Brendan,
Thank you for the question about value investing.
So, to address some of the comments made above first.
The Wisdom of Crowds is a book written by James Surowiecki which sets out the simple but powerful idea that under the right circumstances groups can make better decisions than could have been made by any single member of the group. Examples include the odds at a racetrack which almost perfectly predict how likely a horse is to win (this despite the fact that my mother bets on horses based on their name!), Google’s search engine is another example of a process powered by collective wisdom. In a recent BBC TV documentary Professor Marcus du Sautoy asked a group of participants to guess how many jelly beans were in a jar and the average of all the guesses was within 0.1% of the true number. Another good example of the combined wisdom of crowds is the stock market.
However, critics of market efficiency in financial markets claim that much of the blame for the recent financial meltdown is attributable to a misguided faith in market efficiency that encouraged market participants to accept security prices as the best estimate of value rather than conduct their own investigation.
We asked some leading commentators to join the debate and to share their thoughts with us, first the Father of the Efficient Markets Hypothesis Professor Eugene Fama at the University of Chicago.
“The premise is that our current economic problems are largely due to blind acceptance of the efficient markets hypothesis, which posits that market prices reflect all available information. The claim is that the world's investors and their advisers bought into this model. Because they ceased to investigate the true value of assets, we have been hit with "bubbles" in asset prices. This premise is fantasy. Most investing is done by active managers who don't believe markets are efficient. For example, despite my taunts of the last 45 years about the poor performance of active managers, about 80% of mutual fund wealth is actively managed. Hedge funds, private equity, and other alternative asset classes, which have attracted big fund inflows in recent years, are built on the proposition that markets are inefficient. The recent problems of commercial and investment banks trace mostly to their trading desks and their proprietary portfolios, and these are always built on the assumption that markets are inefficient. Indeed, if banks and investment banks took market efficiency more seriously, they might have avoided lots of their recent problems. Finance, financial markets, and financial institutions are in disrepute. The popular story is that together, they caused the current recession. I think one can take an entirely different position: financial markets and financial institutions were casualties rather than the cause of the recession.”
I doubt any finance professor believes the efficient market hypothesis is completely and literally true. As Fama has pointed out, “the extreme version of the EMH is surely false.” The EMH is an abstraction that allows us to construct a framework for rigorous thinking about how capital markets work. Like any model, it must be false to some degree. The relevant question for investors is “How well do relatively simple asset-pricing models explain a very complicated reality?” Are they perfect? No. But current models do a good job of explaining differences in stock returns as well as money manager results. And researchers such as Fama and his colleague at Dartmouth College, Ken French continue to try and come up with better ways to distinguish high-expected-return securities from low-expected-return securities. If critics can present a superior asset-pricing model, let’s see it so we can subject it to critical review from other financial researchers.
What about the behavioural finance studies which claim that individuals are not rational and are prone to biases in their behaviour?
Fama again; “My academic friends in behavioural finance almost always end up concluding that passive investing is the right choice for almost all investors. In my view, this is an admission that the Efficient Markets Hypothesis provides a good view of the world for almost all practical purposes. “
It is often suggested that investors’ behavioural biases contribute to pricing mistakes which can be exploited by other investors. Many money managers claim to pursue such strategies, but if they were successful in this effort we would see the results in money manager performance studies. We don’t. The results of money managers, including those who claim to apply a “behaviourist” strategy, are well-explained by the same asset-pricing models that critics of market efficiency are so quick to condemn. One of the most prominent economists associated with behavioural finance is Richard Thaler of the Univ. of Chicago. He and Fama don’t agree on much, except when it comes to practical advice for investors. There, his conclusion is essentially indistinguishable from card-carrying market enthusiasts: diversify, keep your costs down, and don’t read your monthly statement. Daniel Kahneman, the Princeton psychology professor who received the Nobel Prize in Economics for his work on behavioural biases, strikes a similar note. Humans often exhibit irrational behaviour, he observes, and, among investors, an example of this irrationality is the persistent delusion that they can outwit the market in the face of overwhelming evidence to the contrary.
Another attack on modern portfolio theory comes from commentators such as Nassim Nicholas Taleb the author of the "The Black Swan" and a fan of the mathematics of Benoit Mandlebrot who attack the use of Gaussian (normal bell curve) mathematics as the foundation of finance. They argue that the bell curve doesn't reflect reality and is critical of academics who teach modern portfolio theory because it is based on the assumption that returns are normally distributed.
Gene Fama again, “Half of my 1964 Ph.D. thesis is tests of market efficiency, and the other half is a detailed examination of the distribution of stock returns. Mandelbrot is right. The distribution is fat-tailed relative to the normal distribution. In other words, extreme returns occur much more often than would be expected if returns were normal. For passive investors, none of this matters, beyond being aware that outlier returns are more common than would be expected if return distributions were normal.”
We asked Larry Swedroe author of Quest for Alpha; what about market timing, surely investors should try to avoid buying just before a market crash?
“Clearly expected returns are based on current valuations, and have nothing to do with historical returns since prices move independently in a random walk. Yes, it is true that high valuations mean low expected returns and vice versa, but that doesn’t mean you can time the market! All high valuations mean is that the Equity Risk Premium is relatively Low, not that it is non-existent.”
But this doesn’t mean that equity returns are more predictable even over the long term. Ask any Japanese investor for last twenty years. All we can say is that current valuations lead us to have a certain expectation of a mean return around a wide potential dispersion of returns.”
We regularly read that investors should follow some form of value strategy. Well here is a newsflash. We are value investors and all our portfolios include an allocation to the value premium. Where we differ from some value investors is that we say that “value” is not a pricing mistake by the market allowing investors to profit from some “unloved” security but rather a risk factor – or compensation for risk. Value stocks are more risky than growth stocks and have a higher expected return as compensation for this additional risk. Legendary investor and Warren Buffet’s mentor, Ben Graham suggested that investors should seek a “margin of safety” when selecting stocks and today many still cite Graham’s 1934 classic Security Analysis. However, just before his death in an interview with Charles Ellis Graham said;” I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook "Graham and Dodd" was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that extent I'm on the side of the "efficient market" school of thought now generally accepted by the professors.”
The key to any market timing strategy is that stock returns are predictable based on observation of various fundamental variables such as P/E, dividend yield, etc. To a degree, academic research supports this assertion: there is some degree of return predictability. The practical question for investors, however, is whether the “signal” from these variables is strong enough relative to the “noise” in the data to develop a useful timing strategy. The evidence here is not compelling. It’s easy to find patterns or variables that have worked in the past. It’s hard to find strategies that continue to work after they are discovered. Many papers have explored this topic, for example A Comprehensive Look at The Empirical Performance of Equity Premium Prediction by Ivo Welch and Amit Goyal which surveys a wide range of variables which allegedly offer useful timing signals. The paper concludes that the evidence of success is weak: “These models would not have helped an investor with access only to available information to profitably time the market.”
The bad news is that, unfortunately, it remains just as difficult to predict where different asset classes will go from here; of course this will not stop many industry experts from trying. In the words of renowned economist, JK Galbraith, "We have two classes of forecasters; those who don’t know and those who don’t know they don’t know."
So, what recommendations do we have for investors when uncertainty is great and emotions are running high?
A final word from Warren Buffett “Most investors ... will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.” It seems that following the wisdom of crowds rather than an investment guru is the practical recommendation for most investors.
By Marc Westlake CFP®,TEP, Grad Dip, Dip PFS, QFA
CERTIFIED FINANCIAL PLANNER TM AND REGISTERED TRUST & ESTATE PRACTITIONER
www.globalwealth.ie