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Saturday, 11 September 2010

In Value, Risk is Not Reward

Free Lunches

In looking for a free lunch many long-term investors gravitate towards value investing where the evidence is that so-called value stocks offer excess returns over medium term periods. This approach, however, brings with it a range of issues of mental discipline that can cause all sorts of strange behaviours, including an unreasoning attachment to stocks that have no merits whatsoever, apart from their consistent appearance on stock filters of a certain kind.

Over and above this, though, there’s a problem with the way that value investing is conceived. To the extent that it offers improved returns the general belief is that it does so by ensuring that the investor takes on more risk. This is exactly the wrong way for most investors to proceed: we want more returns for less risk. And done properly that's exactly what value investing can achieve for us.

Value Metrics

Value investing relies on looking for stocks with a certain set of attributes that hopefully provide the investor with a margin of safety. Typical metrics include a low book to price ratio, so that the company is trading at a discount to its tangible assets, a low price-earnings ratio and a high dividend. There are a range of other possible value filters, but in all cases the aim is to find companies on a lowly rating compared to their peers, with some safety net in case things go wrong.

The market isn’t entirely dumb so stocks on low ratings are often there because they deserve to be. They may be in declining industries or have a history of terrible management or simply be in areas that are wildly unpopular due to wider sentiment in society. Often all three. Whatever the reason, the aim of the value investor is to find these stocks and then bet on them, usually on a portfolio basis, although there are deep value investors who aim to find very undervalued stocks and then go all-in.

Excess Returns

The numbers show that value investing tends to provide good returns over a reasonable period of time – although the short-term pain can be extreme as poorly performing stocks have a tendency to continue to perform poorly, the downside of the momentum effect. So value investors need deep pockets of liquidity and nerves of steel to plough their furrow through thick and thin.

Unfortunately it's virtually impossible to detect which lowly rated stocks are deserving of thieir ratings from a simple financial analysis because, in general, they all look dire. Many value stocks never get re-rated and quite a few go bust. They’re all referred to generally as “value traps”: dead-end, go nowhere investments. This is a downside of the approach, but most investors figure out that company managements generally do stuff that improves performance or get replaced in the attempt.

So although some value stocks turn out to be smelly toads which fail to turn into handsome princes no matter how much we kiss them with our capital – and which are more likely to croak than fly – the dedicated value investor will take this in their stride, confident that the mean reverting properties of the market will eventually yield the higher returns across a portfolio that justify the duff and dull companies that are bound to creep in.

More Risk Equals More Reward?

The most popular evidence for the value investing premium comes from Kenneth French and Eugene Fama who, for instance, in Value versus Growth: the International Evidence show that:
“Value stocks tend to have higher returns than growth stocks around the world. Sorting on book-to-market equity, value stocks outperform growth stocks in twelve of thirteen major markets during the 1975-1995 period”.
The researchers believe that this outperformance can be explained by one thing only – that investors, whether they know it or not, are taking on more risk. In this case stocks trading at a discount to their book value will do so only because they’re in distress and investors prepared to take on this risk benefit because somehow, overall, these companies manage to survive and go on to prosper, at least in relative terms.

So, the idea is, more risk equals more reward. Only this doesn’t make any sense to those of us who live in what we laughingly refer to as the real world. Out here more risk may occasionally produce more rewards but is equally likely to cause us to fall flat on our collective faces. If you think about it the “more risk for more reward” mantra so often trotted out by commentators makes about as much sense as cutting off your arm to stop a paper cut stinging.

Beating Beta

The answer, of course, is that we’re not in the real-world, we’re in econoland where six impossible things can happen before breakfast and no one will bat an eyelid. “Risk” is measured by something called beta, which is the so-called non-diversifiable risk of a security. Basically it’s the risk you can’t eliminate if you build an efficient portfolio. Of course, the only way of measuring this is by looking at history and if that was any guide we’d be living in a world where China was the dominant economic force, Europe was riven by religious wars and Americans were still hunting bison ...

Anyway, the point is that investing in value stocks supposedly produces excess returns because they have high betas and are therefore more likely to swing around more than the market average. By buying high volatility stocks when they’re on their uppers you supposedly weight the game in your favour. So high risk is actually low risk and for taking on less risk you get more rewards. Simple, is it not?

Friends, Romans ...

Well, not, really. The trouble with value stocks is two-fold. Firstly just because they’re cheap doesn’t mean they can’t get cheaper, whereupon all the usual psychological twitches kick in, and secondly, when you have that once in an investing lifetime flash-flood the last thing you want to be holding are a bunch of indifferently managed and badly financed value stocks.

This point has been beautifully made by Jeremy Grantham in Friends and Romans, I come to tease Graham and Dodds, not to praise them (scroll to the end of the newsletter). In amongst a whole host of pithy points he observes that anyone holding small cap value stocks in 1929 would have, more or less, lost everything:
“Basically small cap investing was brilliant for 60 years, but if you had been managing money in 1929, you would almost certainly have been knocked out of the game, having dug too big a hole too quickly. Would any clients have allowed you the time to recover when they were left with 7% of their money?”
Grantham also points out that value investing itself can become a fad, and this compresses the difference between value and glamour stocks to the point where the value premium vanishes, but that’s another story, albeit one well worth telling.

Farcical and Volatile

Despite this, however, not all investors agree that value investing is about taking on more risk in order to obtain more reward. Here’s James Montier on simoleonsense:
“Modern risk management is a farce; it is pseudoscience of the worst kind. The idea that the risk of an investment, or indeed, a portfolio of investments can be reduced to a single number is utter madness. In essence, the problem with risk management is that it assumes that volatility equals risk. Nothing could be further from the truth. Volatility creates opportunity”.
Opportunity is, indeed, what value investing leads to, but only if you’re willing and able to do the proper analysis. By their nature there are a fair few value traps amongst the companies in the lower reaches of the markets – stocks that are a dead end, a dead loss and quite likely to eventually be just dead. Differentiating between the good, the bad and the simply dreadful is important if value investors are to fully reap the rewards of the additional risks that they’re not actually taking.

Value Winners and Losers

Joseph Piotroski has looked at the stratifications of value stocks in Value Investing: The Use of Historical Financial Information to Separate Winners from Losers and comes to a number of interesting conclusions. Firstly he shows that you can gain excess performance by sifting through high book to value stocks on the basis of their historical finances and ignoring the weak ones. Secondly he identifies the fact this excess return disappears where there’s a lot of information flowing around. In essence, he argues that value investing works because of a behavioural quirk not because of excess risk:
“Overall the results are striking because the observed patterns of long-window and announcement period returns are inconsistent with common notions of risk. French and Fama [1992] suggest that that the BM [Book-to-Market] effect is related to financial distress; however, amongst high BM firms, the healthiest firms appear to generate the strongest returns. The evidence instead supports the view that financial markets slowly incorporate public history into prices and that the “sluggishness” appears to be concentrated in low-volume, small and thinly followed firms”.
So there you have it. You don’t need to take on extra risk to get an excess value investing return. You just need to spend your time analysing little followed and barely understood stocks on the margins of the markets. And pray that that once in a lifetime tsunami doesn’t wipe you out in the meantime: some risk is, unfortunately, unavoidable.

Related articles: Alpha and Beta: Beware Gift Bearing Greeks, Do Behavioral Funds Work?, Value in Mean Reversion?


  1. "All intelligent investing is value investing" - Warren Buffett

    I wouldn't call it a free lunch, since its so much work, but if done properly, value investing should both increase returns and reduce risk. In fact, reducing risk can be a major way of increasing returns.

    The recipe is simple to understand, but not so easy to apply.

    1) Find companies you can understand.
    2) Estimate their intrinsic value (ignoring market action and other measures of sentiment).
    3) Buy them if the market offers them at a price well below that intrinsic value.

  2. Super post, but your Grantham link goes to a dead page?

  3. Super post, but your Grantham link goes to a dead page?

    That's annoying, but now fixed. Thanks.

  4. One of the problems about writing about value investing is confusion over what it means. You used the phrase, "Margin of Safety," which is the key concept underlying value investing, but then defined it as cheapness, which is a separate concept, and not what it means. Thus you fell into the trap that most do in writing about value investing, thinking that it is mainly about buying them cheap, when it is mostly about safety.

    Margin of safety means that an investment has protective characteristics that make large losses less likely. Your downside is limited. That can come from a strong balance sheet, hidden assets, sustainable competitive advantages, etc.

    Once the downside is limited, we can look at cheapness. A cheap, safe company will likely do well over a 2-5 year period, yielding reasonable gains for investors.

    That's all. You write a good blog, so don't think this minor criticism means much.

  5. Is there a rule that I forgot to read that says that Value Investing can only be employed by those picking individual stocks (instead of investing in indexes)?

    I agree that the entire idea of Value Investing is to obtain higher returns at less risk. I also agree that picking individual stocks can be dangerous in that you might pick the wrong ones. Why not just practice Value Investing when buying indexes (that is, invest more heavily in the index when prices are good and less heavily when prices are bad)?

    Wouldn't that solve the problem that the company might go under? The entire index is not terribly likely to go under, is it? Valuation-Informed Indexing gives you the best of both worlds (no stock-picking risk and the combination of higher returns and lower risk that goes with Value Investing).


  6. Another take on the value premium -