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Volume 1 - Issue 28
March 21, 2005
Bargain Hunter
By James Montier
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Once again we look at one of my favorite analysts and behavioral finance thinker, James Montier of Dresdner Kleinwort Wasserstein in London. James wrote a fascinating book two years ago called "Behavioural Finance: A User's Guide" and puts out ongoing research like the one we will enjoy today. Long time readers will recognize the name because I have discussed many of his ideas in my weekly letter "Thoughts From the Frontline," my book "Bull's Eye Investing" and in "Outside the Box."
This report by James explores value versus growth investing. This is a topic covered in my book and what James finds is that while over time both produce roughly the same returns, picking value winners is easier and comes with less volatility. So while the street wants you to buy the exciting story and high growth name, the safer bet is to stick with value.
- John Mauldin
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Bargain Hunter (or, It offers me protection)
by James Montier |
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Regular readers will know that I am an unabashed value investor. I like to
buy cheap stocks. If you don't share this viewpoint, or aren't open to be
persuaded of the merits of such an approach, stop reading now for what
follows will only distress you. I am also an empiricist at heart. Theories
are all well and good, but sadly almost anything is possible in theory. The
only way to resolve theoretical impasses is to examine the evidence. I am
fond of quoting the words of Conan Doyle's Sherlock Holmes "It is a capital
mistake to theorize before one has data. Insensibly one begins to twist
facts to suit theories, instead of theories to suit facts" or "The
temptation to form premature theories based upon insufficient data is the
bane of our profession".
So is there an empirical basis to my obsession with value? The short answer
is yes. The long answer takes up the rest of this note. My usual accomplice
and compatriot in adventures involving large amounts of data is Rui
Antunes, of our global quantitative team. It was with Rui's able help, that
I embarked upon an investigation of value strategies.
The methodology
We chose the MSCI indices as our universe. The stocks were ranked first by
trailing PE and then by actual reported earnings growth over the next 12
months (as if we could perfectly predict the future). Each sort resulted in
the formation of quintiles (with 20% of the universe in each quintile).
Given we sorted on two variables, we ended up with 25 portfolios of various
combinations of PEs and delivered earnings growth. The performance of these
portfolios was then tracked over the next 12 months. A sample of our
results can be seen in the table below.
In this particular case, we are examining the global market and measuring
total returns1 relative to the average of the stocks in our universe. The
tables for each of the regions we examined are provided in full at the end
of this note for reference. Portfolio (5,5) represents the cheapest of the
value stocks with the lowest achieved earnings growth. Portfolio (1,1) is
the most expensive stocks with the highest delivered earnings growth.
Portfolio (1,5) is the cheapest basket of stocks with the highest earnings
growth and so forth2.
Does value work?
Several findings are apparent from examining the table. First (and of
foremost importance to me) is that buying cheap stocks did indeed
outperform. Simply buying an equal weighted basket (assuming equal
distribution of stocks across portfolios) of the lowest 20% of PEs within
the MSCI World index generated significant outperformance (9.7% p.a. on
average). Such a strategy would have only resulted in absolute losses in
only five out of the thirty years in our sample.
However such analysis ignores the fact that firms are not equally
distributed across all portfolios. The chart below shows the returns to a
low PE strategy in which the returns have been weighted by the actual
distribution of earnings in each of the categories. The results of the
previous analysis hold. The annual average raw return from a strategy of
buying the lowest 20% of the MSCI World index ranked by PE was 20%. This
represents a low PE stock outperformance of the market of nearly 6% p.a!
Similar patterns were found when we examined the regional breakdowns. The
chart below shows the outperformance of buying the bottom 20% by trailing
PE in the various markets we examined. There is a strongly consistent value
premium across countries/regions.
The anatomy of value
It is also noteworthy that only one of the value portfolios resulted in
underperformance (portfolio (5,5)). The table below shows the distribution
of firms across the portfolios. At the global level, 31% of the bottom 20%
of the MSCI World index end up in the portfolio that generates value
underperformance. 6.2% of all stocks ended up in portfolio (5,5), since by
design the low PE stocks (portfolios (x,5) are 20% of the universe, we end
up with 31% of the value universe in the underperforming portfolio. So the
majority of value stocks outperform.
The table below shows the results for all the regions. None of the value
portfolios generate a negative absolute return (supporting our hypothesis
that value offers protection). However, in general, around 30-35% of the
lowest PE stocks seem to generate underperformance. The most extreme case
is the US where the value premium comes from a minority of stocks3. This
distribution suggests that value investing can be improved by avoiding
losers.
If the underperforming 30% could be identified ex ante then the returns to
value investing could be further enhanced. In previous work, we have
highlighted the findings of Piotroski (op cit), who uses a simple
accounting screen on financial stability to help avoid the value traps. An
alternative to this might be to use some measure of quality as our quant
team has developed in a series of notes.
The siren of growth
If you had perfect foresight and knew exactly what earnings growth would be
achieved, and you bought the highest growth stocks regardless of valuation,
you would have outperformed by 11.3% p.a on average. It is perhaps the hope
or belief that investors can identify such equities that sucks investors
into growth investing, like sailors to the calls of the sirens. However,
the two most common behavioural biases are over-optimism and over-
confidence. We are all massively too sure about our ability to predict the
future.
The chart below shows the distribution weighted average returns if you had
had perfect foresight across the markets. This weighting drops the return
from 11.3% to a still very healthy 7.6% p.a. The eternal hope of growth
investing is clear. If only the winners could be picked ex ante! Combine
this hope of major outperformance with the mental vulnerability to stories
that we have outlined before and the lure of growth is obvious for all to
see.
Growth doesn't mean ignoring valuation
The near monotonically declining performance of the delivered high growth
portfolios (column 1 in the table on page 2) should also be noted. That is
to say growth investors shouldn't ignore value. The cheaper the stocks they
buy, the better the performance achieved. Indeed the two lowest PE bands
provide over 50% of the total outperformance of the perfect foresight
growth premium.
All too often, growth-investing amounts to little more than buying highly
valued equities. The table above reveals that buying the high PE stocks
would have resulted in significant underperformance.
It is also interesting to note that to generate any outperformance from
buying high PE stocks would require you to pick those stocks that delivered
the very highest growth rates (Portfolio 5,1). Even if you could do this,
you would only manage to beat the very worst of the value stock baskets.
That is to say portfolio (1,1) only manages to beat portfolio (5,5). It
fails to beat all the other value portfolios (x,5).
The distribution table on page 3 also shows that within the high PE
universe only 37% of the stocks fall into portfolio (1,5). So growth stock
investing as proxied by buying expensive stocks is all about picking a
minority of winners.
It is also worth noting that buying highly valued stocks also carries an
enormous ‘torpedo' risk. The worst returns were seen in the high PE stocks
with the lowest delivered earnings growth (underperforming by 11.9% p.a. on
average!).
The disappointing reality of growth
Of course, the natural response to these findings is to ask if we can
forecast growth. We decided to investigate exactly that. We were forced to
reduce the time span of our sample because of the lack of analysts'
forecasts going back. However, we were able to start this work in 1988,
giving us 17 years worth of data.
Once again, two-way sorts into quintiles were conducted. This time we
replaced the PE with the forecast growth rate from analysts. So, we are
comparing the forecast of earnings growth with the outturn. And then
tracking the returns delivered by each of the portfolios.
The table below shows the global summary of this analysis. Just to be
clear, portfolio (1,5) is the portfolio that contains the stocks with the
highest actual earnings growth but that were expected to have the lowest
earnings growth, and so forth.
Unsurprisingly, the best stocks were the ones that had the lowest
expectations but delivered the highest outcome (portfolio 1,5),
outperforming by nearly 11% p.a. The worst were those with the highest
expectations and the lowest outturns (portfolio 5,1), underperforming by
nearly 12% p.a on average.
Neither of these findings is likely to shock anyone. However, the table
also shows the difficulty of picking growth stocks ex ante. If you had
invested an equal amount into the 20% of stocks with the highest forecast
earnings growth then you would have underperformed by 2.5% p.a. on average!
In contrast, if you had invested in the 20% of stocks with the lowest
growth expectations then you would have outperformed by 4% p.a. on average. The role of expectations in this process couldn't be much clearer. It is
far easier to surprise on the upside if the expectations are low in the
first place.
Analyst accuracy?
Of course, using these simple averages assumes an equal distribution of
stocks within each portfolio. That is akin to saying that analysts are
completely useless at forecasting the earnings growth. That strikes even me
as slightly harsh (and I am certainly not known as an apologist for
analysts as those who have seen one of my behavioural finance presentations
can attest).
But, we can also use our data to get some insight into the forecast
accuracy of analysts. The table below shows the distribution of forecasts
and outturns for the MSCI World index. Effectively the diagonals represent
the points where analysts were correct. The good news for analysts is that
the majority of forecasts are in the same quintile as the outturn. For
instance, there is a 75% overlap between those firms that analysts forecast
to have the highest earnings growth, and those that actually do have the
highest earnings growth.
Sounds impressive doesn't it? But it still means that one in four of their
forecasts is off the mark. More importantly, the table on page 4 shows that
the outperformance generated by those firms with high expected and
delivered growth is relatively small at 2.6% p.a. Whereas the 25% of firms
the analysts say are going to have the highest earnings growth, but don't
deliver have an average return of -3.7% p.a. The combined effect is that
the weighted average return on the high growth forecast portfolio is an
outperformance of 0.9%.
What about the low growth realm? There is a 70% overlap between those firms
that the analysts think will have the lowest earnings growth, and those
that do indeed have the lowest earnings growth. Indeed if we weight the
returns by the distribution accuracy of analysts, those with low forecasts
generate an outperformance of 0.9%. This is not statistically different
from the high growth result. So effectively analyst forecasts can't tell us
very much at all! They certainly can't help us identify growth stocks as a
source of significant outperformance.
The chart below shows the regional breakdowns of the weighted performance
of forecast growth portfolios. In Japan you could have made money by
shorting the stocks with high forecast earnings growth! Elsewhere,
following the forecasts of analysts would have generated positive returns
on average.
An alternative way to evaluate the power of following the forecasts is to
ask how much the forecast strategy would have managed to capture of the
idealised strategy of knowing exactly what growth was actually going to be
delivered. The table below shows the percentage of the maximum attainable
return that was actually achieved if one had bought the 20% of stocks with
the highest growth forecasts from analysts.
With the exception of the US, the results are sobering. At the global
level, following the analysts' forecasts of growth would have captured just
24% of the total growth premium available. In Europe this improves to 40%,
still not an impressive performance. In Japan, the forecasts are actually a
better contrarian indicator than having any value in their own right! In
the US, the strategy of following the analysts did much better, delivering
70% of the total possible return to the perfect foresight premium.
Value vs. Growth
So to the crucial question...value or growth? The chart below shows the
weighted total return outperformance figures for the value and growth
forecast strategies for the regions since 1988.
In general the results show the massive superiority of being a ‘bargain
hunter'. Ben Graham's concept of a margin of safety is still sound today.
Buying cheap stocks offers significant protection against any potential bad
news.
Only in the US does the return on following the analyst's growth forecasts
exceed the return from buying cheap stocks. However, the chart below shows
the time path of the two portfolios. The impact of the bubble years becomes
immediately obvious.
The US value and growth portfolios have actually generated very similar
returns. The value portfolio has a CAGR of 13.7%, and the high forecast
growth portfolio has a CAGR of 14.0% since 1988. Effectively there has been
little to choose between the two strategies. Although it should be noted
that the value portfolio has a markedly lower standard deviation of returns
(17.7% for the value portfolio, against 25.1% from the growth portfolio).
Thus on a risk adjusted measure value would have significantly outperformed
growth. So much for value stocks being riskier!
The chart below shows the portfolio returns from the global portfolios, the
performance of the low PE portfolio alongside the high forecast earnings
growth portfolio. The high forecast earnings growth portfolio earns a 10.2%
CAGR p.a., whilst the low PE portfolio generates a 15.4% CAGR p.a.
1 The analysis was done in terms of both price and total returns. The results were invariant to the specification used.
2 The portfolio labels always go across the table (columns) and then down the rows.
3 Consistent with the findings of Piotroski (2000) Value Investing: The use of historical financial information to separate winners and losers, The Journal of Accounting Research, Vol 38
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I have always been a big fan of value investing and James has given me even more research to back up my conviction.
Your always looking for value analyst,
John F. Mauldin
johnmauldin@investorsinsight.com
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