Gluttons for punishment – the only fun bit about value investing is the potential return

Otmane El Rhazi from Mindful Money » Shares.

Why would anybody want to be a value investor? It is a difficult, grim and – almost by definition – lonely existence. Take a glamorous area of investing such as personal computers and where are the value investors asks The Value Perspective’s columnist Kevin Murphy…

Are we piling into Arm Holdings because tablets are growing exponentially? No, we are buying the undervalued manufacturers of hard-drives and printers, which tablets barely use.

Clearly we are gluttons for punishment so you would imagine we must have a very good reason for pursuing a value strategy – and you would imagine right. It is effective. It works. From time to time, here on The Value Perspective, we mention our long-standing hunt for any academic study – carried out at any time, anywhere in the world – that has shown otherwise. We are still hunting.

When such academic studies examine the benefits of value investment, they tend to isolate more lowly valued stocks by concentrating on the cheapest half or perhaps the cheapest quartile or quintile of a particular market. That is, however, likely to be a lot of companies so that, for example, if you were looking at US data going all the way back to 1951, the cheapest quintile would number 170 stocks.

We know this because we asked our friends at Empirical Partners to crunch some numbers on precisely that data to see what lessons might be learned from the distribution of returns. No private investor, after all, is going to buy the best part of 200 stocks so what if we reduced the number to something a bit more manageable, such as 40?

Using that US data covering the period from 1951 to 2014, Empirical Partners isolated the 170 companies that made up the cheapest market quintile on free cashflow yield. Then, with the benefit of hindsight, they built three portfolios – the best-performing 40 stocks, the worst-performing 40 stocks and the 40 businesses that were bang in the middle. So what did that show?

As a whole, the cheapest quintile outpaced the wider market by 3.3% a year – sufficient to put it handsomely in the top decile of all funds over that period. Within that quintile, the ‘Best 40’ portfolio outperformed by an impressive 32% a year while the ‘Worst 40’ underperformed by 24% a year – some stocks are, after all, cheap for good reason. For its part, the ‘Middle 40’ outperformed by just less than 1% a year.

The lesson here for the would-be value investor is you can choose to go one of two ways – the first being you take the quantitative route and systematically buy the whole cheapest quintile with no exceptions. That is a perfectly logical approach but, if you do decide to take a more concentrated active path, we would stress that you cannot do things by halves.

If you think you can just cherry-pick a handful of stocks from that cheapest quintile and then outperform the market through some kind of divine right, you are potentially heading for a big disappointment. To succeed as an active value investor, you need to be a first-class fundamental stockpicker with excellent analytical and balance sheet-testing skills – or else you need to know someone who is.