This is my fourth and final piece on value investing. Next year’s four will be on the topic of behavioural investing. In light of Richard Thaler having just been awarded this year’s Nobel Prize in Economics, this seems apt.
"Twenty years ago, real Gilt yields were 4 per cent"
True, Thaler’s work has been in the field of behavioural economics rather than behavioural investing, but ultimately both are linked by human decision making. As Charlie Munger, Warren Buffett’s partner, once said in relation to economics, “If it isn’t behavioural, what the hell is it?”
Anyway, to finish off this series, I thought I’d reiterate three important points that I have made in the past. The first is that value investing is not about buying stocks with low price‐to ‐book or price‐to-earnings ratios. That would be easy. Proper value investing is hard, and it at the very least requires a thorough reading of all 700 pages of Graham and Dodd’s ‘Security Analysis, long considered the bible of value investing.
The second is that one can apply the broad principles of traditional (equities) value investing to other areas such as asset allocation and fixed income. After all, the central principle is about buying things cheap, and this can be applied to anything!
The third is with respect to so‐called safe haven bonds in the UK or other major developed countries. They are still horrendously expensive, and you need to be very careful using them as they have been traditionally i.e. as insurance.
Last year, I wrote in my first quarterly blog piece on value investing: “A stock may have a low price to book ratio but it may deserve to have a low price to book ratio. Such stocks are known in the trade as ‘value traps’, and they should be avoided. How? By considering in detail all sorts of other aspects that drive a company’s longer‐term performance, such as industry trends, barriers to entry, balance sheet strength, free cash flow, to name just a few.”
The piece was about how quantitatively derived factor indices comprising stocks with low price‐to-book or low price‐to‐earnings ratios (‘value’ factors) were becoming dangerously confused with Graham and Dodd’s intricate methodology for calculating the intrinsic value of a stock (as set out in their aforementioned 1934 classic).
I was thus delighted to see in a recent edition of the Financial Analysts Journal a paper by U‐Wen Kok, Jason Ribando, and Richard Sloan entitled “Facts about Formulaic Value Investing”. The paper made exactly the same point that I had made in my blog piece. However, it was a proper research paper, and the authors backed up their argument with a lot of detail and empirical support. If you are a holder of Vanguard’s $44bn Value Index Fund or Blackrock’s $31bn iShares Russell 1000 Value ETF, I strongly suggest you read the paper (assuming my blog hadn’t done the trick!)
On a related matter, my April investment letter argued that artificial intelligence would not signal the death knell for active managers (at least not the good ones). Value investing requires careful assessment of a company’s report and accounts. A computer might be able to ‘read’ the accompanying notes, but I doubt it would understand them.
As for my second point, traditional value investing is about appraising the intrinsic value of a stock then seeking to buy well below it. But intrinsic value is not a concept that belongs to just equities. One can also appraise the intrinsic value of an overall equity market, a bond market, an individual bond or credit, or of other asset types (or indeed of a banana!) You might not use the same methodology for each. In fact you won’t, but that doesn’t mean it can’t be broadly defined as value investing.
This is exactly what we have created at Seneca Investment Managers – an integrated, propriety investment style that we have called 'Multi‐ Asset Value Investing'. For example, one can use risk free rates, market dividend yields, pay-out ratios and assumptions about longer term inflation and growth to evaluate the intrinsic value of an equity market. With safe haven bonds it’s about real yields.
This brings us nicely onto my third point. Traditionally, safe haven bonds have been used as hedges, also known as insurance. In a flight to safety, risky assets fall but safe haven assets rise. This is all very well, but what about the rest of the time when investors are not panicking? It is not enough only to consider the performance of the hedge when it is ‘paying out’. After all, you can’t buy insurance after the accident has happened.
Twenty or so years ago, real Gilt yields were 4 per cent. This meant that you were getting a decent return even if yields stayed at 4 per cent If you include flights to safety when, for example, yields might have fallen by 50 basis points, you might in totality have made a 5 per cent total real return. In other words, the hedge worked.
Fast forward two decades and the picture is very different – real gilt yields are a shockingly low – 1.8 per cent. This means that any flight to safety would have to see yields plummet, perhaps by as much as 500 basis points to make up for the 1.8 per cent real annual cost and get close a 5 per cent real total return. Is this possible? Yes. Is it likely? Absolutely not. There is a price at which you would not buy property insurance because it is simply too expensive. Same goes for bonds.
My advice? Think about other ways to insure your portfolio, such as by employing an integrated value-oriented investment style. Or by investing with a manager who has one.
Published in Trustnet
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.