‘Value Trap’ Shoots and Scores!
publication date: Feb 10, 2020
author/source: Brian Nelson, CFA
Author Brian Nelson is the President of Investment Research at Valuentum. In his role, he has updated and overseen over 20,000 discounted cash flow models during the past 10 years. Prior to Valuentum, he worked as the Director of Methodology at Morningstar, a large independent research firm in Chicago, developing the company’s discounted cash-flow model used to derive the fair value estimates for the company’s coverage universe.
By Brian Nelson, CFA
Before we get started, I wanted to remind you of the fantastic performance of the Best Ideas Newsletter portfolio and the Dividend Growth Newsletter portfolio during 2019. It was another great year for Valuentum members. Read about the Best Ideas Newsletter portfolio here. Exclusive idea success rates have been remarkable, too, and we steered clear of any mistakes in the High Yield Dividend Newsletter portfolio that might have impaired an outsize yield.
Still, perhaps the biggest achievement during the past couple years might have been helping investors avoid the ongoing “quant winter,” where “just 15 per cent of quant mutual funds beat the US stock market last year, according to Nomura.” There are few topics that are not covered in the book Value Trap. The text is an immersion in a variety of topics, from behavioral finance, quantitative theory and stock valuation, in order to provide the context for investors, ranging from the most inexperienced to the most advanced, to start asking some of the right questions, to perhaps start thinking more clearly about the quant discipline.
One of the most difficult things to do, however, is to find out where a learner has deviated significantly off course. Perhaps many are being confused in thinking that Benjamin Graham’s work in the 1930s with respect to net current asset value (NCAV), a cash-flow based process of identifying stocks under liquidation value, is related to today’s quantitative value or a backtest of the B/M? Maybe it’s the view that Warren Buffett’s returns can be mapped to a quantitative model?
We cannot be sure, but we think it is worth emphasizing that fundamental investing and quantitative statistical analysis are two vastly different things--they are not even close. Benjamin Graham’s and Warren Buffett’s principles generally cannot be captured in any regression model that employs reported backward-looking data. At the core of traditional value investing in the Graham and Buffett style is a focus on a company’s future expected free cash flows, and this dynamic cannot be captured in any snapshot one-year multiple, save for the price-to-fair value ratio (which captures future expectations).
We cover a lot of these considerations in the book, Value Trap. But it’s much more than this. Enter the backtest. The backtest might very well be one of the most widely-used items to explain an investment process, but the backtest is just the beginning to any process. Let me repeat: it is the beginning of the study, meaning what happens after the publishing of the backtest is the only thing that matters.
For starters, anybody can create a backtest with spurious correlations and make the chart look pretty. A pretty chart says nothing about whether the data used in the backtest will continue into the future. The bread-and-butter test, and what I think is the only test that matters, is the walk-forward, out-of-sample test. Check this out: As it relates to the walk-forward test, released January 2020, since the novel B/M factor was created reveals the following by Fama/French:
Value stocks in the U.S. produce higher average returns for the full July 1963-June 2019 period than the market portfolio of all listed U.S. stocks (Market). Average value premiums are larger in the 28-year Fama-French (1992) period, July 1963-June 1991, than in the 28-year out-of-sample period, July 1991-June 2019, and we don’t reject the hypothesis that out-of-sample expected monthly premiums are zero. But inferences from average premiums are clouded by the high volatility of monthly premiums, and we also can’t reject the hypothesis that out-of-sample expected premiums are the same as in-sample expected premiums.
This is huge news.
The bottom line is that, in out of sample statistical studies, ones completed by none other than Fama and French, themselves, the value premium, as measured by the B/M ratio might very well be zero. This may come as a shock to the quant community, but for anyone that has built and updated 20,000 discounted cash flow models over the past 10 years and for someone that has overseen the valuation models of a department of dozens of analysts, there’s little chance a statistical value factor such as B/M would hold up…and it did not hold up in walk-forward, statistical studies!
This has been the reality, as I see it. From my perspective, the quant value factor, as in B/M, simply never existed. It was developed by a backtest based on the data that was available at the time, and it was not verified in out-of-sample, walk-forward studies. The takeaway of the failures of the B/M, however, is much more than just the failure of one archaic multiple that arguably served as the foundation of quant factor investing.
Hear me out: Because multiples, themselves, are ambiguous (and enterprise valuation acts as the confounding variable to multiple analysis), most any valuation multiple used in quant analysis, save for the price-to-fair value ratio, might very well be spurious in walk-forward testing. Let this sink in. All of those quant funds and ETFs incorporating ambiguous valuation multiples might very well be charging for randomness. You have to read Value Trap to dig further into what I am talking about, which brings me to another point.
The book also explains how quant and index investing, together, might contribute to a highly irrational marketplace. Michael Burry of The Big Short fame believes index funds are in a bubble and distorting price discovery, and just today, perhaps one of the best podcasts released in some time was made available at Bloomberg, “How the Rise of Passive Investing May Be Creating Huge Distortions in the Market.” Tune in.
I continue to dedicate my time to helping investors learn about investing and protecting them from a lot of the stuff out there that can get them into a lot of trouble. We’ve helped so many investors with our warning on MLPs, but we think the quant and indexing fallout will be even bigger when the music stops. We continue to update investors on new developments as our thesis in Value Trap continues to play out across the board.
Tickerized for holdings in the DIA.
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