Value Investing: Human Nature and the Last Great Anomaly
It's no secret that stocks with multiples of earnings or book value below those of other companies in their relative benchmark can and do outperform that index. Known as the "value premium" to academics and investors alike, this is a market dynamic that is available to all investors, large and small, and it costs nothing extra to capitalize upon it.
That said, the value premium is not an easy anomaly to exploit for a number of reasons. Value investing can be downright mind-numbing: few want to sift through boring, out-of-favor, often unloved companies looking for a diamond-in-the-rough investment. Also, a long-term outlook is prerequisite for value investing and many people tend to lack the patience needed for long-term investing. Indeed, pain avoidance is primary to the human condition, so value investing can feel somewhat unnatural: looking for inexpensive securities where there's little buying interest goes squarely against what most investors do. So while this source of alpha, or outperformance doesn't carry any extra cost versus investing in a growth stock, for example, it does have intangible costs"¦ including the discomfort of fighting one's own instincts.
How meaningful is the potential outperformance from value investing? Figure 1 shows the value premium over the decade in different equity markets, i.e. the outperformance of value stocks relative to the broader indexes specified. For the long-term investor, value investing may offer entry price advantages in many regions. So why isn't everybody doing this?
Fight or FlightOne place to start when attributing this behavior is the brain and its cognitive biases. Fight or flight is one of the most primal responses found in human behavior and involves making a quick decision when confronted with something identified as a threat. In the case of investing, this threat can translate into losing money. Clearly, many events can be perceived as a threat in equity markets, and there is seldom perfect information. Sometimes there are days when markets are euphoric and other days where markets are consumed with fear. Often referred to as "Mr. Market" by value investors, there is an overriding emotionality to the movements seen in markets, and when it comes to making a decision, fear often causes an investor to sell for the wrong reason when the long-term value of the equity remains compelling.
When taken in context of Figure 2, we see that there is no free lunch in equity investing: value doesn't outperform growth every year. For that matter, it doesn't even produce a positive return every year. The last two years are particularly notable, as growth outperformed value by about 500 bps per year.
Still, the value premium is one of the most persistent sources of excess return found in equity markets. Studies going back to 1926 in the U.S., 1900 in the U.K., and different periods worldwide have shown that the value premium averages about 3% on an annualized basis (See: Triumph of the Optimists: 101 Years of Global Investment Returns; Dimson, Marsh and Staunton, 2002.) The key takeaway here is that a long-term focus on value investing and unwavering discipline has paid off in the past, and did so without taking the forecast risk of trying to predict when value would be out of favor.
So what other factors cause investors to try and gamble against the advantages of value investing?
Overconfidence and HindsightTo certain questions, people will confidently say that they are certain of their answer when they are wrong much of the time. And don't we all know someone who claims to be among the safest of drivers? It's easy to know someone like this because over 80% of drivers make this claim (according to Principles of Management; Bauer, Carpenter and Erdogan, 2009).
There are also several examples of hindsight being a bias in perception. Perhaps you've watched a football game and, after the game is over, heard your uncle say, "I knew those clowns were going to lose anyway"¦." Of course he did - but he's not mentioning the fact that he bet on them to win before the game started.
Fortunately, quite a few people like your uncle play the stock market, and biases like these leave behind exactly the kinds of opportunities that value investors seek.
There are plenty of examples to show that people tend to be highly overconfident of their abilities whether it's in the area of skill or in forecasting. The equity markets are one of the natural homes for these biases to manifest. Consider any of the bubbles that we've seen in financial markets and one sees the level of overconfidence involved in assessing that "house prices never go down" or that "companies don't need to produce cash flow to be highly valued." This overconfidence leads to valuations being bid up beyond rational levels and squarely into the level of overvaluation. And when the bubble bursts, hindsight kicks in and a perpetuating cycle of selling begins: companies are overly punished and trade far below their intrinsic value. Seldom do markets stay at average or median levels of valuation over an extended period. This process happens on an intraday basis as well as over the long term, and the last 10 years is no exception, as shown in Figure 3.
The extreme valuations that result from biases play to the value investor's strengths revolving around price discipline and a long-term investment orientation: by insisting on paying low multiples for an investment, a value investor may avoid the frothy valuations associated with bubbles. In the dotcom bubble, the trademark of a value investor wasn't which internet stock he owned, it was whether he owned any at all. Trafficking in merchandise at 100x two year's forward earnings was, and still is, an offense that will relieve you of the title "value investor."
Often, long-term investment horizons correspond with using discipline in buying an investment. Taking a long-term view on a stock that exhibited a meaningful discount to its intrinsic value and had strong business characteristics led to an attractive return on a 10-year horizon despite market volatility.
Figure 4, which shows the stock price for a non-cyclical consumer goods and services company, provides a strong example of the potential benefits of a disciplined approach. At many points over the last decade, selling a stock like this when the intrinsic value was still substantially higher than the price would have been far riskier than simply holding the stock. Calculating intrinsic value is an inexact science, but basically it attempts to produce a more accurate measurement of a security's value (versus market value or book value) by incorporating intangible benefits such as brand reputation, trademarks, etc.
Despite occasional periods of declining prices, selling an equity like this due to market volatility when the equity still exhibited a broad margin of safety (the difference between intrinsic value and market price) would have forced the investor not only to take on the risk of trying to sell at the right time but also take on the risk of trying to time a re-entry. And the opportunity cost for taking on this timing risk? This particular company has delivered a 22.5% annual return over the last 10 years (excluding the effects of currency-related gains or losses), according to Bloomberg data. Of course, some value stocks don't bounce back over the long term. Professional money managers like PIMCO are tasked with separating these potential "broken eggs" from the resilient "rubber balls."
The discipline that comes from value investing works when making a decision to buy as well. As shown in Figure 5, this particular large cap pharmaceutical company was a darling of the stock market in the 90s, reaching its all-time high price in 2000. There have been plenty of false dawns with this stock since its peak price, but the continued downward trend resulted in part from hindsight bias. It became a self-fulfilling prophecy in the pharmaceutical industry that these are bad businesses with bleak prospects. Investors ignored the strong cash flow generation from current products as well as emerging market growth. The overreaction to the downside from hindsight bias created its own opportunity for a value investor to purchase. The result? The stock is up 35% over the last six months for the investor who had the patience to wait for a floor in valuation, and picked it correctly.
Of course, success or failure in an example like this ultimately depends upon when the value investor enters the position. For example, if the security was purchased in 2001, and the investor held it throughout until mid March 2011, he would not have recovered the initial investment. Finding the right valuation level to buy a stock like this is complex. While attractive valuation and improved financials helped sustain the price of this particular equity in our illustration, stocks have the potential to be a value trap: staying stagnant or even further declining in value, even when empirically considered cheap.
Recent Performance of Value As was mentioned earlier, value has underperformed as a style in global equities over the last two years. Further, looking at a long series of annual returns shows that there are periods where value as a style underperforms broader indexes. As shown in Figure 6, with the exception of the dotcom bubble in 1998 and 1999, the periods of underperformance are shown to be sometimes related with economic uncertainty of different types.
One potential rationale in explaining the underperformance of value in periods around economic concern is the expectation of further economic weakness: people tend to be linear in their thinking and have difficulty processing changes in trends. As a result, equity investors seek comfort in stocks that have good news surrounding their business. This good news is often expressed in the valuation multiples of the stock, and names with value attributes are neglected while the good news stories are bid up.
Investment ConclusionsWhile value investing has had a difficult few years relative to other approaches, the outlook is quite good, mainly because the elements of human behavior that created and support the value premium haven't changed. Despite the substantial changes in the global economy that we've seen due to the financial crisis and that we expect to persist over a longer horizon, investor behavior continues to fuel this phenomenon.
Simply put, we believe the value premium may be a reliable way to generate attractive returns while managing risk over the long term. But the process of searching for undervalued and neglected equities is one that can be tedious, trying and challenging. Even when proper investments are identified, tolerating market uncertainties and the volatility that cloud intrinsic value is difficult. The very existence of a market with differing viewpoints can be a source of doubt to an investor and irrational fear has driven many investors from compelling long term investments. Value investing isn't easy, and it's not suited for most. It's not glamorous in any way, shape or form - and this is exactly why the anomaly will likely continue.
And now, if you'll excuse me, I have to go back to getting my hands dirty looking under rocks. You never know what you might find by looking where other people don't.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Investments in value securities involve the risk the market's value assessment may differ from the manager and the performance of the securities may decline. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Performance results for certain charts and graphs may be limited by date ranges specified on those charts and graphs; different time periods may produce different results.
This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2011, PIMCO.
The MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. Since June 2007 the MSCI World Index consisted of the following 23 developed market country indices: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom, and the United States. The index represents the unhedged performance of the constituent stocks, in US dollars.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2011, PIMCO.
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