Part 1 of 3
Despite decades of academics and practitioners promoting the ”value factor”1, it generates marginal to no long-term alpha. We believe four reasons have contributed to slow the discovery process from the current accepted “value” regime (low price to something) towards a more robust and realistic true value regime (worth measured independent of market price and focused on the value of future cash flows).
1. No theory. There is no clear link between commonly used “value” variables and true value. Yet academics and practitioners have developed no viably accepted competing perspective to explain future returns. As a result, they accept what seems to work and try to expand its application.
2. Correlation, not causality. Because there is no solid theoretic framework to link accounting book value, earnings, and other such variables to true value; academics and practitioners have explicitly or implicitly focused on improving correlation with returns rather than attempting to create a path to explain causality.
3. Lacking knowledge. Clearly testing hundreds of ratios until a handful are correlated with future returns is easy with databases and computers. Testing true value is much more difficult as such estimates are not widely available and creating them for backtests is very suspect as it is too easy to inject look ahead biases into DCF valuations. To our knowledge no live database2 exists, other than Applied Finance’s, that has consistently estimated true values for thousands of stocks globally each week for over 20 years.
4. Self-interest. With hundreds of billions to trillions invested in the existing “value” regime, it’s not surprising existing stakeholders will vehemently defend and support current “value” investing research and practice.
Graham and Dodd believed that true value investing involves deriving the value of a common stock independent of its market price. This belief/theory provides a rational causal relation to test – do stocks trading below their true value, as determined by a particular valuation model, generate higher future returns than those trading above their true value. The problem with the conventional view of “value” investing (buying low price to some fundamental variable such as: book value, earnings, and others) is that, unlike the Graham and Dodd belief, there is no clear theory to test since a low price to book ratio does not imply a stock trades below its intrinsic value. While a low price to book ratio stock may be undervalued, it may also just describe a fairly valued stock that generates low returns on assets or has few growth opportunities. However, there seems to be little critical thinking among academics and practitioners to assess if the “value factor” alpha results from identifying stocks trading below their true value or if the “value factor” is simply correlated with an undiscovered variable that does have a causal relation with future returns. We will show that the alpha attributable to the “value factor” results from correlation with Applied Finance’s Intrinsic Value Factor™. Untangling the conventional “value factor” from the Intrinsic Value Factor™ essentially eliminates the “value factor” as a viable alpha source. Given the hundreds of billions to trillions invested to capture “value” returns, financial advisors paying active fees for currently constructed “value” strategies should reassess their allocations as they likely are exposed to cheapness which differs significantly from true value and offers very little alpha on a stand-alone basis.
This article has three parts, consisting of:
Part 1 discusses true value investing vs cheapness investing, and the implications for investors and fiduciaries.
Part 2 discusses Applied Finance’s Intrinsic Value Factor™.
Part 3 discusses the data and research methods used to perform this study.
Knowledge and its discovery often travel down unexpected, ironic roads. It’s not that researchers are stupid or systematically make the same mistakes, it’s that they just don’t have the required knowledge or information to make better sense of their world. Or they have such vested interests, that accepting what appears to reinforce their interests happens subconsciously or as the behavioralists say, they have a confirmation bias. For instance, 70 years ago, the concept of Value Investing involved actually analyzing and evaluating a company’s traded price against an estimate of its true value. Interestingly, the era of cheap computational power, readily available security price data, and systematic archiving of financial statements ushered the “Value Factor” era, converting Value Investing to nothing more than buying companies with low “price to something” ratios. The study of applying discounted cash flow techniques to value companies is often met by derision by finance researchers3. Even in leading business schools, valuing companies is often taught by the accounting department and not finance professors. This is unfortunate as instead of valuation forming the foundation to understanding a company’s true value and investment potential, the accepted definition of value today revolves around the relative price of a stock compared to one or various fundamental variables such as book value, earnings, sales and so on.4
The “value” literature today tends to degenerate into various interested factions passionately arguing what archaic adjustments to a fundamental accounting variable leads to the perfect “value” ratio. While the debate for framing the perfect ratio is heated, very little argument seems to take place regarding the core issues central to the debate:
Does use of the “value factor” really represent true value investing?
Do the documented excess returns attributable to the “value factor” result from a causal relationship or is the “value factor” simply correlated to something more theoretically valid to explain excess returns?
It is time for the debate to change. After all, it borders on ridiculous to think a simple accounting variable, available to everyone on Yahoo! Finance should form the foundation for State-of-the-Art Portfolios. No one believes that a price to book ratio is a reasonable estimate of a firm’s true value, but it is easy to calculate and readily available for study. This is also the case with earnings, sales, cash flow or any other financial variable used to scale price to assess “value”. It is sad that the infinite expansion of analytic computational ability has led to such simplistic metrics for the investment management profession to define “value”.
To begin the debate, we must first clearly define the difference between true value investing and cheapness/“value” investing, as promoted in today’s investment literature:
True Value Investing – buying a stock when its market value is below its estimated monetary worth (e.g. purchasing a new Porsche 911 for 50,000 that usually sells for over $100,000 = bargain)
Cheapness/“Value” Investing – buying a stock because it is inexpensive (e.g. purchasing a Mazda Miata at 20% over sticker price instead of a Porsche 911 = cheap)
To put it another way, a cheap stock, is not always a bargain and a bargain stock is not always cheap. For example, let us explore the ability of a ratio to explain whether an investment in a company offers the opportunity for excess returns. We will create a simplified valuation and set of economic assumptions to explore the primary flaws of ratios to make investment decisions between a no-growth/”value” and growth stock.
Example 1 below, assumes each company is all equity financed, cash flows = earnings, all cash flows are distributed to owners each year, the cost of capital for both firms is 0%, and both firms have an initial investment of $100.
Company A is a classic low/no growth “value” stock. Company B is a classic growth stock, with cash flow growing 275% by year 5.
Company B is 22.5% more valuable than Company A and the difference is reflected in their prices. Each company is fairly priced, since their price equals the PV Future Cash Flows. Yet based on forward one-year earnings, Company A has a P/E of 5, while Company B has a P/E of 12.5. In today’s investment world, Company A would be considered a “value” stock and expected to outperform company B. From another “value” perspective, Company A trades at a 22.5% cheaper price to book ratio than Company B, and again per “State-of-the-Art” financial theory, Company A would be expected to outperform Company B.
Company A’s price is below Company B’s, but both firms are fairly priced. Purchasing either firm at their market price will not generate alpha. Cheapness/”Value” Investing incorrectly assumes Company A with its lower ratios is a better investment than Company B.
That such conclusions are so easily accepted defies logic. Building a theory of “value” around such variables because they are readily available is lazy or reflects a lack of knowledge regarding “value” and valuation. Ratios mainly provide information regarding a company’s characteristics, not valuation. For example, high P/Es generally indicate increasing future earnings, while high P/Bs reflect a high Return on Investment. The definitive method to determine if a company is under, fairly, or overpriced is to actually forecast future cash flows and perform a valuation.
While utilizing ratios to define true value investing is sloppy nomenclature, it does represent brilliant marketing. After all, who seeks identification as a cheapness investor, one who seeks low growth, low return companies that may or may not be undervalued. While “value” is likely to stay defined into the immediate future as low “price to something “, so long as this is the case, it will only represent cheapness.
Whether due to marketing, profit, difficulty, or ignorance; academics and the largest investment firms entrusted with investing hundreds of billions refuse to address the basic problems behind simple ratio/cheapness investing. Instead, they create increasingly complex formulations to construct portfolios premised on a fundamentally flawed view of ratios. This further begs the question as to whether the “value” factor is a causal variable that generates future alpha, or is it correlated to a more theoretically sound undiscovered factor that provides a more intuitive, succinct, and robust explanation for future alpha?
Confusing causality and correlation are nothing new to knowledge discovery. Humans are wired to make sense of relationships. Fire burns, don’t touch. Lions kill, avoid. They are perfectly valid interpretations of obvious relations. However, sometimes relationships are more complicated and it’s easy to create and believe perfectly reasonable and often elaborate theories for why certain relationships exist. For example, our ancestors probably did not enjoy being leeched. After doctors found enough patients improved after being leeched, however, a new medical treatment ensued. Along with the observation that the treatment worked, were many (now crazy) theories to justify leeching. Until true causal reasons to improve sick patients were discovered and accepted, leeching persisted. We are sure, as the transition to better medical approaches unfolded, leeching doctors vehemently resisted these improved treatments.
Similarly, scattered across the financial research landscape, hundreds of variables and specifications have been formulated and discarded due to their inability to explain future stock returns. From the endless and ongoing data mining expeditions, a handful of fundamental variables tend to define the current “value” investor toolkit. They are book value, sales, cash flow and accounting earnings. Investment managers seem to have an endless capacity to argue about which of those variables or combinations of variables are the right way to generate alpha. What most practitioners take as given, however, is that some combination of the above variables adequately defines “value”, and cheapness/“value” investing is a long-term source of alpha.
But why should that be the case? As stated earlier, none of those variables, alone or in combination with one another, begins to represent a reasonable approximation of a firm’s true value. Therefore, why should they successfully identify stocks likely to generate alpha? The answer is they don’t.
Instead, their ability to generate alpha results from their correlation to true value. Specifically, conventionally defined “value” stocks (low price to something) generate alpha to the extent they are also stocks trading below their true value. If a “value” stock is not trading below its true value, it effectively generates zero tradable alpha. Conversely, stocks trading below their true value, regardless of whether they are conventionally defined “value” stocks, generate significant, tradable alpha5. The upshot for investors is simple- if you have invested in conventionally defined “value” (low price to book, price to earnings, price to sales, price to cash flow) strategies, you have some accidental exposure to true value, but not as much as you think your fees purchased. Similar to how leeching sometimes resulted in cured patients to the extent they were already on the mend, conventional “value” stocks sometimes outperform, but only to the extent they are undervalued according to Applied Finance’s Intrinsic Value Factor™.
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Part 2: Understanding Applied Finance’s Intrinsic Value Factor™
Part 3 Data and research methods used to perform this study.
1 While Fama/French popularized the term “value factor” in reference to high book to market portfolios adding alpha, we refer to the value factor more broadly to include a ratio of low price to any of the following fundamental variables: book value, earnings, sales, and cash flow.
2 The Applied Finance Group, Ltd. has delivered weekly intrinsic value estimates for 20+ years on over 20,000 companies globally to its institutional clients using the same valuation model incorporating systematic estimates of: economic profit, capital growth, risk, and competitive position. These live, time stamped, publicly distributed valuation estimates have all been produced with the same framework and model. We are not aware of any other such database.
3 Academics and quantitative investors stress the need for an objective value measure that eliminates any potential qualitative biases.
4 Ironically, Fama/French’s introduction to their 5 Factor model uses a dividend discount model to explain that the value of a security is the present value of its future dividends.
5 An equivalent relationship holds with overvalued stocks as measured by the Intrinsic Value Factor™. Regardless of whether they are “expensive” or “cheap” from a conventional “value” perspective, these stocks underperform. However, “expensive” stocks (high price to something) do not underperform unless they are also overvalued as measured by the Intrinsic Value Factor™.