Tuesday, September 28, 2010

Is Stock Picking Really Dead? Part II

In my previous post on this topic, I explained that active stock pickers benefit from significant tailwinds when smaller companies outperform larger ones.  Similarly, recently they've been hurt, or at least not helped by the reverse.

A similar factor bet, (fancy term for "investment style that can be explained by something simple",) applies to fundamental valuation.  There are a class of investors who call themselves "value investors".  What the heck is a "no value investor"?  No such thing.  That's why I'm comfortable calling most investors value investors without hiring Pew to work the phones for me.

Value means different things to different investors.  Ratios of letters really matter to value investors: P/E, P/B, EV/FCF, P/EBITDA, the list goes on.  Each of these measures is highly correlated with all of the others.  The differences aren't necessarily rounding error, but they are similar.

Fundamentally, the equity value of a company depends on what remains after the company pays off its debts, dividends out all its earnings, and liquidates at the end of time.  So, you value the future earnings stream. You want to buy that future earnings stream on the cheap.  You also want to know those earnings exist, that they aren't in the imagination of management.

At times, the market allocates greater value to management dreams than shareholder reality, (that is, current earnings and dividends versus earnings that may arrive in the future.)  That's the opposite of value investing.  The market doesn't price Apple for it's earnings distributed to shareholders.  Apple is priced for the theoretical liquidation at the end of time because the company grows so quickly.  That's the "opposite" of value investing: Growth investing.

In fact, even "growth" investors often tilt toward the "value" end of growth companies.  An incredible pile of academic research shows value investing generally outperforms (historically, in sample, out of sample, you name it,) so, everyone does it.

That's why Russell and S&P have "growth" and "value" indexes.  So, why does this matter?  In this plot, you see that the Russell 1000 Value dramatically outperformed the Russell 1000 Growth from 2001 to year end 2006.  The Russell 1000 Value index rose by 40%, while the Russell 1000 Growth Index fell by 20%.  That gives quite a tailwind to buyers of value stocks.  In contrast, since 2007 began, Growth has outperformed Value by roughly 20%.

Again, we return to the question: Is stock picking dead?  My guess is no more dead than it's been before, but yet another stock picking tailwind shifted into a headwind.

To be continued...we still need to talk about correlation!

No comments:

Post a Comment