Contrarian investing

What is value investing?

The most realistic distinction between the investor and
the speculator is found in their attitude toward stockmarket movements. The speculator's primary interest lies
in anticipating and profiting from market fluctuations. The
investor's primary interest lies in acquiring and holding
suitable securities at suitable prices. Market movements
are important to him in a practical sense, because they
alternately create low price levels at which he would be
wise to buy and high price levels at which he certainly
should refrain from buying and probably would be wise to
sell.

Assume that a run-of-the-mill common stock is not particularly

well suited to a formal valuation because there are too many
uncertainties about its future to permit the analyst to estimate its
earning power with any degree of confidence. Should analysts reject
the valuation technique in such cases and form their opinions about
the issue by some other approach?

The soundness of a common stock investment, in a single issue or a

group of issues, may well depend on the ability of the investor or
the analyst-advisor to justify the purchase by a process of formal
valuation. In plainer language, a common-stock purchase may not
be regarded as a proper constituent of a true investment program
unless some rational calculation will show that it is worth at least as
much as the price paid for it."

Margin of safety
"[To] have a true investment, there must be a
true margin of safety. And a true margin of
safety is one that can be demonstrated by
figures, by persuasive reasoning, and by
reference to a body of actual experience."
Ben Graham

A portrait of failure: the performance of every US large cap fund with a 15

year history vs the S&P500 and CRSP 1-10 indexes. 15 Years ending 31
December 2001 (285 Funds)

Picture credit: Dimensional Fund Advisors

Efficient markets hypothesis

Weak form: all past market prices and data are
fully reflected in securities prices. (Technical
analysis is of no use.)
Semi-strong form: all publicly available
information is fully reflected in securities
prices. (Fundamental analysis is of no use.)
Strong form: all information is fully reflected
in securities prices. (Even insider information is
of no use market is omniscient.)

The implications of EMH:

There are only two ways to outperform the
market:
1.Getting lucky
2.Taking on higher risk

Traditional EMH:
Stock prices move in random walks.
Prices always reflect best estimate of value
based on all available data.
Dart board as good as any analyst.
Best approach is passive or indexed
investing.

Warren Buffett: The Superinvestors

of Graham and Doddsville, 1984
Name

Index Return

Period

WJS Partnership

8.4% 21.3%

1956 1984

Tweedy, Brown and Co.

7.0% 20.0%

1968 1983

Buffett Partnership

7.4% 29.5%

1957 1969

Sequoia Fund, Inc.

10.0% 17.0%

1970 - 1984

Warren Buffett: The Superinvestors

of Graham and Doddsville, 1984
Name

Index Return

Period

Charlie Munger

5.0% 19.8%

1962 1975

Pacific Partners Ltd

7.8% 32.9%

1965 1983

Perlmeter Investments

7.0% 23.0%

1965 1983

Fama and Frenchs Three factor model

Your returns mostly come
down to asset allocation:
The mix of stocks vs bonds
The average company size
The value characteristics of
the stocks - how cheap
stocks are compared to book
value.

Picture credit: Dimensional Fund Advisors

Modern finance today resembles a MesoAmerican religion, one in which the high priest
not only sacrifices the followers - but even the
church itself. The field has been so indoctrinated
and dogmatised that only those who promoted the
leading model from the start are allowed to
destroy it."
- Comment on Fama/French value findings

Academic definition of value

Fama and French sorted stocks by book to
market or BtM, which is the inverse of the
measure most investors use, price to book ratio.
Using BtM rather than PBR avoids divide by
zero (infinite) values. Value stocks are stocks
with a high book to market.
Other parameters have been tried out, like sorting
by earnings, sales, cash flow, dividend yield etc,
but many researchers find that BtM gives better
results, partly due to the fact that book values are
less volatile than other measures.

Dreman major findings:

Analysts tended to be bad at forecasting with
low precision on all time frames in all industries
in all market capitalisations.
Overall, analysts tend to be too bullish and
overestimate future earnings growth.
When a stock surprises the market with
earnings higher or lower than expectations,
significant price movements can result.
Stocks tend to react differently depending on
their price and market expectations.

Growth stock earnings surprises

Dreman found that growth stocks tend to have very
bullish expectations built into them. (Hence the high
prices of course). As a result, when growth companies
have earnings surprises, they more commonly surprise
on the downside.
Interestingly, he found that when growth stocks tended
to surprise on the upside, little price action resulted. It
seems that investors sometimes can be so bullish about
a company that even good news doesnt surprise them.
When growth stocks surprised on the downside though,
the result was often a sharp selloff.

Value stock earnings surprises

Dreman found that value stocks tend to have very
poor expectations built into them. (Hence the low
prices of course). As a result, when value companies
have earnings surprises, they more commonly surprise
on the upside.
Interestingly, he found that when value stocks tended to
surprise on the downside, little price action resulted. It
seems that investors sometimes can be so bearish about
a company that even bad news doesnt surprise them.
When growth stocks surprised on the upside though, the
result was often a sharp rally.

Net effect of all earnings surprises

Great things are expected from growth stocks so
when they deliver great things the market can be
hard to impress (more), but if the worst is feared
from a value stock the result can often be pleasing.
The earnings surprises tended to result in value
stocks having higher returns and lower risks than
growth stocks.

Lakonishok, Josef, Andrei Shleifer, and Robert Vishny, 1994,

Contrarian investment, extrapolation, and
risk, Journal of Finance 49, 15411578.

For momentum investors, who pin their expectations to

high growth rates, any slip in quarterly performance can
cause grievous results. There is little solace in missing
targets by tiny amounts, even though accounting practices
leave ample wiggle room. Most companies that are close to
earnings targets should meet those targets - particularly
when the stock price hangs in the balance. In high p/e
territory, if lofty growth expectations are missed by an inch,
it may mean that a company has really missed by a mile.
Whatever the actual amount of the miss, uncertainty alone
can mete out tough punishment, and creative accounting
practices ultimately catch up to offenders.
- John Neff, John Neff on Investing

Value or growth?
The whole concept of dividing it up into "value" and
"growth" strikes me as twaddle. It's convenient for a bunch of
pension fund consultants to get fees prattling about and a
way for one advisor to distinguish himself from another. But,
to me, all intelligent investing is value investing. That's a
very simple concept. And I don't see how anybody could
really argue with it. Buffett says, In our opinion, the two
approaches are joined at the hip: Growth is always a
component in the calculation of value, constituting a variable
whose importance can range from negligible to enormous
and whose impact can be negative as well as positive.
Charlie Munger, 2000 Berkshire Hathaway AGM

Two very different forms of value investing

Active (Graham and Dodd) investors look at stocks as
shares in a business, try to understand that business and
buy them when they are cheap relative to their intrinsic
value, usually using some form of discount cash flow
valuation.
Passive or quantitative investors simply sort stocks via
some measure like price to book ratio and divide them
up into value, neutral and growth. This is not
value investing the way any active investor would
recognise it. This causes much confusion, so perhaps
unglamour and glamour would be better.

Variations on a theme

Deep value active

Deep value passive
Growth at a Reasonable Price active
Stock pickers

Disclaimer:
This article contains the opinions of the author but do not represent a
personal recommendation of any particular security, strategy or
investment product. The author's opinions are subject to change
without notice.
Information contained herein has been obtained from sources believed
to be reliable, but is not guaranteed.
This article is distributed for educational purposes and should not be
considered investment advice or an offer of any security for sale.
Investors should seek the advice of their own qualified advisor before
investing in any securities.