O Value, Where Art Thou?

Lord Darlington.  What cynics you fellows are!

Cecil Graham.  What is a cynic?  [Sitting on the back of the sofa.]

Lord Darlington.  A man who knows the price of everything and the value of nothing.

Cecil Graham.  And a sentimentalist, my dear Darlington, is a man who sees an absurd value in everything, and doesn’t know the market price of any single thing.

(Lady Windermere’s Fan, Third Act)

The value of an asset is the discounted sum of its future payouts.

This definition is essentially tautological. All it says is that a tree is worth the fruits it bears, and that an apple for sure today is worth more than an apple maybe tomorrow. For most financial assets, payouts are in cash, so we say their value is the discounted sum of future cash flows, or DCF. But payouts can be non-monetary: Gold and works of art, for instance, repay the owner with security or pleasure. Live-in properties spare their owners the payment of a rent. I leave it to you to figure out the payouts of Bitcoin.

Payouts should not be confused with the proceeds from the sale of an asset. A sale just transfers the right to the payouts from the seller to the buyer. It is an exchange at an agreed price. The price might be higher or lower than what the seller paid to acquire the asset. But the entailed gain or loss comes from the sale, not from the asset. Who would buy a fruitless tree, if not with the intent to sell it to a greater fool who would also buy it for the same purpose?

Investors do not, or should not, disagree on what value is. But they do differ in the use they make of the concept, and in particular in the distinction they make between value and price. In this respect, we can divide them into three groups:

1. Grahamians. They place great significance on the concept of value, as distinct from the notion of price. They believe that values can and often do differ from prices.
2. Cynics. They place no significance on the concept of value. They believe there are no values, only prices.
3. Bogleheads. They are indifferent to the concept of value. They believe that, apart from some fleeting anomalies, there is no difference between values and prices.

Notice the similarity between Grahamians and Bogleheads: they both believe there is a magnetic force attracting prices to values. But Grahamians see the force as weak and variable, thus allowing other forces to open gaps between values and prices. While Bogleheads see it as strong and overpowering, thus preventing any significant gaps to open in the first place.

Cynics, on the other hand, believe there is no such a thing as value. They think prices are subject to various forces, but value magnetism is not one of them. In this sense, then, there is also a similarity between Cynics and Bogleheads: they both ignore value. Cynics see it as a pointless concept. Bogleheads think that, whatever it is, it is inseparable from price.

Their ignorance shows up whenever Cynics and Bogleheads talk about value. The most common misconception that unites them is the confusion between value and valuation. This is typically exemplified by their definition of a ‘value’ asset – e.g. a company stock – as one exhibiting a low ratio between its market price and some item on the company’s balance sheet, such as Net Income and Shareholders Equity. A ‘value stock’ – so they say – is one with a relatively low Price/Earnings or Price/Book Value ratio. Notice this is not what they believe: remember Cynics think there is no such a thing as value, and Bogleheads do not distinguish between value and price. But it is what they believe Grahamians see as a ‘value stock’. That is, they believe Grahamians think that value can be reduced to some function of E and BV, and that, therefore, a low P/E or P/BV is an appropriate measure of the gap between value and price.

This is obviously a gross misrepresentation. Any self-respecting Grahamian knows that “The whole idea of basing the value upon current earnings is inherently absurd“. The value of an asset is the discounted sum of its future payouts, and a company’s stream of payouts depends on its ability to earn a return on equity above its cost of capital, and on the value of equity increases accruing from its future investments (here is a sketch of how I look at it). To say that the value of a company can be represented by a number on its balance sheet is like saying that the value of an apple tree can be gauged by the look of one of its apples.

Still, the idle notion that lower P/E or P/BV stocks are ‘value stocks’ is pervasive, even beyond Cynics and Bogleheads. And so is the even sillier notion thar higher P/E and P/BV stocks are ‘growth stocks’. Worse, asset managers whose portfolios have stocks with lower than average valuation ratios are labelled ‘value managers’, while those invested in stocks with higher than average ratios are marked as ‘growth managers’.

Serious Grahamians know this is nonsense. A value stock is one whose true value is significantly higher than its market price. This has nothing to do with lower valuation ratios. Obviously, given anything at the denominator, a lower ratio means a cheaper stock – believe it or not, paying a lower price is better than paying a higher price. But a value stock can have any valuation ratio, including a negative P/E if a company is currently loss-making, or a high P/E if earnings are temporarily depressed or if they are deemed to grow at a fast pace in the future. Conversely, a low P/E or P/BV stock is not necessarily a value stock, as it may be a value trap, i.e. a stock whose true value is even lower than its low price.

Thus value versus growth is a false dichotomy, and the ensuing categorization of stocks and asset managers based on valuation ratios is a persistent source of confusion.

Far from being a semantical subtlety, the value-growth jumble has real consequences. As it is often the case, much of it revolves around the cynical Bogleheads duo par excellence, Eugene Fama and Kenneth French. Under pressure from an avalanche of empirical failings of the Efficient Markets Theory and the associated Capital Asset Pricing Model, in the early 1990s the duo came up with a Three-Factor Model, with the objective of ‘explaining’ the behaviour of stock returns while salvaging the totem of market efficiency. One of the three factors in the model is HML, which stands for High Minus Low book-to-market ratio. In their words: ‘Returns on high book-to-market (value) stocks covary more with one another than with returns on low book-to-market (growth) stocks’ (Fama and French, JEP, 2004, p. 38). That’s it: low P/BV=value stocks, high P/BV=growth stocks.

The other cornerstone of the model is SMB, or Small Minus Big: ‘Returns on the stock of small firms covary more with one another than with returns on the stocks of large firms’. Unlike HML, SMB does not carry a semantic baggage – small and large are just that: different market capitalisations. But they both have the same connotation: they are risk factors. Ever obedient to their EMT faith, Fama and French do not imply that investors should buy low P/BV ‘value’ stocks and small cap stocks: what they are saying is that the extra return they would get by doing so is ‘explained’ by the usual all-embracing EMT panacea: extra risk. Nevertheless, since the Fama-French launch, a flood of evermore plethoric ‘Multifactor models’ has generated a whole industry of ‘Factor Investing’. Their overt message to investors: we’ll get you better returns. Their covert message – often obscure to ‘factor’ investors themselves: we’ll get you extra returns by exposing you to extra risk.

The mantra ‘A higher return always comes with a higher risk’ is the central pillar of the EMT. Factor investors get sucked into it by construction: they are more or less self-aware Bogleheads. Cynics are cynical: they know their trades can go wrong, and hedge their bets accordingly. Plus they know that the more they bet, the higher their gain or loss – and leave it at that. But Grahamians are cerebral. They ask: what is risk? And why should it be positively related to expected return? Their view on the subject is very different from the EMT mantra. They define risk as the probability of a permanent loss of capital, and think that more risk means a lower, not a higher probability-weighted expected return. To a Grahamian the risk of an asset is proportional to the size of the gap between its true value and its market price. The wider the gap, the bigger is the Margin of Safety of an investment, and the lower its risk. A bigger Margin of Safety increases the magnetic force that attracts price to value. Of course, value can change, in a positive or negative direction, and so can its assessment. Hence the investment is and remains risky, despite the size of the value gap. But why should that risk have anything to do with P/BV or market cap?

Fama and French’s reasoning about P/BV is disarmingly circular. They essentially say: a low P/BV means that the market is placing a relatively low value on the company’s equity. This must be because the market considers the company riskier. That is: a company is riskier because the market says so. Or: The company is riskier because it has a low P/BV, and it has a low P/BV because it is riskier. This wouldn’t pass Excel. As roundabout as it is, however, the P/BV argument bears at least some relation to price and value. But what about size? Why should a small company be riskier that a large company? Here the argument rehashes the flimsy sophistry used to ‘explain’ Rolf Banz’s (1981) size effect: small companies are riskier because they are younger and therefore more fragile, while large companies are safer because they have been around for longer and are therefore more robust. No matter their price or value. So for instance the small caps in our Made in Italy Fund are a lot riskier than Tesla. Oh well.

Like factor investors, Grahamians want to get better returns – but with less risk, not more. This raises the outrage of EMT faithful, to which the proposition is anathema. Better than what? – they ask, with the smug assurance that, whatever the answer, it will be wrong. Well – say Grahamians – better than the average returns of asset managers investing in the same universe. So, for example, if we invest in US stocks our aim is to get significantly better returns than other US managers – not every quarter or even every year, but certainly over a 5-to-10-year period. Before you say so, that includes passive investing Bogleheads, whom, we agree with you, are strong contenders, as they tend to get better than average after-costs returns. And since all that Bogleheads do is to replicate the composition of some index – the S&P500 in the case of US stocks – we also want to outperform the index. And look at our track record: that’s what we have done – say successful Grahamians (it should go without saying that it is not enough to call oneself a Grahamian to be a successful investor).

Ah, but which index? – is the standard retort. Echoing the Three-Factor Model, an army of index providers and performance analysts use intricate grids of boxes to place funds and fund managers along the HML and SMB spectrums. The most prominent is SPIVA – S&P Indices Versus Active. For each fund they ask: is it Value, Growth, or Core? Is it Large Cap, Mid Cap, Small Cap, or Multi Cap? Their message: When placed in the right box (or ‘style’, in their ludicrous parlance), most ‘active’ funds underperform their assigned index.

Grahamians shrug off such classifications. They think value versus growth is a misnomer, and they do not regard market cap as a relevant criterion to assess the true value of an investment. Still, their funds are forced into one of the boxes, based on the HML and SMB scores of their holdings. And – like Native Americans protesting against being called Indians – Grahamians rejecting this nonsense are simply ignored.

This messy Babel can be traced back to Grahamians’ characterisation of one of the major forces they see as creating gaps between true values and market prices: the average investor’s tendency to be carried away by sentiment. As Benjamin Graham put it: the stock market is a voting machine rather than a weighing machine. This works both ways: negative sentiment can push stock prices below true values and positive sentiment can pull them above. Grahamians are attracted by the former: in this sense, they tend to regard low valuation ratios as a sign of excessive pessimism. But only a lazy Grahamian would confine himself to simply casting a net amidst low ratios in the hope of catching as many value stocks as possible. A serious Grahamian would perhaps screen for low ratios, but would thereafter know that his job has, if anything, just started. Likewise, Grahamians are deterred by positive sentiment, which – as an earlier Graham, Cecil, put it – sees an absurd value in everything and knows the price of nothing. Hence they tend to regard high valuation ratios as a sign of excessive optimism. But again only a lazy Grahamian would stop there and simply avoid high valuation stocks. A serious Grahamian would be interested in them and would want to check whether high ratios are perhaps justified by high true values, possibly above market prices. In doing so, he is aware that excess optimism is a tougher nut to crack than excess pessimism. When excess pessimism drives a stock price below what a Grahamian thinks is its true value, all he needs to do is to buy the stock and wait for value magnetism to work. If it doesn’t, he needs to decide whether to wait a bit longer or admit he has caught a value trap, take a loss and move on – an error of commission. But when excess optimism drives a stock price above its supposed true value, a Grahamian will either do nothing or, if he is so inclined, short the stock, again waiting for value magnetism to take effect. If it doesn’t, however, being short means dealing with a time-sensitive, potentially indefinite and expanding loss. And, if he is not short, he needs to deal with the growing anxiety of having missed the boat – an error of omission that many Grahamians who never managed to bring themselves to buying Amazon are sorely familiar with. In addition, while the value that excess pessimism tends to neglect is often a hard, tangible one, embedded in existing assets, the value that excess optimism tends to overblow is usually an uncertain, impalpable, non-linear condensation of future growth opportunities. Grahamians are naturally more confident dealing with the former and more sceptical about dealing with the latter: value traps are bad enough, but ‘growth’ traps – where one surrenders to sentimentalism and buys a meteor only to see it crushing down to earth – can be devastating. Yet, a serious Grahamian knows he needs to handle both risks, and that his job is a great deal more complicated than the lazy reliance on a couple of balance sheet numbers.

So there it is: Cynical Bogleheads think that all Grahamians are as lazy and disinterested in value as they are. They aren’t.