Thursday, July 3, 2008

"What's Wrong with Today's Value Investing?"

On Seeking Alpha, columnist Marc Gerstein asks, "What's Wrong with Today's Value Investing?"

That a veteran investor (see Gerstein's bio) would ask this question should give you a sense of how poorly many value strategies have performed recently.


Remember the days when you could count on value investing as a solid defensive strategy? It worked that way as recently as the downturn we experienced earlier this decade. Lately, though, value has not been fulfilling this role. And there are reasons to wonder if this is more than a temporary oddity and whether the entire approach needs to be overhauled.

Later in his essay, Gerstein speculates on why value-oriented strategies may have under-performed recently:

This isn't the 1970s when the best source of market data for many investors was the monthly S&P Stock Guide (I'm not even sure they still exist). Back in the day, if a stock had such characteristics [low valuation metrics such as P/S, P/B, P/E, etc.], it could be because the investment community was neglectful. But in this day and age, with so much information so quickly and so widely available, it's likely that stocks have low valuation metrics because investors believe that's all the stock deserves.

It's a fair point that the wider availability of information today, via the Internet, may have made the stock market more efficient (thus making it harder to uncover mis-priced stocks1), but certainly this was also true earlier in this decade, when (as Gerstein noted above) value strategies performed better. Gerstein is on firmer ground when he writes,

Success can't come from identifying cheap metrics. Anyone today can do that with a few mouse clicks. Instead, success comes from doing a better job in assessing company merit.

Since he is a "rules-based", or by-the-numbers investor, Gerstein addresses this by adding another metric to some basic value screens, this one based on revisions of analysts' earnings estimates for each company in his sample. This has the virtue of being a forward-looking metric, and one would think that securities analysts take into account macro trends when estimating future earnings. Gerstein mentions nothing about whether or how an individual investor ought to take into account relevant macro trends, or otherwise qualitatively asses companies' prospects -- this is beyond the scope of strict rules-based investing. There is no reason, of course, that an individual investor can't use a rules-based system (whether the Magic Formula, Gerstein's latest strategy, or any other mechanical screening system) to narrow down a universe of stocks into a smaller sample, and then use that sample as a starting point for further research.

1"Mis-priced" in the sense that the market price of the stock is lower than the stock's intrinsic value.

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