THE AGE OF EVIDENCE-BASED INVESTING
Is the finally the end of the Ouija board?
WE ARE OUR GREATEST ENEMY TO SUCCESS
Our emotions systematically hold us back
THE DIFFERENCE BETWEEN VALUE AND GROWTH
Why would you invest in growth?
MOMENTUM ISN'T GROWTH
Your gut instinct is wrong
SUMMARY OF INVESTMENT THEMES
THE AGE OF EVIDENCE BASED INVESTING
Charlie Munger of Berkshire Hathaway and business partner of Warren Buffet says, "Avoid extremely intense ideology because it ruins your mind."
"Avoid extremely intense ideology because it ruins your mind." - Charlie Munger, Berkshire Hathaway
As you know, I was recently interviewed by the value-oriented investing website, Guru Focus. You can find the interview by clicking here. What was interesting was that the interview wasn't about value investing, it was about momentum investing.
When I was in school and through my early years as a financial advisor I was a staunch supporter of the value style of investing. Search for companies where the current market price was trading at less than the intrinsic value or the sum of the parts and invest until fair value was reached. By investing in the unloved companies, you hoped to capture the so-called "value premium" that academics say has existed for at least the last 100 years.
While working for that big investment bank for my first nine years in the business, we were taught that it made much more sense to invest in both value-oriented companies and growth-oriented companies. When I asked, what is the reason you would want to do that, it was met not with actual data, but with ouija board-like, "because companies growing their earnings at a faster rate can provide diversification and potential above-market returns". I never actually saw any data that supported that conclusion.
Over the past decade or so, I have immersed myself in academic and practitioner related studies of different investment strategies. About 3 years ago, I began reading studies by Wes Gray, Ph.D. and Jack Vogel, Ph.D. These two became tired of the old Wall Street way of peddling product. "Here is what works. Why? Because we say so". They, like I went in search of a better way. About a year ago I met the two of these men at the Ritholtz Conference on Evidence-Based Investing in NYC. Engaging and astute, we had a great conversation in between breaks and are still connected today.
I tell you all this because after reading their books, Quantitative Value and Quantitative Momentum it engrained what I had long thought. A disciplined, systematic approach to investing in the value and momentum factors can provide a balanced equity portfolio while reducing or even eliminating exposure to areas of the markets that exhibit neither cheapness nor momentum. No strategy is infallible and there is no guarantee that what worked in the past will work in the future but approaching the stock market in this fashion has academic research going back over the past 80 years to support it versus the Wall Street mantra of "Just Trust Us". If you are interested in getting in the weeds with the data check out both books on Amazon (Quantitative Momentum and Quantitative Value).
John Maynard Keynes, an early 20th-century economist was a noteworthy investor in his time but even he had his struggles. He once uttered one of the most widely repeated mantras of all time, "Markets can remain irrational longer than you can remain solvent."
"Markets can remain irrational longer than you can remain solvent."- John Maynard Keynes
How can this quote resonate so much in the real world as opposed to academia? The major issue I have with the efficient market hypothesis is its two assumptions. Humans are definitely not always rational, and the attempt to exploit market mispricing is risky and not always actionable. These two points are the hallmarks of the reasonably new area of study "behavioral finance".
As an example of unactionable mispricing, Gray looks at a potential mispricing of oranges. The assumptions are as follows"
- Oranges in Florida sell for $1 each
- Oranges in California sell for $2 each
- The fundamental value of an orange is $1
EMH suggests that investors would buy oranges in Florida and ship them to Florida to sell at the higher cost, thus bringing the cost down until oranges in California also sell for $1. However, there are obvious limits to this opportunity. The shipping costs may be prohibitive to the point that the mispricing will remain. One would not buy in Florida and Ship to California if the cost was $1 to ship.
His second point is that humans are far from rational. How many people have driven without a seatbelt? While rationally, we know that seatbelts save lives, countless Americans still refuse to wear them. We have two parts of our brain, the one that aims to keep us alive, and the other helps us make rational long-term decisions. Unfortunately, both sides of the brain can come into conflict.
These two factors are essentially what creates the opportunity for mispriced assets. The question is can you take advantage of them?
WE ARE OUR GREATEST ENEMY...IN THE WORLD OF INVESTING
Over long time frames, we may be very aware of mispricings such as the value or momentum premium, the quality or the size premium, but in the short-term investors can become so frustrated by volatility that they abandon ship before the mispricing can benefit them.
Further, smart, active managers, sometimes even avoid long-term market opportunities if their investors are focused on short-term performance. Typically, sustainable edges are only potentially available to strategies that require a long time horizon AND an indifference to shorter-term underperformance to be successful.
THE DIFFERENCE BETWEEN VALUE AND GROWTH
Cheap stocks may have had poor earnings growth in the recent past. Expensive stocks have wonderful earnings growth. Value stocks are deemed cheap for a good reason and the market says that these poor earnings growth rates will continue into the future. Growth stocks are deemed expensive for a reason. The market believes that the accelerating earnings growth will continue into the future.
Is that really true? This is easy to be tested and fortunately, that work has already been done. What was found is not surprising. Reversion to the mean is often at work. Those stocks with wonderful earnings growth may start to underperform expectations and those with terrible growth may sometimes begin to outperform low expectations. This historical anomaly has been called the value anomaly. For further detail on the data please feel free to contact me or reference the book Quantitative Value by Wes Gray and Jack Vogel.
In my mind and apparently in Dr. Gray and Dr. Vogel's as well, the reason it exists is that investors tend to extrapolate the recent past into the future. You have heard me say that many times in the past.
This helps in part to explain why generally expensive, growth stocks sometimes underperform the market and cheap stocks sometimes outperform the market.
Rob Arnott of Research Affiliates' view is that no one should own growth stocks. Bear in mind that value stocks can perform differently from the market as a whole. They can remain undervalued by the market for long periods of time. From a poker playing perspective, buying growth stocks and selling value stocks is akin to systematically poor hand strategy. A great hand last round does not equal a winning hand in this round.
Despite the data, the problem with value investing is that it can be lonely. Being a value investor requires patience, discipline and faith. In theory, value investing is easy, buy cheap, sell expensive... but in practice, true value investing is almost impossible. Thankfully, in my opinion. there is a solution.
MOMENTUM INVESTING ISN'T GROWTH INVESTING
Momentum Investing, simplisticly, is the strategy of selecting investments that have performed well compared to the peers over the previous twelve months with the expectation that will continue to do so into some point in the future. The momentum factor is relatively uncorrelated with the value factor which can provide excellent diversification benefits.
The initial reaction for most people when they hear momentum investing is that it is the same thing as investing in growth. That is not the case. While they could be related at times, in my opinion, momentum is a much more sustainable strategy and a better diversifier. Momentum is purely based on price trend and does not look at company fundamentals. Unlike the Value factor, which has some famous investors backing it like Warren Buffett, Seth Klarman, Benjamin Graham, Joel Greenblatt, Jeremy Grantham, momentum investing doesn't currently have as many noteworthy backers. Stanley Druckenmiller, George Soros and Paul Tudor Jones are three of the most famous investors who show that technical analysis (price metrics) might be an even better anomaly than value, but there are less outspoken believers of the strategies because the data is newer.
So, what is the difference between growth and momentum? Growth-oriented investing strategies typically invest in securities that have high prices relative to their fundamentals in the past. The bet is that their growth rates will continue accelerating. Momentum investing is the practice of selecting securities that have strong price performance relative to their peers, REGARDLESS of the security's fundamentals. For further detail on the data feel free to contact me or reference the book Quantitative Momentum by Wes Gray and Jack Vogel.
Momentum stocks can be growth stocks, value stocks or anything in between. The ONLY criteria is strong price momentum compared to their peers.
One of the proponents of momentum investing is AQR Capital founder and University of Chicago graduate, Cliff Asness. He said, "We discovered the world was flat before we understood and agreed why."
"We discovered the world was flat before we understood and agreed why."-Cliff Asness
The Value factor is much easier to explain as to why it exists. Momentum is not as clear.
The best explanation I have seen is that both the momentum and the value factors exist because of behavioral biases. Greed and fear seem to drive systematic investment errors that can be routinely exploited.
In summary, I feel that momentum investing, rather than growth investing could be an important part of a well-diversified portfolio and is a better strategy than growth investing.
Feel free to contact me via email if you would like to learn more about momentum investment strategies and if they could be a benefit to your investment portfolio.
- Rather than trying to “beat the market”, focus on beating inflation and the rate on cash. Plan for safety and liquidity while seeking positive returns.
- Equity valuations are very rich but masked due to the distortion of the Treasury curve. Volatility is returning to the markets and I think long/short managers are best positioned to capture this volatility by owning companies with strong businesses, barriers to entry, and good valuations and selling short weaker companies with high debt loads that have risen sharply with the broad market rally. I think this strategy of hedged equity may have the potential to produce attractive risk-adjusted returns if and when investors begin to question the valuations of companies. Stock investing involves risk including loss of principal. No strategy ensures success or protects against a loss. Long positions may decline as short positions rise, thereby accelerating potential losses to the investor.
- Monsoon country investments. Attempting to take advantage of demographic, educational and investment possibilities in the countries surrounding the old spice routes of the Indian Ocean. International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets.
- A potential U.S. infrastructure upgrade cycle may be around the corner. Moving from our current grade of D+ to B would require an investment of $3.6 trillion by 2020.
- Supply problems remain high across the energy asset class. While there isn’t a current shortage of energy on the planet, it is taking more and more energy and capital to discover, drill, transport and refine it. Long term Demand should continue to grow globally, particularly in China, India, and other developing countries.
- Potential food shortages due to inclement weather and higher demand from the emerging Asian middle class could result in a boon to agricultural land and potash fertilizer companies. International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.
- The rise of E-Commerce has coincided with an increased desire for efficient warehouse distribution real estate. As e-commerce moves toward even faster delivery, positioning of distribution becomes even more important.
- Precious metals mining companies have been extremely beaten down over the past four years. Mining is an industry that spans hundreds of years. Companies that mine for commodities are often highly cyclical, meaning they have sustained moves both up and down. When investing in the mining space it is important to be a contrarian. Ideally, you would want to accumulate miners when sentiment is poor around them and sell them when sentiment is positive. Historically this has been a good strategy.
No strategy ensures success or protects against a loss.
Colin B. Exelby
Celestial Wealth Management
- The information herein was obtained from various sources and we do not guarantee their accuracy.
- The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
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- No security, financial instrument or derivative is suitable for all investors.
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- The fast pricing swings in commodities and currencies may result in significant volatility in an investor's holdings.
- There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
- Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.
- The prices of small and mid-cap stocks are generally more volatile than large-cap stocks.
- An investment in Exchange Traded Funds (ETF), structured as a mutual fund or unit investment trust, involves the risk of losing money and should be considered as part of an overall program, not a complete investment program. An investment in ETFs involves additional risks such as not diversified, price volatility, competitive industry pressure, international political and economic developments, possible trading halts, and index tracking errors.
- High yield/junk bonds (grade BB or below) are not investment grade securities and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.
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