” (…) Today, as we honour the legacy of Graham and Dodd, it is important to remember that value investing is not a perfect science. Rather it is an art, with an ongoing need for judgement, refinement, patience and reflection. (…) ” (Seth Klarman)
Recently, I read an interesting research paper about value investing called Fact, Fiction and Value Investing by Clifford Asness et al. (2015). It is certainly one of the better research papers about value investing out there. Nevertheless , did I stumble over certain claims and conclusions of the paper that left me bewildered and in disbelief.
This post will highlight what I regard as shortcomings of the paper. I have to admit that in general I quarrel over academia trying to explain to a practitioner what works in investing and what does not. I will argue that academia is ignorant concerning what is really important in successfully implementing a value investing strategy.
Value Investing and Momentum Strategies: A Match in Heaven?
Let us start with the paper’s basic conclusion. The authors found out that a pure “deep” value strategy is only the third best investing strategy. Combine the “deep” value strategy with qualitative factors (i.e. profitability and quality of earnings), than spice it up with a momentum strategy and volà, you just created the perfect portfolio with a much better sharp ratio than a pure “deep value” portfolio.
What did I find most disturbing in the paper?
Firstly, certain definitions. Already on the second page I even got a little amused. What the heck is the “(…) highly diversified “academic” (…) version of value.”? And more importantly, does it matter? I would argue that it does not! Because, as the authors very likely know, value investing takes time, often years, to play out.
Every know and than the portfolio suffers severe draw- downs during the value realization phase. Some value investors prefer to diversify more in order to handle such periods emotionally. Others, like me, hold a highly concentrated portfolio. Especially, the highly concentrated value investors are willing to “suffer” during corrections or prolonged periods of the value strategy lagging. In addition, do they not see volatility as risk. They have internalized the fact that the stock market in the short run is a voting machine and in the long run a weighting machine. In short, successful value investors are not as obsessed with diversification and volatility as academia is.
Moreover, in its paper the authors go on to note that their starting point is a “(…) “pure” value (…) strategy, based solely on quantifiable measures and not adjusted for other qualities (…)” But what is pure value? Certainly, pure value was never suggested by Graham and Dodd. In the book Security Analysis they advocated as much discrimination as possible when it comes to selecting stocks.
I think for any "real" value investor a “pure” value strategy does not exist. Value investing is a very big tent. It is a heterogeneous framework and strategy, and not homogenous as the adjective pure implies. Here the importance of being flexible comes into play. Peter Cundill once told an anecdote about a guy he has money with and who is interpreting the Graham and Dodd framework in the strictest sense, observing that: “ (…) he is going nowhere, because he is too rigid (…)”.
Intelligently Implementing Momentum into The Value Portfolio
In addition, as the successful value investor is open minded and flexible he certainly will not be shocked, as the authors claim, by their assertion that momentum is a significant contributor to overall portfolio performance. Often enough has the intelligent investor witnessed the powerful forces of momentum in his career. But the practitioner of value investing will ask himself how to implement a momentum strategy intelligently?
Hopefully, will he come to the conclusion that the strategy advocated by the authors of adding momentum stocks to the portfolio is not a viable one for him. Because his circle of competence and his comfort zone is certainly not chasing the hot stocks irrespectively of their intrinsic value. Chasing momentum stocks will break the rules (and not only bend them) of the framework to intelligent investing outlined by Graham and Dodd. No flexibility here, at least not on my side. Irrespectively of how robust the author’s statistical findings are!
Nevertheless, is the practitioner of value investing flexible regarding strategic shifts when following his process to investing. He sees selling too early as a strategic mistake and is well aware of the powerful forces of momentum. Thus, for the practitioner of value investing a viable strategy adding momentum to its portfolio would be, for example, selling only half of his holdings when the stock price reached intrinsic value. Those stocks often are high momentum stocks, because for the value of a deeply undervalued stock to materialize the stock needs to go way up. And for a stock to go up significantly it needs huge price momentum. This is a cost effective way adding momentum to a value portfolio and the practitioner of value investing is not entirely leaving his comfort zone.
Value Investing and Academia: The Mismatch
Let us now focus on my general problem when academia is trying to tell the practitioner of value investing what works in investing and what does not. The strategies they advocate always look very nice on paper. The data they use is abundant, diligently processed and thoroughly back tested over a long period of time. The statistics academia presents to the public are sophisticated and the cause of action appears to be logical, simple and easy.
The only problem is that value investing is simple but unfortunately not easy. And academia keeps on ignoring this fact. They are pretty ignorant concerning the behavioural aspect to investing. Those guys know very little about the emotional trades a successful value investor needs. Mainly, because they have never invested a substantial amount of their net wealth on the stock market. If they had they would have come into contact with manic depressive Mr. Market. They would have experienced first hand how Mr. Market can put even the most level-headed investor on an emotional roller coaster ride. If financial academia had a skin in the game they would be less confident and more humble about their conclusions and suggestions when it comes to stock market investing.
In short, they would acknowledge that the concept of value investing is much more art than it is science! They would concentrate more on the fiction aspects when it comes to value investing, which are a fact.
Unfortunately, the fiction aspects, or better art aspects of value investing, are not quantifiable, and thus for academia they do not matter.
Clifford Asness, Andrea Frazzini, Ronen Israel and Tobias Moskowitz; Fact, Fiction, and Value Investing; April 2015-06-11
Seth Klarman in the Outstanding Investor Digest; March 17, 2009