The Trials & Temptations of a Value Investor
Defining the 'value' in value investing, and why value investing means more than just searching for low P/B stocks
This Insight is not investment advice and should not be construed as such. Past performance is not predictive of future results. Fund(s) managed by Seraya Investment may be long or short securities mentioned in this Insight. Any resemblance of people or companies mentioned in this Insight to real entities is purely coincidental. Our full Disclaimer can be found here.
This Insight is an extract adapted from the Panah Fund letter to investors for Q3 2017.1
TABLE OF CONTENTS
Value Investing by Numbers
In 1992, an academic paper by Eugene Fama and Kenneth French famously suggested a three-factor model to explain excess returns in a fund manager’s portfolio. One of those factors was ‘HML’ (High Minus Low book-to-market ratios). The paper suggested that companies with high book-to-market ratios2 outperform peers which have the opposite characteristics – value outperforms growth! Although various other out-of-sample studies have been unable to replicate this price-to-book value effect,3 this study has nevertheless had a lasting impact on investment over the last two-and-a-half decades.
Within a year of the paper’s publication in 1993, Dimensional Fund Advisors were already offering a ‘US Large Cap Value Portfolio’ that invested in US >$500mn market cap companies with a book-to-market ratio in the top-three deciles of listed stocks. Over the subsequent 25 years, a combination of rapid technological advances (including increases in computing power), the development of financial databases, and the rise of low-cost indexing have meant that systematic value funds of this sort have become almost ubiquitous.
Such funds have also managed to gather a large amount of assets. (Two of the larger funds which label themselves ‘value’ are Vanguard’s Value Index Fund, with a current AUM of US ~$26bn, and Blackrock’s iShares Russell 1000 Value ETF, with a current AUM of US ~$38bn.)
How do such ‘smart beta’ index providers define ‘value’? For Russell, value has meant a high book-to-price ratio; for S&P it has been high book-to-price, earnings-to-price and sales-to-price ratios; for MSCI, high book-to-price, high forward 12mth earnings-to-price, and dividend-to-price ratios. Even as the popularity of composite value factors has increased, the value indices are largely constructed quantitatively with reference to fundamental valuation ratios only and little else.
Does such formulaic value-investing work? A recent Wall Street Journal blog post – entitled ‘Is Value Investing Dead?’ – suggests that formulaic value approaches have been struggling: “Value investing, as proxied by a portfolio that buys cheap stocks based on price-to-book ratios, ate crow over the past ten years”. The reasoning given was that ‘value’ portfolios were too concentrated on low price-to-book financial stocks going into the Great Financial Crisis.
The article mentions that although a price-to-earnings value strategy performed better over this period, the portfolio had been more volatile than the markets. Despite lacklustre performance for value over the last decade, the post noted that price-to-earnings and price-to-book factors had nevertheless still managed to outperform over the long haul. This led the author to conclude that “value investing is extremely painful and difficult to hold through thick and thin”. (We would agree, though our approach to ‘value investment’ is very different.)
A June 2017 research report from Goldman Sachs, with the somewhat downbeat title ‘The Death of Value’, pointed out that “from 1940 through 2007, the long/short value factor pioneered by Eugene Fama and Kenneth French returned 5% on average each year… But in the last decade the factor has experienced an average annual loss of 2%.”
The authors pointed out that this underperformance of value occurred at the same time as rapid allocations towards passive investing and quant strategies (i.e., the value effect is being partly arbitraged away as more capital pursues it). Reassuringly, however, they pointed out most of the underperformance was probably cyclical rather than secular, and added that other value factors (e.g., price-to-earnings, EV-to-EBITDA,4 and a blend of metrics) had performed better.
Unsurprisingly, the Goldman Sachs quant team had managed to produce their own value factor which outperformed everyone else. In the conclusion, they added that investors have been led to “question the future viability of value investing, which has been embraced by academic literature and espoused by investors including Benjamin Graham and Warren Buffett”.
These reports on the ‘death of value’ have been widely exaggerated. Neither Benjamin Graham nor Warren Buffett have ever advocated investing in companies purely on the basis of a low price-to-book or price-to-earnings ratio. In fact, Graham specifically warned against it: “Some time ago, intrinsic value (in the case of a common stock) was thought to be about the same thing as “book value”, i.e., it was equal to the net assets of the business, fairly priced. This view of intrinsic value was quite definite, but it proved almost worthless as a practical matter because neither the average earnings nor the average market price evinced any tendency to be governed by book value.”5 Instead, he suggested that the intrinsic value is determined by its future earnings power, and that this should be determined by careful analysis.
A fascinating paper published by the CFA Institute earlier in 2017 (authored by U-Wen Kok, Jason Ribando and Richard Sloan) noted that “the term ‘value investing’ is increasingly being adopted by quantitative investment strategies that use ratios of common fundamental metrics (e.g., book value, earnings) to market price. A hallmark of such strategies is that they do not involve a comprehensive effort to determine the intrinsic value of the underlying securities.”
The paper further noted that screens based on simple accounting metrics did a bad job of identifying attractive investment targets, and that instead such strategies “systematically identify companies with temporarily inflated accounting numbers” (i.e., value traps). Mean reversion in valuation metrics typically come not from a rise in price, but instead as book values are written down and earnings decline.
They concluded that such problematic formulaic value strategies should not be confused with value strategies that use a “comprehensive approach” (i.e., old-fashioned hard work and analysis by a human) in determining the intrinsic value of the underlying securities. We couldn’t agree more.
Conviction Value Investing
Our own experience of screening Asian stocks suggests that this paper’s concerns about identifying potential investment targets on only one or two simple metrics are well-grounded.6 When we screen Asian stocks on the most obvious metrics (e.g., P/B and P/E ratios), most of the ‘cheapest’ stocks at the top of the list in the Asian region are cheap for good reasons.
This universe is not just inhabited by stocks with temporarily elevated earnings (which are due to revert to the mean) and assets which might once have generated earnings but no longer do. It is also populated by plenty of more sinister examples of stocks which employ overly aggressive accounting techniques or are even engaged in outright fraud.
An unwary investor might think that it is easy to search for gems by simply turning over likely-looking rocks, but the risk is that he or she will be bitten by one of the vipers that lurk beneath.
Lower valuations are supposed to provide a margin of safety to investors, but this won’t help much if the numbers are unsustainable or unreliable. In the wise words of Graham & Dodd: “In the mathematical phrase, a satisfactory statistical exhibit is a necessary though by no means a sufficient condition for a favourable decision by the analyst.”7
Despite these words of warning, there are indeed some diamonds in the rough. We find that one way to increase the odds of finding a winner is to winnow out those companies which are most obviously problematic.
Panah employs both quantitative and qualitative techniques in attempt to do so. Our quantitative ‘red flags’ methodology compares each company in our Asian universe (~17,000 companies) against all other companies within the sub-industry on >80 different metrics.8 It is normal for a company to trigger a few red flags due to differences in business models with peers in the same sector, but a high proportion of red flags on most metrics is usually a cause for concern.9
From a qualitative perspective, we continuously seek to build up a network of reliable partners across the region – including like-minded fund managers, experienced local brokers, and independent researchers – with whom we can exchange information about which companies and entrepreneurs in each market can be trusted, and which are best to avoid. While our dual quantitative-qualitative approach is of course not failsafe, we hope that it will nevertheless help us to steer clear of some of the worst offenders. (We are not aware of any way one can completely avoid ‘problem’ companies, although we would welcome suggestions.)
Despite our earlier warnings about relying on screens which employ simple valuation metrics, we nevertheless do make use of screening in our attempt to find attractive investment opportunities. Without going into too much detail, we consider the following attributes:
Deep value – does this company have a strong balance sheet, rich in cash and investments? This can help to lessen the impact of external shocks (e.g., an economic downturn), and can also mean that the company has the latitude to increase shareholder returns (through increased dividends and share buybacks). The risk is that the company sits on assets which generate low returns, and without a catalyst, it might simply be a ‘value trap’.
Value - a ‘going concern’ with a high cash flow and/or earnings yield. Sometimes, one does come across stocks with a cash flow-to-enterprise value yield of 25% or more. In theory, this is extremely attractive, as if one were able to buy the entire company tomorrow, then the price of the acquisition could be repaid out of organic cash flow in less than four years (and one would still own an asset that provides strong cash flows each year). The key risks are that the firm’s cash flows have hit a cyclical peak, or even worse that they have hit a secular peak and the firm’s business model is in decline. In both cases, this would mean that the normalised cash flow yield is far lower than it might appear at first glance.
Quality – high and stable return on capital over time (above a hurdle), and ability to grow the net asset value of the firm over time. Such metrics can be the sign of a company which is operating with high barriers-to-entry, or perhaps management has an unusually strong ability to allocate capital.10 Moreover, companies with higher margins and returns can be more resilient in a downturn. Sustainability of returns, however, is a concern. Other companies are constantly trying to enter profitable business areas, and if they succeed then they may compete away excess returns for the incumbent. We would also note that in recent years, there has been a tendency for investors to (over)emphasise ‘quality’ in the investment process, meaning that ‘quality’ stocks are often expensive - it is easy to overpay.
The diagram below (Figure 4) is a representation of the way in which we would ideally like our overall screening process to work. Of course, it would be ideal to be able to build a portfolio of high-quality companies, with strong balance sheet protection, and a high cash flow yield (i.e., the ‘Panah Focus’ sweet spot). Such investment opportunities, however, are not on offer every day, week, month, or even year.
Indeed, it is rare to find good companies on sale at less than their intrinsic value, which is why – after carrying out research and analysis which validates and creates confidence in the investment thesis – it makes sense to build such stocks into more concentrated ‘conviction positions’, of as much as 10% of the portfolio.11
When we do manage to find a high-quality company trading at a low valuation, we are effectively attempting to take advantage of what we perceive to be a market inefficiency. But why does an inefficiency of this sort exist? If we cannot find a good reason, then it might be that we have missed something important, and the stock is cheap for a reason. If we can identify the reason for such a market inefficiency, however, then this might help us to validate our investment thesis, and also understand how and when a rerating might occur.
Interestingly, we have often found inefficiencies to be ‘clustered’ within particular areas, whether a specific geography or sector, or even both. Over the last few years, we have found a higher proportion of interesting investment opportunities in two particular markets.
One is these is Japan, a broad, deep and liquid market with language and cultural barriers as well as weak analyst coverage. The other is Vietnam, which two years ago was still a small and relatively ignored market with structural impediments to investment (such as foreign ownership limits and settlement rules), although this is now starting to change.12
We anticipate that the further advance of passive investing, as well as other regulatory changes (such as the upcoming MiFID2), will lead to reduced sell-side coverage and likely make Asian markets slightly less efficient. While this might reduce liquidity, it should also help to increase our opportunity set.
Patience is a Virtue
Why go to all this trouble to find cheap, quality stocks? In a certain type of market environment not dissimilar to the one in which we find ourselves at present, wouldn’t it just be easier to chase growth and momentum?
There is of course no guarantee that a value investing approach works all the time. Indeed, value can lag the markets considerably for long periods of time. During these difficult times, the temptation is for value managers to compromise by chasing the stocks which are doing well.
While the virtues of value are not always apparent during a raging bull-run, however, the value approach does help to mitigate downside risk when the markets turn. For that reason, patient value managers with a strong sense of ‘deferred gratification’ are more likely to prevail in the long term.
As expressed succinctly in a recent note by Tim Price of Price Value Partners:
“Eleven years before its more notorious prison experiment, Stanford University introduced the world to a subtler but just as intriguing exercise – a landmark study in delayed gratification known now as the Stanford Marshmallow Experiment. Children aged between four and six were taken into an empty room, then presented with a treat of their choice – a cookie, marshmallow or pretzel. The children were allowed to eat this treat, but were told that if they could wait for 15 minutes without giving in to temptation, they would be rewarded with a second tasty reward.
“A minority of children gave in to temptation almost immediately. They would go on to become investment bankers¹. Or politicians². Of those who tried to withstand temptation, one third displayed enough willpower to earn the second treat. They would go on to become (successful) value investors³.
“¹This is a lie. ²So is this. ³And this. But it ought to be true, and probably is.”
Thank you for reading.
Andrew Limond
The original source material has been edited for spelling, punctuation, grammar and clarity. Photographs, illustrations, diagrams and references have been updated to ensure relevance. Copies of the original quarterly letter source material are available to investors on request.
Stocks with a high book-to-market ratio are those which are trading at a market cap which is low in relation to the net asset value (i.e., the book value) of the company.
The Fama-French model works well for the in-sample period from 1963-1981, but not so well outside this period.
Enterprise Value to Earnings Before Interest, Tax, Depreciation & Amortisation - the lower the metric, the ‘cheaper’ the company.
‘Security Analysis’ (1934) by Benjamin Graham and David Dodd (p.17).
Asia has not been the subject of many academic value factor studies (which are mostly focused on the US), and fundamental indexing has not yet really taken off in Asia.
‘Security Analysis’ (1934) by Graham & Dodd (p.40).
For more information, see the Panah Fund letter to investors for Q4 2015, as well as the following Seraya Insight: ‘Single-Stock Shorts: A Focus on Aggressive Accounting’.
Usually, but not always… One of Panah’s more successful ‘Special Sit’ investments in 2016 was in a natural gas company with a very large number of red flags. Many of these flags had been triggered because this was an exploration company with no cash flow; our standard metrics did not reflect the fact that an oil and gas major had already committed to making a substantial cash payment to this junior (contingent on various conditions). We had got to know the management of the exploration company over the previous two years, and thus had confidence to establish a sizeable position when the market cap of the junior fell below the size of the expected cash payment from the major. Our thesis was that it would make more sense (and would be much cheaper) for the major to buy out the explorer rather than make the cash payment. Sure enough, two takeover bids for the company were forthcoming. For more information on this investment, see the Panah Fund letter to investors for Q2 2016, as well as the following Seraya Insight: ‘Looking for Inefficiencies & Defining our Downside’.
For a more detailed discussion of the way that we view the role of capital allocation in the investment process, see the Panah letter to investors for Q4 2016, as well as the following Seraya Insight: ‘“Capital Allocators” versus “Capital Alligators”’.
What about buying companies that trade at really cheap valuations even if they have poor quality businesses? This can certainly work sometimes. Indeed, Panah explicitly embraces this approach in our ‘deep value’ sub-strategy, when we think we identify an imminent catalyst. (For more information, see the Panah Fund letter to investors for Q3 2015, as well as the following Seraya Insight: ‘Two Case Studies: a Japanese 'Deep Value' Investment & a Thai 'Special Sit' Turnaround Opportunity’.) In general, however, we find good opportunities of this sort to be rare, making this a rather more difficult way to make a living.
For more information on the investment case for Vietnam, see the Panah Fund letters to investors for Q2 2015 and Q2 2016, as well as the following Seraya Insights: ‘Vietnam: from Frontier to Emerging Market?’ and ‘The Investment Case for Vietnam’.
