Value Investing Lessons on the Pacific Coast Highway
Today I'd like to share a story, about this one time in band camp... Actually, it was February 2014 on a coach bus traveling from Newport Beach to San Diego.
We had just finished a jam-packed day of presentations and lectures at Brandes Investment Partners and Research Affiliates as part of our school's value investing road trip. Ironically it was on this coach that I digested the real lesson of the day: That there are passive approaches to investing which are superior, at least for now, to the skills I had so far developed in securities analysis and stock picking.
It was an hour drive to San Diego, where we were invited to a dinner to cap off the day. We were starving and exhausted but chatting with good friends and classmates, debating our opinions on the content we had received that day. Everything from securities analysis, emerging markets and Europe market analysis, a terrific lesson in bond pricing, and a rather technical lecture on fundamental indexing.
It was the fundamental indexing presentation that threw us for a loop. We had just spent the past 5 months managing a fictitious $10 million portfolio with 10 real companies. The goal was to compete with other groups in the class to generate returns above a certain benchmark. After careful analysis of financial statements, accounting policies, market profiles, and competitors we had to determine the intrinsic value of the firms in our portfolio and recommend a buy, hold, or sell action for each.
It was hard, painstaking work.
So after all this effort and training we find ourselves sitting through a presentation about passive investing on indexes that, instead of being cap weighted, are weighted on fundamental business metrics such as cash flow, sales, dividends, and book value. The theory behind this is that a cap weighted index, by definition is going to be overweight on stocks that are expensive, and underweight on stocks that are cheap, and as a value investor you want to buy stocks that are cheap. Fundamental indexing, in their view, created a value tilt.
Through their research, Research Affiliates proposed that:
"using fundamental measures of company size to select and weight index constituents can add value of approximately 2-4% in developed markets when compared to traditional market cap weighted indexes."*
Essentially, you can implement a contra-trading strategy on expensive stocks without getting off the couch. In practice, of course, you cannot invest in an index and must use some type of fund which will provide you a real return over time. Since these funds are still fairly young, it is too early to tell whether they really will return 2-4% above market. However, the results so far are positive and the concepts seem sound to me.
This was all interesting but a little bit discouraging. Where could we take our securities analysis skills if one could theoretically beat the market by 200 basis points using a passive strategy?
This was a very personal question each of us asked and debated on the bus. For me, it means that I will spend most of my efforts dividing my assets into passive investment vehicles while honing my value investing skills over time in a separate, smaller portfolio. Only time will tell if my skills are worthy of taking the plunge all the way.
*Source: Research Affiliates white paper: FTSE RAFI Index Series.pdf