Saturday, March 15, 2008 1 comments ++[ CLICK TO COMMENT ]++

Value vs Glamour

Being contrarian generally means buying out of favour assets. Often, contrarians and value investors are indistinguishable and they follow the same strategies. Does buying out of favour stocks work well over time?

David Dreman has shown in his books that low valuation stocks, as measured by P/E, P/B, P/S, or dividend yield, outperform high valuation stocks. John Neff has also remarked that his highly successful strategy of the 70's and 80's is best considered as a low P/E investing strategy. If you want to see how out of favour stocks can do better than the popular ones, consider the following example from the Brandes Institute, run by the value investing firm, Brandes. In their article entitled Value vs Glamour: The Challenge of Expectations they present the following example of 5 largest popular stocks from the 1st decile vs 5 largest unpopular ones from the 10th decile:

source: Value vs Glamour: The Challenge of Expectations, Brandes Institute

The 5 stocks in the top decile (in 1998) were popular, had excellent profitability ratios, and seemed to have the future under their control. The five in the bottom decile had declining profits, very low ROE and ROIC, and were generally considered "old" companies with a deteriorating future. Although this isn't a statistically signficant sample, note that the sample is reasonably unbiased in including companies from different sectors. Would you have been better off investing in the top decile in 1998?

The answer is a resounding no! Over the next 5 years, the top decile had a 1.4% return versus 14.7% for the bottom decile (all figures annualized). The article points out that this pattern (of bottom decile outperforming top decile) is the case for 87% of all the rolling 5 year periods between 1980 and 2007.

David Dreman has also pointed out similar results with low valuation stocks (P/E, P/B, P/S, dividend yield) versus high valuation stocks. It does pay to look in the trash bin!

So how come very few seem to follow a strategy to exploit this? The main difficulty is human psychology. It's really hard to overcome the temptation to avoid beaten-down or unfavourable businesses.

The other problem I see for stockpickers is that it is difficult to figure out which of the unfavourable stocks are safe enough to worth investing in. As the table shows, even if you look at 3 year averages (of say ROE or income growth), the unfavourable businesses look terrible. It is awefully tough to put your money into something that posts poor results not just for one year but even for a 3 year period. How does one get comfortable with knowing that the weak profitability is an anamoly rather than the norm?

Investors like David Dreman mitigate the risk by buying a large number of stocks. But if you don't have enough money to buy many (eg. transaction costs too high) or are following a concentrated stockpicking strategy, these investments are awefully tough to make. Such difficulty, of course, is what produces the rewards...

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1 Response to Value vs Glamour

March 15, 2008 at 4:34 PM

What constitutes a concentrated portfolio varies greatly from person to person. I've seen some say 50 holdings is concentrated, many more say 20 holdings is a concentrated portfolio.

It's really a personal choice. I'm comfortable holding 20-25 stocks in a fully invested portfolio. Others 10 or so. Obviously, the smaller the more volatility one may have to put up with.

The main thing is there's no proven formula showing which is best. Walter Schloss used to have 100 positions but would at times put 15% in one name if he felt strong enough about it. Other successful investors hold just a handful.

I guess there's no one path to prosperity...or the soup kitchen. ;-)

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