The Search for Value Continues
Thought leaders from academia and industry were in New York recently for two days of engaging discourse at a conference on Security Analysis and the Search for Value, hosted by CFA Institute and the New York Society of Security Analysts.
The influence of value-investing pioneer Benjamin Graham was a common thread through many of the presentations, beginning with that of Aswath Damodaran. Professor Damodaran, from the Stern School of Business at New York University, focused on the discounted cash flow model as a primary tool for measuring intrinsic valuation and on the unique challenges posed by “hard-to-value” firms. Damodaran warned analysts to avoid the temptation of falling for “paradigm shifts” and new metrics (remember the “eyeballs” metric from the dot-com bubble?), encouraging them to focus on the numbers and not be swayed by a compelling “story.” The noted authority on valuation has previously addressed DCF analysis for CFA Institute audiences, and his presentation entitled “Valuation Inferno: Dante Meets DCF – Avoiding Common Mistakes in Valuation Analysis” is an informative step-by-step dissection of the DCF model.
David Cowan, a portfolio manager at GMO LLC, struck a similarly quantitative theme as he presented findings from his research examining why high beta stocks historically underperform low beta stocks, which is at odds with the accepted risk/reward trade-off of the capital asset pricing model. This “beta puzzle” has historically been explained away as peoples’ willingness to pay a premium to gamble, and others argue that beta is a form of “implicit leverage.” Cowan contended that while these theories hold grains of truth, they also miss something important. What is needed, according to Cowan, is a theory that explains the beta puzzle without having to assume irrationality or levered returns. Beta’s return profile is one of high correlation with the upside movement of the stock market, but there is lower correlation with downside moves in the stock market. In short, beta provides asymmetric returns, or convexity. Cowan’s beta puzzle explanation is that convexity is a good thing, and good things are rarely free. For those interested, Cowan’s findings are presented in greater detail in this white paper.
Nicholas Colas, chief market strategist at ConvergEx Group, encouraged the audience to look for “off-the-grid” data that may give an early indication about changes in the health of the U.S. economy. Colas noted, “Traditional economic indicators are slow and archaic. We seek out the harder-to-capture social trends because markets exist in a broad social context.” It may be as simple as looking for the top 10 “autocompletes” on Google, Yahoo!, and Bing for “I want to buy…” or “I want to sell my…” to determine how people are thinking about their lives, discretionary spending, and savings. Purchasing trends, for example, can give great insight into Americans’ uneasiness about the world, as shown in the changes in the demand for guns and gold or silver coins. “Rising sales of guns and silver coins (the precious metal coin of choice today due to the high price of gold) may signal that people are insecure about American society,” said Colas. Another negative indicator he’s watching is the number of active food stamp recipients, which has nearly doubled in the last four years, rising from 25 million to 45 million people, or 20% of U.S. households.
On a brighter note, Colas pointed to the rising trend in used car sales since January 2009 (though slightly down in 2011), which he sees as indicative of people’s willingness to spend now — and possibly on new cars in the future. Pickup truck sales are also moving in the right direction as workers transition away from construction jobs to other more profitable sectors, such as farming or oil, in which trucks are useful. “Job quits,” which correlates well with consumer confidence, are also on the rise.
Richard Bernstein, CEO of Richard Bernstein Advisors LLC and previously chief investment strategist at Bank of America Securities-Merrill Lynch, observed that “periods of volatility always signal a change in leadership.” Before the “Lost Decade” (2000–2009) began, investors were anchoring to the best-performing sectors from the prior five years, Bernstein noted. And he sees the same thing happening today with investors’ heavy focus on emerging markets. Bernstein warned that investors now moving into emerging markets and gold are setting themselves up for another lost decade.
Bernstein said the long-term case for U.S. equities rests on three pillars: valuation, sentiment, and the corporate sector. “Relative valuations between the U.S. and emerging markets are totally opposite from those of thirteen years ago when emerging market valuations troughed,” Bernstein said. Sentiment, a contrary indicator, is currently giving a positive signal, as evidenced by the strength of gold. And the stability of corporate earnings and cash flows, increased transparency, and positive earnings revisions and surprises are additional reasons for optimism.
Bernstein also emphasized that diversification is one of the least understood areas in the markets today. Zero risk-free rates help to make virtually every risk asset class look attractive and, as a result, correlations of all asset classes to the S&P 500 have been exceptionally high in the recent past. “U.S. Treasuries are the only diversifying asset class,” Bernstein said.
Jean-Marie Eveillard, senior adviser at First Eagle Funds and a veteran value investor, advocated for both quantitative valuation principles, as espoused by Benjamin Graham, and qualitative analysis, as practiced by Warren Buffett. Preaching patience, he opined that the term “value trap” is merely an “invention of momentum investors and traders” and cited fellow value investor Martin Whitman’s distinction between “temporary unrealized capital losses” and “permanent impairments of capital.”
Reflecting on the current environment, Eveillard criticized banks that have strayed from a traditional banking model as “hedge funds in disguise” and pointed to gold as “protection against extreme outcomes.”
Andrew Lo, professor of finance at MIT’s Sloan School of Management, whose work, most notably his adaptive markets hypothesis (AMH), has sought to reconcile the efficient markets hypothesis (EMH) and behavioral economics, explored a number of behavioral biases — including risk aversion, loss aversion, randomization, and probability matching — as well as their practical implications.
Lo did not suggest that the EMH is wrong, only that it’s incomplete because it doesn’t consider evolutionary principles. Competition drives adaptation and innovation — and this evolution is what determines market dynamics. According to Lo, a better understanding of human behavior can only improve the investment process. Lo delivered a similar message in this 2010 webcast on the AMH.
Howard Marks, CFA, chairman of Oaktree Capital Management, is well-known as a voice of reason in investing circles, and his memos have long been considered required reading by many. In his presentation, Marks quoted everyone from Yogi Berra to John Kenneth Galbraith in delivering common sense advice to the audience. In urging delegates to avoid the herd, he noted that “at most points in time, the real bargains are found in doing things others won’t do.”
Also known as a contrarian, Marks endorsed Graham’s margin of safety principle and reminded the audience that “smart investing doesn’t consist of buying good things, but rather of buying things well. Price is what matters most for investment success.”
Marks closed by challenging the EMH and reminding the audience that “inefficiencies—the investing crowd’s mistakes—arise all the time and are the superior investor’s raison d’être.” For more from Marks, see this brief interview in which he discusses his client memos and his investment philosophy. And this article describes how Marks has instilled in his firm an investment culture which emphasizes risk control above all else.
Mike Mayo, CFA, banking analyst at CLSA, pronounced the “Three Rights of Analysts” to be the right to ask for information, the right to get information, and the right to act on information. Mayo lamented the lack of sell ratings on Wall Street, invoking Standard III of the CFA Institute Standards of Professional Conduct, which covers duties to clients. He reviewed the state of the banking industry today, describing U.S. banks as “Japan-lite,” noting that U.S. banks are better managed and more profitable, and benefit from better demographics. Mayo recounted a number of his run-ins with bank managements, which are also well-chronicled in his recently released book Exile on Wall Street. In a review of the book, The Wall Street Journal praises Mayo for having “the guts to warn that the system remains riven with conflicts.” And Bernie Madoff whistle-blower Harry Markopolos adds, “If you want to know the sickening truth about the largest banks, read Mike Mayo’s exposé.” For those interested, here’s a brief excerpt of his book.
Full-length webcasts of the presentations from this conference are available on the CFA Institute website:
- “Think Differently: Off-the-Grid Economic Indicators,” Nicholas J. Colas
- “Valuing Young Growth Companies,” Aswath Damodaran
- “The Origin of Behavior,” Andrew W. Lo
- “Positioning Portfolios for the Long Term,” Richard Bernstein
- “Conversation with a Veteran Value Investor,” Jean-Marie Eveillard
- “The Most Important Thing: The Human Side of Investing,” Howard Marks, CFA