Value Stocks Are Hot—But Most Investors Will Burn Out

"Most people aren't cut out for value investing, because human nature shrinks from pain," the money manager Jean-Marie Eveillard told me this past week. His words are a reminder that making money on cheap stocks—the goal of every value investor—is harder than it sounds and can take years to play out.
Lately, value investing has seemed easy. Over the past year, the Russell 1000 Value Index, a yardstick of cheap stocks with sluggish expected earnings, is up 19%, compared with 11% for pricier "growth" stocks and 15% for the full Russell 1000 index of big U.S. stocks. The public has started to notice: Mutual funds specializing in large value stocks took in $2.4 billion in January.

But as Mr. Eveillard warns, the long-term rewards don't go to people who think value investing is easy. Superior returns can be earned only by those who know that it is hard—and stay put.
Take it from Mr. Eveillard. From 1979 through 2004, he was the lead manager of the SoGen International Fund (now First Eagle Global ). Over that period, the fund earned an average of 15.8% annually, versus 11.3% for the MSCI World Index of global stocks—one of the widest and longest margins of outperformance on record.
But in the late 1990s, "new economy" stocks—think Internet startups—were hot. Mr. Eveillard owned the old economy: railway, gold-mining and Japanese insurance companies. His fund trailed the index by 25 percentage points in 1998.
"After one bad year investors were upset," he recalls. "After two they were mad, and after three they were gone." Between 1997 and early 2000, investors yanked out two-thirds of the fund's assets—and then missed out on its later years of superb performance.
The fund industry has long marketed the chimera of "consistency," the idea that a great stock picker can always earn higher returns than the market. Investors who buy into this myth often sell in a panic as soon as the next crash proves that no stock picker can always outperform.
Over the decade ended Dec. 31, value funds specializing in large stocks returned an average of 6.7% annually. But the typical investor in those funds earned just 5.5% annually, according to Russel Kinnel, director of fund research at Morningstar .
That is partly because many investors bailed out after these funds lost an average of nearly 37% in 2008; the subsequent rebound was captured only by those who stuck around. "Too many investors tend to think that [value] strategies are flawless or 'bearproof,'" Mr. Kinnel says—and then sell out in shock when they realize the strategies aren't.
Summit Street Capital Management, an investment partnership in New York, recently analyzed a group of value investors with long records of superior returns and found that even the best underperformed one-third to 40% of the time. "It's hard not to get shaken out unless you understand that and have conviction," says Summit Street partner Jennifer Wallace.
You also should understand how the present and future might differ from the past. Since 1926, value stocks have outperformed growth stocks by an average of four percentage points annually, according to the authoritative index compiled by finance professors Eugene Fama of the University of Chicago and Kenneth French of Dartmouth College.
But be warned: Today's typical value fund might not be able to deliver the superior returns generated by bargain stocks in earlier decades.
Nowadays, most value managers search for stocks that are cheap relative to current or expected earnings. The bargain stocks in the best-known Fama-French index were selected on a different measure: book value, a basic yardstick of corporate net worth.
Many stock pickers don't pay much attention to book value anymore. And while small-company returns accounted for much of the historical high returns on the Fama-French index, most managers today favor larger companies.
Value stocks also are less of a bargain than they used to be. Historically, they averaged 54% cheaper than growth stocks, as measured by prices relative to earnings, says Eric Weigel, director of research at the Leuthold Group, an investment firm in Minneapolis. Today, value is 40% cheaper.
So value might fade again before long. To be a value investor, it isn't enough to buy cheap stocks or the funds that own them. You have to stick around until the market recognizes their worth. Mr. Eveillard, now 73 years old and an adviser to his old fund, is still finding bargains in Japan and among gold-mining stocks—but he is prepared to "suffer" until the market proves him right.

Buffett’s Favorite Valuation Metric Surges Over the 100% Level

For the first time since the recovery began, Warren Buffett’s favorite valuation metric has breached the 100% level.  That, of course, is the Wilshire 5,000 total market cap index relative to GNP.  See the chart below for historical reference.

I only point this out because it’s a rather unusual occurrence and the recent move has been fairly sizable.  It happened during the stock market bubble of the late 90′s, but then occurred again just briefly during the 2006-2007 period when the valuation broke the 100% range in Q3 2006 and stayed above that range for about a year.  We all know what followed the 2007 peak in stock prices.

Here we are in this wonderful new world where everyone values nominal stock prices more than they value the actual output that underlies it.  If this indicator isn’t a sign that we are still residing in this Fed driven asset targeting mania then I don’t know what is.

To me, the whole thinking is backwards and more disruptive than anything else, but the party must go on.  Lord knows the Fed isn’t taking the punch bowl away any time soon.  So drink up.  Maybe you’ll get so drunk you’ll sleep through the inevitable bad parts when they arrive.

Chart via Orcam Investment Research:

Housing Market vs. S&P 500 Financials, w/ 2 Yr. Lag (Chart)

Performance of Morningstar's New Analyst Ratings For Mutual Funds in 2012

Last year I wrote about Morningstar's new analyst ratings for mutual funds (here as well). These are different from their Star Ratings in the fact that these are meant to be "forward looking". From Morningstar (bold added by me)

"The Analyst Rating is based on the analyst's conviction in the fund's ability to outperform its peer group and/or relevant benchmark on a risk-adjusted basis over the long term. If a fund receives a positive rating of Gold, Silver, or Bronze, it means Morningstar analysts think highly of the fund and expect it to outperform over a full market cycle of at least five years."

Now it should be clear that these ratings are longer-term in nature so take the following breakdown with a grain of salt but I said I would follow-up on these so I am.

First lets start with a review of what the distribution of Morningstar's Analyst Ratings looked like at the start of 2012

While the distribution of ratings has gotten a little better it remains a mystery why Morningstar has an allergic reaction to assigning negative ratings. As of the start of 2013 they have now rated 1069 funds but only 52 (or less then 5%) have negative ratings. Although the neutral ratings have increased to 28%, Bronze to 25%, Silver is down to 24% and Gold down to about 18%.

Without further ado, below is how the rated funds performed in 2012. These only include funds rated at the start of 2012.

Not much really stands out after the first year. While their was a slight positive result for Gold and Silver rated funds, Neutral rated funds did even better. As for Bronze and Negative rated funds, outperformance was pretty much a coin flip.

Below is the Average Rank for each, as you can see Neutral rated funds performed the best and Negatively rated funds performed the worst.

Take this for what it's worth, which at this point is not much because full market cycles are indeed a better measuring stick. For instance, in 1999 and 2006/2007 a lot of bad managers did good thinking the unsustainable was in fact sustainable while a lot of good managers did bad as they realized irrationality when they saw it. However, this is at least a starting point for looking at the performance of these Analyst Ratings.

Smaller Hedge Fund Managers Outperform: A Study of Nearly 3,000 Equity Long/Short Hedge Funds

One of the most vexing issues in the hedge fund industry is the relationship between growth in assets under management (AUMs) and future returns. An abundance of anecdotal evidence suggests that smaller managers with great performance attract capital quickly, which dilutes future returns. Further, the recent concentration of capital among large hedge funds has raised questions as to whether this has contributed to the decline in industry-wide alpha.
In a recent report, we analyzed nearly 3,000 equity long/short funds in order to get to the heart of this issue. Prior studies have had limited usefulness due to three issues:  (a) the inclusion of backfilled database returns, which seriously distorts the overall results (Pertrac and Barclays); (b) a population of funds across the industry as a whole which includes differing strategies with divergent capacity issues; and (c) a failure to exclude managers or funds below a reasonable AUM threshold (most studies), which results in an impractically small average fund size. By contrast, we focused narrowly on the equity long/short space since these managers are likely to face similar capacity constraints (as opposed to, for instance, macro investors or CTAs). Backfill issues were addressed by including fund returns only from the date when the funds began to report to the database; our studies show that “pre-reporting” returns are 6-8% above “post-reporting” results, which shows the magnitude of the issue. Finally, we grouped funds according to manager since many funds have multiple share classes and since some growth-related issues are firm-specific as much as they are fund-specific.
In our study, we divided the universe into firms that managed $50 million to $500 million in equity long/short AUMs (“Small”) and those that managed more (“Big”). The $50 million lower bound was selected to make the sample more representative of an actual emerging manager investment program. The result of the study clearly demonstrates that smaller hedge fund managers tend to outperform larger ones – a conclusion that will resonate with many hedge fund investors:

• Small firms outperformed Big by 254 bps and 220 bps per annum over five and ten years, respectively;
• Outperformance was most pronounced preceding and following the crisis, especially 2009, while drawdowns were in line during the crisis;
• Virtually all of the outperformance was due to alpha, not beta; and
• The dispersion of returns among smaller funds was greater than those of larger firms.

The fund population in the Beachhead study consisted of 2,827 equity long/short hedge funds drawn from the HFR database of live and dead funds. Funds were included based on strategy classifications for fundamental value, fundamental growth and sector specialists in technology, healthcare, energy and basic materials; quantitative-driven, market neutral and short biased funds were excluded.  For each year, the funds were grouped into Small and Big portfolios that were equally weighted and rebalanced monthly. To mitigate backfill bias, the returns for a given fund were only included as of the date it began reporting to the database.
In the sample, the number of Small and Big firms was roughly equal. In 2012, a Small firm managed $193 million on average while a Big firm managed $3.7 billion.  Interestingly, average Big firm assets have tripled over the past decade while Small firm assets have remained roughly constant, which reinforces the view that Big firms have had a much easier time attracting capital.
Over the past ten years, Small equity long/short managers returned 7.56% per annum and outperformed their larger peers by 220 bps per annum (over the past five years, outperformance was 254 bps per annum). Small managers showed a moderately higher annualized standard deviation, but drawdowns were in line and the Sharpe ratio was significantly higher. The chart below shows the returns of Small and Big managers over the past ten years.

As shown below, Small managers materially outperformed both before and after the crisis, especially during the post-crisis recovery. Somewhat surprisingly, despite somewhat higher beta, smaller firms did not underperform larger ones during the crisis, which may reflect superior risk management or a more manageable capital base.

The remarkable consistency of the outperformance is evident in the following chart. The date on the top row reflects the inception of an investment that terminates in the year on the vertical column; the percentage in the corresponding cell reflects the compound annual return differential of Small less Big over the specified period. For instance, the cell on the upper left shows 2.20% of compound annual outperformance of Small vs. Big over 2003 to 2012. Green boxes show periods of outperformance of Small.

It’s notable that outperformance does not appear to be attributable to rapid or regular changes in market exposure; rather, the beta of Small to Big is quite consistently around 1.1 with stable correlations above 0.95. Consequently, comparable drawdowns during the crisis itself seem to reflect somewhat larger market-driven losses offset by persistent positive alpha.
The following chart examines the alpha of the Small portfolio relative to the Big portfolio over the ten year period.  Note that alpha is annualized in the box. The vast majority of outperformance is due to alpha, not beta, which confirms that higher risk taking does not explain the differential.

We also studied the dispersion of returns in order to test the hypothesis that smaller managers are motivated to outperform, while larger firms are likely to be more risk averse. The chart below shows the annual returns of the funds in the Small and Big portfolios with the mean, minimum and maximum fund returns. In virtually every year since the late 1990s, the top performing Small funds have materially outperformed the comparable Big funds.  Interestingly, the worst performing Small funds matched or outperformed the comparable Big funds in the vast majority of years, which supports the argument that Small fund outperformance is not driven by higher symmetric risk taking.

As a final test, we analyzed what would happen if the “threshold” between Small and Big managers was lowered or raised. The chart below shows the differential in returns over the past five and ten years and clearly shows that outperformance of “smaller” managers declines as AUMs increase. For instance, when “small” is defined as less than $1.0 billion, the outperformance relative to larger managers is 1.1% over ten years and 0.6% over five years.

The key question for investors is what factors drive the differential in returns. Three potential factors include:

• The most talented managers self-select to start firms rather than work at larger firms. Many talented managers build experience in larger firms before launching their own firms.
• Smaller managers have a better opportunity set:  based on trading volume, the number of potential long and short side investments declines by up to 80% between $100 million and $1 billion in AUMs. Off the run and less efficiently priced stocks can have a meaningful impact on returns. Anecdotally, capacity issues materialize sooner on short positions.
• Pressure to perform:  performance fees are a higher percentage of overall compensation and drive asset growth. Our analysis suggests that up to 80% of the enterprise value of larger firms is due to capitalized management fee EBITDA as opposed to performance fees.

The study is part of a series of papers on the equity long/short space and is available at www.beachheadcapital.com.

Notes From Bruce Berkowitz's CSIMA Talk

- On diversification: it dumbs us down because we can't focus on a few things that can make a difference.  You're most likely not the only fund your investors are in so you have to be more risk averse for your own job safety.  Most managers hold too many positions.  Less than 10 positions typically equals career risk.  The benefits of diversification fall off between 10-30 stocks in a given portfolio.  If investors put around 10% in one fund and that fund holds 10 stocks, they effectively hold 100 stocks.

- On spending time with clients: it's actually a disservice to them to spend time away from investment research.  You need to be focused on your investment process as it will benefit them more than spending time with them.

- On time management:  the best way to maximize your time is to say "no" to a lot of people.  He likes to get the most out of every minute so he's even listening to books on tapes.

- On investing: If you hustle on the investment trail and do it 24/7 you'll be a great investor 30 years from now.  Take 2 steps back to take 10 steps forward, sometimes it's necessary. He reads company reports before going to bed and is always listening to conference calls.  He also emphasized decoupling from the herd or the groupthink of Wall Street (most likely why he's in Miami instead of New York).  To do well in life, you've got to be excited. 

- On Sears (SHLD): He still likes the stock and the real estate is what's attractive to him.  It has more commercial square feet than Simon Property Group (SPG), but SPG is worth 10x more than Sears (using enterprise value).  Some investors argue that Eddie Lampert isn't a retailer, but look at AutoNation  (AN), which he's also been involved in.  Berkowitz feels that he has a nice margin of safety at the prices he bought at and has the potential to make a lot of money.  (We've previously posted Berkowitz's case study on Sears.)

- On Bank of America (BAC): A lot of people are fixated on the Countrywide problems, but great earnings are there and in the future that Countrywide drain won't be there so the earnings power is just starting to show.  (We've also posted Berkowitz's Bank of America case study.)

- On American International Group (AIG): The company will eventually become a profitable insurance business as they're the price leader.

Read more: http://www.marketfolly.com/2013/02/notes-from-bruce-berkowitzs-csima.html#ixzz2KcCUKzLJ

Great Rotation hovers on the horizon (Hasenstab + Arnott)

When will there be a change in the wind? For four years it has blown investors in one direction: out of stocks and into the relative safety of bond funds.
But while there are plenty of warnings that bondholders face losses from rising interest rates, rallying stock markets have yet to be propelled by a real gust of enthusiasm.

Flurries of interest in the new year, though, have brought rising interest in the idea of a ‘Great Rotation’: the idea that money will flow out of bonds and back into stocks.
US stock funds attracted $21bn in the first four weeks of the year, according to Lipper, the largest inflow for any four-week period since the peak of the dot-com boom in April 2000.
Meanwhile equity funds globally took in assets at three times the pace of bond funds, according to EPFR. The research group also found that equity flows from retail investors, who tend to be slow to react to turning points in markets, are on track for the strongest start to the year since 2006.
The inflows come as some influential bond investors have already positioned themselves to avoid interest rate risk.
“There’s probably a growing understanding that interest rates have to go higher at some point,” says Michael Hasenstab, who oversees $175bn in fixed income for Franklin Templeton. “We’ve actually taken that conviction and put it in place.”
At the same time there are signs of investor optimism. UBS says its long-only and hedge fund clients were net buyers of equities in crisis-hit eurozone “periphery” countries in eight of the last 11 weeks, with average flows at the highest level in more than two years. Unloved Spanish equities have seen buying for four weeks in a row.
But Nick Nelson, UBS global equity strategist, argues for context. “It is not a rotation, it is a mini-rotation. It doesn’t look to us that it’s euphoria or super extended,” he says.
And Romain Boscher, head of equities at Amundi, says that in Europe it is not as simple as money flowing from fixed income straight to equities. “This is not new money moving in favour of equities. We’re just seeing money that left Europe coming back again.”
Indeed, the term is in one sense a misnomer. “Every stock certificate and bond certificate must be owned by someone at every point in time,” says John Hussman of Hussman Funds.
Rather it reflects the sentiment at the margin, where new savings are directed, and increased demand for stocks is still tentative and cautious.
“We’re still in a world where if there’s a shock to equities, bonds will do well. So bonds still play an important role as a diversifier. In five years’ time, who knows, but stocks and bonds stapled together are a very interesting investment in the near term,” says André Perold, chief investment officer for HighVista Strategies, an investment firm for endowments.
Patrik Schowitz, global strategist for JPMorgan Asset Management, says he is overweighting stocks relative to bonds, but largely because the latter are so expensive.
“It would certainly help if we had a rip-roaring economic environment,” he says.
Robert Arnott, who runs two asset allocation funds for Pimco, sees recent moves in the stock and bond markets as opportunities to be tactical, selling what has rallied and buying what has fallen.
He also says the source of January inflows may simply be the flurry of bonuses and special dividends paid out in the US ahead of this year’s tax rises. He describes this as “a flood of demand from income that would have normally occurred in January, February and March that needs a home”.
Even were there a greater sense of optimism though, there is much built-in inertia at big investors such as pension funds and insurers.
Solvency regulations in Europe encourage insurers to hold bonds, while accounting rules have pushed US pension funds in the same direction.
“A good two-thirds of corporate pensions have put derisking plans in place,” says senior Mercer consultant Richard McEvoy.
That will continue a trend which the consultancy calculates has caused pension funds of S&P 1500 companies to cut equities from 65 per cent of assets to 50 per cent over the past decade, while bond allocations have risen 10 percentage points to 39 per cent.
So the investment weather remains mixed. Looking back over his 44-year investment career, Charles Brandes, chairman of Brandes Investment Partners, says the current period most reminds him of 1980.
In 1974 the US market dropped 47 per cent. It rallied in the following two years, but by 1980 interest rates were rising to combat inflation and the economic outlook remained uncertain. “It wasn’t until 1982 that we saw the start of the big bull market, and maybe we are two or three years away from that,” says Mr Brandes.

the hockey stick

Yesterday, Alhambra Investment Partners posted a revealing set of charts about earnings growth (or lack thereof).  So much focus is given to whether company reports beat estimates, but estimates don’t mean much if they have dropped like rocks in the months leading up to the reports.
That’s what we’ve seen of late — and the actual results have been lackluster to say the least.  But never fear, estimates for this year show remarkable growth is on the way:

Could that happen?  Sure.  But you might want to bet against it, since this is the way it pretty much always looks at this time of year, before the relentless decline in estimates begins.
If you are using sell-side forecasts, there are things you can rely on.  (Yesterday’s chart on research puzzle pix highlighted three of them.)  Another is that a hockey stick is almost assuredly baked in the cake.  Pull it out.

Is the Secular Bear Market Coming to an End?

 

A decade ago, I concluded that we were in the early stages of a secular bear market, and that investors needed to adjust their risk postures accordingly. Back in December 2003, I penned a piece for the Stock Trader’s Almanac, titled Managing the Very, Very Long Term, based on this blog post from November 2003.
Long time readers know this is a major theme to for me. Much of my commentary, presentations and investing posture has been about longer term, secular cycles. Search the Big Picture for the phrase “secular bear market” and 659 results come up (in quotes, 130).
Here’s what I wrote back in 2003:

“The panoramic view leads me to the present conclusion. Following an 18-year Bull market [1982-2000], and a three year Bear market, we are now committed to what looks like a long-term military obligation in Iraq. In the grand scheme of things, I suspect we are in for a harder long-term slog than the mere 3 year Bear market suggests.
Historically, this suggests an extended period of range bound trading as the highest probability long-term scenario in my view. I expect vicious rallies, and wicked sell-offs to occur — over shorter term cycles — within the larger timeline. Active management and capital preservation are going to be the key methods of outperformance.”

Let’s put this into more specific quantitative terms. According to data from Fidelity:

• Average secular bull market lasted 21.2 years and produced a total return of 17.2% in nominal terms and 15.9% in real terms. The market’s P/E more or less doubled, from 10.1 at the start to 20.5 at the end.
• Average secular bear market lasted 14.5 years and had a nominal total return of +1.0% and a real return of –2.3%. The market’s P/E compressed by an average of 9 points, from 20.5 at the start to 11.3 at the end.

Here we are, a few weeks away from the start of the 14th year of the secular Bear market that began March 2000. The question on more than a few peoples’ minds has been whether or not it is reaching its end.
To answer that question, we need to understand exactly what a secular bear market is. Over the years, I have developed a my own definition of Secular Bear Markets:

“A of Secular Bear Markets is a long term cycle which typically begins after a long term bull market peak and crash. It is primarily characterized by strong, even excessive rallies and selloffs, all occurring within a broad trading range. Despite the strong rallies, markets often appear to be unchanged a decade or so into secular bears.
The psychology is one of compressing Price to Earnings multiples, as investors become increasingly unwilling to pay the same price for each dollar of earnings. There is often a general malaise to the broader society, sometimes encompassing political scandals and/or war.
On Main Street, there is a general disinterest in equities. Ratings for financial television and other media fall. Interest in non stock investments — especially Bonds, Commodities and Real Estate — rise.”

To conclude that the Secular Bear is ongoing, we need to see a few factors:

-Are markets still rangebound? Have we made new highs in various indices?
-Are P/E multiples still contracting?
-Are financial news media ratings still falling?
-Is society generally pessimistic?
-Is Main Street still disinterested in equities?

Some of the answers to these questions are purely quantitative, and do not require any human judgment. A few of these do require a squishier answer. After 36 months or so of capital outflows from equity funds, we should not rush to judgement after the first month of inflows.
And there is a major caveat to this: The Fed’s extraordinary ZIRP/QE intervention creates an impression of inorganic gains. Without the unprecedented FOMC actions, I am unsure markets would be anywhere near current levels.
Regardless of your answer to our broad question, there is one thing that I believe to be clear: We are much closer to the end of this secular cycle than to the beginning. Many optimists — most notably, famed technician Ralph Acampora — believe the secular bear market has ended. Even skeptics have to agree that we are more likely in the 7th or 8th inning than earlier stages of the game.  Only the “America is Japan” crowd thinks we are in the 3rd or 4th inning.
The key question for investors: Are you prepared to make changes to your portfolios?

Secular Cycles

Source: Haver, Factset, Robert Shiller, FMRCo. Monthly Data, since 1871

Paul Singer Gives gold an "A" and Bernanke a "D"

http://www.hedgefundintelligence.com/Article/3147894/AbsoluteReturn-News/Paul-Singer-gives-gold-an-A-Bernanke-a-D.html