value investing today

S&P’s Indexology blog posted an article yesterday on value investing in the US, titled “Losing My Religion.”

The gist of the post is that both over the past one- and ten-year periods, value investing strategies have generally, and pretty steadily, underperformed the S&P.  The author, Tim Edwards, senior director of index investment strategy for S&P, suggests that this may be because value investing has become too popular.  In his words, “With so much energy directed to exploiting the excess returns available through value investing, maybe the only “value” stocks left are the value traps, those stocks whose prices are low as their prospects are determinedly poor.”

my semi-random thoughts

  1.  Value investing has been around at least since the 1930s and is the dominant investment style for professionals worldwide.  Growth stock investing may be a close second to value in the US but is a non-starter elsewhere.
  2. Value investing does not mean buying stocks that are cheap relative to their future prospects, i.e., bargains.  Rather, it’s a rule-governed process of buying, depending on the flavor of value an adherent espouses, the stocks with the lowest price to earnings, price to cash flow or price to net assets ratio–on the idea that the market has already factored into prices the worst that can possible happen, and then some.  So once the market begins to turn an objective eye toward such stocks once more, their prices will rise.  At the same time, downside is limited because the stocks can’t fall off the floor.
  3. As a dyed-in-the-wool growth stock investor (who has worked side by side with value colleagues for virtually all of his professional career),  my observation is that value stock indices routinely include growth stocks.  Growth indices, in contrast, are often salted with stocks that are well past their best-by date and that are ticking time bombs no self-respecting growth stock investor would own.  Academics use these mischaracterized indices to “prove” the superiority of value over growth.  Indexers use similar methodologies.  Be that as it may, this is another reason for surprise at the years-long underperformance of value.
  4. Early in my career I became acquainted with a married couple, where the husband was an excellent growth stock investor, the wife a similarly accomplished value stock picker.  She outperformed him in the first two years of a business cycle; he outperformed her in the next two years.  Their long-term records were identical.  This is how value and growth worked until the late 1990s.

The late 1990s produced a super-long growth cycle that culminated in the Internet bust of 2000.  That was followed by a super value cycle that            ran most of the next 4-5 years.  Both were a break with past patterns.  The strength of the second may be a reason value has looked so bad since.

5.  Still, what I find surprising about the past decade is the persistent underperformance of value, despite the birth of a post-Great Recession                    business cycle in 2009.  The cycle turn has always been the prime period of value outperformance.  Why not now?     …the Internet.


More tomorrow.



to raise cash or not

raising cash

I find myself raising 10%-15% cash in the taxable joint brokerage account my wife and I use to pay for much of our living expenses.  No change in our fully invested stance in our IRAs or 401ks, just the taxable account.

Thirty years of professional training and experience tell me this is always a mistake.  But I’m doing it anyway.

why pros don’t do this

The easy answer is that pros typically can’t.  Their contracts with pension funds routinely require that the managers they hire remain fully invested.  The idea is that the pension fund and its consultants control the asset allocation (thereby justifying paying themselves the big bucks) and parcel out various pieces of the overall portfolio to specialists.  If managers stray from the asset classes where they’re experts they risk mucking up the overall asset allocation strategy.

Although mutual fund charters usually offer much more leeway, the manager will be pilloried if he raises a large amount of cash and the market goes up.

More importantly:

–to make a significant difference in performance, you have to raise a ton of cash–30%-40% of the portfolio at least.  This turns the portfolio into a Las Vegas-like all-or-nothing bet.

–I’ve never met an equity professional who’s any good at timing the market.  People tend to either understand either market bottoms very well–when to invest aggressively–or market tops–when to become defensive–but not both.  So they either raise cash much too early, or they get that timing right and never put the money back to work.  In either case, the cash-raising exercise tends to backfire.

This doesn’t mean there aren’t any successful market timers.  I just don’t know, or know of, any.  And I’ve seen lots of managers punch big holes in the bottom of their performance boats by trying their hand.

–the desire to raise cash invariably comes at times of stress and high emotion.  Emotional decisions in investing are almost always bad ones.

what pros do (or should do) instead

Make the portfolio less aggressive, so it will perform better in a downturn.  Eliminate speculative, smaller-cap, or highly economically sensitive names.

Look harder for new names.  If everything in the industries you feel most comfortable in looks too expensive, broaden your scope to include other sectors.

Go on vacation.

If you absolutely have to sell something (for your own emotional well-being), do it in small enough size that it won’t do much damage.

why I’m ignoring my own advice

Several reasons:

–low interest rates have forced me into a very high equity allocation

–in this account, I’m more interested in having money on hand to pay bills than in beating the S&P.  So I’m willing to accept underperformance.

–history says that stocks go sideways to up during periods when the Fed is removing emergency money stimulus from the economy.  I think this should hold true again.  On the other hand, while stocks appear reasonably priced to me, the size of the interest rate raise now underway is about double the normal size.  So there is an uncharted waters aspect to this Fed move.

Also, the tone of the market seems to me to be increasingly set by short-term traders who don’t have the skill or temperament needed to analyze economic fundamentals.  Their behavior is harder to predict with confidence–just look at what’s going on in Japan.

why is it so hard to stay ahead of a rising market?

staying ahead of a rising market is difficult

That’s the cliché, anyway.  And, for what it may be worth, my experience is it’s true.  It’s much harder to stay ahead of a rising market than a falling one.

but why?

Let’s first get a technical, or maybe a definitional, point out of the way.

The world consists of growth investors and value investors–both, by the way, claiming to be in the minority (because that’s cooler than being run-of-the-mill).  Value investors stress defense.  They’re more risk averse.  As a result, they typically make their outperformance during the part of a market cycle when stocks are going down.  Of course, they’d like to outperform an uptrending market.  But because they put defense first, deep down they know they should be satisfied (even ecstatic) to keep pace in a rising market.  Their approach to the stock market, their longer term strategy, is to protect against possible downside.  So they know that not falling too far behind is the best they can realistically hope for. Let’s not count them.

So our question really is:  why is so hard for growth investors, whose strategy calls for them to make their outperformance in an up market, to do so?

I think a lot is due to the fact that a rising market attracts substantial amounts of new money to stocks.  Not only that, but the new money doesn’t come in all at once; it arrives at different times.  depending on timing, new money can create demand for many stocks, not necessarily those best positioned to benefit from the bull run.

For example:

— (Almost) every professional investor is taught from day one not to “chase” stocks that have already risen a lot before he starts to look at them.  Instead, he’s told, look for stocks that may not be quite as good but which haven’t moved yet.

Someone late to the smartphone party might not buy Apple or ARM Holdings.  He might buy Qualcomm instead.  Money arriving later still might gravitate toward a contract manufacturer like Hon Hai, or to Intel, or maybe even Verizon or Sprint, on the idea that smartphones or tablets will add oomph to those businesses.

These latter stocks may not necessarily be the purest plays or the greatest companies, but buyers will tell themselves (sometimes rightly, other times wrongly) that the risk/reward tradeoff is better for them than for the more expensive “pure play” stock like AAPL or ARMH.

Put another way, when the leading lights of an industry make a major move upward, they tend to drag a lot of the lesser lights along with them–at least to some degree, from time to time and with a lag.  It’s very hard psychologically–and arguably not the best idea financially–for someone who has identified a trend early and holds all the major players to rotate away from them and dip down into second-line stocks to play these ripples.  But during a period while others are playing catch-up by bidding up the minor stocks, the holder of industry leaders will underperform.

–There’s also a more general arbitrage in an up market–in any market, really, but more so when stocks are moving up.  It’s not only among relative valuations of participants in an industry which is on Wall Street’s center stage, but between that industry and other sectors/ industries/stocks.

Let’s say that tech stocks have gone up 40% in the past six months, while healthcare names have lost 5% of their value.  At some point, even tech investors will start to say that healthcare stocks look relatively cheap.  As this perception spreads, the market will direct its new money flows to healthcare.  Investors may even begin to rebalance–selling some of their tech stocks, and using the funds to buy healthcare, until a better relationship in valuation is restored.  While this is going on, anyone overweight tech and underweight healthcare will probably underperform.

should you want to outperform all the time?

If there were no tradeoffs, the answer would be easy.  But there are.

–All of us have different goals and objectives.  Younger investors, for instance, will probably want maximum growth of capital.  Older investors may want preservation of income, instead.  The former objective is consistent with trying to shoot the lights out in a bull market.  For the latter, that strategy is too risky.

-Not everyone has the temperament to be good at investing.  That’s just the way it is.  Someone who falls below the market return year in and year out should realize that for him active management is an expensive hobby.  Index funds would be a better wealth-building alternative.

–We also have different knowledge bases, aptitudes and interests.  That may make us better at defense than offense, or better at value investing than growth.  As in just about everything else, we should play to our strengths, not our weaknesses.

–Contrary to the wishes of the marketing departments of investment firms, no investor–not even the best professional–outperforms 100% of the time.  The other team eventually gets a turn at bat.  If you can outperform for two or three years out of five, and if your overall results match or exceed the market return for the half-decade, that’s more than enough.  That would put you deep in the top half of all professionals.

I don’t think this last is a crazy expectation for a non-professional.  Investing is a craft skill, like, say, baseball or shoe repair.  It can be learned.  Knowing a few things better than the market does will likely bring better than average long-term returns, even with occasional bouts of underperformance.

two tricks of performance calculation arithmetic

measuring performance

The acid test of active management–both of our own efforts and of the professionals we may hire to invest for us–is whether they add value versus an appropriate index.  Picking the benchmark against which to measure results is a pretty straightforward task, though judgment issues do sometimes arise.  (For example, if all a manager’s outperformance of the S&P 500 over the past three years comes from holding a large position in Baidu (BIDU), the Chinese internet company listed on NASDAQ, is the S&P really the right index to be using?  But that’s a story for another post.)

What I want to point out here is a quirk in the way performance calculations are done:

–in a rising market, outperformance tends to look better than it really is;

–in a falling market, outperformance tends to look worse than it really is.

The opposite is true of underperformance.

in a rising market, underperformance tends to look worse than it really is;

–in a falling market, underperformance tends to look better than it really is.

Here’s what I mean:

Let’s take an example where the numbers are impossibly large, just to illustrate the point.


We’ll suppose that on Day 1 of the measurement period the index is unchanged but our portfolio gains 50%.  At the end of Day 1 we’re 50 percentage points ahead of the index.

a.  rising market.  Suppose that for the rest of the year, our portfolio matches the market performance exactly and that the index doubles from Day 2 through the rest of the year.  How far ahead of the index is our portfolio for the year?

Your first instinct is probably to say “50 percentage points,” since we’ve made no further gains after Day 1  …but that’s wrong.  The actual outperformance is 100 percentage points.

If the index starts the year at 100, its ending value is 200.

If our portfolio starts the year at 100, we’re at 150 at the end of Day 1 and we double from there–meaning we’re at 300 on the final day, or 100 percentage points ahead of the market.  Whatever positive thing we did on Day 1 has been magnified by the rising market.

b.  falling market.  Let’s take the same portfolio, up 50% in a flat market on Day 1.  This time, let’s suppose our portfolio matches the index for the rest of the year, but that the index falls by 50% between Day 2 and the end.  How far ahead are we for the year?

Having seen a., you’re already going to guess that 50 percentage points is wrong.  …and 50 is wrong.  But what’s the right number?

Well, if the index starts at 100 and loses 50%, at the end of the year it’s at 50.  At the end of Day 1, we’re at 150, but we lose half that amount through yearend.  So we end up at 75, or 25 percentage points ahead of the index.


Let’s start again with crazy numbers.  Assume Day 1 is the day from hell and we lose half our money in a flat market.  We’re 50 percentage points behind the index.

c.  rising market.  The market doubles from Day 2, going from 100 to 200 by yearend.  We match the market.  Our 50 goes to 100.  We’re 100 percentage points behind the market.

d.  falling market.  The market declines from Day 2 on, and drops from 100 to 50 by yearend.  Our 50 is cut in half to 25.  We’re 25 percentage points behind the market.


There are all sorts of implications for professional investors, who tend to earn most of their compensation based on annual performance vs. an index.  You never want to get behind in a rising market, for instance.  Or, a falling market tends to compress out- and underperformance numbers closer to the index, so that’s the best time to play catch-up.

For the rest of us, the lessons are:

–don’t get too excited about the “phantom” outperformance that a rising market (2009, 2010) brings, and

–more important, a decline of 15% like the one we’ve been in will reduce your under- or outperformance by 15%.  Don’t think your stocks are suddenly doing better/worse than they are.  To see your real performance during the downturn, don’t check the year to date figures, check them from the start of the downturn until now.

NOTE:  If you’ve constructed a portfolio for a rising market, or if you were ahead year to date before the current decline began, you should expect some slippage in relative performance as the market sags.  Similarly, if your holdings are geared for a down market, you should now be seeing a pickup in relative performance.

How much relative gain or loss?  That’s another post-full.  A lot depends on the level of risk you’ve assumed and your skill in picking stocks.  But if you’ve battened down the hatches, you should be seeing at least some benefit.  If you’ve continued to keep a lot of sail let out (which is my usual position), you shouldn’t be surprised/dismayed by a modest relative loss.




more on absolute vs. relative performance

One of the earlier posts I wrote on this blog had to do with absolute vs. relative performance.  I reread it today and am generally satisfied with what I wrote then.  One exception, though.  I think the post came at the topic from the rather narrow perspective of a professional investor, who is already convinced that the best way–or at least one good way–to achieve absolute performance is to try to achieve relative results.

In this post, I’d like to broaden my discussion of the topic by adding two observations, one psychological, the other economic:

1.  One of the most important of the (many) clichés Wall Street uses is that market turns, especially upturns, come out of nowhere and catch most investors by surprise.  Not only that, but the initial move up can cover a lot of ground in a short time.  Missing this initial surge, so the argument goes, is virtually impossible to recover from.  Brokers typically cite academic studies that the greatest part of the market’s gains over a business cycle come in only about 10% of the trading days.  Be out of the market on those days and you’re toast.

I think there’s something to that argument.  I’d like to add my own twist to it, though.

In my experience, lots of professionals can either tell when the market is getting toppy or when it’s stunningly cheap.  But I don’t know anyone who has been able to do both.  Wall Street is a very gossipy place, so if there were such a person, word would get around–despite the individual’s desire to keep his ability to time the market a secret (so others wouldn’t begin to study his every move and his skill would remain his edge alone).  In addition, just off the top of my head I can think of three former professional acquaintances who “called” the top of the market, one in 1984 and two in 1986, with disastrous results for both them (two were fired) and their clients.

Look at the record of hedge funds, whose aggregate performance failed to match that of the S&P 500 every year since 2003.

Anyway, I think some investors have bearish temperaments and can call tops but not bottoms.  Others, like me, have a bullish cast of mind.  We can call bottoms but not tops.

2.  Assume that we live in a world that’s characterized by:  a) inflation; and b) economic growth.  Each implies that stock prices will tend to rise.

a.  Modern economics comes out of systematic study of the Great Depression of the 1930s.  One of the highest goals of monetary policy around the world is to avoid a recurrence.  In particular, the world wants to avoid a repeat of the deflation that marked that period.

Other than in the case of Japan, which has consistently chosen to have deflation rather than permit structural societal change, the world has been successful in doing so.  Let’s suppose (and fervently pray) that this continues.  What does this mean for stocks?

Stocks are priced in nominal terms, in dollars of the day.  But they represent ownership claims on real assets and business operations.  Inflation means that nominal prices in general are rising.  So there should be a tendency for the nominal value of the corporations whose shares of stock are publicly traded to rise as well.  Ultimately, this should translate into a tendency for stock prices to rise, even in the absence of real economic growth.

b.  But, as an empirical observation, there’s real economic growth all over the place.  The US economy, which has been closer to the caboose of the world economic train than the locomotive, is still 50% larger than it was a decade ago.  New nations have entered world commerce.  We have notebooks, netbooks, tablets, iPhones, iPods, social networking, online shopping, biotech, medical advances–lots of stuff we didn’t have ten years ago.  Why?  …because many people around the world like to build and invent new things.  Publicly traded firms–where else do entrepreneurs get the money they need to grow their companies–participate very substantially in this growth.

My point is that the path of least resistance for stocks–due to inflation and to real economic growth–is up.

Yes, I believe what I’ve just written is true.  Maybe it’s a cartoon version of the truth, but it’s true.  That’s not really what I’m trying to convey in this post, though.  What I want to say is that professional investors in general opt to try for relative performance rather than absolute because they believe this, too.

No more reversion to the mean?–Mohamed El-Erian (I)

“uncertainty changing investment landscape”

The other day I was paging through some old newspapers that I never got to during August (yes, I read the business news on paper).  Sometimes it gives you a sense of perspective to read, a couple of weeks after the event, what trivial things people were thrilled or fearful about at a certain moment.  But mostly I got lazy when the weather got hot and read novels instead of news.  So I was catching up.

I ran across an article from August 2nd with the above title in the Financial Times. It was written by Mohamed El-Erian and Richard Clarida, a professor of economics at Columbia.  Mr. El-Erian is the chief executive of the mammoth bond manager Pimco and an occasional columnist for the FT; Mr. Clarida consults for Pimco.

I usually skip over what Mr. El-Erian writes.  It typically reflects the economic consensus.  Besides that, Mr. El-Erian has seldom been known to use one small word when six or eight big ones will do the same job.  He’s also the public marketing face of Pimco, so we know in advance what his investment conclusion will be namely:

–The global economic landscape will be bleak for many years to come.

–Therefore bonds, even at today’s super-expensive levels, are still a buy; stocks, which are the same price today as a decade ago and the cheapest they’ve been vs. bonds for sixty years, are still a sell.  Pimco’s only change to this mantra over the past year or so has been to kick dividend paying stocks off the approved list.

Nevertheless, I did read this piece.  Despite the fact Mr. El-Erian comes to his usual (horribly incorrect, in my opinion) conclusion about stocks and bonds, I’m glad I did.  For once, Mr. El-Erian wrote something really thought provoking.

I’m going to write about this in two posts.  Today I’ll outline what Mr. El-Erian says.  Tomorrow I’ll write about where I disagree.

the article

The article makes five points.  Four of them are different facets of the same idea–that the disinflationary era that began with the appointment of Paul Volcker as Fed chairman in the US almost thirty years ago is over.  As a result, we can no longer depend on continuingly rising bond prices and falling yields to bail us out of investment mistakes.  Investors have to rethink and retest their strategies.

That isn’t the interesting part.  Equity investors have been soulsearching about excessive leverage and unwarranted risk-taking since the collapse of the Internet bubble in 2000.  (If so, how did the financial meltdown happen?  Investors made three basic mistakes:  we assumed the banks’ accounting statements were reasonably accurate; we wildly overestimated the capabilities and appetite of the regulators to enforce banking and securities laws; and we attributed to bank managements a level of integrity and risk-management competence that most American industrialists possess but many in this industry didn’t.)

The intriguing point is Mr. El-Erian’s first, that “investing on ‘mean reversion’ will be less compelling” in the future.  He implicitly describes the (bond) investing process over the past twenty-five years as having two steps:

–determine the consensus economic forecast, and

–find securities whose valuations imply an outcome that deviates markedly from the consensus.  If the imbedded expectations are too pessimistic, buy the security; if they are too optimistic, sell it short.

Why won’t this work anymore?  In the past, a compilation of expectations from professional economists would form a bell curve, with the areas at and around the mean having very high probability.  The “tails” of the distribution, that is, the forecasts that deviate a lot from the consensus, were short and stubby, that is, highly unlikely and increasingly so the farther away from the consensus they were.

Today, the compilation of forecasts looks less like a bell with a sharp, fat peak in the middle, and more like a straight line with a small bump up in the center.  The economic situation around the world is so uncertain, and the policy actions governments may take to stabilize their countries so unpredictable, that there is, in effect, no solid macroeconomic consensus to bet against.  Not only that, but the more extreme “long tail” outcomes, both bad and good, have become much more likely.

What do you do in a world like this?  Mr El-Erian’s answer is (surprise, surprise)–buy bonds, sell stocks.  You do so because (government) bonds are liquid and default-free.  Therefore, they protect you against the world going to hell in a handbasket.  I guess this means individual investors haven’t been panicking over the past year or more but responding rationally to the current situation by dumping their stocks and embracing bonds.  I suppose that if you really wanted to secure yourself against the worst, you should also think about a cabin in the woods, stocked with freeze-dried food and near a good source of water, maybe with a bow and arrows in case you need to hunt.  Maybe people are.

I’m with Mr. El-Erian up until his conclusion, with which, to put it mildly, I disagree.  Not so surprising, since I’ve spent all my investing life on Wall Street.  The real question, the thought-provoking aspect of the article I’ve linked to above, is to be able to say why I disagree.  What’s wrong with what he’s saying?

More tomorrow.