Recession

Value Investing Isn’t About Buying “Cheap” Stocks

I understand the appeal of using approaches that rely on buying “cheap stocks” as someone who likes a more quantitative approach to investing.

Q4 hedge fund letters, conference, scoops etc

Recession

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At the same time, I have always felt that many people have the misconception that value investing is about buying cheap P/E, cheap P/B or high dividend stocks.

This is completely wrong!

As someone who likes a more quantitative approach to investing, I understand the appeal of looking at “hard numbers”.

However, value investing is really about buying companies at a discount to intrinsic value, and valuation is only one part of the equation when assessing whether a company is cheap to buy.

Buying “cheap” does not mean cheap valuation

Valuation ratios are highly useful, but can be very misleading.

A company with a low P/E ratio could have a large one-off earnings. Other scenarios could be that its earnings are at a cyclical high, and are unsustainable.

Likewise, a company with a very high P/E ratio (100x) may simply be in the situation that where it is turning around and taking large charge offs as it undergoes its restructuring.

Likewise, companies with cheap P/B ratios could have assets that are overvalued and diverge greatly from actual market values (oil and gas is one such sector where this has been a major problem).

Assessment of earnings power

A company’s intrinsic value is ultimately all the expected future cash flows discounted to the present.

The problem is that DCFs are notoriously unreliable given that small input changes will change the outcome dramatically.

The central idea is that you have to move beyond just looking at spreadsheets and start thinking very hard about the qualitative aspects of the business.

The quantitative aspects of valuation must tie in with the qualitative elements of the future earnings power of the business.

The important thing is that these are just estimates, and understanding what we know well (our circle of competence) is crucial.

Relying on the numbers as a “crutch” alone is not enough.

But doesn’t buying cheap stocks work?

There have been plenty of studies that show that buying cheap stocks work. Tweedy and Browne have best summarized it in their study:

What has worked in investing

So my answer is yes – it does work from that perspective.

At the same time, I would like to draw some distinction between relying purely on academic backtests and real world application.

First off, its importance to remember that these backtests apply in aggregate. They are literally buying let’s say the cheapest 10% of all the stocks in the market universe.

In reality, an average investor is unlikely to be buying that many stocks, but relying on individual valuation metrics looking at a couple of stocks.

Secondly, there are plenty of times where backtests rely on conditions that don’t exist in the markets we operate in.

Many backtests are in western centric markets where corporate governance and shareholder rights are much stronger.

Shareholder rights and corporate law have their own development pathways (they didn’t start out perfect too), and the US markets specifically have the benefit of having particularly robust shareholder rights and an active shareholder base that is able to utilize these rights.

The mechanism and path for revaluation is much more murky in my mind if we were to look at countries like Hong Kong or China.

Cheap stocks that aren’t frauds many a time have no clear path to revaluation even if an activist shareholder were to appear.

In more extreme situations, screening for just cheap stocks on cheap P/B ratios in Singapore would have landed you with a bunch of S-Chips which mostly turned out to be fraudulent.

So yes – applying backtests require plenty of skepticism and a whole lot of salt.

The cautionary tale of Anthony Bolton (think of him as a UK Peter Lynch), a great fund manager in the UK who went on to do horrendously in China is highly instructive.

Anthony Bolton: ‘The Chinese are great liars’

Ending thoughts:

Quantitative value investing strategies are of great appeal to many investors including myself. However, investors must take caution in applying such strategies wantonly without due regard for its constraints especially in Asia.

Article by Jun Hao, The Asia Report


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