The fundamental flaw in value investing
Posted on January 17, 2007 by Richard Beddard
Filed Under Investing |
Some of us have made good money in the markets over the last seven years - looking where others weren’t and buying shares that others wouldn’t. These are the value shares, so called because their prices are low relative to some measure of a company’s worth: its profits, its assets, its sales, or its dividend, for example. They are the antithesis of growth shares, which are in fashion and priced accordingly.
So should value investors be overjoyed at the emergence of a new breed of ‘fundamental funds’? Funds that will take the graft out of picking stocks and automatically track an index of companies with high yields, say, or low price/earnings ratios. Funds that beat the market by automatically investing in ‘undervalued’ shares.
Well, no. Not according to John Bogle and Burton Malkiel, granddaddies of the index tracking revolution. In the Wall Street Journal last summer they warned that traditional index funds will reign supreme and that the success of the value investors is ephemeral.
Being an active stockpicker, I’m no great fan of index trackers and much of the article amounts to blood-letting within the index tracking world: fundamental funds, the authors say, charge more than conventional trackers and churn their portfolios more.
But their final warning should provoke a degree of self-examination in value investors. Value funds they say, do better for periods, then growth funds take over. In the long run, both revert to the mean. Whichever you invest in, over decades you’ll probably get the same return as the market. But you’ll pay more than if you had bought an index tracker. They say:
Never think you know more than the markets. Nobody does.
Ken Fisher, father of the price/sales ratio and CEO of Fisher Investments, would disagree. I interviewed him last week. His new book is The Only Three Questions That Count. It’s devoted to “investing by knowing what other’s don’t”. I’ll review it eventually, but it’s full of things I didn’t know, so it’s taking a while to read!
One of the things Mr Fisher says he knows, that other’s don’t, is that statistical analysis proves there is no correlation between PE ratios and returns. Since value shares tend to have low PE ratios and growth shares have high PE ratios it corroborates Mr Bogle’s and Mr Malkiel’s observation that neither is a winning strategy over the very long term.
Later in the book, he extends this observation to every well known category of stock:
Many investors incorrectly assume their pet category - small-cap growth, energy, tech, large value, emerging markets, whatever it is - is inherently superior. It’s so provably wrong, yet precious few bother to check, which is why this myth is a great myth to debunk.
The difference between Mr Bogle and Mr Malkiel, on the one hand, and Mr Fisher on the other is that Mr Fisher believes he has the nous to predict some of the inflexion points; where one category takes over from another. According to his analysis, late last year it looked as if the supremacy of the value strategy was drawing to a close - though he had yet to call the inflexion point.
If he’s right, the implication for value investors is clear. They’ve been riding an almighty tail wind for the last seven years, but sooner or later it’s going to turn into a headwind. Tech investors will remember how the marketing of tech funds reached its frenetic height at the same time as the wind turned against tech stocks. Perhaps the emergence of the fundamental fund is a harbinger too.
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11 Responses to “The fundamental flaw in value investing”
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I learnt a new word today
‘ephemeral’
…
Apart from that, I was reading the last ever UK Bloomberg Money Magazine in December and Ken Fisher wrote that (and I quote) ’stocks are very cheap - cheaper than they have been in a quarter-century’.
Now I am no expert, but that suggests to me that he is saying that they are undervalued. That seems a bit contrary to what you have mentioned above.
Incidentally, does anyone know why Bloomberg Money has ceased publication? It is completely out of the blue (I hope I get the refund I have been promised :-().
Hi Mr Soole,
It’s nice to hear from you again on our blog.
Hmm, sounds contradictory but I don’t think it is. Mr Fisher would explain it more eloquently but I think it depends on what you mean by cheap. When he says the market is undervalued I think he means in relation to bonds. Undervalued implies superior returns from stocks but which particular type of share (growth or value) delivers those returns is a different question. So the stockmarket could be ‘cheap’ but it wouldn’t necessarily be the ‘value shares’ (i.e. those with low price earnings ratios) that you ought to buy. I’ll seek clarification from Mr Fisher and/or re-read the chapter in the book that explains it when I get a moment
Regarding Bloomberg Money - just in case you are looking for an alternative when you get your refund I hope you don’t mind me being a bit cheeky and pointing you in the direction of our sister publication: Moneywise Magazine, ( http://www.moneywise.co.uk/ ) also published monthly!
Also, I believe Mr Fisher is still writing his column in Forbes ( http://www.forbes.com ).
Richard
Hi Richard. Many thanks for your response. You have made this much clearer for me.
Also, I re-read the paragraph and you are correct that Mr. Fisher was comparing them to bonds (so please do not disturb him about it).
He concluded, assuming I understood correctly, that the cheapness of stocks, compared to bonds, would prevent a major bear market in 2007.
Hopefully he is correct!
Thanks for your links.
I agree that in index of value stocks will not outperform over the long run.
I disagree that looking at value measures is a mistake. If you have a long term buy and hold strategy, looking at value measure to help select which stocks to add during an accumulation phase is very helpful.
Here is a good resource on value investing “The Little Book of Value Investing” http://www.amazon.com/Little-Book-Value-Investing/dp/0470055898/sr=8-1/qid=1169932024/ref=pd_bbs_sr_1/002-3405502-3828838?ie=UTF8&s=books
Hi Kerry
Actually I should have been clearer in the article - Mr Fisher says the pe ratio *alone* has no correlation to returns, and the situation is probably the same for any other well known value measure. In combination with other factors, or in certain phases of the market though value measures are very useful. In a recent FT.com Q&A somebody asked how he spots undervalued companies. He replied:
“I start by looking for stocks that sell at a combination of P/E, PSR and Price to Book, that is below the average of the sector that the stock comes from. Then I look for classic macro quality issues like market share, brand name strength, regional strength. Then I look for emergent qualities like growth.
But then I also just simply look at what has lagged for a long time and apply the same principles other than valuations because sometimes superficial valuations for single stocks can mislead. ”
Thanks for book link.
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Oh, and did not know about it. Thanks for the information …