Value Investor

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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 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, 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.

Finances by age

We’ve all heard of general financial guidelines which wisdom would suggest we follow. Dave Ramsey talks about them, financial planners use them, we all interact with them on some level. As you move through life the guidelines also move a little bit, some things you didn’t have to deal with in your 20’s become pressing in your 40’s, and vice versa. This is a breakdown of these financial guidelines by age, things that you should be thinking about based on your stage of life. This does not mean that you’ve failed if you’re working on some 20’s things in your 30’s or 40’s, or even 50’s. But these guidelines are a helpful measuring stick to see how you’re doing currently, and they provide a good pathway for lifetime financial success. Let’s dig in.

Teen years:

  • The number one thing you can do in your teens is to start developing good financial habits.
  • Stay away from consumer debt. These debts are often subject to high interest rates (credit cards), tied to depreciating assets (cars), and often end up funding things that are unnecessary. They encourage bad spending habits and can cost years to catch up from.
  • Learn to save money. Instead of unnecessary spending, practice going the other way, save up money for things you want. 
  • Learn to work hard. Financial guidelines will certainly help you succeed, but you won’t get far if you can’t earn money. 
  • Get through college with minimal student loans.


20’s:

  • Now you’re out of college and real life is set in. The number one thing you can do is create a zero-sum budget and stick to it as if your life depends on it. Give yourself some spending money, make sure to budget your savings, and again, avoid consumer debt. The budget is not a forecast of your future spending, and it’s not just for tracking your spending either, it’s for planning your spending. You intentionally decide what you’re going to spend money on and how much, and you don’t spend beyond that. 
  • Start a financial plan. Meet with an advisor, learn about how the market works, and start putting together a loose plan for retirement. Things will obviously change, but the plan will ensure that you’re pointed in the right direction.
  • Create an emergency fund. Dave Ramsey says save $1,000, that’s a good place to start. Eventually, you might work up to a month or two worth of expenses. This is how you will pay for life’s curveballs instead of using your credit card.
  • If your company offers a 401k plan, start putting some money away. The money you invest in your 20’s will work the hardest for you over the long haul. If your company’s 401k plan offers some sort of match, try to contribute whatever is required to take full advantage of the match. The free money is hard to pass up.
  • Be aggressive about paying off student loans (and any other consumer debts).
  • Start saving for a house.


30’s & 40’s:

  • Now that you’ve set the stage in your 20’s, you’re ready to start executing in your 30’s and 40’s. Keep meeting with your advisor and updating the plan, keep learning, and keep on the straight and narrow.
  • Become debt free (aside from a potential mortgage loan). If you have any consumer debt or student loans, be aggressive about paying them off.
  • Think about buying a house. Your financial plan will show you that buying a house is the most cost-effective way to provide housing, a home is a good asset. Save up a large down payment and ensure the payment fits nicely in the budget, there are few things more financially stressful than being ‘house-poor.’
  • Make a plan to pay off the house, ideally in 15 years or less. Owning a home free and clear is one of the most impactful things you can do for your retirement. It’s also a great way to help kids through college if that’s a goal of yours.
  • Increase retirement savings. You’ve been contributing enough to take advantage of the match, but there’s no need to stop there. Bump up your 401k percentage or put some extra money away in an IRA. 15% of your income is a good goal.
  • Buy some term life insurance, especially if you have children. A 20-year policy is often sufficient, the goal is to ensure that your family will be well-off in the event of a tragedy.
  • Put together a will, again, especially if you have children. It’s another way to ensure the family will be well-off in the event of a tragedy.
  • Increase the emergency fund to cover 3-6 months (or whatever number feels most comfortable) worth of expenses. Think about this money as insurance. It’s not going to earn much if anything, but that’s not what it’s for. The investments will earn money for retirement, the insurance is to shield you from unforeseen events.

50’s:

  • Talk to your advisor about your investment allocations. As you move closer to retirement, you’ll want to ensure the retirement funds will be available for you, which means you’ll probably scale back the risk factor in your portfolio, or at least have a plan in place to do so. This means owning a higher percentage of bonds and fixed income type assets and fewer equities (stocks). A good advisor will engage with you on this subject pro-actively.
  • Adjust investment contributions. It could be a good time to increase savings again to maximize what will be available in retirement. It’s the home stretch!
  • Pay off your home. I mentioned this earlier, but paying off your home is one of the most significant things you can do for your retirement. From a cash-flow perspective, it makes a ton of sense. If you owe $100,000 on your mortgage, and your payment is $750 per month, you’ll gain $9,000 in spendable cash-flow per year for spending by paying the $100,000. If you instead saved that $100,000, you would be able to pull about 5-6% per year ($5,000-$6,000) and you’d still be making the mortgage payment. A mortgage-free budget will also be much more flexible. Many people end up working in retirement mainly because they still have to cover the mortgage.
  • Look at your social security estimate. This is available online (https://www.ssa.gov/benefits/retirement/estimator.html) and will be helpful as you get more detailed in your retirement plan.


60’s+:

  • Finalize your retirement plan. Determine when you’ll retire, what your new income sources will look like, how your advisor will manage the retirement funds, when to take social security, all the exciting stuff. These are important details to nail down as you move into retirement.
  • Revisit your budget. Income, expenses, taxes, and cash-flow all change significantly in retirement. A good comparative cash-flow analysis from your advisor could prove very helpful. Usually, retirees can achieve a similar or better cash-flow with significantly less income because of how the taxes and expenses shape up (especially if that mortgage is gone!).
  • Decide what you’d like to accomplish in retirement, maybe even set some goals. The great benefit of retirement is not the ability to stop doing anything, it’s the opportunity to focus on the things you want to do. A part-time job or some sort of enjoyable work, more family time, travel with loved ones, important hobbies, these all can be part of a richly fulfilling retirement; but don’t let them simply happen to you, do them on purpose.

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.

You should know something about ETFs

First things first, if you’re unsure what an ETF (exchange-traded fund) is, let me explain broadly. An ETF is something you can invest money into, it’s an investment vehicle. Like mutual funds, ETFs provide a way for investors to own multiple companies through one fund. You might even have some money invested in ETFs through your 401k or other investment accounts.

ETFs have quickly become a very popular investment option in the US. We hear a lot about robo-advisors these days, their offerings consist almost exclusively of ETFs. In 2016, seven of the top ten traded securities in the US market were ETFs. Assets deposited and held within ETFs have grown substantially within the last 15 years:

Besides all that, ETFs are cool. They’re based on algorithms, you can buy and track them through really nice apps, they’re usually super cheap, the list goes on. They’re the perfect investment for this generation. I’ll admit, they appeal to my millennial preferences too. But, there are a few important things to understand about ETFs before making any investment decisions, and there’s a reason we don’t recommend them.

Now let’s define ETF a little more specifically. The easiest way to explain them is by a comparison with mutual funds. Mutual funds have been around for much longer, they’re a little simpler, and probably a little more familiar. We’ll look at two distinguishing characteristics between mutual funds and ETFs:

1) Ownership.

A mutual fund owns shares of different companies. So if you buy one share of a mutual fund, you’re actually investing in each of the different companies that the mutual fund owns. Different mutual funds make different decisions on which companies they own. Some are actively managed, meaning there’s a manager buying and selling different shares within the mutual fund; some are passively managed, meaning they own a group of companies that are chosen based on a set of rules and the companies don’t change too much; some are index funds (which is a type of passive fund), which means they own the same companies that an index tracks (like the S&P 500); there’s no shortage to the type of mutual fund you can own, there are lots of them, and they’ve been a very popular investment vehicle for a long time. The thing to remember is that the value of a mutual fund is the value of the stocks it owns. Mutual funds actually own stock shares.

ETFs also invests in different companies, and different ETFs have different criteria for the companies or sectors they invest in (the most popular ETFs track with the S&P 500). However, ETFs don’t actually own stock shares in those companies. Instead, they own pledged assets, which are contracts to provide shares. Essentially, ETFs own rights to shares. This brings benefits like low expense ratios within ETFs (no fees for buying and selling stocks since the only things that trade within an ETF are contracts) and occasional tax savings (if you have a taxable account).

2) Fund type.

Mutual funds are their own separate type of investment, they’re not like stocks. Mutual funds are only valued once per day, after the close of market. Then all the stocks and investments within the fund are added up and the value of the mutual fund is determined anew. Because of this, you can only buy and sell mutual funds once per day, when the value has been calculated. Mutual funds are a longer type of investment by design. That doesn’t mean the holdings within the mutual fund are long term, a mutual fund manager could be making trades inside the mutual fund at any time, but the mutual fund itself can’t be day-traded or hedged or anything you might do with stock holdings.

ETFs however, are traded on an exchange, which means they act like a stock. You can make inter-day trades, the value is moving whenever the market is open, you can hedge and short and order stops, and engage in all sorts of risky stock market things. It also means there’s a fee for each trade, which isn’t necessarily a problem, but you wouldn’t want to be executing lots of ETF trades. This extra trad-ability makes mutual funds appealing for many. The trade costs are a bit of a deterrent, but you can actually day-trade with ETFs.

So that’s what ETFs are. The rise of ETFs in one of the most significant changes in the world of investing over the last 20 years and many people are excited about the opportunity. Here are a few reasons why I’m less excited, and why we don’t recommend ETFs for our investors.

Regulation surrounding ETFs has proven insufficient. I’m usually not a big proponent for the increase of regulation, but when it comes to ETFs, the lack of regulation is a real problem. There currently isn’t even an official legal definition for ETFs so they’re regulated individually, fund by fund, under mutual fund rules. As you’ve seen above, ETFs differ from mutual funds in significant ways, and mutual fund regulations simply can’t account for the discrepancies.

Since ETFs own contracts for shares instead of actual shares, the value of an ETF is tied to the viability of its contracts to perform, its arbitrage mechanism. Theoretically, the value of an ETF should be the value of the promised shares (like mutual funds are valued based on the shares they own), and usually, it is, but not always. When the price diverges, the arbitrage mechanism has to kick in to bring it back. So there’s a whole new type of risk involved, the reliability of the arbitrage mechanism, which can also dramatically affect the price. The fact is, when the market is stressed, the arbitrage mechanism can fail, causing massive swings in the pricing of ETFs, unrelated to the underlying stock assignments. That’s not just a hypothetical, it has happened, and continues to happen. August 24, 2015, is one specifically egregious example. It’s not entirely clear how or why these things happen from a market perspective, and the differing regulations (even between funds with the same pledged assets) only cause more uncertainty. The whole system is shrouded. What we know is that the inconsistent regulation, the cloudy definitions, and the unreliable arbitrage mechanisms have created more risk for ETFs. Unfortunately, it’s impossible to quantify the additional risk in any meaningful way because there are still too many unknowns. Investopedia even admits in reference to ETFs, ‘the perceived increase in volatility needs further research.’ In its current state of affairs, the ETF market is simply not reliable enough to recommend as a vehicle for a person’s life savings. There seems to be increasing support for research and regulation surrounding ETFs so the issue is certainly not over-with, perhaps we could even end up recommending ETFs to all of our investors in the future, but for now, stick with some good old mutual funds.

 

Sources:

Financial Times: The $5tn ETF market balances precariously on outdated rules

Financial Times: Market turbulence revives fears over ETF structural issues

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