The value effect and efficient markets

Richard Beddard has blogged on some interesting new evidence for the value effect. He also refers to our long running argument over active investing. I have more to say on that, and I also disagree with Richard's attack in financial theory.

My position is this:

1. I accept that many securities are mispriced (i.e. not at the price they should be according to the efficient markets hypothesis).
2. I am very sceptical about an investor's chances of finding mispricings through stock picking. I have no doubt that the small number of investors who seem to be able to out-perform consistently are almost all simply at the far end of the probability distribution.
3. I do favour mechanical investment strategies because the right strategy will exploit any consistent bias in valuations. Mechanical strategies can be rigorously back-tested.
4. The existence style index trackers means many mechanical strategies are cheap and easy. Even better, others require only infrequent trading and are still cheaper.

It should not be hard to find a fair number of investors who have consistently out-performed. Survivorship bias (unsuccessful private investors give up, under-performing fund managers get fired, etc.) will ensure this, the more so if returns are more “fat-tailed” than the normal distribution. However this is a matter of luck. Even accepting that there are a few investors who can out-perform consistently because they are good stock-pickers, how can one tell them apart from the merely lucky? How can on tell even is oneself is lucky or good?

The new evidence supporting the value effect is interesting, and I particularly liked the fact that it uses valuations based on price/cash flow rather than PE ratios — after all cash flows are what most value investors focus on. However there was already fairly good evidence for the value effect. A very simple analysis of freely available data convinced me that large cap growth stocks, should be avoided in favour of small cap growth. It may be worth tolerating the value destruction caused by index-trackers' constant re-balancing as, in the case of style index trackers, it keeps the portfolio focused on the right investments.

I also need to take issue with Richard's comments on financial theory. It is an overstatement to say that the efficient markets hypothesis is part of “conventional finance theory”. There is far to much argument and accepted uncertainty about it. There are three different forms of the EMH, and much discussion about which holds when. Much of financial theory is concerned with why markets deviate from efficiency.

I would say, in fact, that Richard's own assumption that finding inefficiencies is worthwhile implicitly accepts as much market efficiency as I believe in. It is worth finding inefficiencies because they tend to shrink in the long term, thus allowing those who find them to out-perform significantly over comparatively short times (a few years or less).

The greater riskiness of growth stocks is also exactly what one would expect from financial theory. Any type of DCF valuation will discount cash flows that are further off in the future more heavily. This means that the cash flows of growth stocks will be discounted more heavily. While part of this reflects the time value of money, the rest comes from compounding the risk premium.

Comments

Richard Beddard

Hi Graeme

First off I am probably guilty of confabulating the stronger versions of EMH with the whole of financial theory!

In fact I don't think we disagree about much - it's mostly semantics. Another example is mechanical investing. I like it too. But I think it's a form of active investing. Once you've decided to buy shares that have high yields, or low pes, or small caps you're taking an active position against the market.

I would say my own method is 80% mechanical. I search for stocks that have low long term pe's, high interest cover and cashflow roughly equaling or exceeding earnings over the long term. Then I rank them and look among the low pe shares for companies that are in businesses that are still relevant. Judgement only comes into the last bit.

Whether that adds value or not is up for debate. Whether its skill or luck is too. Buffett had an answer to that in a speech he gave called the Superinvestors of Graham and Doddsville. Basically he identified a group of investors including himself that massively outperformed and said that of course, it could be luck, but the fact that they all outperformed using the same technique (variants of value investing) suggests otherwise.

My position is that it's not skill or luck but strength! i.e. I have the psychological strength to withstand the herd and buy deeply unpopular shares that actually aren't that bad, and hold them even if they get even more unpopular!

Concerning your last point - it's not what you'd expect from the EMH (shares that give high rewards - i.e. value, being relatively low risk). So again, perhaps I shouldn't have been more specific about which financial theory!

A pleasure trading ideas, as always.

Richard.

Value investor not conservative enough : Interactive Investor Blog

[...] to one I favour, I’ve plucked this explanation from a comment I left on Graeme’s Moneyterms blog: I would say my own method is 80% mechanical. I search for stocks that have low long term PEs, high [...]

Graeme

Thanks for the detailed comment Richard.

I do not want to argue semantics too much, but I do feel that a strategy that can be followed by buying a tracker fund should be regarded as passive. I accept that there is a grey area here.

I suspect the common aspects of the success of Buffett's group of investors could be captured by the right mechanical strategy.

Furthermore, even if a few exceptional people are good stock-pickers in a way that cannot be captured by a mechanical strategy, very few investors have a good reason to believe that they can join that group.

I also wonder about the extent to which consistent out-performers have <a href="http://pietersz.co.uk/2007/07/insider-trading" rel="nofollow">consistently better access to information than the rest of us</a>.

I do agree about having the strength of character to withstand the herd is important. This is one area where we know markets get it wrong (otherwise bubbles would not happen), and it is often not obvious. There are huge incentives to go with the herd (fear and greed), as fund managers who were fired for under-performing by staying out of technology during the dotcom boom found out.

In the last paragraph I refer specifically to the riskiness aspect of it. The value effect is not explained by any DCF model, it probably can only be explained by a behavioural model.