Big But…

big_butt_chairThe Price Action Lab has a post up this morning stating what seems to be obvious.

“[M]arkets will not reward naive perceptions of inter-market relationships that one learns in school because mass knowledge carries no edge.”

That’s true generally.  But there’s a big but….

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Explaining the Value Premium

Planning FallacyValue has persistently outperformed over the long-term.  Why is that? 

In the most general terms, growth stocks are those with growing positive attributes – like price, sales, earnings, profits, and return on equity.  Value stocks, on the other hand, are stocks that are underpriced when compared to some measure of their relative value – like price to earnings, price to book, and dividend yield. Thus growth stocks trade at higher prices relative to various fundamental measures of their value because (at least in theory) the market is pricing in the potential for future earnings growth. Over relatively long periods of time, each of these investing classes can and do outperform the other.  For example, growth investing dominated the 1990s while value investing has outperformed since. But value wins over the long haul.

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Get a Good Pitch to Hit

Ted Williams was almost surely the greatest hitter of all-time. He was a two-time MVP, led the league in hitting six times and in home runs four times, and won the Triple Crown twice. A 19-time All-Star, he had a career batting average of .344 with 521 home runs, and was inducted into the Baseball Hall of Fame in 1966.

Williams was also the last player in Major League Baseball to hit over .400 in a single season (.406 in 1941). Ted’s career was twice interrupted by service as a U.S. Marine Corps fighter-bomber pilot.  Had his career not been limited by his military service – especially since it was in his prime – Williams would likely have hit over 700 career home runs and challenged Babe Ruth’s record.

During spring training of his first professional season, Williams met Rogers Hornsby, who had hit over .400 three times and who was a coach for his AA team for the spring. Hornsby emphasized that Ted should always “get a good pitch to hit.”  That concept became Williams’ “first rule of hitting” and the key to his famous and innovative hitting chart (shown below).

The concept is a straightforward one — it’s easier to hit a pitch that’s belt high and right down the middle than one at the knees and “on the black.” Investors should be mindful of this concept too and always seek a “good pitch to hit.”

In part, getting a good pitch to hit mean focusing on approaches and sectors that have the best opportunities for success.  These include momentum investing (see here and here, for example), including highly quantitative (algorithmic) investing based upon momentum (such as managed futures).  Another area for potential outperformance is low beta/low volatility stocks. This surprising finding (since greater return is generally connected with greater risk) has been deemed to be the “greatest anomaly in finance.”  Significantly, this approach works well in the large cap space, where closet indexers predominate.  Moreover, despite rational “copycat risk” fears, there is good research providing reasons to think that this anomaly may well persist. Looking at this opportunity on a risk-adjusted basis only makes it more attractive.

The mid and small cap sectors provide more opportunities despite some liquidity constraints.  International equities tend to provide the best opportunities due to the wide dispersion of returns across sectors, currencies and countries.  Indeed, the SPIVA Scorecard demonstrates that a large percentage of international small-cap funds continue to outperform benchmarks, “suggesting that active management opportunities are still present in this space.”  Moreover, managers running value strategies outperform and do so persistently, in multiple sectors, especially over longer time periods, although lengthy periods of underperformance must be expected and survived.  In the current secular bear market I also encourage the use of portfolio hedging.   

I wish to re-emphasize, however, that success in this arena is extremely hard to achieve and success achieved through good asset allocation can be given back quickly via poor active management. That is why I prefer an approach that mixes active and passive strategies and sets up a variety of quantitative and structural safeguards designed to protect against ongoing mistakes and our inherent irrationality.  I want to be most active in and focus upon those areas where I am most likely to succeed.  I also want to be careful to seek non-correlated asset classes (to the extent possible) in order to try to smooth returns over time and to mitigate drawdown risk. For advisors, surviving in this business can be a major challenge.  Succeeding by actually providing clients with real value is that much more difficult.  It demands the bravery to incur much greater risk – but career and reputation risk rather than investment risk.  For individuals, it requires the bravery to go against the crowd.  Ultimately, investing is a zero sum game.  In other words, all positive alpha is financed by negative alpha. It’s a mathematical certainty.

Value surely exists, but it can be very hard to find. In the equities markets I recommend starting by being very selective — getting a good pitch to hit. I suggest using active investment vehicles within portfolios for momentum strategies, focused (concentrated) investments, in the value and small cap sectors (domestic and international), for low volatility/low beta stocks, and for certain alternative investments.  Passive strategies can be used to fill out the portfolio to provide further diversification.  When you don’t have a good pitch to hit, don’t swing.  When you do, hack away.

Value

I grew up in this business in the early 90s at what was then Merrill Lynch.  My decade of legal work in and around the industry didn’t prepare me for big-time Wall Street trading.  I’d ride the train to Hoboken early in the morning, hop on a ferry across the Hudson, walk straight into the World Financial Center, enter an elevator, and press 7. Once there, I’d walk into the fixed income trading floor, a ginormous open room, two stories high, with well over 500 seats and more than twice that number of computer terminals and telephones.  When it was hopping, as it typically was, especially after a big number release (like today’s non-farm payroll data), it was a cacophonous center of (relatively) controlled hysteria.  

It was a culture of trading, which makes sense since it was, after all, a trading floor.  Most discussions, even trivial ones, had a trading context.  One guy (and they were almost all guys) is a seller of a lunch suggestion.  Another likes the fundamentals of the girl running the coffee cart.  Bets were placed (of varying sorts) and fortunes were made and lost, even though customers did most of the losing because we were careful to take a spread on every trade.  The focus was always on what was rich and what was cheap and the what if possibilities of and from every significant event (earthquake in Russia – buy potato futures).  The objective was always to make the most money possible, the sooner the better.

Interestingly, value was almost never at issue.  The idea was to exploit inefficiencies and – especially – the weaknesses of whoever is on the other side of the trade right now.  Michael Lewis’s wonderful first book, Liar’s Poker, re-issued in 2010 and finally being made into a movie, captures this culture (in his case, at Salomon Brothers) pitch perfect.

Now that the focus of what I do has changed, I am primarily consumed with finding value through investing – which must be distinguished from trading.  As Barry Ritholtz put it recently, “[t]rading (as opposed to investing) is more about laying out probabilities of risk versus reward; investing is about valuations within the longer secular macro picture.”  I would suggest that trading is about selling what is rich and buying what is cheap while investing is about finding, acquiring and holding on to value.  That distinction is, I think, the key to why so many analysts misapprehend the market relevance of another terrific Michael Lewis book (which has been made into a recent movie), Moneyball (nicely satirized here).

Moneyball focuses on the 2002 season of the Oakland Athletics, a team with one of the smallest budgets in baseball.  At the time, the A’s had lost three of their star players to free agency because they could not afford to keep them.  A’s General Manager Billy Beane, armed with reams of performance and other statistical data, his interpretation of which was rejected by “traditional baseball men” (and also armed with three terrific young starting pitchers), assembled a team of seemingly undesirable players on the cheap that proceeded to win 103 games and the divisional title. 

Unfortunately, much of the analysis of Moneyball from an investment perspective is focused upon the idea of looking for cheap assets and outwitting the opposition in trading for those assets.  Instead, the crucial lesson of Moneyball relates to finding value via underappreciated assets (some assets are cheap for good reason) by way of a disciplined, data-driven process.  Instead of looking for players based upon subjective factors (a “five-tool guy,” for example) and who perform well according to traditional statistical measures (like RBIs and batting average, as opposed to on-base percentage and OPS, for example), Beane sought out players that he could obtain cheaply because their actual (statistically verifiable) value was greater than their generally perceived value. 

In some cases, the value difference is relatively small.  But compounded over a longer-term time horizon, small enhancements make a huge difference.  In a financial context, over 25 years, $100,000 at 5%, compounded daily, returns $349,004.42 while it returns nearly $100,000 more ($448,113.66) at 6%.

We live in a world that doesn’t appreciate value.  In the investment community, indexers are convinced that value doesn’t exist and most other would-be investors don’t have a good process for analyzing the data and are too focused on trading to recognize value when they see it.  While proper diversification across investments can mitigate risk and smooth returns within a portfolio, too much portfolio diversification (“protection against ignorance,” in Warren Buffett’s words) requires that value cannot be extracted. 

Similarly, behavioral finance shows us how difficult it is for us to be able to ascertain value.  Our various foibles and biases make us susceptible to craving the next shiny object that comes into view and our emotions make it hard for us to trade successfully and extremely difficult to invest successfully over the longer-term.  Recency bias and confirmation bias – to name just two – conspire to inhibit our analysis and subdue investment performance.  Investing successfully is really hard.

In another context, stockholders are not demanding value from the executives of the companies in which they invest and are frequently acquiescing to their being paid far more than they are worth.  For example, Stan O’Neil, the guy who ran my old firm Merrill Lynch into the ground, was rewarded with an astonishing $161 million for doing so. Ken Blanchard, who lives one neighborhood over from me, said in church just last week that the ridiculous explosion in executive pay is wrong but it’s the way the score is kept.  We’re nuts for allowing it.

To expand the idea (perhaps to the point of breaking), we must always resist the urge to trade – even a good trade – when investing makes more sense.  While I don’t mean to suggest that a one-off trip to Vegas for a week-end of fun can never be a good idea, too many trips like that can come between you and your goals and can thus be antithetical to a rewarding future.  My ongoing analysis of human nature suggests that we are not just subject to the whims of our emotions.  We are also meaning-makers, for whom long-term value (when achieved) can be fulfilling and empowering.  It simply (it is simple, but not easy) requires the process and the discipline to get there.  What we really need is not always what we expect or want at the time.

This point was driven home to me anew by the terrific movie, 50/50, written by Will Reiser about his ordeal with cancer.  As Sean Burns noted in Philadelphia Weekly, Reiser’s best friend was the kind of slovenly loudmouth that you’d usually find played in the movies by Seth Rogen, except that his best friend really was Seth Rogen.  Rogen’s fundamental, unexpected decency and supportive love grows more quietly moving as the film progresses.  Rogen was undervalued generally and his love and support provided great value to Reiser. 

As the cliché goes, nobody lies on his deathbed wishing he’d spent more time at the office.  We appreciate meaning and value more in the sometimes harsh reality of the rear-view mirror rather than in our mystical (and usually erroneous) projections into an unknown future.

Are you looking for value or just the next trade?