and lower dividend growth rate).

Interestingly, even though these stocks face similar risks, the bird-in-the-hand approach associated with the high yielders seems to win out over time. This effect can be viewed as investors irrationally and systematically over-estimating growth rates. Not always, just on average over long periods of time. At the extreme end of this spectrum, investors typically pay too much for small rapidly growing companies. This lottery ticket effect is also seen in the preference to bet on long-shots and in the pricing of single stock call options.

Thus, mechanical value investing can work over time because:

  1. Value stocks are fundamentally riskier.
  2. Mechanical value will systematically buy when prices fall below IV due to irrational investor behavior.
  3. Growth stocks underperform over time since investors typically overestimate future growth rates.

As with all approaches to “beating the market,” if it becomes too popular, then we should worry that the effect will diminish over time. However, value investing has a lot going for it to mitigate this risk. Value investing has an immense capacity for managed assets before being arbitraged away. It’s typically low turnover, buys assets when prices are falling, sells assets when prices are rising, and works on a longer time scale than more active strategies such as momentum and trend-following. In fact, value investors often gladly share their ideas with other value investors.

Because there’s a good risk story associated with the value effect that’s consistent with an efficient markets view, we expect the value effect to never permanently go away. It may not work for 10 or more years, perhaps due to over use, or just out of the randomness of the markets. Investors are asking that question now as growth stocks have done so much better than value stocks since the 2008 financial crisis. However, I have great confidence that mechanical value investing will outperform the market over the next 100 years.

This is no different than other risk premiums being negative for a decade or longer. In 2011-2012, long U.S. treasuries bonds outperformed U.S. stocks over a 30-year period. Few market participants questioned whether stocks would outperform in the future. Small-cap stocks have also had long periods of underperformance, even though historically they’ve outperformed the market. A risk premium can’t work every year, or even every decade; otherwise, everyone would use it.

Asset Class Value Investing

Remember that an asset class is any grouping of individual securities that are expected to move roughly in unison with the infinite variety of information that moves prices. Individual company idiosyncratic risk is generally mitigated when investing in asset classes.

The message associated with value investing in the previous sections gives the sense that simply buying cheap asset classes leads to outperformance. That’s likely true and is consistent with the efficient markets view that returns and risk are related.

There are drawbacks to this approach with asset classes. Riskier securities typically lose more during recessions and depressions (think high-yield bonds vs. high-grade bonds, for example). The value effect may not work for years, which must be accounted for in expectations. Finally, mechanical value is much more difficult to implement when comparing one asset class to another since risk sensitivities can be vastly different.

I’m less interested in simply tilting a portfolio towards riskier assets to achieve higher returns. I’m much more interested in identifying mispriced asset classes due to irrational investor behavior. Successful identification of such a mispricing leads to higher rates of returns than mechanical value. Irrationally undervalued asset classes also have lower drawdowns than is typical.

Asset Class Value Investing is identifying moments in time when an asset class appears irrationally mispriced based on an assessment of long-term intrinsic value.

We want to specifically identify moments in time when an asset class seems mispriced absolutely (versus cash or inflation) or relatively (compared to other asset classes) based on an assessment of long-term intrinsic value. With this definition, we can buy growth stocks if they appear mispriced and thus undervalued. We may even favor buying tax-exempt bonds instead of stocks if the bonds are irrationally mispriced.

There are many significant practical issues with assessing IV, which I’ll discuss in the next blog entry. Practicing the skill of assessing and judging the relative value of asset classes is a lifelong mastery process.

 


References

  1. Schroeder, A., The Snowball: Warren Buffett and the Business of Life, 2009.
  2. Buffett, W., Berkshire Hathaway Shareholder Letters, 1977-present.
  3. Graham, B., The Intelligent Investor: The definitive book on value investing, 1949. Most recent revised edition comes with commentary from Jason Zweig, 2006.
  4. https://en.wikipedia.org/wiki/Warren_Buffett
  5. Anonymous, “What Is Intrinsic Value, And Who Decides It?”, Philosophical Economics, December 19, 2014. http://www.philosophicaleconomics.com/2014/12/what-is-intrinsic-value-and-who-decides-it/
  6. Greenwald, B.C.N, et al., Value Investing: From Graham to Buffett and Beyond, 2001.
  7. Marks, H., The Most Important Thing: Uncommon Sense for the Thoughtful Investor, 2011.
  8. Spier, G., The Education of a Value Investor, 2014.
  9. Kaufman, P.D. and Wexler, E., Poor Charlie’s Almanack: The Wit and Wisdom of Charles T. Munger, 2005.
  10. Pabrai, M., The Dhandho Investor, 2007.
  11. Thorndike, W. N., The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success, 2012.
  12. Greenblatt, J., The Little Book that Beats the Market, 2006.
  13. Greenblatt, J., You Can Be a Stock Market Genius: Uncovering the Secret Hiding Places of Stock Market Profits, 1999.
  14. Asness, C.S., et al., “Value and Momentum Everywhere”, J. of Finance, Vol. 68, No. 3, pp. 929-985, 2013.
  15. Fama, E.F. and French, K.R., “The Cross-Section of Expected Returns”, J. of Finance, vol. 47, No. 2, pp 427-465, 1992.
  16. Fama, E.F. and French, K.R., “Size, value, and momentum in international stock returns”, J. of Financial Economics, Vol. 105, No. 3, pp. 457-472, 2012.
  17. Asness, C. et al., “Deep Value”, Working paper, November 2017.

 

Disclosure 

The content contained within this blog reflects the personal views and opinions of Dennis Tilley, and not necessarily those of Merriman Wealth Management, LLC. This website is for educational and/or entertainment purposes only. Use this information at your own risk, and the content should not be considered legal, tax or investment advice. The views contained in this blog may change at any time without notice, and may be inappropriate for an individual’s investment portfolio. There is no guarantee that securities and/or the techniques mentioned in this blog will make money or enhance risk-adjusted returns. The information contained in this blog may use views, estimates, assumptions, facts and information from other sources that are believed to be accurate and reliable as of the date of each blog entry. The content provided within this blog is the property of Dennis Tilley & Merriman Wealth Management, LLC (“Merriman”). For more details, see the Important Disclosure.

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