Monday, November 17, 2008

The Death of Value Investing and Buy-And-Hold

Two strategies for dealing with investing that have held up over time are value investing and buying and holding.  Value Investors--exemplified by Buffett--buy things that are cheap and high quality (what is everyone else doing?), while the buy-and-hold people say it's useless to time the market or pick winners, and just buy some of everything whenever they can.  

Value Investing has a decent historical track record.  Cheap companies (many ways to measure this, just say their profits are large compared to the market valuation) do tend to perform well over time relative to the universe of picks.  The value mavens, and the field is growing, chalk this up to impatient markets.  

But the world of cheap stocks is cheap for a reason.  These companies are characterized by high leverage, are often cyclical, and have a high probability of going bankrupt.  Buying these companies is equivalent to taking on the risk that the entire economy won't crash, things will get better, and liquidity will flow again.  Which is completely fine; it's just that this risk premia delivers results exactly because of the low probability--perhaps even a probability so low you can't find it in historical data--that things may get really, really bad.  

I think we just saw one of those events.  If you look back at the track record of the value guys, they bought up cheap stuff earlier this decade and wound up doing pretty well.  That makes sense; the economy was in trouble some time ago, but liquidity, rising asset prices, and continued consumer spending propped up the levered, discretionary (cheap) portions of the market.  Then things crashed.  And then the value guys, if anything, were burned worse than most.  They mostly never saw how bad things could get--when your mindset is shaped by the Great Moderation and you think long-term, it's hard to--and so were pitching finance stocks, real estate, construction, even airlines, the whole way down.  It seems likely to me that, rather than being compensated for picking companies that were "psychologically" out of favor, value investors were instead compensated for bearing a "value" risk that paid off during the liquidity boom and hit a "black swan" as that funding died off and the risk embedded in low prices became evident.  

This is a very broad picture and doesn't capture everyone.  If Buffett read financial papers, he would no doubt refer to Piotroski's great paper, which shows that it's possible to discriminate between cheap stocks to find the ones with high quality.  He'd then argue that this the quality comonent matters as much as the cheap part.  I don't have much to say against that; the part of the paper I found most interesting was that within the class of poorly covered companies there are a few gems.  Still, with Buffett down as much as he is (and coming back through deals only he could get) the presence of accounting "quality" seems to cut out exactly when you need it.  

So maybe on a risk-adjusted basis, you can still find some good bargains.  Suppose that you can't.  What's the optimal strategy?  Many people resort to some sort of "buy and hold" idea, based on the historical trend that stocks go up about 10% a year.  Again, as with value investing, you have the problem that though there's a wealth of historical data, your true sample size is something much smaller because shifts in a few macroeconomic variables explain a lot of the changes in overall stock performance (and those variables are very historically contingent on all sorts of things).  Do we expect stocks to grow to infinity?  If the true risk-adjusted interest rate was really large, then a family could simply keep putting money away and grow arbitrarily rich.  Maybe this works for a few people but definitely not everybody.  Presumably embedded global political and economic risks crash wealth to zero every now and then.  Russian, Chinese, and German bonds were very popular about a century ago.  This is another way of saying that the equity premium, measuring the overperfomance of stocks relative to other investments, reflects actual risk which comes out at inopportune times.  

Another approach--interestingly, lining up with what Buffett has long said--is that stocks are like bonds.  That is, their returns are not distributed randomly, but can instead be reasonably predicted considering something like their dividends and price, much like how bonds are priced given their yield.  This makes sense from both a fundamental view--stocks are claims on the profits of a company--and an asset pricing view--the premium that investors are willing to pay for risk depends on broader circumstances.  Cochrane uses this to make the point that price volatility is not that big of a deal.  Another point is that--just as you don't go out and buy "bonds" regardless of the interest rate--you would do better to buy or sell in varying amounts depending on how cheap markets are overall.  Yeah, this is a lot similar to the value investing world.  But there are a few differences--one, you pick entire industries (or the market as a whole), not individual stocks.  Also, you don't depend on psychology for your returns, but rather on understanding risk premia at different times, for different asset classes.  You don't buy and hold "forever," but look at implied yield rates.

Here's what that would look like.  You take some stock of capital and divide it up into different asset types ("things"--real estate, commodities, materials, bonds--international equities by market cap, etc.) and you cycle money in and out of these asset types by judging aggregate valuation levels.  So you would have bought all sorts of equities (many emerging and small) several years ago, then commodities sometime in the last few years, then you would have shorted real estate, then equities (especially foreign), then commodites.  Any analysis you can do helps you make decisions.  Within asset types, you move out of expensive into cheap.  For all asset types, you buy quality.  Risk management is important; you hedge risks, including risks that assets start to move together, and volatility risk (out of the money puts).  

I realize I've just replicated a "hedge fund" but hopefully not all of them behave this way.  For one, a disturbingly large number of them turn out to be not that much into shorts.  The broader idea is that you don't claim any ability to "pick stocks," but rather you exploit different risk premia across different asset classes in a consistent manner.  As far as the individual asset components go, we may be in a world where the prices of many assets starts to link.  But even if you're playing only with one asset, timing long-short opportunities and remaining in quality should help you out.  

I'd have to backtest this with a more systematic approach.  May or may not "beat the market" but should get some returns while being explicit about the risk.  

I don't know why I'm so stupid as to write up every potentially profitable idea I have.  Hopefully no one reads this.  


kirkco said...

I suggest you look at another approach demonstrated and tested in Charles Kirkpatrick's "Beat the Market." (FT Press, 2008) This has to do with relative stock price strength, relative earnings growth, and relative valuation. It works.

Thorfinn said...

Hard to get a good summary of it online, but looks a little too focused on technical analysis for my taste. You come up with a great way to make money, and decide to write a book about it?

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