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The contrarian case for active investing Add to ...

Investors are increasingly disenchanted with active portfolio management and stock picking, and are voting with their feet.

They are exiting actively managed stock funds and moving their money to bond funds and exchange-traded funds. Between 2001 and 2011, domestic U.S. stock funds have lost $51-billion (U.S.), while U.S. bond funds have gained $591-billion and ETFs have gained $870-billion.

But, to paraphrase Mark Twain, the death of active portfolio management is greatly exaggerated. Studies showing that “passive” index funds that beat managed funds generally report the average performance of active funds and compare that with the passive strategy. This can be misleading, because it’s not clear how much of this result reflects a lack of stock-picking skill on the part of active managers and how much reflects the environment in which portfolio managers operate.

If portfolio managers are concerned about losing their jobs or losing funds under management, they may avoid standing out from the crowd and become closet indexers, with portfolios that look a lot like the broad market. It is not that they lack stock-picking abilities, but rather that institutional forces encourage them to over-diversify their portfolios, making it impossible to beat the market.

But not all active managers are the same. Value investors, for instance, tend to hold “concentrated” portfolios with fewer stocks than many of their peers. They prefer companies that can be reliably valued with stable cash flows and a history of steady earnings. And they insist upon buying stocks that offer a margin of safety, which provides downside protection.

Is it possible for value investing to outperform active growth or indexing strategies?

Performance: Adding Value?

Let’s look at the evidence. Two recent Journal of Finance articles “On the Industry Concentration of Actively Managed Equity Mutual Funds” and “Fund Manager Use of Public Information: New Evidence on Managerial Skills” examined whether skilled managers exist.

The researchers studied about 1,700 actively managed U.S. funds from 1984-99 and 1993-2002. They found that the more concentrated a fund was – in other words, the less diversified – the better it did. The outperformance resulted from selecting the right sectors or stocks, not from market timing. Additionally, the studies found that the lower the reliance on public information and the greater the reliance on portfolio manager’s own skill, the greater the outperformance. This sounds and smells like value investing.

In a recent study published in the Journal of Investing – “Do Value Investors Add Value?” – I examined whether value investors add value over and above a simple rule that dictates they invest only in stocks with low price-to-earnings (P/E) and low price-to-book (P/B) ratios. I found that actively managed value investing outperformed both index funds and active growth management.

I first determined that stocks with low P/Es and low P/Bs beat stocks with high P/E and high P/B ratios by 2.4 per cent a year between 1985 and 1998. Between 1999 and 2007, the outperformance was 16.6 per cent per annum.

I next focused on the low-P/E, low-P/B stocks, which I carefully assessed to identify the truly undervalued stocks. I estimated the intrinsic value of each stock in this group using both a balance sheet and a cash flow approach and a lot of strategic analysis and then selected stocks that met my pre-established margin of safety.

I found that value investors do add value, in the sense that their process of selecting truly undervalued stocks produced significantly positive excess returns over and above the naive approach of simply selecting stocks with low P/E and low P/B ratios. The average annual outperformance between 1985 and 1998 was 1.1 per cent, while in between 1999 and 2007 it was 13.2 per cent.

To get a sense of absolute returns, the average annual return of the truly undervalued portfolio was 15.3 per cent in 1985-98 and 47.7 per cent in 1999-2007. This performance, on average, persisted over a 22-year period.

As noted investor Sir John Templeton said, “It is impossible to produce a superior performance unless you do something different from the majority.” Doing something different from the majority is precisely what value investing is all about.



George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario

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