(comments: well researched article, my nitpicks are (a) it paints the value investors with a common broad stroke (b) it is early days yet and the investing horizon isn't long enough to be conclusive (c) a weaker point but compared with most hedge funds, these value funds are performing relatively better(d) Lastly, BennyG failed in 1929 crash, hence he focused on safety first, and not the other way round as suggested by author. Article culled from Alpha Magazine, and later Breaking View.com (free trial available). -------------------------------------------------------------------------The death of value investingBy Edward ChancellorInefficient market: Value investors deny that the market is efficient. In their view, stock prices are subject to irrational waves of optimism and pessimism. That's mostly true. But just sometimes, the market's mood isn't too far off. A value trap appears when a falling share price correctly anticipates a company's deteriorating fundamentals. Over the last year, some of America's best investors have been misled by apparently cheap prices into buying financial stocks. The worst may not be over. If the economy goes into a deep recession, investors could face the greatest value trap since the Great Depression.As a group, value investors have many attractive qualities. They are contrarian and stoical, knowing that successful investing requires long-suffering patience. They also have fewer illusions than most, modestly acknowledging that they can't forecast the twists and turns of the economy. Instead, value investors adopt a bottom-up approach, valuing each company on its own merits. They like to think of themselves as owners rather than speculators and tend to operate with longer time horizons.....<Snip> Mentions BennyG's Security Analysis Book and looking for value via Book Value, concept of mr. Market, mentions Buffett ...............The crash of the technology bubble provided value investors with their finest hour. In the late 1990s bull market, they avoided growth companies like the plague and instead piled into those out-of-favour stocks which met their stringent valuation criteria. This was a painful strategy before the bubble burst, but afterwards it paid off handsomely. The current bear market, however, has produced rather different results. Many value investors have lost heavily, unwitting collateral damage of the credit crunch......... snipped... mentions early half where Value Investors missed out on the easy credit fueled stock market as well as P.E.......Furthermore, the credit crisis is revealing a profound weakness in the value discipline Graham maintained that analysis should be "concerned primarily with values which are supported by facts and not with those which depend largely upon expectations." The housing bubble, however, changed many facts. But some of the world's leading investors appeared not to have noticed. First, several prominent names piled into housing stocks when they were selling at around book value. This proved a disastrous move as falling land prices and slowing sales generated massive losses for homebuilders. Then, some of the same investors charged into banks, figuring they were cheap. That also turned out to be a poor idea.......<Snips.... mentions Eugene Farma & French >But the market isn't rational, says Societe Generale strategist James Montier, a prominent exponent of value investing. In a recent report, Montier takes issue with Fama and French. Value has outperformed the market in every economic downturn since 1975, says Montier. "Much as fans of the Efficient Market Hypothesis would love us all to believe that value tends to underperform because it is riskier, there is virtually no evidence that this is the case the risk-based explanations of the value premium are as hollow and meaningless as the rest of EMH".The trouble with this analysis is there has been no truly devastating economic downturn during the study period. Value stocks tend to be found among smaller, more cyclical companies. When the hundred-year flood arrives, such stocks are likely to be hardest hit. Graham recommended buying stocks which were priced in the market at less than their net current assets (calculated as cash and working capital less all liabilities). Montier recently published a list of current stocks which met Graham's deep value criteria. Yet many of the names on this list look like potential value traps, vulnerable to both the continuing credit crisis and an economic downturn. For instance, the list includes several homebuilders, an Irish credit insurer, and a British technology firm which has already entered into administration......<snip>...Mentions Grahams' failure in the 1929 stock market which saw a loss of 70% of capital by 1933. Author uses this as proof that P/S ratios don't work>The credit bust is bringing fundamental changes to the economy at a mind-numbing speed. Investors have been drawn into one value trap after another. As the credit crisis continues and the global economy worsens, things could get a lot worse for Graham's disciples. In the three-quarter of a century since the Great Depression, value investors have earned a generous premium for investing in smaller and more cyclical stocks. Now they are paying the price.
I think it's difficult to draw a conclusion when we're in the middle of this financial crisis (or the beginning... or the end... who knows). But many value investors know that valuing stocks based solely on book value is a flawed approach. Ben Graham's principles are still the same, investors may need to modify their valuing methods. I think this article will be an interesting read years from now.
Graham's failure occured because he used leverage, which is the lesson that taught modern value investors to avoid it.And buffett's great periods of outperformance occured during bear markets, that's when values are most attractive. Avoiding value traps is what makes a great value investor.
Value investing is also concerned with the ability to value a business. It must be understood well.Open up a 10-K of a bank, and tell me if you understand everything. My guess is, you wont be able to.I would bet a very few number of value investors were investing in banks during this bubble who actually understood and knew what was going on.Value investing isn't just running some numbers, it's also about understanding the operation of a business and weather or not the economics look favorable for the long term, and weather or not the total market cap of the company seems reasonable.Value investing isn't dead, it's just not understood very well by those who don't do it.
PennyPincher12:"Value investing is also concerned with the ability to value a business. It must be understood well."Well said. Unfortunately, understanding a business today involves deciphering the gobble-de-gook of financial engineering, if only to assess the potential 2nd/3rd order risks involved. So far, looks like not too many people had a clue on this - neither regulators, nor the Masters of Wall Street's parallel Universe.I certainly didn't."Value investing isn't dead, it's just not understood very well by those who don't do it."IMO, not even by most who claim to 'do it' :0)Witness the parade of pundits proclaiming fire sales everywhere for most of this year - BRK, SBUX, MSFT, PFE, GM ...What seems to pass for 'understanding' is most often a 20-20 rear-view mirror image. At best you get some picture of catalysts for a better future. But, you'll be very lucky to find somebody who knows the business and its ecosystem well enough to articulate what will drive it down. No self respecting 'value' pro can justify that label without showing he/she has a good handle on the inevitable downside risk of any investment.
PennyPincher12:"Value investing is also concerned with the ability to value a business. It must be understood well."TMFCogitarius:"Well said. Unfortunately, understanding a business today involves deciphering the gobble-de-gook of financial engineering"Cogitarius,Not every business dabbles with financial engineering though. Having learned the hard way that I don't understand banks I now put them into my "too difficult to understand" pile and move on. Investors aren't obliged to invest in every single company in the market and there are non-gobble-de-gook companies in the world that are profitable and debt free with tangible assets on their balance sheets. If one sticks to buying these companies at a discount to a conservative estimate of their intrinsic value then that is value investing and I should expect it to prove profitable over time.regards,toothbrush
toothbrush: " Not every business dabbles with financial engineering though"True! My concern is that even non-financial companies are taking on arcane financial instruments, such as Credit default swaps and currency and other derivatives, without much of a clue as to the risk involved or its potential impact. Remember what happened to P&G a few years back with their foray into derivatives? That's pretty boring compared to the exotic concoctions being inhaled in global boardrooms nowadays.
TMFCogitarius: "Well said. Unfortunately, understanding a business today involves deciphering the gobble-de-gook of financial engineering, if only to assess the potential 2nd/3rd order risks involved. So far, looks like not too many people had a clue on this - neither regulators, nor the Masters of Wall Street's parallel Universe."My take on it is, if I can't read the 10-K and understand it, there's either one or two things going on:1) The business is totally out of my comprehension.2) The business does not want investors to understand what's going on.Both of these are not good. If I can't understand a years worth of business, how in the world can I (or any reasonable investor) have a good feeling about where this ship is going to sail to in the next 10 or 20 years?If management does not want investors (owners) to understand what's going on, these are not trustworthy people. They could probably explain what's going on, but if they put it out there, the investors would not be happy.A serious, business-like investor has to be very skilled and have a great understanding of banking or financial services to really consider purchasing shares.I started getting interested in BAC this year when it hit 19. I looked at the 10-K and couldn't get through the first page! I decided to toss it in the too tough bin, and let someone else stick a number on it.Meanwhile, companies I do own, (McDonald's, Coca-Cola, Reynolds American, among others) I can read their reports with the TV on drinking a Coke Zero and finish it with a good understanding of what's going on.TMFCogitarius: "Witness the parade of pundits proclaiming fire sales everywhere for most of this year - BRK, SBUX, MSFT, PFE, GM ..."Lol, very true. 'Triage Trades' - Fast Money style! Sometimes I think, people think value investing is just about buying stocks that have had a significant decline in market cap. When it's really about how much cash your asset (stock) is going to earn and how much you pay for it. It's possible to get value at a 52-week high I suppose.
KO is one of my favorite examples of the hidden dangers of financial engineering in otherwise "simple" companies.Goizueta re-engineered its balance sheet to transform it into an FCF-spewing ATM while burdening bottlers with heavy asset loads. That, plus his various other successes, made a hero out of him and his company's stock.Ten years later, investors still haven't recovered their capital.What's worse, the bottlers have been pushing back, forcing KO to either pay them more for carrying those asset loads, or, take back what should have been on its BS in the first place.I'm pretty sure I would also have been too dazzled by Goizueta's brilliance to even anticipate, let alone value, the long term corrosion he set in motion.
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