In my opinion, stock-picking with the right process and the right temperament works. And value investing is all about process and temperament, both of which are definitely skills acquired through genetics, but also honed during one’s upbringing and training.
Academic papers presented at the Ben Graham Centre’s 8th Symposium on Intelligent Investing in Toronto agreed that stock-picking skills do, in fact, exist. This is an interesting assertion as academics, believers in market efficiency, have generally and historically ignored stock-picking and due diligence and focused more on diversification and passive investing.
According to these Symposium papers, the tide seems to be turning. Value investors believe that markets move many times irrespective of fundamentals – hence their belief in market inefficiency. Yale University’s Kelly Shue presented a paper in which she provides evidence that “the well-documented negative relation between risk and size is actually driven by nominal prices, rather than fundamentals.” That is, rational investors should think in percentage terms rather than dollar terms when they evaluate the effect of news on the price of a stock. But investors tend to think about the impact of news in dollar terms, which leads to extreme return responses to news for low-priced stocks that have to do nothing with fundamentals.
In the same vein, Joshua Mitts from Columbia Law School found that pseudonymous attacks on companies are followed by stock-price declines and sharp reversals. He identified over $20.1-billion of mispricing in U.S. markets and showed that “pseudonymous authors exploit the perception that they are trustworthy, only to switch identities after losing credibility with the market.” In both papers, stock prices are shown to move for reasons unrelated to fundamentals, consistent with what value investors have always believed.
Other papers presented at the Symposium provided evidence that the quality of accounting information has improved in recent years. This is of fundamental importance to (and good news for) value investors who spend a tremendous amount of time valuing companies and estimating intrinsic value, for which good quality accounting information is key. Robert Stoubmos from Columbia University’s Business School finds that “the explanatory power of fundamental information has increased in recent years, which is consistent with regulatory changes, such as Sarbanes-Oxley and the Global Settlement, making disclosures more informative”. And Theodore Sougiannis from the University of Illinois at Urbana Champaign provides “evidence that an important dimension of accounting quality – predictive ability – has improved after mandatory IFRS adoption”. Both findings are of importance to the valuation methods followed by value investors.
The value-investing process involves three steps. In step one, value investors look for possibly undervalued stocks by screening stocks using P/E, P/B, firm size, analyst coverage and so on – the lower these metrics the better. The stocks that pass the first step look like they are undervalued, but this is not certain. In step two, value investors take the possibly undervalued stocks and determine their intrinsic value. And in step three, value investors make a decision to buy only truly undervalued stocks, namely stocks that meet the margin of safety requirement, which nowadays is about one-third of intrinsic value. Most academic work has looked at only step one and shows that, in the long run, value stocks (i.e., low P/E stocks) outperform growth stocks (i.e., high P/E stocks) by about 7-10 per cent across various markets and world economies. But academics, in general, have not looked at the full three-step value-investing process. I’ve done so in my research and found that the three-step process outperforms the first step of the process by about 2-13 per cent, depending on the time period.
The outperformance of the value approach in the long run rests on the weaknesses of human nature, the conflicts of interest of professional portfolio managers and the biases the interaction between those two creates. This is consistent with what Warren Buffett says he is looking for in his successor. He’s indicated that his successor must understand human nature and institutional biases. And human nature is not going to change; neither are institutional conflicts. As a result, in my opinion, the approach used by value investors that combines process with temperament (a definite set of skills) will continue to outperform in the long run.
And this is consistent with the paper that Mathew Ringgenberg from the University of Utah presented at the Symposium, in which he showed that “skill in generating and processing information is an important source of hedge-fund returns."
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.
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George Athanassakos