Low Price to Something investing, or “value” investing as it has come to be known since Fama/French introduced the “value” factor has been a disaster for investors over the past 10 plus years.
Academics and quantitative managers continue to argue that the time for cheap stocks will return, because it always does. While hope is comforting, it is not a wealth creation strategy. Indeed, “value” stocks may become so neglected by the market that they become a compelling purchase again, but at what cost to client portfolios in the meantime? The siren song of “the time for cheapness stocks is now” is very alluring, causing principled portfolio managers to secure fame and fortune as asset allocators rather than stock pickers. Unfortunately, cheapness approaches bank on correlation rather than causality, which in portfolio construction as most things in life leads to unexpected ruin quite often. For the investment management industry, so long as the focus on “value” is determined by cheapness indicators, client portfolios will suffer from not receiving the full the full long-term benefit of buying stocks at a discount to their intrinsic value.
Cheapness investing suffers from confusing correlation with causality much like the practice of leeching in the 18th century. Did leeches improve patient health, or did patients benefit from some other unknown factors? Perhaps, patients benefited from the rest involved in completing a leeching cycle? Maybe it was the medical equivalent of an extraordinary hot streak? We don’t know. But over time with better theory, research, and empirical study we did resolve that leeching is not best practice. The same applies to cheapness investing.
Cheapness investing has through brilliant marketing, co-opted the definition of Value Investing, which is unfortunate. A painting from Monet or a first grader is still a painting. The definition of painting has not been perverted. However, allowing value investing to be defined by the use of cheapness variables is a brilliant marketing deception.
As Webster’s would define:
Value: Monetary worth
Cheap: Obtainable at low cost
In the context of investing, Value Investing SHOULD be defined by estimating companies’ intrinsic value, to estimate their monetary worth, and constructing portfolios from those trading below their intrinsic value.
Instead unfortunately,”value investing” has come to be defined by identifying companies that can be purchased at a low cost relative to some fundamental variable such as: earnings, book value, and sales among others.
This is the source of the problem. Earnings, book value, and sales among other such variables do not define the intrinsic value of a company. In the same way the tires on a car are at best only correlated but not the source of how fast a car goes, so are simplistic fundamental variables only at best correlated to a company’s intrinsic value. Since academics and practitioners, do not have access to a reliable estimate of intrinsic value, they focus on commonly available variables they have access to study and feel in some way determine intrinsic value. They then hope there is enough correlation between such variables and intrinsic value that those portfolios will over time beat the market. To be clear, this is not a slight on the intelligence or work ethic of those doing research and practicing in this area. Instead this is simply an acknowledgment of the limitations they face to study and build true value portfolios.
Many current and past academics and practitioners in the area are brilliant men and women. While we believe they are wrong, we don’t diminish their research, in the same way to this day we recognize Christopher Columbus as brilliant, regardless of future advancements in geography. We believe as the investment community continues to learn about our research and our track records continue to lengthen and dominate, the use of multiples as a proxy for value will decline. The reason is simple, markets are very difficult to beat and reward those that do it consistently. With that in mind, lets explore Applied Finance’s Economic Margin™ Valuation further.
Book equity, earnings, sales, and cash flow among other accounting factors are incomplete proxies of a firm’s intrinsic value, yet such metrics are held up by the academic community and the largest quantitative investment firms as tradable proxies for firm value. This is factually correct, as virtually any long-term study will show portfolios consisting of stocks that are cheap on the basis of such measures add alpha.
Three questions then become immediately relevant:
- Is it possible to estimate intrinsic value consistently and accurately through time?
- Do intrinsic value estimates create portfolio alpha?
- If such estimates exist, how do they perform relative to the simplistic intrinsic value proxies advocated by academics and quantitative managers?
The short answers are: Yes, Yes, and Much Better!
In order to begin understanding the properties of intrinsic value in portfolios, it is first required to properly define an approach to measure intrinsic value across: time, sectors, styles, and countries.
Intrinsic value is a function of:
- Economic Profitability
- Capital Investment
There is no shortcut to understanding intrinsic value. Approaches that do not account for each factor ultimately are irrelevant to estimate intrinsic value. Further from a practical perspective, if the same approach is not applied in estimating and combining such factors consistently through time, any interpretation of the results of such intrinsic value estimates are useless due to a lack of consistency and look-ahead bias. The only way to test the efficacy of intrinsic value is begin calculating and storing real time estimates of intrinsic value derived from the same model and framework consistently applied. After 10, 15, or 20 years one will have enough data to begin meaningful study. Applied Finance has been estimating real time intrinsic values for companies over 25 years.
In 1995, Daniel Obrycki and Rafael Resendes created the Economic Margin® framework systematically, and consistently applying the four factors required to properly estimate intrinsic value: Economic Profitability, Capital Growth, Risk, and Competition. Applied Finance applies its Economic Margin® framework to calculate the intrinsic value of 20,000 companies around the world each week. As a result, Applied Finance has a growing database of over 20,000,000 real time weekly valuations applying the same model across: time, sectors, style, and countries. This allows Applied Finance to study in-depth the properties of Valuation versus Cheapness unlike any other firm.
An insight from Applied Finance’s unique intrinsic value database is the ability to directly observe and understand the robustness of cheapness as a source of excess stock returns when combined with intrinsic value.
The short answer is that in the same way leeching may have improved the health of some patients as a result of being correlated to other factors, cheapness based portfolios do outperform the market over time, as cheapness metrics are loosely correlated to stocks trading above or below their intrinsic value. However, after accounting for intrinsic value, cheapness offers little to no portfolio alpha. In fact, a power valuation arbitrage exists exploiting portfolios formed on the basis of simple cheapness metrics.
For a detailed exploration of Valuation vs Cheapness, including a review of the Economic Margin™ Valuation Framework, and the data explaining why cheapness is an inferior approach to portfolio construction we invite you to join our upcoming webinar: Deconstructing Value.