Price Multiples Have Been Lying to You
Most professional investors acknowledge the problematic nature of price multiples, yet they continue to be used heavily in the industry. Multiples are easy to comprehend, they provide a common language for investment professionals and offer a simple solution for defining growth/value indices. Despite the ease of use, price multiples provide no insight into the value of a company and even worse, deliver negative alpha on a risk-adjusted basis. Yet, some of the most recognized factor-based investment firms today have conditioned their investors to believe that a multiple is the “value factor” and have continued to defend its use to the point of delusion.
Recently, Clifford Asness of AQR published The Long Run Is Lying to You, criticizing our take on quantitative value investing contained in Quantitative Value Investing is Broken. Like a magician that has their trick revealed, they are left only with jokes and poking fun to keep the audience’s attention. We think the Asness piece has numerous problems which we addressed in our Valuation vs. Cheapness in Tactical Allocation rebuttal. Like a roll of dice or a spin on the roulette wheel, expected returns have no memory or catch up. If a stock is 10% undervalued today, it is 10% undervalued regardless of if it underperformed the market by 100% in the past 10 years. The trick has been revealed that a multiple is not the “value factor”, nor anything close to a complete valuation approach.
This begs the question, if a multiple is nothing more than a communication tool, why would investment firms continue to use it for portfolio construction or indexes use it to define growth/value stocks? If all you have is a butter knife and you are trying to sell it to a person to sink a screw, you better convince your buyers that a screwdriver isn’t necessary. You may have settled on the butter knife because that is what you had available, but once you realize the usefulness of a screwdriver you will never use a butter knife to sink a screw again. Investors should focus on valuation, otherwise, they may end up like the screw!
Further compounding the many drawbacks of factor-based investing is the indiscriminate punishment of growth. By blanketly punishing companies that grow their invested capital base, factor-based investors have missed out on some of the greatest wealth compounding firms over the past 20 years i.e. FB, AMZN, GOOGL. Rafael Resendes recently explained the importance of wealth creation on the Valuewalk’s ValueTalks podcast. The main gist is that growth and profitability should not be evaluated independent of one another, the market will reward profitable firms that are reinvesting in NPV positive projects.
Applied Finance has released a more complete asset pricing approach that incorporates valuation and wealth creation CFA Presentation: Valuation Beta, Derek Bergen, CFA. This exciting new research has garnered a lot of attention because it leverages 23 years of out-of-sample valuation data and disrupts 20 years of academic research. We look forward to keeping you informed on our research and how we plan to make it available to investors through a new ETF at the beginning of May.
The Valuation Edge™ Newsletter Articles:
Rafael Resendes on Valuewalk’s ValueTalks podcast
Understanding Wealth Creation with Rafael Resendes, Partner at Applied Finance. Mr. Resendes discusses the shortcomings inherent in the Quantitative Value approach to investing and introduces a more refined approach to understanding the concepts of wealth creation and understanding valuation.
CFA Presentation: Valuation Beta, Derek Bergen, CFA
Derek Bergen, CFA (Partner, Applied Finance) shared Applied Finance’s “Valuation Beta” research with a CFA chapter discussing the importance of intrinsic value in portfolio construction, including its alpha characteristics and applications in asset pricing.
Valuation vs. Cheapness in Tactical Allocation
Many investors have abandoned their security analysis discipline in the search for low-cost investment products, and most academic research has applauded that decision for decades. Applied Finance has established an extensive out-of-sample systematic track record to confidently defy these trends with a disciplined valuation approach. We provide evidence and return comparisons that should encourage investors to look beyond “cheapness” strategies and consider a comprehensive valuation metric in all of their stock selection, portfolio construction, and asset allocation decisions.
Market in Pictures #7
This month’s Market in Pictures discusses the hidden risk in long duration stocks, the meteoric rise of $TSLA market cap and its inclusion in the $SPY index.