Value Premium and Value Investing
Value Premium and Value Investing
Value Premium and Value Investing
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
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
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
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?
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
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.
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
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
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 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
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.