Value Premium and Value

Investing
Dr Showkat Ahmad Busru
 Outline

 Value premium
 The equity premium puzzle
 Excessive Volatility
 Bubbles
 Behavioral asset pricing model
 Value Investing
 Central Tenets of Value Investing
 Evidence and prospects of value investing strategies of some well- known value investors
 Why retail and institutional investors to choose growth over value stocks
Value V/S Growth Stocks
 Value Premium

 Value stocks are defined as stocks which have a low P/E ratio or low price to cash flow ratio or
low price to book value ratio.
 Growth stocks are defined as stocks which have a high P/E ratio or high price to cash flow ratio or
high price to book ratio.
B/P Ratio and Investment Performance

 A similar anomaly is based on the book-to-market ratio. Research

suggests that firms with high book-to-market price ratios tend to
outperform firms with low book-to-market price ratios.
 The equity premium puzzle (EPP)

 The equity premium puzzle (EPP) refers to the excessively high

historical outperformance of stocks over Treasury bills, which is
difficult to explain.
 Theoretically, the premium should actually be much lower than the
historical average of between 5% and 8%.
 Standard theory suggests that stockholders should receive perhaps
a 1% greater return from stocks than from bonds, to compensate for
the bigger risks of equity investing, rather than the 6% average
equity premium.
 Why is It Puzzling

The neoclassical finance model implies the following:

o The equity risk premium should be very low barely 0.1 per cent for
the U.S. and not the historical 3.5 per cent (given the reward for
only market risk).
o The standard deviation of the market should be 12 per cent not the
historical 18 per cent (Volatility puzzle).
o The stock prices are always right, but we have periodic episodes of
bubbles (Bubbles puzzle).
What Explains the Equity Premium Puzzle

 An important rational explanation is based on survivorship bias

(Due to wars or nationalization, more than one-half of these
suffered at least one major breakdown. Such events often inflict
huge losses on investor. But if we consider only markets with
continuous trading record, the average market returns will be
biased upward, on account of survivorship bias.
 There are two main behavioral explanations for the equity premium
puzzle. The first one is based on ambiguity aversion and Myopic
Loss aversion
 Ambiguity Aversion Example

If You have missed the Quiz Test.

The Faculty gives you marks without writing test. (Any Number
from 1-10)
At which number you will be satisfied (As high as possible)
What if you know the average.
 Ambiguity aversion

 Ambiguity aversion describes a behavioral bias towards known outcomes.

 If the equity risk premium is attributed only to risk aversion, the implied risk
aversion is incredibly high.
 But what if investors in addition to being risk averse are also ambiguity-
averse.
 An ambiguity-averse individual would rather choose an alternative where
the probability distribution of the outcomes is known over one where the
probabilities are unknown..
 Survey evidence reveals that investors disagree widely on the level of ex
ante equity premium, suggesting that investors don’t know the mean of
the return distribution.
 Myopic Loss aversion

 One behavioral theory by Shlomo Benartzi and Richard Thaler attributes

the equity premium puzzle to what’s known as myopic loss aversion
(MLA) –.
 Benartzi and Thaler propose that myopic loss aversion may be the cause
of the equity premium puzzle.
 The idea that loss-averse investors (as all investors are) take too short-term
a view of their investments, leading them to react overly negatively to
short-term losses. Since investors are especially worried about losses, they
need to know that equities have high return potential to justify investing in
them – hence the equity premium.
 EXCESSIVE VOLATILITY

 Apart from valuations that sometimes seem bizarre, the stock market
seems to be characterized by excessive volatility.
 Excess volatility is the name given to that level of volatility over and above
that which is predicted by efficient market theorists. In Sheller's eyes this
excess volatility can be attributed to investors' psychological behavior.
 Shiller argued that rational investors would price a stock at the present
value of expected future dividends. However, he found stock prices
fluctuate more than can be explained by fluctuations in dividends.
 BUBBLES

 Although the stock market is generally efficient, it is prone to

commit mistakes, given the extraordinary difficulties in divining the
future. As an investor you should be aware that occasionally the
market displays high irrationality causing a substantial discrepancy
between intrinsic value and market price. In market parlance it is
called bubble time.
 A rise in the price of an asset encourages more people to buy it
which, in turn, fuels further price rise and induces more and more
people to join the bandwagon.
 Four Phases of Bubble

 Stealth Phase During this stage the “smart money” enters the market quietly,
causing a very modest – almost imperceptible price rise.
 Awareness Phase In this stage, institutional money flows into the market,
leading to a perceptible take off in prices.
 Mania Phase As the price momentum builds up and the activities of
institutional investors receive media attention, the general investing public
participates enthusiastically, leading to a self-reinforcing upward movement.
 Blow off Phase The irrational exuberance at the end of the mania phase is
followed by a return to sanity when prices decline. The price fall, however,
triggers fear and sets in motion a downward spiral.
 What prevents people from seeing
predictable surprises?

 Over-optimism The tendency to look at things through rose-colored lenses

blinds us to the dangers posed by predictable surprises.
 Illusion of control The belief that we can influence the outcome of
uncontrollable events lulls us into complacency.
 Self-serving bias People tend to interpret information in ways that support
their self-interests.
 Myopia Obsessed with the short run, people tend to ignore the long-term
consequences of their action.
 Inattentional blindness A final barrier to spotting predictable surprises is
inattentional blindness: we are not likely to see what we are not looking
for.
 The Internet Bubble

 The big daddy of all the bubbles in human history, the Internet bubble was
spawned by a new technology and new business opportunities.
 Many believed that the Internet heralded the New Economy and its drum
majors, such as Amazon.com and Priceline.com, soared to dizzy heights. The
obsession with Internet enabled companies to double their price by merely
changing their name to suggest some web orientation (such as .com or .net).
 VA Linux climbed over 730 per cent on its first trading day to nearly $200 per
share. In 2002, the same share fell below $1.
 Investment bankers, analysts, and media contributed to the hot air inflating the
Internet bubble which finally burst as sanity returned to the market.
 Behavioral Asset pricing model

 (CAPM) – a model in which beta is the sole factor that determines expected
stock returns.
 In 3 factor Model market capitalization and book-to-market ratios are
considered as measures of risk: small-cap stocks and stocks with high book-to-
market ratios (value stocks) are considered to be high risk stocks and hence
have high expected returns.
 In behavioral asset pricing model, in contrast, the same factors are interpreted
as manifestations of affect, an emotion, and representativeness (a cognitive
bias).
 Investors consider large-cap stocks and stocks with low book-to-market ratios
(growth stocks) as good stocks and small-cap stocks and stocks with high book-
to-market ratios (value stocks) as bad stocks.
 Value Investing

 Value investing refers to purchases of securities or assets for less

than their worth.
 value investors do careful valuation and believe in investing, not
trading or speculating.
 Value aficionados regard Benjamin Graham as the intellectual
father and Warren Buffett as the most pre-eminent practitioner of
value investing.
 They believe the market overreacts to good and bad news,
resulting in stock price movements that do not correspond to a
company's long-term fundamentals.
 Central Tenets or Ideas of Value Investing

 Mr. Market and Mr. Value : The stock market is very exciting and misleading
in the short turn, but boringly reliable and predictable in the long run. These
two facets of the market may be called Mr. Market and Mr. Value.
 Fractional Ownership: Value investors regard securities as fractional
ownership in the underlying business and not as speculative instruments. So,
the value of a security reflects the value of the underlying business.
 Margin of Safety: Value investors buy stocks at a significant discount to their
intrinsic value, implying that they look for a large ‘margin of safety.’
 Circle of Competence Based on their competence and the perceived
opportunity set, value investors have clarity about where they’ll look for
investment ideas. Instead of relying on tips or paying attention to the continual
flow of news, value investors conduct in-depth, proprietary, and fundamental
research.
 Mean Reversion Business cycles and company performance tend to revert to
the mean. Value investors understand the importance of mean reversion and
profit from it.
 Concentrated Portfolio Value investors take large positions, in line with their
convictions. In other words, they make few but big bets. As a result, they often
have a concentrated portfolio.
 Focus on Absolute Returns Value investors don’t focus on their performance
relative to a benchmark. Instead, they focus on achieving satisfactory
absolute performance.
 Humility A common trait of value investors is humility. They admit their mistakes
and learn from them.
Bottom Up Approach bottom up investors (and value investors are typically
bottom up investors) pay little heed to macroeconomic and sectoral analysis.
Instead, they assess individual stocks, one at a time, on the basis of fundamental
analysis.
Skepticism of Wall Street Recommendations As Jean–Marie Eveillard, a highly
respected international value investor, says: “We look at outside research, but we
don’t trust anybody. There is a conflict of interest associated with investment
banking and research.
Contrary Thinking Investors tend to have a herd mentality and follow the crowd.
contrary thinking’ should not, of course, be literally interpreted to mean that you
should always go against the prevailing market sentiment. A more sensible
interpretation of the contrarian philosophy is this: go with the market during
incipient and intermediate phases of bullishness and bearishness but go against
the market when it moves towards the extremes.
Marathon and Patience Value investors consider stock investing to be a
marathon, not a 400-meter sprint. In this marathon, winners and losers are
determined over periods of several years, not months.
Composure Value investors (a) understand your own impulses and instincts
towards greed and fear; (b) surmount these emotions that can warp your
judgment; and (c) capitalize on the greed and fear of other investors in the stock
market.

Flexibility and Openness in investing, there is nothing permanent except

change. The investment manager should try to cultivate a mix of healthy
skepticism, open-mindedness, and willingness to listen.”

Decisiveness it does not mean rashness. Rather, it refers to an ability to quickly

weigh and balance a variety of factors (some well understood and some not-so-
well understood), form a basic judgment, and act promptly.
Different View of Risk When financial academics refer to risk, they almost always
mean only market risk and that too very short-run market risk. For value investors,
such risk is of little concern. What matters most to them is investment risk (the
possibility that something could go wrong with the company)

Selling Discipline The decision to sell a stock is often harder to make than the
decision to buy. Value investors try to achieve selling discipline by laying out well
defined criteria for determining when to sell. As James Gipson, a value investor,
said: “We will sell a stock when it reaches intrinsic value.
 Prospects for Value Investing

 With the growing competition in the investment business, one may argue
that market inefficiencies and mispricing may be corrected.
 Most managers focus on growth, momentum, or indexing, as they find value
investing unappealing. (short investment horizon and Performance Pressure)
 The personality traits required for value investing—patience, diligence,
discipline, independence, and risk-aversion-are perhaps genetically
determined.
 Value investors are inherently value-conscious people. As Kirk Karanzian says
in his book Value Investing with the Masters, “By and large, they look for
bargains in life as much as they do in the stock market.
 Benjamin Graham: The Quantitative
Navigator

 Before Graham, money managers behaved much like a medieval

guild, guided largely by superstition, guesswork, and arcane details.
 Graham’s Security Analysis was the text book that transformed this
musty circle into a modern profession.”
 Till the end of his long and illustrious professional career, Graham
emphasized the “look for values with a significant margin of safety
relative to prices approach to security analysis.”
Warren Buffett: The Ultimate Businessman

 To Warren Buffett, investing is neither an art nor a science. Rather, it

is a study of human nature and a willingness to follow a ordinary
path (Basic/Mundane).
 His investments are guided by his famous words: "It's far better to
buy a wonderful company at a fair price than a fair company at a
wonderful price.“
 Buffett likes to snap up a stock when a scandal, big loss, or other
bad news passes over it like a storm cloud as when he bought
Coca Cola after its disastrous roll out of Diet Coke.”
 Key tenets of the Warren Buffett’s
Investment Strategy.

 Turn off the stock market.

 Don’t worry about the economy.
 Buy a business, not a stock.
 Manage a portfolio of business.
 Turn Off the Stock Market

 The stock market exhibits manic-depressive tendencies. At times it is

widely euphoric and at other times it is unduly pessimistic. Hence
Buffett says that one should not take direction from the market.

 As Buffett says, “As far as I am concerned, the stock market doesn’t

exist. It is there only as a reference to see if anybody is offering to
do anything foolish.”
 Don’t Worry About the Economy

o Economic Indicators are important for success of business.

o Buffett, however, does not subscribe to this approach for two reasons:
(a)It is as difficult to predict the economy as to forecast the stock market.

(b)A strategy of selecting stocks that benefit from a particular economic

environment invariably leads to speculation and excessive turnover.
Instead, Buffett prefers to invest in businesses that do well irrespective of
what happens to the economy.
 Buy a Business, Not a Stock

 Buffett believes that when one invests one must buy a business, not a stock.
This means that the investment must be viewed from the long-term
perspective of a businessman.
 Buffett is interested in businesses which satisfy the following criteria:
 Business Tenets : Simplicity and Understandability and Consistent History and
Franchise.
 Management Tenets: Management Rationality, Managerial Candour (
openness), Resistance to Institutional Imperative .
 Financial Tenets: Return on Equity and Profit Margin.
 Market Tenets: Value of the Business and Purchase at a Significant Discount.
 Manage a Portfolio of Business

 Since Buffett manages a portfolio of businesses and not stocks, he does

not believe in wide diversification.
 He thinks that wide diversification makes sense only for the “know-nothing”
investors who would do well to buy an index fund.
 “On the other hand,” Buffett argues, “if you are a know-something
investor, able to understand business economics and to find five to ten
sensibly-priced companies that possess important long-term competitive
advantages, conventional diversification makes no sense to you.”
 Buffets Smart Moves

 In 1987, Buffett famously stated, "I'll tell you why I like the cigarette business. It
costs a penny to make. Sell it for a dollar. It's addictive. And there's
fantastic brand loyalty."
 While he later stated that the tobacco industry was burdened with issues
that made him change his opinion of it, this statement sums up Buffett's
description of the perfect investment.
 Berkshire Hathaway is the largest shareholder of both Coca-Cola (KO) and
Kraft Heinz (KHC), brands that are ubiquitous throughout America's
supermarkets.
 Buffets Value Picks (Coco Cola)

 When the price of Coca Cola stock crashed in 1988 in response to a

disastrous roll out of Diet Coke, Warren Buffett started buying up Coca Cola
like an addict.
 Within three years, Berkshire’s Coca Cola holding was worth more than the
entire value of Berkshire when the investment was made.
 When Coca Cola’s price was depressed, Buffett considered it as a
compelling bargain for three reasons.
 First, consumers have a very strong brand preference for Coca Cola.
Second, an average American, once he starts drinking Coca Cola, requires
five bottles a day for the rest of his life. Third, 40 per cent of Coca Cola is just
fizz.
 Other Value Picks

 When the stock of China Petro was selling cheap Warren Buffett invested
$ 488 million. Subsequently, he divested his holding for $ 4 billion.
 He commented: “Yes, Virginia, you can occasionally find markets that’re
ridiculously inefficient - or at least you can find them everywhere except
the finance department of leading business school.”.
 In 2002 Berkshire purchased Brazilian real which in Buffett’s assessment was
undervalued vis-a-vis the U.S. dollar. This position yielded a profit of $ 2.3
billion over a five-year period.
 Reasons for Value Picks

 Warren Buffett is exceptionally well prepared to grab investment

opportunities. He spends 5-6 hours a day analyzing various
investment opportunities.
 Over the years, Buffett, through diligent and sustained study, has
become quite skillful in different investment domains: stocks, bonds,
currencies, and derivatives.
 A well- prepared and decisive investor with a contrarian mindset,
operating on the principle of margin of safety, can exploit such
inefficiencies.
Why Still retail and institutional investors
choose growth over value stocks

 Joseph Lakonishok, Andrei Shleifer and Robert Vishny suggest that there are four
behavioural reasons by retail and institutional investors seem to prefer growth over value
stocks:
 Investors tend to extrapolate past growth rates far into the future. So, they are surprised
when value stocks outperform growth stocks. This is referred to as the expectational error
hypothesis.
 Representative Bias: By choosing companies with steady earnings and buoyant growth,
institutional investors appear to act prudently in fulfilling their fiduciary obligations
 Short term horizon of the Institutional Investors.
 Overconfidence Bias: Retail investors, in particular, might exhibit overconfidence bias,
believing they can accurately predict future growth of companies with high potential
(growth stocks). This overestimation of their abilities might lead them to favor growth stocks
over value stocks, which are perceived as less glamorous or promising.
 Herding Behavior: Both retail and institutional investors are prone to herding behavior, where they
follow the actions of others in the market, especially in times of uncertainty. If a particular segment of
the market, such as growth stocks, starts gaining momentum and popularity, investors may feel more
comfortable joining the herd rather than investing contrarily in value stocks.
 Availability Bias: Retail investors, in particular, may be influenced by availability bias, where they
overweight information that is readily available or easily accessible. Growth stocks often receive more
media attention, hype, and coverage compared to value stocks, making them more salient in
investors' minds and leading to a preference for these stocks.
 Recency Bias: Both retail and institutional investors may exhibit recency bias, giving more weight to
recent performance when making investment decisions. Growth stocks, especially those in industries
perceived as innovative or high-growth, may have recently outperformed value stocks, leading
investors to extrapolate this recent performance into the future and favor growth stocks.
 Disposition Effect: Retail investors, in particular, tend to exhibit the disposition effect, where they hold
on to winning investments (growth stocks) too long and sell losing investments (value stocks) too
quickly. This behavior can contribute to a bias towards growth stocks, as investors may be reluctant to
sell stocks that have provided substantial gains.
 Risk Perception: Institutional investors retail investors may have lower risk tolerance leading them to
prefer growth stocks, which are often associated with higher growth potential but also higher volatility.
Institutional investors may perceive value stocks, with their lower growth prospects but potentially
lower volatility, as riskier due to concerns about underperformance relative to benchmarks or peer
funds.