Does active fund management pay off?

ringledman

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Lots of interesting stuff here. I just want to pick up on one aspect - are Value stocks riskier than Growth stocks? The following definition is taken from Investopedia:
To me this definition points in either direction.

At one level a Value stock is one which looks cheap. On the well worn adage that "if it looks to good to be true then..." that would point to there being some higher risk associated with Value stocks.

But I'm with Brendan, I interpret Value stocks using the other characterisations of the above definition - a boring old stock with solid dividend and earnings performance and other good "fundamentals" and thus lacking scope for spectacular future growth. A growth stock on the other hand boasts its lack of dividends and its negative earnings! Intuitively, to me, a Value stock is a bird in the hand whilst Growth stocks are two in the bush, and Brendan's example clearly illustrates this.

It is indeed circular to argue that since Value stocks have outperformed Growth stocks ergo they were more risky. This states that risk must always be rewarded. A more correct interpretation is that the risk in Growth stocks didn't pay off and one would have been better off in boring old Value stocks after all.

Duke,

I totally agree, value produces better returns over the longer term and at less risk than with growth stocks. Jeremy Grantham and James Montier at GMO have conducted much research into the area from a beahavioural point of view. The facts speak for themselves.

http://blog.iii.co.uk/value-beats-growth-the-evidence/

http://books.google.co.uk/books?id=rSLlFQ-gICEC&pg=PA57&lpg=PA57&dq=is+value+really+riskier+than+growth+dream+on&source=bl&ots=Oaa4wwRk30&sig=D978JNuuZPJf5rbBBKu-dc-Jtfs&hl=en&ei=Y_i2TpquHs2q8QPWqd2HBQ&sa=X&oi=book_result&ct=result&resnum=1&ved=0CBsQ6AEwAA#v=onepage&q=is%20value%20really%20riskier%20than%20growth%20dream%20on&f=false
 

darag

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Investing in boring value in which dividend yields are present, low P/Es and P/B is a less risky approach than investing in growth stocks or asset classes that are is a speculative boom that will one day pop as every bubble does.
Stocks with low P/E and P/B are risky; e.g. Irish bank shares before they imploded. A portfolio of value stocks will always include companies in very poor shape. Value stocks are cheap because few people want to own them.

If you have discovered some reliable (quantitative) method to distinguish "good" value stocks (i.e. steady/undervalued) from "bad" value stocks (i.e. distressed companies), the world will be your oyster. Wealth, fame, offers to run hedge funds, tenure in ivy league business schools, a seat on the board of Goldman Sachs, etc. all awaits.
 

ringledman

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Stocks with low P/E and P/B are risky; e.g. Irish bank shares before they imploded. A portfolio of value stocks will always include companies in very poor shape. Value stocks are cheap because few people want to own them.

If you have discovered some reliable (quantitative) method to distinguish "good" value stocks (i.e. steady/undervalued) from "bad" value stocks (i.e. distressed companies), the world will be your oyster. Wealth, fame, offers to run hedge funds, tenure in ivy league business schools, a seat on the board of Goldman Sachs, etc. all awaits.


At least read the evidence and provide a better counter. I am happy to read why growth is less risky if it is backed up by some reasearch rather than the statement: 'banking stocks were value in 2007 and look at them now, hence value is risky'.

Sure banking stocks were a value trap back in 2007. But if you hadn't been stupid and thrown all your portfolio into this one sector alone then you would be in a decent position now.

Supermarkets, consumer staples, telecoms, tobacco, utilities, pharmaceutical. Diversify across value.

A higher risk approach in my humble opinion is to invest in growth for which there is no shareholder dividend return, lofty p/e multiples, lofty p/b multiples. One bad earnings results and the share price can collapse. Sure these stocks can provide huge returns on the way up but also huge losses on the way down. If one is a momentum trader then perhaps money can be made. For the long term investor I believe that value is the only way of returning a decent return at considerably less risk.

Boring value produces more consistent returns over the longer term. The fact that value traps exist as a risk is no different from the fact that growth stocks are at risk of imploding to zero once the speculative and irrational bubble that it may be riding upwards is seen for what it is.

Value is mostly based on sounder fundamentals (earnings, dividends, cash flow) than growth.

Value is mostly based on past fundamentals (ie known) than future fundamentals (unknown).

Growth stocks rely on future potential earnings for which no one can predict how they will play out. Hence a diversified portfolio of value stocks is less risky than a diversified portfolio of growth stocks.
 

Duke of Marmalade

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I think we will all agree that if you seek out the stocks that look good value in a reasonably homogeneous sector you will be picking up the riskier stocks in that sector.

But sheer common sense dictates that to buy a sector which has never paid a dividend and has negative earnings, on the basis that it has explosive potential, must be higher risk than buying a stodgy traditional sector with robust divies and earnings but without spectacular growth potential. Ans so it has proved to be the case.

To me that was what distinguished Value vs Growth strategies, not the search for cheap stocks.
 

Marc

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What does the international evidence say about this question?
Size%20and%20value%20effects_0.JPG


In the historic data, in every market except perhaps Europe Small Value vs Europe Small Growth, the volatility of a value strategy is greater than that of a growth strategy.

This would seem to support the argument that value is a more risky strategy at least as far as most of the major international markets and as far as we have recorded history is concerned.


Size%20and%20value%20effects_0.JPG
 

Duke of Marmalade

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Marc

I would need more detail to make a judgement. What is that reference to simulations about? Should it not be that Value stocks are higher than 70th percentile and vice versa.

In recent years I have tended to identify Growth stocks with the Nasdaq and Value stocks with, say, S&P. It was my understanding that Nasdaq was more volatile than S&P.
 

Marc

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Duke,

What you are looking at is the output from empirical research. The reference to simulations is due to the fact that commercial index data is not available in all markets for all asset classes and for all time periods, so researchers must construct a simulation of an index to test a hypothesis.

In order to prevent random and inconsistent definitions of asset classes, researchers must also employ a standard definition of the value and growth asset classes. The top 30% of book to market ratio stocks was selected as the breakpoint between value and neutral book to Market ratios.

The important thing is not to use some arbitrary definition of value and growth or this would result in endless semantic arguments around stocks or sectors that one might feel or seem like they should be value.

An asset class is a section of a Market with common risk return characteristics (see post below) Failure to define what we mean by value sets up endless futile debates.

So to reference the original researchers why they use book to Market as the preferred definition of value.

"A stock's price is just the present value of its expected future dividends, with the expected dividends discounted with the expected stock return (roughly speaking). A higher expected return implies a lower price. We always emphasize that different price ratios are just different ways to scale a stock's price with a fundamental, to extract the information in the cross-section of stock prices about expected returns. One fundamental (book value, earnings, or cashflow) is pretty much as good as another for this job, and the average return spreads produced by different ratios are similar to and, in statistical terms, indistinguishable from one another. We like BtM because the book value in the numerator is more stable over time than earnings or cashflow, which is important for keeping turnover down in a value portfolio.

Nevertheless, there are problems in all accounting variables and book value is no exception, so supplementing BtM with other ratios can in principal improve the information about expected returns. We periodically test this proposition, so far without much success."
 

Marc

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Sometimes the NASDAQ is referred to as an asset class, but it's not. It's an exchange that contains several asset classes. A partial index of NASDAQ stocks might proxy for a tech stock "asset class"—but there's little theoretical reason to think tech stocks are an asset class either.

Talking about what is or isn't an asset class might seem trivial, but it's important because people use asset classes as key components of diversified portfolios. For this purpose each asset class needs to have a specific risk-return function.

Sorting securities on anything other than the dimensions of expected returns can fudge the clarity of the investment process and undermine portfolio diversification. When investors mistake where returns come from, the asset classes they assemble become arbitrary. This can lead to inadvertent tilts on the underlying factors that actually determine returns.

For example, investors sometimes manage industry exposure, as if sectors constitute asset classes. Analysts on TV talk about what companies produce and how it affects the prospects for their stock prices. As Adam Smith pointed out over 200 years ago, a company's industry bears no direct relation to the flow of capital.1 Expected returns relate far more to a company's health and size than to whatever it is that the company makes or does.

In "Industry Costs of Equity", 2 Fama and French cast Adam Smith's notion in an empirical light. They find that risk factors of market, size, and book-to-market seem to account for virtually all the differences in returns across industry groups (except real estate stocks, which for that reason probably constitute their own asset class). For example, if technology stocks had spectacular performance in the late 1990s, it wasn't because of a new business model, but because tech stocks happened to be growth stocks in a market that strongly favoured growth. Lots of investors projecting ahead to a "new economy" were left holding the bag when growth stocks went out of favour.

We should instead set out to sort stocks along the true explanatory dimensions—in the above case by forming a growth portfolio—and include whatever industries happen to fit that asset class. After all, industries drift in and out of asset classes. They get bigger and smaller, healthier and more distressed through time. Tech stocks might have been growth stocks back in 2000, but many stocks are now considered smaller companies or perhaps in the value category. Sorting stocks on secondary criteria like industries can therefore cause a portfolio to drift across asset classes.

Investors should determine how much exposure to have to stocks in general (market risk), and how much of a tilt to have based on company size and value which represent dimensions of equity markets with their own risk-return profiles.

Asset classes are most relevant when sorted along these dimensions, as combinations of "small cap," "large cap," "value," and "growth." These asset classes are transparent, focused, and consistent with research.


1. Smith, Adam, "Employment of Capitals", The Wealth of Nations, 1776.
2. Fama, Eugene F., and French, Kenneth R., "Industry Costs of Equity", Journal of Financial Economics, 1997.
 

Duke of Marmalade

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Marc,

Fair play to you for engaging so thoroughly in this useful debate.

On the definition of Value v Growth stock I was simply wondering whether the definition was mistated. Seems to me that anything between 30th and 70th percentile would qualify as both. Look again at the definition, I may be misinterpreting it.

Back to the substantial point. I was led to believe that Value stocks were boring old traditional stocks with a proven track record whilst Growth stocks were exciting new ventures which might shoot the lights outs. Ergo, the former were boring but safe whilst the latter were exciting but risky.
 

darag

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ringledman, I am well aware of the evidence that shows a value portfolio historically has offered a return premium over growth. (But as an aside, I've also recently read that this premium seems to have reduced.)

But the point I was trying to make is that unless you are advocating beauty contest style stock picking, then you need to state your objective definition of what represents a "boring" value stock before you can advocate safe value investing. Otherwise you have to accept what Marc has so well explained about the quality of the returns from a diversified value strategy.

An general recommendation to pursue value investing can not be given without qualification. Finding higher investment returns with lower volatility is far more difficult than what was being suggested.
 

Marc

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Duke

The benchmark portfolios are rebalanced quarterly using two independent sorts, on size and book-to-market (the ratio of book equity to market equity, BE/ME). The size breakpoint (which determines the buy range for the Small and Big portfolios) is the median NYSE market equity. The BE/ME breakpoints (which determine the buy range for the Growth, Neutral, and Value portfolios) are the 30th and 70th NYSE Percentiles.

So, everything between value and growth is neutral.

Your comment about the substantial point takes us full circle.

If one defines a value stock as an "unloved" security then "value" is a pricing mistake. The Market has screwed up and left money on the table for an analyst to collect by identifying undervalued securities.

Growth and value in this sense would be trends. Stocks would be cyclical based on investors taste. Somehow analysts would become trend following lemmings and leave unresearched stocks seemingly to be "discovered" by some genius with a laptop and access to the Motley Fool - which will show you (and only you mind) the "secrets" of investing.

This could possibly have been true in the 1930s when Graham and Dodd came out but it just doesn't seem credible in the 21st Century that despite the widespread availability of the internet that we must have all failed to notice that say Tesco has a boring but highly profitable business and has a good dividend yield. Yep, the Market is insane, it's got it all wrong chasing some tech dream based on electronic tablets. No, I've got it all figured out nobody else could possibly have the same information as me, therefore the price is wrong, only I know the correct price so I can profit from the value I have uncovered.

People genuinely believe some version of this nonsense.

However if you subscribe to the view that the Market does a pretty good job of pricing securities then value has little to do with trends and fashion for sexy tech stocks vs boring value industries.

Under the conditions of "fair" prices then Value and growth are risk factors.

Growth companies are healthy companies with good balance sheets . Investors are willing to pay more for a "safer" company. If an investment is safer then it has a lower expected return. They are low book to Market.

Whereas value companies are unhealthy they are in some distress they have weaker balance sheets. So they are less safe. Investors are willing to pay less to own these companies so they have lower share prices. The are high book to Market and have higher expected returns as compensation for the extra risk.

Clearly the leap of faith for many investors is that the price in this ratio is correct.
 

Duke of Marmalade

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Marc,

This topic asks a question. I agree with you (I think) that the answer is No.

On a technical point, look again: is the def of a value stock right? Seems to me that everything between 30 and 70 qualifies as both. Maybe that is the intention, seems corny to me.
 

Marc

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Duke,

The investopedia definition you referenced is as follows:

What Does Value Stock Mean?

A stock that tends to trade at a lower price relative to it's fundamentals (i.e. dividends, earnings, sales, etc.) and thus considered undervalued by a value investor. Common characteristics of such stocks include a high dividend yield, low price-to-book ratio and/or low price-to-earnings ratio.

This seems to capture most of the important issues.

The price trades at a discount to some fundamental which shows up in a ratio.

This is consistent with the widely accepted version that it is some fundamental price ratio that counts. Above some cut off is value and below is growth the middle is neutral.

We can argue where the buy and sell ranges should be but in principle it fits with my earlier post that said;

We always emphasize that different price ratios are just different ways to scale a stock's price with a fundamental, to extract the information in the cross-section of stock prices about expected returns. One fundamental (book value, earnings, or cashflow) is pretty much as good as another for this job.
 

Duke of Marmalade

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Above some cut off is value and below is growth the middle is neutral.
Strange how difficult it is to communicate in this medium. Your footnote clearly states Value is above 30% and Growth is below 70%. I think you mean the other way round.
 

Marc

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Ah I see what you mean.

No I think it is the right way round.

High book to market are value stocks. So a high book value numerator relative to a low price denominator and vice versa for growth stocks.

So value stocks are the top 30% by book to Market ratio.
 

Duke of Marmalade

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Ah I see what you mean.

No I think it is the right way round.

High book to market are value stocks. So a high book value numerator relative to a low price denominator and vice versa for growth stocks.

So value stocks are the top 30% by book to Market ratio.
jayz why is this so difficult? I think you are a smart guy. I know I am:D You state in the footnote Value stocks are above 30%, surely you mean above 70%.:confused:
 

Chris

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Marc,

Fair play to you for engaging so thoroughly in this useful debate.
I second this, fair play to very well researched posts and comments.

Marc, where I agree with you is that the current price of an asset is a representation of the opinion of all buyers and sellers based on all available information. But that is basic economics about price formation.
You stated in an earlier post that "Markets don’t have to be RIGHT to be EFFICIENT" and "The end result is that the current price of the stock is usually a good estimate of its intrinsic value." This is where I think that the whole EMH theory does not have good enough premisses. Prices are the result of buyers and sellers coming together, but they may be wrong, and they may be wrong a lot more often than is assumed by EMH.

Stocks with low P/E and P/B are risky; e.g. Irish bank shares before they imploded. A portfolio of value stocks will always include companies in very poor shape. Value stocks are cheap because few people want to own them.

If you have discovered some reliable (quantitative) method to distinguish "good" value stocks (i.e. steady/undervalued) from "bad" value stocks (i.e. distressed companies), the world will be your oyster. Wealth, fame, offers to run hedge funds, tenure in ivy league business schools, a seat on the board of Goldman Sachs, etc. all awaits.
Yes indeed, banks were a perfect value trap at that time, but one way to avoid bad value stocks is to factor in the debt level of companies. Highly indebted companies that show other value characteristics should trigger a warning signal.

In the historic data, in every market except perhaps Europe Small Value vs Europe Small Growth, the volatility of a value strategy is greater than that of a growth strategy.
But again you are choosing to use the definition of risk being measurable by volatility. I would not agree that risk can be measured or that volatility is a good characteristic to use.
 

Marc

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Duke

I see your frustration. We are counting from one from the top of the Market so 1% is the most value and 100% is the end of the series. The percentage isn't a measure of how much value but rather a measure of progression through the series.

I guess when you look at it it is counterintuitive but as I have always looked at it the other way round I had a blind spot to your point. A two faces or a candlestick moment.
 

Duke of Marmalade

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Ok Marc, I'll buy that but maybe your footnote needs a bit more clarity.

I agree with your general argument. Personally I have been burnt enuff by stock markets and my humble little pile is almost entirely on deposit, which contradicts everything I was weaned on in the financial services industry.
 
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