Successful Equity Investing
To become an equity investor, you need three foundational elements:
- to tell a fundamentally strong company from one that is not based on it’s financial statements, it’s business model, and the dynamics of it’s industry
- to put those fundamentals in the context of the prevailing market price and how those prices are subject to variation based on swings in the nebulous concept called market sentiment, and
- to recognise, and protect against the potential influence of those market sentiments on our decision-making i.e. our susceptibility to behavioural biases when making investment decisions
These elements are common sense, but they take a lot of conscious effort (learning) to understand and even more effort to implement. Most investors aren’t able to.
Ryan Shmeizer, in his post on “Cached thoughts” drew a parallel between how we typically think about any topic to a computer retrieving data stored in it’s RAM, or cache. He says, when a concept is spoken of, our mind dips into it’s memory cache to access precomputed thoughts instead of computing our opinion or understanding of the topic based on the facts available to us at the time.
If our information diet consists only of a twitter stream of borrowed quotes by Buffett, Munger et al, we’ll be able to readily access phrases like “buying for less than intrinsic value”, “buy stocks like you would buy groceries, not like perfume” thinking we really understand value investing, but our investment results will suggest otherwise.
We need resources rich in insight, that will help us build understanding of those foundational elements to keep learning, unlearning and relearning.
What has worked in investing
One such resource, is a paper “What has worked in investing – Studies of investment approaches and characteristics associated with exceptional returns” by Tweedy, Browne Company LLC. It is a compilation of the findings of over 50 major quantitative studies over 50 years, some academic, others by investment companies about the returns from various schools of investing.
The key findings of the paper, as to what works in investing according to Tweedy, Browne are:
- Low Price in relation to Asset Value: Stocks bought at less than book value or even more conservatively, at less than Net Current Assets (cash, receivables, inventory minus liabilities)
- Low Price in relation to Earnings: Stocks bought at low Price / Earnings offer high earnings yield when considering their potential dividend payment to prevailing stock price
- Insider buying: Inside information on likely improvements, not a tough one to imagine
- Significant Price decline: Poor recent performance resulting in lowered expectations
- Small Market Capitalisation: Smaller base, higher growth rates and therefore more price appreciation
These findings apply to studies done for markets outside the US, a couple included India.
The full paper is available at the end of this post.
Two things stood out as I read the paper:
- Some of those factors tend to be correlated. Example: A stock having seen a significant decline is likely to be at a low Price to Book value, low Price to Earnings and relatively high dividend yield
- While the paper mentions it, it does not give enough credit to the underlying theme that drives returns superior to the market i.e. Mean Reversion
Mean reversion – what really drives returns
Let’s take the analyses supporting the hypothesis that “a portfolio of stocks priced relatively low to Book value will outperform the index”.
Buying stocks based on low price in relation to book value is the oldest approach to value investing. Ben Graham applied an even more conservative measure of buying only stocks valued at less than 66% of Net Current Assets (All current assets i.e. cash, receivables, inventory minus liabilities.). A study by Henry Oppenheimer, Associate Professor of Finance at State Univ. of New York from 1970 to 1983 of a hypothetical portfolio where stocks meeting the “priced below 66% Net Current Assets” criteria were bought on Dec 31 and replaced the subsequent year over 13 years, gave a mean annual return of 29.4% compared to 11.5% from the NYSE-AMEX Index.
Another study on buying stocks based on low prices relative to book value. Table below shows findings of a study by Prof. Ibbotson, Finance practice at Yale School of Management in 1986. The compound annual return of the NYSE over this period was 8.6%
So far so good. But before dumping all high P/B stocks to buy the lower decile stocks, consider the table below.
A study by Debront and Thaler, over the same period also considered the performance of the stocks relative to the index over a 4 year period before the study period and after. Simply put, yes, the low P/B stocks did better than the high P/B in the study period but they had just come off poor performance leading up to the study, when the portfolio was formed.
This drastic decline in market performance is borne out by the trend in Earnings per Share of the “low P/B” versus “high P/B” companies. The chart below shows the (de)growth in EPS of the two categories of stocks. Normalizing the EPS for both at 100 on the day they are selected for the portfolio, low P/B stocks show stronger cumulative EPS growth over subsequent four years (ending at 124.4 v/s 108.2). However, consider the three years leading up to the selection where the EPS of low P/B companies shows a drastic fall from 142 while that for high P/B companies shows steady growth (69.8 to 100).
The blue line stocks identified today as low P/B were stars just a few years ago. They were coming off a few successive good years where they delivered consistent EPS growth and trading at high Price to Book values before growth and / or profitability stalled. Displeased investors started offloading their holdings driving prices down for the next few years before they appeared on the radar of the value investor, in time for the upswing.
It’s not enough to identify a set of stocks having low Price to Book or Price to Earnings or any other price-related metric today as a stock picking strategy. Future returns are likely determined by whether those stocks have undergone a period of underperformance leading up to today which in turn followed a period of above average performance.
Mean reversion might therefore be, the simplest, most powerful, but far from easiest concepts, for value investors.
“From financial history and from my own experience, I long ago concluded that regression to the mean is the most powerful law in financial physics: Periods of above-average performance are inevitably followed by below-average returns, and bad times inevitably set the stage for surprisingly good performance.” – Jason Zweig
“Importantly, reversion to the mean in the investment business extends well beyond the results for mutual funds. It applies to classifications within the market (small capitalization versus large capitalization, or value versus growth), across asset classes (bonds versus stocks) and spans geographic boundaries (U.S. versus non-U.S.). There are few corners of the investment business where reversion to the mean does not hold sway.” – Michael Mauboussin