| Investment Strategy
Value investing is our investment
philosophy. The essence of this strategy is to take advantage of price
inefficiencies in the stock markets that are caused by less informed
traders' overreactions to good or bad news announcements. ViamInvest
applies a 100% quantitative and
model dependent type of value investing
that allows us to test our investment system on long time series of
historic data before we apply the system for real stock investments.
Pretesting and validation is only possible because ViamInvest's system
does not depend on tacit or unspoken information. Such information is accumulated by the
asset managers in the more traditional type of
manager dependent value investing. It is also important to stress that ViamInvest's
historic test system does not imply that we are doing technical
analysis. Technical analysis is based on analysis of historical price
patterns and extrapolation of time series. We do not do that. To be
sure, we are a value investing company and our asset management system
is therefore based on fundamental value analysis. The following text is
an introduction to the general meaning of value investing. It also
explains more carefully why our value investing system is capable of
being validated by external parties while other kinds of value investing
systems are not.
History
Value investing was originally advocated by Benjamin Graham (1894-1976) and the
most well know and successful practitioner of this investment method is Warren
Buffett at Berkshire Hathaway Inc. The value investing strategy has been known
and practiced by professional investors in public stock markets since they
started trading in the early days of industrialism. However, it was the investor
and the academic Benjamin Graham that first wrote two books about it and
therefore he is often accredited as the father of value investing.** Today value
investing is sometimes referred to as the long/short equity strategy because
hedge funds often implement it by short selling overvalued stocks while going
long in undervalued stocks. Value investing is one of the few investment
strategies that are proven to be able to outperform the long-term market return
on a risk adjusted basis. There are an increasing number of scientific
references that confirm this and it can also be seen from the long-term return
of publicly available stock indexes.
Common Issues
There are different types of value investing methods but they all
have a few issues in common. Firstly, all value investing is based on
the idea that the stock price does not necessarily reflect the true
income potential of a firm. That is, the market price of a stock may
sometimes be underpriced or overpriced relative to its truer potential
value or fundamental value. Secondly, all value investing is also based
on the idea that in the long-term the average stock price is rather
similar to its truer potential value. However, unpredictable events,
such as, overreactions to good and bad news announcements about the firm
or the industry cause the stock price to be temporarily underpriced or
overpriced. To combine these two ideas one could say that all value
investing is based on the principle that the stock price fluctuates
semi-stochastically around its truer potential value. These
semi-stochastic price fluctuations create investment opportunities for
value investors that have some sort of asset management system in place
that is able to determine whether the stock price is underpriced or
overpriced relative to its truer potential value and by how much. The
asset management systems that value investors use are all based on a
more or less information intensive kind of fundamental value analysis
that seek to determine the truer stock value. The investment
opportunities are exploited when the value investors buy stocks that are
underpriced and sell stocks that overpriced relative to their truer
stock value. Such market actions will eventually force the stock prices
back to their truer potential values. Value investors are therefore
essential for the well functioning of stock markets because they are the
only kind of investors whose market actions prevent the stock price from
being grossly out of line with its fundamental value. In other words,
the value investors are the only long-term price makers in the stock
market.
The profitability of the value
investing strategy will depend not only on the ability of the value
investing system to correctly identify the profitable deals but also on
the associated costs of running the investment system. Moreover, the
profitability of value investing will also depend on how many other
value investors that are operating in the market and how good they are
at what they do. If the market is crowded with very skilled value
investors the stock prices will be very close to their truer potential
value and the value investors will therefore not be able to make high
returns. Consequently, they may lose investment alpha compared to the
passive investment strategies that have much lower implementation costs.
In this case value investors will leave the market and that again will
cause stock prices to be more mispriced and consequently the
profitability of value investing will increase to the point where
further exit of value investors is stopped. This is how the stock market
restores its equilibrium level of mispricing in the long-term when it
comes from a period of too accurately priced stocks. On the other hand,
if the market for some reason has too few value investors and that they
may not be very good at what they do the stock prices will be very
mispriced. In this situation value investing will be very profitable
compared to passive investment strategies and that will cause new value
investors to enter the market. This again will cause the stock prices to
become less mispriced and that will reduce the possible profits from
value investing until the influx of new value investors to the stock
market is stopped. This is how the stock market restores its equilibrium
level of mispricing in the long-term when it comes from a period of too
inaccurately priced stocks.
Types of Value
Investing
The above issues describe the common features of the various value investing
strategies. These various strategies can be roughly categorized as 1) manager
dependent value investing and 2) model dependent value investing. This
categorization describes two archetypes of value investing. In reality the stock
market contains the full spectrum of value investing strategies ranging from the
very manager dependent strategies to the very model dependent
strategies. The following describes these two distinct types of value investing.
- Manager dependent value
investing: The key distinguishing feature is that the stocks
ultimately are picked by the personal judgment of the asset managers. This strategy uses all available information
including tacit or unspoken information. Typically this kind of
analysis starts by screening a large number of firms using a simple
value ratio to identify a smaller number of potentially mispriced
firms. A few more simple steps may be used to locate a handful of
target firms that subsequently are studied by thorough analysis of
the fundamental value drivers of a firm to determine its truer
potential value. Such fundamental value analysis is always done by
experienced asset managers who obtain a thorough understanding of the
target firm’s financial and strategic situation. This strategy may
also require that the asset manager get to know the top management of the
firm and is able to judge that the firm is in good hands for many
years to come. Such extensive analyses are expensive in terms of
time and money. Consequently, the investment funds that use such
investment strategies will only be able to invest in a limited set
of firms that they consequently need to trade large ownership stakes
in. Manager dependent value investing may even imply that the
investment fund acquires a controlling ownership stake in order to
make changes in the way these firms are operated with the intention
to make them more profitable. This extreme form of manager dependent
value investing is practiced by the so called private equity funds.
To mention a more typical investment fund that uses manager dependent
value investing Berkshire Hathaway Inc would be a prime example.
-
Model dependent value
investing:
The key distinguishing feature is that the stocks ultimately are
picked by a proprietary value investing model. The roles of the
asset managers are mainly restricted to run this model and to
develop it further in order to increase its performance. This strategy uses only publicly available and quantifiable
information. Model dependent value investing uses data from
financial information retrieval services, such as, Thomson,
Bloomberg and FactSet to make a quantitative model that is able to
determine whether a stock is underpriced or overpriced and by how
much. These models typically only require data that are available
electronically. As a result it is possible to evaluate a larger
number of firms using this investment strategy without spending much
time and money. However, because these models use less information
they may not be particularly accurate in identifying the profitable
deals. The investor Benjamin Graham is a prime example of an
investor that has used an information saving value investing
strategy. For instance, one of his models is the so called Relative
Graham Value: RGV = V/P where V is fundamental stock value and P is
the stock price. V is again calculated by V = EPS(8.5+2g) where EPS
is earnings per share and g is expected long-term (7-10 years)
growth rate in earnings. To be sure, ViamInvest is practicing model
dependent value investing.
Comparing The Two Strategies
The major advantages/disadvantages of
using model dependent value investing are: 1) the performance of the
exact investment strategy can be tested ahead of its implementation by
reproduced return data because this strategy is independent of tacit
information, 2) the costs of implementing the investment strategy are
low with respect to data gathering and analysis but high with regard to
system development and trading related expenses, and 3) it is easier to
diversify the portfolio on multiple stocks in order to avoid liquidity
issues when trading. The major advantages/disadvantages of using manager
dependent value investing is that it produces a better estimate of the
truer potential value of the stock thereby enabling higher gross
investment returns. Unfortunately, this value investing strategy cannot
be tested and reproduced ahead of implementation because it depends on
tacit information. Furthermore, the associated company analyses are time
consuming and expensive. For these reasons it has to focus on large
stock holdings in a few firms. This again may create liquidity problems
when trading the stocks of the target firm.
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** First book: Graham, Benjamin and
David Dodd (1934). "Security Analysis," 1st ed. Whittlesey House.
Second book: Graham, Benjamin (1949). "The Intelligent Investor,"
1st ed. Collins.
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