Value Investor (part 1)

sean-stratton-ObpCE_X3j6U-unsplash.jpg

Value investing sounds really cool. It sounds savvy, it sounds smart, it sounds responsible, it sounds like it makes a lot of money. I mean, Warren Buffet is a value investor!

So what is a value investor? Well, a value investor is someone who invests in value companies. So what’s a value company? I’m glad you asked. Essentially, a value company is one whose stock price is about the same (could be a little higher or lower) than its intrinsic, or book, value. A lot of words there but stick with me. The intrinsic value of a company is what you get when you add up all the company’s assets, its land, warehouses, products (which can include patents), equipment, cash, etc. It might seem a little odd that a company’s stock price wouldn’t always be close to its intrinsic value, but the stock market prices of growth companies (the opposite of value companies) can actually trade multiples of 8 times higher than its intrinsic value. This happens because the market expects the growth company to continue growing. Value companies aren’t typically expected to grow much, they’re often characterized as distressed. So value investors are analyzing these value companies and deciding which ones they think are actually undervalued and which ones could bounce back. Again, it sounds great, they’re the brilliant nerdy guys reading all of the fine print and finding the deals in the stock market, the companies that are underpriced. All you have to do is hitch up to their wagon and ride those value companies up when everyone else figures out how valuable they actually are. Sounds pretty responsible, right?

A semi-famous value investor, Michael Burry, featured in the Big Short (as Christian Bale) crushed the growth stock market from 2001-2005. In the middle of 2005, he was up 242% when the U.S. large growth market (S&P500) was down 6.84%. Michael Burry is the quintessential weird genius that we love to fall in love with, and hand our money over to. He did things differently, he didn’t take normal massive fees, he was incredibly awkward with people in person, he kept to himself, he obsessively studied the interworkings of the companies he invested in, just about everything you would expect from the next market genius. He’s most famous for predicting, and attempting to short, the housing crash in 2007. And now’s he’s rich, and semi-famous, and still investing. He recently stated that passive investing is a bubble, that he’s concentrated on water (you get it), that GameStop is undervalued, and that Asia is where it’s at. While these investment tips might accord with the laws of value investing, they hardly seem prudent.

Michael Burry is definitely smarter than I am, but here’s what I know:

1) Ken French, a professor of finance at the Tuck School of Business, Dartmouth College, who has spent much of his adult life researching and publishing in the sphere of economics and investing, conducted a study of mutual-fund managers (Luck versus Skill in the Cross-Section of Mutual Fund Returns) and found that only the top 2% to 3% had enough skill to even cover their own costs. Eugene Fama, another father of economic and investing academia, who co-wrote the paper with Ken French, summarizes their findings this way: “Looking at funds over their entire lifetimes, only 3% demonstrate skill after accounting for their fees, and that’s what you would expect purely based on chance.” Of the managers who do exhibit enough skill to cover their own costs, it’s hard to determine whether an actual skill is at work or it’s simply a facet of luck; most free-market scholars lean towards luck.

2) Fama continues: “Even the active funds that have generated extraordinary returns are unlikely to do better than a low-cost passive fund in the future.” Some managers do well enough to cover their own costs and beat the market in a given year. Unfortunately, their success languishes quickly and they regress to the same plane that active managers on the whole occupy, which is underperforming the market.

So is Michael Burry, or any value investor, the weird, brilliant savant that we desperately want to attach our life-savings to, or is he one of the 3% of managers who have done well enough to cover their own fees, but who the data says is more likely to regress to market underperformance mean than to do it again? I know which side I’m playing.

2018 Book Recommendations

I would say that reading, specifically reading books, is the single most important method of self-improvement that a person can engage in. A few years ago, in a desire to improve myself and my circumstances, I decided to read more books, and the payoff has been overwhelmingly positive. Probably the main benefit reading has imparted to me these last few years is to change the way I think. My goals and ideas and aspirations are bigger, my concept of what’s possible has grown. This change in thinking has also affected my behavior, my actions have been more consistent and more ambitious, I even waste (a little) less time with TV and on my phone. Basically, reading books can have a transformational effect. So, I want to share some of the best books I read last year (2018) in the hope you can reap some similar benefits from them. The list is broad, ranging from self-help and productivity to history to fiction and anything in between. Dig in!

The Three Laws of Performance is top shelf coaching material. Steve Zaffron delves into what actually causes transformation in people’s lives and organizations, how to really induce change. It’s not the typical rah-rah motivational material, this is real, strategic, transformative coaching. It’s also filled with real-life examples and stories, which makes it very accessible.

What’s Best Next is an incredible guide to greater personal productivity. Matt Perman is a confessed productivity junky who has gathered and distilled some of the best productivity literature available, conducted interviews with accomplished subjects, and drawn from his own experience to build his best strategies for increased effectiveness. It’s organized, well-researched, very practical, I even found it inspiring. The structure of my entire week is based on things I gleaned from What’s Best Next.

The Marks of a Spiritual Leader is not simply for pasters and Bible-study leaders. This little book is packed with practical and helpful advice for anyone in any type of leadership role. It’s clear, concise, practical, and at less than an hour total read time, it is well worth the investment.

The One Thing may be the best book on setting and achieving goals that I’ve come across. The title is a giveaway, but Keller stresses the need to determine your most important one thing and focus on that one thing tenaciously. It’s full of practical, actionable advise presented in a fun and engaging way.

Tim Keller is a leading Christian apologetic. Making Sense of God builds upon his previous popular work The Reason For God. Whether or not you’re a Christian, this inquisition into foundations and defenses of Christianity is remarkably insightful.

Reset is a type of self-help book, but instead of pushing readers to do and be more and more, David Murray encourages us to understand our limits and work within the bounds. Humans tend towards arrogance, limitations are seen as an inconvenience, but our unwillingness to acknowledge them leads to burnout. Through his concept of ‘Repair Bays,’ Murray encourages us to slow down and live consistently with reality.

I started reading Earnie Pyle during my WW2 phase in high-school. I still remember the day I finished Pyle’s Brave Menit was the most visceral, funny, and affecting account of war I had, and probably still have encountered. Ernie Pyle in England is his first collection of essays during WW2 (Brave Men is his third collection). Before the U.S. had joined the effort Pyle spent several months in England observing and reporting for an American newspaper.

In the Garden of Beasts is a look at the rise of Hitler’s regime through the eyes of the American ambassador’s family in the 1930s. It’s fascinating. Larson is a historian, but In the Garden of Beasts is not like the college history textbooks that may have put you to sleep, it reads almost like a novel, very accessible.

The Last Kingdom is the first installment of a multi-book series called The Last Kingdom Series (Cornwell just published the 11th book of the series in 2018). The genre is historical fiction, the setting is 9th and 10th century Britain, the story features protagonist Uthred of Bebbanburg fighting the Danish invasion. Cornwell is simply a great story-teller. I’ve gladly resolved to read the entire series after finishing The Last Kingdom.

I picked up The Richest Man in Babylon on a whim a few months ago. The book is a series of parables, all taking place in the context of ancient Babylon, and all dealing with a point of wisdom surrounding life and work. It’s surprisingly compelling. Clason weaves the stories around wisdom in such a unique and interesting way, and it sticks.

The Call of the Wild is an old classic that my sister encouraged me to revisit last year. Jack London’s brilliant use of language and word pictures are on full display. It’s short and profound, well worth the read.

You Need a Budget is another little gem. Jesse Mecham is the founder and CEO of YNAB, the best personal online budgeting tool out there. But the book is not a sales pitch, he digs into the nuts and bolts of building and operating a successful, zero-sum budget. This look book is packed with valuable guidance for your personal finances.

Sometimes you need to kick back and read something for the pure enjoyment of it. Ready Player One was that for me, I could hardly set it down. It’s certainly not perfect, but it’s interesting, it moves quickly, and it’s thoroughly entertaining.

Pay attention to asset classes, not returns

When people think about deciding between investment advisors, or mutual funds, or even stocks, the temptation is to look at past performance. That’s the default. And it seems basic, you’re looking for returns, what else would you look at? What else could you even look at?

The problem is the past performance we see is short term. You’ll see three to five year histories on your account statements, Morningstar defaults at a ten year history (if the fund has been around that long), and the news rarely talks about anything further back than the last year. Those are relatively short periods of time, especially when we’re talking about market returns. Instead of comparing past performance in advisors and mutual funds over the past ten years, we should be looking at long-term historical returns of asset classes.

An asset class is a group of similar securities that tend to move together. The main general asset classes are equities (stocks), fixed income (bonds), and cash. Each of these, but especially the equities group, can be broken down further. In equities, we see large vs small, value vs growth, U.S. vs international. For an example, a very popular asset class is U.S. Large Growth, which is basically the S&P 500. We have returns data on these asset classes all the way back to the early 20th century. That information can tell us much more than the past ten years. We can see which asset classes tend to outperform others, we can see how the different asset classes correlate to each other, and we can know what returns and risk a fund or portfolio can expect over long periods of time. A ten-year history of returns is almost irrelevant. Over ten years any asset class could outperform any other, but we don’t know when or which. So to look backward at the performance of a fund is not only unhelpful, it’s more often hurtful. A good ten-year history on a fund, or even an asset class, deceives us into thinking the performance will continue in the future. The short-term history the only information we know to use, and besides that, it seems to make sense. But that’s the opposite of a good investing strategy. Instead, let’s analyze the asset class data going back as far as it goes, understand where returns come from, and diversify our portfolio’s in a way that’s consistent with the data. Then we let the market perform and deliver results. Our balanced diversified portfolio won’t always be the big winner year by year, but over the long haul, it will outperform anyone trying to predict market movements based on ten-year histories, or any other material information.

Part 3: The Three-Factor Model

The Three-Factor Model was introduced by Eugene Fama and Ken French in 1991. You might remember Fama from Part 1, he is also responsible for the Efficient Market Hypothesis back in the 1960s. The Three-Factor Model is a sort of subset theory to Modern Portfolio Theory, it takes things a step further. In Modern Portfolio Theory (Part 2) we see that strategic diversification is important for successful investing, The Three-Factor Model deals with the ‘strategic’ part of diversification. This research is very important for constructing portfolios. It means that you don’t want to simply owns lots of different asset classes, you want to own the right amount of the right asset classes to increase returns at minimal risk (volatility). As you might have guessed, there are three factors:

  1. Stocks outperform bonds (market effect). We want to be in the stock market. Bonds are good as you get closer to retiring because they’re not as volatile, but stocks will give the long-term returns that will allow for you to retire in the first place.
  2. Small companies outperform large companies (size effect). Large companies are the popular investment. We hear about the S&P 500, Dow Jones, and Nasdaq in the news almost exclusively; they’re all measurements of the largest US companies. Large companies are cheap to own, easy to trade, and you’ve heard of many of them, they make for a very popular investment. But over time, small companies will give you better returns. An ideal portfolio will not only include small companies, but it will also lean towards them.
  3. Value companies outperform growth companies (value effect). ‘Value’ means that the stock of a company is valued more closely to the actual worth of its assets. The stocks don’t have a built-in premium for growth potential because the companies aren’t expected to grow much. The stock prices of growth companies are much higher than the actual value of the company’s assets because of their potential, their expected growth. They’re also more popular than value companies, examples include Apple and Amazon and Google. Over time, value companies will give a better return than growth companies. Again, an ideal portfolio will not only include value companies, but it will also lean towards them.

The point of all this research is to help construct a better portfolio. Investing is not a shot in the dark or a gut feeling. It’s not even an educated guess about which asset classes or companies will make a jump next year. Investing is an academic exercise. We put these pieces of research together to model a portfolio that will put investors in the best position to capture market returns next year, and the year after, and every year moving forward. There are no pretensions that we know what will happen next year, we simply stay disciplined and diversified, we follow the rules, and we let the market do its work.