´´ The Art of Value Investing: The Fiction That is a Fact

Thursday, September 24, 2015

The Art of Value Investing: The Fiction That is a Fact

” (…) 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 volĂ , 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


  1. Hi O-tone,

    I do share many of your issues with "mechanical" value investing. However one comment: Cliff Asness does publish academic paper but he is also a very succesful HF manager. He applies his theories and seems to make them work.


  2. Hi mmi,

    "Cliff Asness does publish academic paper but he is also a very succesful HF manager. "

    I know that he is also a practitioner. Do not know how successful he is to be honest. The last part of the post was more referring to academics in general.

    I said that I find the paper interesting. And I find his other papers interesting, too. Still I have my
    issues with them. If it works for him I am more than happy. Just saying that it won't work for me.


  3. Hello O-tone,

    good article, the sentence I like most is "In short, successful value investors are not as obsessed with diversification and volatility as academia is." How true, and therefore I also prefer a concentrated portfolio.

    The discussion about which strategy or flavor of value investing works best is interesting, but the most important thing is: strategy not tactics. Follow a strategy and be persistent! Don't be fooled by focussing on the minor things.
    Interesting for me is as well, what you write about momentum and about selling only half of the position at reaching intrinsic value. I came to a similar conclusion in one of my older posts, that sometime we need to be "contrarian" and do nothing: let the momentum push the stock upwards for a last icing on the cake.

    Regards Covacoro

  4. Hi Covacoro,

    thank you. And thanks for commenting.

    "How true, and therefore I also prefer a concentrated portfolio."

    I do not advocate concentrated portfolios! It depends on the behavioral pre- conditions of the indivdual investor. Some would fare better being diversified.

    " Follow a strategy and be persistent!"

    I would like to add the adective congruent. The momentum strategy suggested in the paper is not congruent with the process outlined by Graham and Dodd.

    " (...) we need to be "contrarian" and do nothing: let the momentum push the stock upwards for a last icing on the cake."

    Nothing to add here. But always within the framework outlined by Graham and Dodd. Not easy though!