Investors place huge sums of money into what are called value funds, hoping that these funds will outperform. It’s not enough to observe their failure, as we need to understand why.
The concept of intrinsic value has always been one that has served to confuse a lot of investors. It’s not that the concept itself is that hard to understand, where we think that a stock is worth more than the market prices it at, and then expect for the market to somehow change its mind at some point in the future and start liking it more, it’s the fact that we think that this is the way things happen is where we the confusion lies.
We’ve touched on what we’ll call perceived intrinsic value in other articles, but given how many people still believe the myth that is perpetrated by it, it’s a topic deserving of even closer examination. First and foremost, we don’t want to just accept this belief or any belief outright, without even thinking about it at all, and just accept it because it may seem plausible enough and then just buy the thing and wait for our ship to come in.
We need to go into this concept in a little more depth, as a follow-up to yesterday’s article where we explained why momentum strategies are not only much better aligned with both the realities of market behavior and company performance, as well as discussing a little more what actually goes into stock prices, which does not include these calculations of intrinsic value that form the basis of the value strategy.
Just to recap a bit though, we talked yesterday about how companies with better outlooks will have higher stock prices quite naturally, and companies that do have a better outlook are more likely to maintain their advantages, where being better leads to being even better in the future, and where not doing as well likely leads to continuing to being even worse over time.
What this cashes out to is that it is more likely for an outperforming stock to outperform, and for an underperforming stock to underperform, all things being equal. Plenty of people believe the opposite though, and the opposite of what happens is the wrong side to be on. We do need to pay attention to the part that isn’t equal, but if you plan on basing your investing philosophy on intentionally seeking to be wrong, you won’t be disappointed.
Value investing isn’t just about buying beat-up stocks, as stocks whose stock prices have gone down may have done so for a good reason, and it’s very easy to show why that’s a bad idea, as there are often good reasons for this, poor business performance in particular. We don’t have to wonder why Macy’s stock has collapsed for instance, as their business has suffered, although we want to be careful when we try to affix a value on it and look to trade it based upon that, as there is more involved in stock prices than a company’s recent performance and its near-term view.
The failure of the concept of intrinsic value isn’t that hard to expose either, but this does involve a different mechanism, not how far the stock has moved down with a purely reversion to the mean strategy, but how far off the current price is from where analysts believe it should be valued, a reversion to a mean based upon price to recent earnings expectations.
Stocks reverting to the mean is at least a concept that can be understood and explained, even though this was at one time something to pay at least some, attention to, when people acted upon these beliefs more, and changes do require action to produce them. In the old days, when investors used to get excited about pullbacks, there was a greater tendency to jump on these plays, although it wasn’t as if this was a good approach overall anyway.
In what should strike people as pretty incredible, although it’s actually the norm, a lot of investors don’t bother to even check how well their ideas work in the real world. The reversion to the mean strategy is dying, and this is something that has been very apparent in modern times, although if you go back to the long bear markets of yesteryear, during times where you got your quotes from the newspaper or ticker tape at your broker’s office, when stocks were often oversold during the long bear markets we had then, and there was an actual reason to revert as they became oversold, this plan did at least work better than it does.
The rationale here is that stocks that get sold off can get sold off too much, and the reversion here is to where the stock would be if not for this overselling. Our coronavirus infected bear is a perfect example of this, with panic running in the streets, running the price of stocks down more than they should, and this did provide a fabulous reversion to the mean play, if we want to call it that.
The reversion part doesn’t happen by itself, by way of an invisible hand, and this call was based upon long-term investors gaining enough confidence in this stopping to step in and buy stocks at these overly low prices. That’s exactly what happened this time, although most of the time stocks go down in price, and especially when they buck the overall trend, this is a reason to stay well clear, as we need the perception of higher value that occurs with pullbacks like the one we just got, and without it, the outlook of these beaten up stocks remains beaten up.
We need two things to happen before we can make sense of a play like this, we need the market to be moving down as well, and both the stock and the market need to be oversold. When fear takes over, as it did in February and March, the fear itself, as well as the negative momentum, creates a temporary situation that should improve when things settle down more. You buy it at depressed prices and just seeing the fear be reduced can be enough, as the coronavirus bounce showed us.
We might think that this involves stocks moving back more toward their true value, their intrinsic value, but the idea that stocks could even have such a value, an “intrinsic” one that drives prices independent of the things that actually drive them, investor beliefs, is nonsense. This starts with understanding that stock prices are not in any sense intrinsic, even though a lot of people like to pretend that they are, and even think that they are intrinsically determined.
Lots of Things Affect Stock Prices, and Looking at Just One Doesn’t Cut It
The most that we can say about stock prices is that the price a stock trades at any given time is influenced by a great many things, most of which aren’t even things that analysts even look at. They do some simple calculations and determine what they believe is the true value of a stock, based upon their current and near-term earnings, see the market price it differently, and perceive the difference as the market mispricing the stock, and then assuming that an invisible hand will come to their rescue and make them right.
There is a concept in securities trading called arbitrage, although arbitrage doesn’t happen by itself and requires actors, traders who actually do the trading that corrects prices that are out of line. A simple example would be a stock that is traded both in New York and London, where the price of the stock on each exchange would be a reflection of the supply and demand on each.
If traders in London bid the stock up more than in New York, people can buy it in New York and sell it in London, and this will keep their prices moving together for the most part. When they differ, the arbitrageurs swoop in and correct it. This sort of thing goes on all the time in financial trading, and improves the efficiency of markets.
Value investing seeks to arbitrage the actual price of a stock with what they think the value is, which is arbitrage for dummies as it turns out, involving real dummies not just someone who needs to learn about something, and you don’t know you are investing like a dummy if you are one, so the practice continues to thrive.
This is a one-sided arbitrage play, and you need two sides to this, the price that the security is trading at now, and being able to get the other price somewhere else. There has to be a real opportunity to capture any differences here, and while others may hold the belief that a stock is worth more in their eyes and by way of their calculations, there has to be a corresponding change in the market for it for this to happen.
The value strategy doesn’t even consider the mechanism that will cause the actual price and what they think the price should be to converge, and this is supposed to happen by itself presumably. That is an unspoken assumption, but this is where the idea completely falls on its face, because stock prices do not change by themselves and require changes in the supply and demand for the stock to produce it.
There are a lot of things that influence stock prices, and among them are indeed the ones that these people bet their farms on, near-term earnings. We look at what companies are making now and what they are expected to make in the near term, along with a lot of other stuff, including the beliefs of investors that extend far beyond the timeframe that these analysts look at, beliefs about both the company’s prospects and the prospects for its stock price.
They then apply their narrow view to the current price of the stock, and then believe the market will arbitrage the price to bring it up to the price they get when they do this. How this is supposed to happen is left out.
One stock may have its price only ten times their projected earnings for the year, and another may be priced at 30 times, with the market average being 20 we’ll say. The reason for this difference lies in all the other factors that go into price, and the market is as aware of these earnings projections and has priced in these earnings along with everything else, where the sum of all these factors is its current price.
In order for this arbitrage to work, people would have to bid up the lower valued stock towards the mean, and if this were true, we’d also see them bid down the higher valued one, just based upon this one thing, and turn their backs on all of the other influencers, including matters of no small importance like the direction of these businesses in the future, where Ford may be headed compared to Tesla for example.
These other influencers turn out to be even more influential, and as they play out over time, will tend to expand the earnings to price ratio, not converge them. These divergences itself portray the perceived difference between the present value of the stock, these earnings, with its future value, where investors see the stock heading.
In order for the value strategy to work, the market would have to become as myopic as they are, and ignore the future and just look at how much a company is making now, which is far too much to expect. Somehow, this strategy not only lives on but thrives, and shows how little thinking goes into putting together some of our investing ideas and how little sense they need to make to have a lot of investors follow this idea. A great many only need to hear the tune of the Pied Piper and they will follow, where neither the piper nor their flock have any idea of what they are doing.
What distinguishes this approach from the one that has us buying sell-offs based upon value is that when a market or stock truly gets oversold, when the normal demand for it has been overwhelmed by fear-driven selling, and the value that the market has placed upon it gets so diminished, we may expect that when the dust settles, we will at least recapture this excessive loss and get back to looking at the value of the stock long-term instead of just selling to avoid further short-term losses.
Stock Prices Represent the Future Value of the Company, Not its Present Value
This strategy accounts for this future value and looks to arbitrage our getting off-course with that, instead of seeing this future value which dominates stock prices as being the aberration, trying to swim against this powerful tide and having no real basis to even think that the tide will turn mysteriously and without the participation of the market.
Oil stocks are a perfect example of how this goes so wrong, and their lower ratios are simply a matter of their dimmer futures than, say, Amazon, whose price to earnings ratio remains sky-high. If we step back a few years, Amazon’s ratios were higher then, as people saw this company growing a lot, where they haven’t seen this with oil companies even though both may have been making plenty of money.
A stock’s price to earnings ratio is actually a valuable tool when understood, as a way of measuring this future value, and a lower one tells us directly that the market sees how much a company is making but has discounted this. Whatever may cause the market to change its mind and start liking a stock more, it cannot be its present earnings, especially given these earnings have already been fully accounted for in its present price.
There is no invisible hand at work here, and there aren’t any other forces working behind the scenes in their favor, there are only their mistaken beliefs at work. You could pick your stocks at random and handily beat this value strategy, because they are actually seeking out underperformance, picking disliked stocks and just hoping the market will like them more without even needing anything to change. This is just madness.
The world of investing is for the most part a pretty mad world though, where ideas have just gotten thrown out there with very little thought, and over time, people don’t think about them very much, they just follow them, like the kids don’t wonder where the Pied Piper is leading them, or sheep obey the stick of their shepherd.
What has kept so many on this course is the belief that while they may lag behind the market so much during bull markets, the market will be sorry when a bear market comes, with their believing that their higher value will protect them more during these times. Even if this were true, they don’t bother to calculate whether what they are giving up for this would be worth it, but these are questions we at least know that they need to ask, so we’ll have a peek at this.
We’re going to use a popular value fund, the iShares Edge MSCI Value Factor ETF, and compare it to an index, the Nasdaq 100, to get a feel for how much this value fund has given up over the last 5 years, and also look at how these two have fared in 2020, with a real bear showing up and producing the conditions that these value funds are supposed to be superior in.
This is a top-rated value fund and they actually averaged 8% from 2015-2019, where investors who have held this fund may have thought that they did pretty well in fact. When we compare with the 23% per year that the Nasdaq has earned, we come to understand that this 8% isn’t very good at all, and an additional return of 15% over 5 years adds up to 75%, which is a huge difference.
If you started with a portfolio of $100,000, the value ETF would have you sitting with $140,000 at the start of 2020, where those who invested in the index instead would have $215,000, or $75,000 more. 2020 has been ugly though, so maybe the day of this value investing has now come.
Without even looking, we should be able to figure out that because these stocks are actually of a lesser value if we use the term correctly, and are weaker essentially, when the time comes to sell, these stocks should be at closer to the head of the line.
Let’s extend this comparison to today, after the bear pullback and the recovery, to see how each have fared. The value fund is down 25% year to date, while the Nasdaq is up by 3%. We now have an additional 28% in just 5 months to add to the Nasdaq’s 75% advantage, where we’ve now seen the Nasdaq more than double this value fund over the last 5 years and 5 months.
To make this worse, as if that were needed, if we were going to use the concept of intrinsic value more correctly, given the massive amount of money that people pour into these value funds, their actual value if people were more aware of how bankrupt this idea was would be considerably lower.
We’re actually seeing more and more people wake up to this each year, and people moving away from this is actually something that does move prices, by way of this increasing supply and decreasing demand for these stocks. The gap with the market is increasing, and the more people see how green the grass is on the other side, they will notice how less green their own lawns are and drive the value of value funds down further.
There is always an equilibrium with stock prices, and when you get to it, prices will stabilize, but there’s no telling just how much more value funds need to extend the degree of their underperformance to get there.
At some point, the dividend hounds would swoop in and stabilize this fall, but there’s no question that the artificial demand being created with this type of fund that is based upon both a misunderstanding of stocks and an ignorance of relative performance has propped up the prices of these stocks considerably. Knowing that you own a fund that underperforms this much already, and given that this only will get worse over time, is simply not an exciting prospect and not a situation we should continue to choose to be in.
This transition won’t make the stock market run colder, it will make these stocks run colder, and make stocks that are outperforming to outperform even more, including the Nasdaq, who in itself may expect money to continue to flow into it from the other indexes which it regularly trounces.
This means the better stocks will get even better, and the weaker stocks will weaken further, and picking weaker stocks is a bad enough idea without the expectation of the situation worsening to deal with. There is also a huge amount of potential for this effect to grow, and all we need to do is to look at just how much money goes in and stays in these value funds to appreciate just how much room there is.
This is a gradual process though and takes a long time to play out, where decades have not been anywhere near long enough. We are seeing an acceleration of this process though over the last few years and the ship that value investors are in is moving further and further away from the coast all the time, marooned by simply not paying attention at all and still hoping they will set sail to somewhere nicer one day.
Investors have a strong thirst for others to do all of the thinking for them where their investments are concerned, but there is a minimal amount of thinking that they need to do whether they like it or not, as we need to at least be able to figure out whether those who we let do our thinking for us have done much themselves. If they are lost and confused, these are not pipers we should be following, but we won’t be able to tell unless we listen to their tune a lot more closely.