http://www.ft.com/intl/cms/s/0/77f0077c-c35a-11e0-9109-00144feabdc0.html#axzz1YtylE6lL

“…there is a simple, although not easy…alternative (to  benchmark-focused investing)…use a value approach across a wide range of assets. Buy when an asset is cheap, and sell when an asset gets expensive – buy low and sell high, a  sensible approach to both the preservation and growth of capital.

Valuation is the primary determinant of long-term returns, and the closest thing we have to a law of gravity in finance. For instance, buying assets when  they are expensive (high price/earnings ratios in the equity space and low  yields in the bond space) tends to result in low returns. In contrast, buying  cheap assets generally leads to high long-term returns. So moving your assets in  response to valuation signals makes sense.

Of course, there is a downside to this style of investing. In order to pursue  a value-driven approach you need two key traits – patience and a willingness to  be contrarian. Unfortunately these traits are in rare supply, and become almost  extinct when people act in groups (such as committees).

Let’s end as we began with a quotation from Sir John Templeton: “If you buy  the same securities as other people, you will have the same results as other  people. It is impossible to produce a superior performance unless you do  something different from the majority. To buy when others are despondently selling and to sell when others are greedily buying requires the greatest  fortitude and pays the greatest reward”.

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Howard Marks has also been delivering great risk-adjusted returns for his investors for years. You see, like virtually every great investor of the last 100 years, Howard Marks is a value investor.

In this week’s “Intelligent Investor” column, Jason Zweig quotes Marks’s thoughts on risk. Although the concept in Marks’s comments is not new—virtually every great value investor knows the truth of it—it does completely contradict Modern Portfolio Theory (MPT). You know the theory; it, along with the Efficient Market Hypothesis (EMH), has kept the Nobel committee busy printing economics prizes for much of the last few decades.

Zweig’s column this week is critical of James K Glassman’s predictions—both his 1999 prediction of Dow 36,000 and now when Glassman predicts further disaster. Both predictions depend on Glassman’s assessment of risk. Glassman believed in 1999 that the equity premium was going to decline rapidly, possibly to zero, meaning stocks and bonds would have the same discount rate because they would finally be perceived to have the same risk. That meant there was a lot of upside room for the stock market, hence the title of his book: Dow 36,000.

Zweig’s column:

http://online.wsj.com/article/SB10001424052748704329104576138271281667798.html?KEYWORDS=zweig#articleTabs%3Darticle

Glassman insists his argument wasn’t radical. In one way he is right: Economists contend that riskier assets must offer higher returns, or no one would invest in them. That is a fallacy, says Howard Marks…Mr. Marks is author of a superb forthcoming book, The Most Important Thing, that helps explain risk clearly.

Riskier assets don’t necessarily offer higher returns, Mr. Marks says; they only appear to do so. “It’s really simple,” he says. “If risky investments could be counted on for higher returns, then they wouldn’t be risky. And if investments weren’t risky, then they probably wouldn’t appear to promise higher returns.”

By chasing the potential for higher return in riskier assets, investors drive prices up…by Mr. Marks’s common sense definition of risk—“the likelihood of losing money”—rising prices are pure investment poison. The higher and faster prices go up, the farther and harder they have to fall.

Marks’s common sense approach to risk has repeatedly been proven to be true in academic research and in practice. For example, Fama and French, two of the biggest academic proponents of MPT and the EMH, have shown that value stocks consistently provide superior long-run returns. The only way that Fama and French could reconcile that fact with their belief system was to claim (without proving it) that it was because value investments are riskier. Lakonishok, Shleifer, and Vishny (LSV) later proved that Fama and French’s riskiness claim for value stocks was patently untrue.

James Montier, Robert Haugen, LSV, and many others have used the classic definition of risk—volatility, as opposed to loss—against EMH and MPT proponents. Below is Montier’s 2008 chart of the return and risk characteristics of US companies from 1950 through 2007. Montier used the cash flow to price ratio to separate value companies from growth companies in this analysis. The 20% of companies with the highest cash flow to price are value companies. The 20% with the lowest CF to price are growth. The figures in the chart are average annual data for the 57-year period.

So, using the favored risk measurement of EMH and MPT proponents–volatility–we can completely discredit the MPT hypothesis that one has to accept more risk to earn a higher return.  This shows that Marks is correct. When you focus on and minimize risk, you wind up with better returns. Value investors tend to use intrinsic value estimates to estimate risk. To manage risk, they only buy when they receive a margin of safety.

This chart is consistent with all of the data available for value and growth companies, so whether we separate value from growth via cash flow, book value, dividends, or some other metric, value companies deliver consistent, superior, long-run risk-adjusted returns. And, it is a long-run edge that is not likely to disappear any time soon.

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This first post shows that market buzz, such as the Goldman Sachs induced mania on Facebook, often creates inflated values and losses for investors’ portfolios. At the end of this post, I will provide a short list of businesses with inflated market values relative to objective measurements of business value. I will leave it for you to decide whether these valuations make sense.

In the second post (above), I will write about a method of analysis that helps asset managers stay grounded and ignore the mania. Charlie Munger, Warren Buffett’s partner, describes this method as: “Invert; always invert.” Jason’s column provides two good examples of this method with respect to Facebook’s valuation.

Facebook

The market mania on Facebook this month was created by Goldman’s “underwriting” of Facebook’s private equity and the offering of that equity to Goldman’s “most favored” clients. Jason Zweig correctly explains that “the market for Facebook’s stock, reportedly around $50 billion, or some 25 times the company’s revenues, has been set in a closed feedback loop rather than in an open market.”

Good Companies versus Good Investments

Jason explains what too few investors are able to grasp: that companies may offer great products and services—products and services that you would buy from that company over and over—but make lousy investments.

“Even if Facebook continues to hit the mother lode of social-network profits, new investors could end up with little to show for it.”

Zweig gives an example from the 1870s of a silver mining company in Nevada that was bought by late investors for fifteen times revenues that ultimately destroyed investor wealth despite the firm’s profitability. But, there were hundreds of such businesses only ten years ago in the dot com bubble. For example, here is what Scott McNealy, CEO of Sun Microsystems said in Business Week of his company’s stock at the time. This quote can be found in James Montier’s Value Investing:

“(In 2000) we were selling at 10 times revenues. At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold…That assumes zero expenses, which is really hard for a company with 39,000 employees. That assumes I pay no taxes…and that assumes zero R&D for the next 10 years…Do you realize how ridiculous those basic assumptions are? …What were you thinking?”

Cognition versus Behavior

I say too few are able to grasp it, but it seems to me that there is a lot more to it than a lack of understanding. After all, there are some high IQs running around on Wall Street and it only takes a minority to arbitrage away the insanity. No, it seems to me that the best investors are almost programmed to avoid these investments; to look for objective ways such as Munger’s to reject them. It also seems that the majority of investors are programmed to run with the herd and seek them out.

What are the odds?

Zweig writes that there are some businesses that traded at extremely inflated values that turned out okay for investors, such as Google and Apple, but that for every one that turned out well there were hundreds that destroyed wealth. In other words, taking an outsider’s perspective, the odds are overwhelmingly against investors who buy companies that trade at high prices relative to objective measures of value such as sales or tangible book value.

High Priced Firms Relative to Objective Values

Here is a  simple list of some high price-to-sales firms. Of course, everyone should employ extensive fundamental analysis to find high priced firms that are most likely to fall in value and use several methods to measure price-to-value. It is also wise to have strict limits on how much capital you can dedicate to a short on a single company because as John Maynard Keynes once said:

“Markets can remain irrational longer than you can remain solvent.”

Keynes knew this well; he reportedly became insolvent several times because of his investments. So, one of the most respected economists of the twentieth century, and by some accounts one of the most intellegent people on earth, could not avoid making a series of bad investments. Some programming must be impossible to overcome.

Select List of High Price-to-Sales Firms with Over $1 Billion in Market Capitalization

Data as of January 7, 2011, from Thomson-Reuters

I believe I caught all companies with a P/S ratio of 20 or higher. Notice the preponderance of natural resource and biotechnology firms on the list. Companies in these industries are most difficult to value for the lay investor and most susceptible to cocktail party chatter. I am somewhat surprised that only one Chinese firm made the list.

Also notice that The St. Joe Company made the list. JOE was the subject of market attention when David Einhorn, outstanding value investor at Greenlight Capital, gave a presentation at the Value Investing Congress last year explaining why he was short the company. Also, Open Table makes the list. Whitney Tilson has written extensively on why he is short OPEN. OPEN is another example of a great service, but probably a lousy investment. 

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I have highlighted the years of the Great Depression, and the three years leading up to it, in orange and the comparable years of the Great Recession in Blue.

I find it remarkable that many of the annual return observations during the Great Depression are found in the tails of the distribution, while many of the observations from the Great Recession are found at or near the mode.  In fact, none of the years of the Great Depression are found in the mode.

I think this fits with James Montier’s thesis that the “New Normal” is overblown and that reversion to the mean will always be with us. The Great Recession observations are not consistent with a New Normal of fat tails. It seems the Great Depression was the original New Normal, but we know that things did get back to the old normal eventually.

I first saw a histogram of the return of the Friess Associates and Yale market a few years ago and found it fascinating. Barring a major crash on the last trading day of the year tomorrow, Generic 100mg Viagra’s drug sales yield increased 70%. By following this link, you will learn about buying this medicine.

What should we expect in 2011? Taking an outside view as per Michael Mauboussin’s suggestion, there is about a 70% chance that the market will rise next year and about a 24% chance that the rise will be anywhere from 0.1% to 10%. You need something more concrete than 24%? Okay; there is about a 73% chance that market returns will be between -10% and +30%. Happy New Year!

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The attached blogpost summarizes his talk. The money quote:

So where do the new normal proponents get it wrong? Montier argued that they are confusing the distribution of economic outcomes — and the forecast of those outcomes — with the distribution of asset market returns. Although the distribution of economic outcomes may well be wider than was the case historically, anyone trying to invest on the back of an economic forecast is, to use Montier’s indelicate word, “insane.”

Montier contended that proponents of the new normal also misunderstand fat tails, which are nothing new and which “create fat pitches” — the opportunities that investors seek to exploit through mean reversion strategies. Investors, he said, shouldn’t throw out the old ways of investing; they should embrace them.

Seven “immutable laws of investing” apply, Montier argued, as they have in the past:

• Always insist on a margin of safety.
• This time is never different.
• Be patient and wait for the fat pitch.
• Be contrarian.
• Risk is the permanent loss of capital, never a number.
• Be leery of leverage.
• Never invest in something you don’t understand.

With these rules in mind, Montier noted, somewhat bleakly, that “not very many assets have any margin of safety.” 

Montier is correct to say that few assets this year carried a margin of safety. Wait for the fat pitch.

http://eic2010.posterous.com/gmos-james-montier-says-rumors-of-the-death-o

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Efficient Market Hypothesis proponents, like good lawyers, argue that there is absolutely no such thing as a permanent edge in investing and any permanent edge that does exist is riskier than the alternatives. (“Your honor, my client was never in that woman’s apartment and he was only there to return her lost kitten”). I mean, why paint yourself into a corner?

Fama and French (F&F) and almost every other speaker in the above video said that the reason that value stocks consistently outperformed “growth” (glamour) stocks was that there was some additional risk in value stocks. Unfortunately, this only seems to be F&F’s hope because they certainly do not quantify that risk in their now-legendary 1992 paper in the Journal of Finance, “A Cross Section of expected Stock Returns.” To my knowledge they were not able to quantify that risk at any point in the last eighteen years.

F&F thought that they saw some evidence of low earnings in small cap stocks and value stocks. That led them to write the following in the conclusion to “A Cross Section of expected Stock Returns:”

“The systematic patterns in fundamentals give us some hope that size and book-to-market equity proxy for risk factors…”[1]

So, to summarize F&F’s conclusion: immediately prior to a company being added to a value cohort in their study, some value stocks experienced a period of low earnings. That was all they had.  I am not aware of any follow up in the last eighteen years to F&F’s hope that small stocks and value stocks proxy for risk because of low earnings or for any other reason. It seems to me that hypothesis could be tested pretty easily.

Real risk usually has little to do with a period of low earnings alone; virtually every company goes through that. But, real risk is related to high leverage, which can quickly lead to bankruptcy. What are the odds that a highly leveraged business will have a high book-to-market ratio (book value / market value)? That is, what are the odds that a highly leveraged business would finds its way into F&F’s value cohort? Considering that for a given capital structure, book value is reduced by leverage, all other things being equal, I suspect you will find few highly leveraged businesses in the F&F high book-to-market (value) deciles but that you will find a higher percentage of highly leveraged businesses in the low book-to-market  (glamour) deciles.

Other real risk factors include low operating leverage; product obsolescence; low barriers to entry; regulatory risk; loss of suppliers; a concentration of buyers; low current ratios or long periods of low cash flow relative to short-term liabilities, to name a few. These are not mentioned in the F&F literature as risk factors that need to be managed.  In fact, the people in the video identify risk with volatility because most of the academic finance literature of the last fifty years identifies risk with volatility.

But the coup de grace to F&F’s riskiness tack came as early as 1994. LSV picked up on F&F’s genuflection to hope and empirically demonstrated in another Journal of Finance article, “Contrarian Investment, Extrapolation, and Risk,” that risk had nothing to do with value’s superior results. LSV (and Haugen, Montier, and many others since LSV) showed that when using the various proxies for risk—Beta, volatility, etc.—they could prove that value stocks exhibited less volatility than glamour stocks. That is, value stocks are significantly less risky than glamour stocks. LSV also showed that in periods of stress—recessions, bear markets, etc.—when risky investments tend to be punished and safe investments tend to be hoarded, value stocks consistently beat glamour.

[1] P. 452

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