What's Wrong with Today's Value Investing?
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Remember the days when you could count on value investing as a solid defensive strategy? It worked that way as recently as the downturn we experienced earlier this decade. Lately, though, value has not been fulfilling this role. And there are reasons to wonder if this is more than a temporary oddity and whether the entire approach needs to be overhauled.
The good old days
I created a very simple value screen that uses the following tests:
- P/E (based on trailing 12 months EPS) should be less than 25, and
- P/E (based on trailing 12 months EPS) should be less than the industry average, and
- PEG ratio (P/E based on estimated current-year EPS and growth based on consensus Wall Street long-term EPS growth rate projection) should be less than or equal to 2
- Market capitalization must be at least $250 million (to eliminate the often-erratic price trends we can see in penny stocks)
I recognize the widespread assumption that a PEG ratio should be less than 1.00. Actually, there is no logical real basis for that and in the real world, PEGs up to 2.00 tend to be fine (I'll address this as a separate topic another time). Otherwise, this is a very plain-vanilla value screen.
A quick study I conducted using the Portfolio123.com backtester confirmed that during an earlier market downturn, 4/1/02 through 3/31/03, this screen did its job for value investors. (This study, and all others referred to here, assumes portfolio rebalancing every four weeks.)
click to enlarge
Figure 1
Of course we'd all like to see gains all the time. But realistically, I'll accept a model if, during bad times, it slips more gently than the market. Figure 2 shows the numbers behind the above chart.
Figure 2
We see that the Russell 2000 fell 21.7 percent during the test period, while my value screen dipped only 9.9 percent. More interesting is the last line of the performance summary at the bottom. During months in which the Russell was down, the screen outperformed by an average of 1.39 percent, a much better degree of relative strength than was present in up months.
It's broken
Look what happened when I examined a recent 12-month period (specifically, 6/26/07 through 6/25/08). Figure 3 tracks the less-happy story.
Figure 3
Figure 4, a numerical summary of the above backtest, shows something especially bothersome on the last line of the performance summary.
Figure 4
During down months, the screen underperformed the Russell 2000 by more than it did during up months. The degree of deterioration was mild, but that's not the point. We might be able to live with a lagging value model if it was lackluster in good times, but was superior, or at the very least less weak, during bad intervals. But for a value model to be worse during down months, even if only slightly, is not acceptable.
Clearly, something is wrong.
Maybe my screen is poor. It is, after all, just a quick study, not the result of a substantial research effort. And we do have the matter of PEG being allowed to rise to 2.00, instead of 1.00
Disposing first of the PEG question, I re-set the rule to bar stocks with PEG ratios above 1.00. As I expected, the backtest produced moderately worse results. Instead of dropping 18.1 percent, as it did when PEG was allowed to go as high as 2.00, the screen now falls 21.1 percent and in down months, the average decline was 0.89 percent.
We still have the question of whether the simplistic nature of the model is what proved fatal. I am doing further research on value models. But a quick visit to the IndexUniverse.com Data tool showed me that my quick study is not a disaster relative to models used currently being by others. During the latest 12 months available in their database as of this writing, the average value-oriented ETF declined 14.07 percent, versus a 12.32 percent fall for the Russell 2000. The time period does not precisely match my study (it's almost a month off), but value's degree of underperformance is almost the same. And interestingly, the iShares S&P 500 Value ETF underperformed the overall S&P 500 (the former fell 12.11 percent while the latter dropped only 8.85 percent).
I still won't claim the value screen I used here is necessarily a great one. And superior value investors may still be getting good results. But the ETF comparison suggests the screen is consistent with what is being done in the value mainstream and that the mainstream is not achieving what it had in the past.
Working toward a repair
Wikipedia may not be the most authoritative source of a value-investing definition, but the introductory text is consistent with the beliefs of many and could well reveal an important leak. With regard to value stocks, Wikipedia states:
As examples, such securities may be stock in public companies that trade at discounts to book value or tangible book value, have high dividend yields, have low price-to-earning multiples or have low price-to-book ratios.
Forget the textbooks. Look at the world. This isn't the 1970s when the best source of market data for many investors was the monthly S&P Stock Guide (I'm not even sure they still exist). Back in the day, if a stock had such characteristics, it could be because the investment community was neglectful. But in this day and age, with so much information so quickly and so widely available, it's likely that stocks have low valuationb metrics because investors believe that's all the stock deserves.
Cheap prices (even when cheap is defined relative to EPS, book value, etc.) may no longer be what value investing is about. Instead, value may mean identifying company fundamentals and prospects that are better (or less worse) than the market thinks they are.
Success can't come from identifying cheap metrics. Anyone today can do that with a few mouse clicks. Instead, success comes from doing a better job in assessing company. merit. If this view is correct, value investors should probably devote most of their effort toward the exact same analytic issues other investors examine. The difference between a value investors and, say, a growth investor may boil down to just one philosophical point. The value investor wants a great company whose stock with price metrics that reflect a lesser level of greatness (including, for example, a P/E of 30 for shares of a company that deserves a P/E of 35). A growth investor would be more willing to allow a company to grow into a P/E that, at the present time, might assume a little more greatness than has thus far been demonstrated (such as a P/E of 40 for shares of a company that deserves a P/E of 35).
Testing the idea
I modified the above screen to add one more requirement:
- The company must score 90 or better (with 100 being perfect) in an estimate-revision rank I created in Portfolio123.com.
This is the same three-factor rank I used recently to identify potentially superior energy stocks. It's based on the four-week change in the consensus estimate of earnings in the current fiscal year, the four-week change in the consensus estimate of earnings in the next fiscal year, and the extent of uniformity among analysts in raising estimates.
Figure 5 reveals a much better picture of screen performance in the 6/26/07-6/25/08 period.
Figure 5
Figure 6 shows the numbers produced in this test.
Figure 6
Addition of the estimate-revision rank boosted the performance of the screen; now it beats the Russell 2000 by 6.9 percentage points. And it outperforms on average in months that experienced market declines.
Let's see what happens when I use the rank to limit the number of stocks to 15, which better reflects what an investor could easily hold.
Figure 7
The performance is actually a bit better.
As long as we're dabbling with day-to-day reality, I decided to go full out. I inputted the model and the 15-stock limit into the Portfolio123.com simulator and added four extra conditions:
- Assume we start with $50,000.00
- Assume a $10.00 per share commission on each trade
- Assume, for each trade, 0.25 percent price slippage (in other words, I'd always execute each purchase at 0.25% more than the database price and sell for 0.25 percent less
- No sector can be more than 30 percent of the portfolio (otherwise, given present conditions we'll wind up mostly in the hot energy sector)
As we see in Figure 8, this strategy was a success, having outperformed the Russell 2000 by 13.13 percentage points net of expenses.
Figure 8
A different perspective on value
We can't over-interpret the above test. It's only one model used in one time period. We'd want to test it and other models over more time intervals.
But it does at least give us hope that we can repair value investing if we are suitably focused on other aspects of the stock selection. In fact, one might even debate whether we're doing value at all. Perhaps this is another style altogether and that we're confining our interest to a value-priced subset. But maybe that's what value investing today needs to be.
Here are the stocks (only 14 as of 6/30/08) that make the estimate revision-value strategy illustrated above.
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Marc Gerstein
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This article has 16 comments:
would be interesting to see what the result would be?
schutte
Gerstein
Note that this, and many other, value approach is based on the profit stream of a going concern, as opposed to a point-in-time snapshot of the asset base. Omission of financials helps now because their earnings trends have turned unfavorable (a manifestation of the bad things happening to the asset bases). I got pretty much the same result when I turned the estimate revision rank upside down: instead pursuing highly-ranked stocks, I omitted low-ranked issues. I still had some financials, but they were the better ones; in this version, eliminating financials didn’t help.
So essentially, we’re back to the notion of looking at stocks the way other investors do, that being the main part of the analysis, and then adding a value layer.
Gerstein
I appreciate your points. Eliminating stocks with less than $250 million market cap leaves us with about 1550 Russell 2000 stocks. I do think it’s more reasonable to compare such a universe with the 2000; I think a $250 million market-cap threshold is too low to make the S&P 500 or Russell 1000 valid bogeys.
Even so, I decided to alter the tests to address the issues you raise.
Interestingly, dropping the market cap test altogether made the screen performance about 100 basis points worse meaning that value investing looks even more in need of repair.
Going back to the $250 million market cap test and comparing the results with the S&P 500 and the Russell 1000, again the value screen fared even worse. This should be no surprise. Remember the S&P 500 Value ETF underperformed the SPYDR.
Gerstein
I’m with you; fundamentals are critical. Look how much heat Bill Miller took (back in the days when he was still going strong) for owning Amazon in a value fund. His attention to fundamentals (which turned out to be sound) was widely unappreciated. And how many times do you see investors turning bearish on stocks that rally to higher valuations without any discussion of whether fundamentals have proportionately improved. Unfortunately, many pay lip service to fundamentals but don’t really do it, and many more don’t even bother paying lip service. Upside omissions such as those mentioned are annoying. Downside omissions, such as the ones we are more exposed to now given what’s happening today, are worse.
You want the earnings yield from the stock to be atleast 2 X yield from treasuries, to qualify as investment.
sack
I think the problem with a lot of value investors is that they are so focussed on bottom-up analysis (often based on trailing data) that they ignore the relevant macro trends.
Here's one example: a lot of value investors piggybacked on Warren Buffett's holding USG over the last year or two when they saw it had dropped in price. What they didn't consider was the relevant macro trend: in this case, the real estate and residential construction bust. You don't have to have slogged through Security Analysis to know that a company that manufactures sheet rock is not going to have great earnings during a real estate bust; you just have to pay attention to the relevant macro trends and use some common sense.
This is what has separated Ken Heebner from the pack in recent years.
but i guess we´re in a process of transforming valuations.
models rely on todays prices in relation to lets say the last 10-15 years.
but thats too shortsighted.
the market prices dire profits for the coming years.
that makes stocks less attractive.
so if a model would suggest that a pe of 10 is cheap, there´s no law it has to stay that way. it can fall to 7, 5 or 2 - nobody knows.
it´s called pe-contraction and it happende way in the past.
not an easy time for stockpickers...
sack
Good point about multiple contraction. You may be interested in reading what Vitaliy Katsenelson has written about this phenomena during secular range-bound markets. You can check my site, where I've posted about this, or go directly to his site by googling his name.
Value stocks are those that tend to trade at lower prices relative to their fundamental characteristics than their more speculative cousins, the growth stocks; they have higher than usual dividend yields and lower P/E and P/B ratios. So when all stock prices are down significantly, have they all become value stocks? Or, based on the panicky fear that tends to overwhelm media and financial experts alike, haven't they all taken on the speculative characteristics of growth stocks?
Well, to a certain extent they have, because the lower value stock prices go, the more likely it is that they will eventually experience the 15% ROE that typifies the classic growth stock. Interestingly, by definition, growth stocks are expected to be associated with profitable companies, a fact that speculators often lose site of. There are three features that separate value stocks from growth stocks and two that separate Investment Grade Value (IGV) stocks from the average, run-of-the-mill, variety.
Value stocks pay dividends, and have lower ratios than growth stocks. IGV stock companies also have long-term histories of profitability and an S & P rating of B+ or higher. Would you be surprised to learn that neither the DJIA nor the S & P 500 contains particularly high numbers of IGV stocks? Still, since 1982, value stocks have outperformed growth stocks 62% of the time. So when an ugly correction has a makeover, it's likely that all value stocks transform themselves into growth stocks, at least temporarily.
Will Rogers summed up the stock selection quandary nicely with: "Only buy stocks that go up. If they aren't going to go up, don't buy them." Many have misunderstood this tongue-in-cheek observation and joined the buy-anything-high investment club. You need dig no further than the current lists (June '08) of "most advancing issues" to see how investors are buying commodity companies and financial futures at the highest prices in the history of mankind.
This while they are shunning IGVSI (Investment Grade Value Stock Index) companies that have plummeted to their most attractive price levels in three to five years. Many of the very best multinational companies in the world are at historically low prices. Wall Street smiles knowingly (and greedily) as Main Street hucksters tout gold, currencies, and oil futures as retirement plan safety nets. Regulatory agencies look the other way as speculations worm their way into qualified plans of all varieties. Surely those markets will be regulated some day--- after the next Bazooka-pink, gooey mess becomes history.
How much financial bloodshed is necessary before we realize that there is no safe and easy shortcut to investment success? When do we learn that most of our mistakes involve greed, fear, or unrealistic expectations about what we own? Eventually, successful investors begin to allocate assets in a goal directed manner by adopting a more realistic investment strategy--- one with security selection guidelines and realistic performance definitions and expectations.
If you are thinking of trying a strategy for a year to see if it works, you're being too short-term sighted--- the investment markets operate in cycles. If you insist on comparing your performance with indices and averages, you'll rarely be satisfied. A viable investment strategy will be a three-dimensional decision model, and all three decisions are equally important. Few strategies include a targeted profit taking discipline--- dimension two. The first dimension involves the selection of securities. The third?
How should an investor determine what stocks to buy, and when to buy them? We've discussed the features of value and growth stocks and seen how any number of companies can qualify as either dependent upon where we are in terms of the market cycle or where they are in terms of their own industry, sector, or business cycles. Value stocks (and the debt securities of value stock companies) tend to be safer than growth stocks. But IGVSI stocks are super-screened by a unique rating system that is based on company survival statistics--- very important stuff.
In the late 90's, it was rumored that a well-known value fund manager was asked why he wasn't buying dot-coms, IPOs, etc. When he said that they didn't qualify as value stocks, he was told to change his definition--- or else. IGV stocks include a quality element that minimizes the risk of loss and normally smoothes the angles in the market cycle. The market value highs are typically not as high, but the market value lows are most often not as low as they are with either growth or Wall Street definition value stocks. They work best in conjunction with portfolios that have an income allocation of at least 30%--- you need to know why.
How do we create a confidence building IGV stock selection universe without getting bogged down in endless research? Here are five filters you can use to come up with a listing of higher quality companies: (1) An S & P rating of B+ or better. Standard & Poor's combines many fundamental and qualitative factors into a letter ranking that speaks only to the financial viability of the companies. Anything rated lower adds more risk to your portfolio.
(2) A history of profitability. Although it should seem obvious, buying stock in a company that has a history of profitable operations is inherently less risky. Profitable operations adapt more readily to changes in markets, economies, and business growth opportunities. (3) A history of regular, even increasing, dividend payments. Companies will go to great lengths, and endure great hardships, before electing either to cut or to omit a dividend. Dividend changes are important, absolute size is not.
(4) A Reasonable Price Range. Most Investment Grade stocks are priced above $10 per share and only a few trade at levels above $100. An unusually high price may be caused by higher sector or company-specific speculation while an inordinately low price may be a good warning signal. (5) An NYSE listing--- just because it's easier.
Your selection universe will become the backbone of your equity asset allocation, so there is no room for creative adjustments to the rules and guidelines you've established--- no matter how strongly you feel about recent news or rumor. There are approximately 450 IGV stocks to choose from--- and you'll find the name recognition comforting. Additionally, as these companies gyrate above and below your purchase price (as they absolutely will), you can be more confident that it is merely the nature of the stock market and not an imminent financial disaster.
The QDI? Quality, diversification, and income.
Steve Selengut
www.sancoservices.com
www.kiawahgolfinvestme.../
Author of: "The Brainwashing of the American Investor: The Book that Wall Street Does Not Want YOU to Read", and "A Millionaire's Secret Investment Strategy"