AQR Capital Management founder Cliff Asness wasn’t a big fan of value stocks, but he changed his mind last fall, feeling that they are now due. He is still waiting patiently.
For a couple of magical weeks last September, value stocks were all the rage in the financial media when it was discovered that value stocks were actually beating the market for a time. It actually only took two days of this going on to spur the imaginations of a lot of investors who had been waiting years for this, thinking that, at last, value stocks are becoming the place to be.
It didn’t matter that no one has ever been sure of what is supposed to behind this revival, where somehow the weak stocks start taking over, with the weak now becoming stronger than the strong stocks. Longing for this to happen has been enough of a justification, and although all the years of this not corresponding to reality must have been frustrating, they refused to have reality dim their hopes.
It didn’t even matter that their dream has faded more and more with the passing of time, where the gap between weak stocks and strong ones has not reversed but continued to widen, when you believe so strongly that the meek shall inherit the earth and that day will come someday.
Even the worst sports teams get lucky enough to put together back to back wins once in a while, but then go back to what they usually do, lose, and weak stocks, affectionately referred to as value stocks by their fans, quickly got back to what they usually do, perform weakly.
We scoffed at this drunken revival at the time, because none of this made sense to us, to take a small slice of stock performance, a tiny mound in the midst of a great valley that leads further and further below the surface of the ground each year, and pin your hopes on that is simply wishful thinking.
We are trend followers, and all that really means is that you need to look at what’s actually happening and use that to compare your beliefs to. If there was enough evidence to suggest that the enduring negative trend against weak stocks were actually reversing, we would be among the first to stand up and proclaim it.
This move quickly fizzled out as expected, and it scared us that there are investors who know so little about measuring trends that they would even find such an insignificant event even worth talking about, but if you hope hard enough, even beating the market by a little over a brief period can be enough to get your hopes up more.
The philosophy of what they call value investing is a pretty bewildering one, and the bewildering part is the big gaps in the normal cause and effect relationship that is necessary to explain things. How we actually get from beat up to shining stars is the part that is missing from their theory, the bewildering part, and it even seems as if its proponents have not even thought about this at all.
If you instead just build that in as the crucial assumption, that weak stocks, those which perform badly, will magically be transformed by the wand of the investment fairy into above average performers, we’re just setting ourselves up for disappointment, because the investment fairy doesn’t actually exist.
Maybe one day their ship will finally come in, but we need to at least realize that you can’t go from one situation to an entirely different one without something causing the change. We need to at least have our ideas be possible in theory as we wait, but given that investor behavior doesn’t change for no reason at all, theories that rely on changes without change don’t just fall on their face, they never got up to fall down in the first place.
We may wonder how so many investors fall prey to this idea, where the weak become strong by way of some unknown force, and the fact that nary an explanation is to be found among them furthers the shroud of mystery surrounding this investment philosophy. The reason why a causal explanation is lacking isn’t so easy to figure out, as these people aren’t even bothering to look at stocks at all, let alone how the demand for certain ones needs to be transformed for them to ever be right.
What they do instead is to look at a certain aspect of company performance, current earnings, and the less attention that a company’s stock price accounts for these earnings, the more valuable the stock is. They assume a strong causal relationship between a company’s current earnings and its stock price, in spite of a complete lack of evidence to support this theory.
In this equation, we have various levels of earnings and prices, with the earnings with a given stock being the constant at any given point in time, $1 per share last year for example. This $1 per share will weigh into the conversation to some degree, alongside a whole lot of other things, and some having nothing to do with the company at all, and all of these forces determine the supply and demand for the stock, which determines its price.
If we somehow manage to delude ourselves into thinking that current earnings are what determines stock prices, or at least should, we presumably can think that there is actually a casual relationship here, because we’re assuming this.
We remain undaunted when we see how widely different that the market prices these earnings, where this $1 a share per year stock might trade at $5 or $50 or anywhere in between. We are hoping for a reversion to the mean but aren’t put out at all with its not existing. To make this work, all we need to do is to pretend that stock prices should behave more like we think they should, and then resolve to one day profit from when the world finally sees the truth and ignores all of the other things that they do to price stocks and pay a lot more attention to this one thing of theirs.
They then put their money on stocks that are considerably less in demand by the market relative to their earnings, the cheap stocks as they call them. The $5 stock is seen as cheap, because its price is only 5 times their annual earnings, where the $50 stock with the same earnings is seen as horribly pricey.
How Value Investing Gets It Backward
We then need to ask ourselves why, given the same earnings, one stock could be trading at $5 and the other at $50. We know for certain that this has nothing to do with their earnings since they are the same. The difference can only be the sum of all the other factors that influences stock prices, the part that this theory chooses to ignore completely.
This would seem to be pretty hard to do, to ignore all the things that we know move stock prices, and it’s a long list. If you just assume that deviations from what you think should be happening to the stock price is the market just being wrong, you can be lulled into sitting back and waiting for their somehow seeing the err of their ways and start ignoring everything else to a substantial degree at least, as you choose to.
We might even anoint our view as the rational one, and when the market does what markets do and take everything that they wish to take account for in whatever proportion they decide, we can just call that irrationality, and patiently wait for rationality to prevail.
Since this approach seeks out a basket of weak stocks and bets money on them, this involves much more than just debate, as if these ideas cause us to make bad decisions with our money, the price of this is more than just having these illusions about stocks. Real money is won and lost at this game, and even though you might come out with positive returns from focusing on bad stocks, as even the bad ones tend to go up somewhat over time, being so oblivious to the obvious can leave a lot of money behind.
The battle that is fought in the markets to decide the movement of stock prices involve the intersecting forces of supply and demand, where if prices rise, we have a rise in net demand. This net demand, or net supply if the price goes down, can be measured directly in the stock prices themselves.
Weaker stocks are those that possess less net demand, less bullishness we could call it, and stronger stocks have more bullishness behind them. We can even take current earnings out of the picture by using a multiple of price to current earnings, like 5 with our $5 stock and 50 with our $50 stock.
We then can get a clear measure of the impact of all the other forces besides current earnings that weigh in on stock prices by looking at this multiple. Stock prices function to forecast beliefs in the future value of the stock, which is different than the future expectations of the company, even though they are aligned to some degree.
Perhaps we give a premium to a stock that is in a hot sector that has seen its prices rise merely by virtue of the excitement that it has generated, and this needs to be accounted for as well. It doesn’t matter why a stock has a higher ratio than another, as higher ratios express a more positive belief about the future, and right or wrong, this is what really determines stock prices and this ratio.
If we intentionally choose stocks that possess a lesser future outlook, given how important future outlook is to stock prices, we are seeking out stocks that have the lowest potential to grow over those with greater potential.
When we saw all of the ruckus last fall about value stocks primed to finally get their day in the sun, this was therefore very easy to shrug off. As we pointed out, these stocks are not only more likely to not go up as much, they are also more likely to go down as well, with history as well as reason fully on our side.
AQR Capital Management’s Cliff Asness Still Clutching to This Idea
Among those who joined this little value party was AQR Capital Management founder Cliff Asness. You could line up the suspects in this case and it would be a very long line indeed, with some very big names among them, but what stands out with Asness is that he runs a quantitative fund, and hasn’t been partial at all to value stocks up until recently.
We would think that a fund that calls itself quantitative would at least require a connecting of the dots to make sense of this quantitatively, rather than just relying on the dogma that rules the beliefs of the normal crowd that this thinking attracts.
Asness thinking that the gap between these weak stocks and the average stock has been rational for years, up until now that is, but at the time, they somehow managed to penetrate his definition of rationality where stock prices are concerned and somehow became irrationally low priced.
We already know from this that he has taken his eye off the ball and is trying to use alchemy to transform quantitative data from companies into stock data, without really looking into the quantitative relationship between them. We are actually left to mostly wonder about how this alchemy is supposed to occur, or how these are linked enough to want to make such a prediction, or even how this prediction is supposed to manifest.
Asness wrote that “for a long while, even as value suffered, we cautioned against upping the value weight,” but as the gap widened, this just became too tempting it seems. At least he has other things in his formula than value, although quantitative analysis can use whatever inputs it chooses, including the wrong ones.
Asness doesn’t see it that way, and in a quote that embodies the confusion of this strategy majestically, he believes that “value fundamentals have not come in worse over this recent painful period, it’s prices alone that have gone the wrong way.”
This depends on what we consider the wrong way, but when they behave differently than you think they should, that could be the wrong way, and the one he is referring to here. All we need now is the investment fairy to waive her magic wand and the holy grail is at hand.
We’d love to be able to ask Asness why he puts any weight on “value,” which is the big missing link in his argument. He does elaborate a little on his vision though, such as these stocks being valued low historically being an influential factor. His hidden assumption that stocks valued low historically can cause stocks to be valued more isn’t supported though, and just saying bad stocks are worse now than they used to be does not even imply any change.
He also states that the market has gotten it wrong by pricing these stocks so cheaply and they will see the error of their ways, although how this is supposed to happen is left out. The lower demand of these beat-up stocks is even held to be a virtue, as these stocks have the benefit of not being “crowded,” without leaving us with any idea of why this is a good thing.
Asness wrapped up the interview by telling us that timing stocks is an unavoidable sin, and he feels now is the time to sin a little with value stocks.
Timing stocks in of itself need not be a sin, but it can certainly be if you do a bad job of it. It turned out that there wasn’t quite the value in value stocks that Asness believed back in November when he made this call. As for timing, while there is never a good time for this, the weakness of these stocks does not make them a good choice at all in bear markets.
Those who think that the bear market ended are likely talking about the broad market, and may not know that the bears haven’t just visited the value den, they have moved in. No value fund was spared from this, but no fund demonstrates how much value stocks have taken it on the chin than the Invesco S&P 500 Pure Value ETF, because it confines itself to the weak stocks in the index, it is pure “value.”.
The goal with these funds is to beat the market, otherwise you could just invest in the S&P 500 and be better off. Most funds don’t beat it, but some miss by a mile. This fund is down 24% over the last 5 years, and as painful as losses are, the fact that you could have made 40% instead with the big index is simply terrible.
The bears are still hanging out at the Pure Value Fund, that’s for sure, with it still being down 40% on the year. While the S&P 500 dropped 3% on Wednesday and Thursday, the Pure Value Fund gave back 12%. This goes up a lot less, as the last 5 years show, and also goes down a lot more, as we see now.
This is nothing that those who care to look didn’t know, as this fund lost 77% during the 2008 crash, well in excess of the market, the last time we saw something like this. Since these stocks are unloved at the best of times, it only makes sense that this would carry over to the downside as well.
We might think that Asness would be hanging his head sheepishly and maybe even repent his sins, but it you think that, you don’t know value investors. If being so far behind year after year doesn’t dull your enthusiasm, this isn’t likely to either.
Asness has far from given up on this and actually seems even more excited about these stocks now. Given that these people believe price and value are inversely related, value stocks just got a whole lot more valuable lately. They might recover a lot more slowly than the average stock, and they may be knocked down more when the downside takes over again, but no matter, we just need to keep the faith.
He feels that all the stimulus we’re using will finally wake up value stocks and then just watch them go. With all the money that we’ve thrown into this already, they have barely responded and so little that they are still this far down, and this idea has already shown to fail in a big way.
Asness tells us that the value gap has never been higher, although this is because the movement out of value stocks is growing more and more over time. More and more people are waking up to this, and our money should be on more awakening, not more of them falling back asleep, which can only mean this gap continuing to widen.
If it ever does go the other way, we will know it, and if and when value stocks can make up the huge difference that has marked their underperformance and surpass the S&P 500, even for just one year, that would be worthy of notice.
We can even turn this idea on its head, and exclude these stocks from our version of the index, and be made considerably better off. We also might want to look at the exact opposite of this, the lowest valued stocks in their eyes, and as it turns out, this group does the kicking rather than getting kicked by the S&P 500.
We can therefore sometimes learn something from even the worst of investing ideas. We do want to pay attention to the value theory of stock prices, but only in order to turn it completely around to have this sit right side up instead of upside down.