A hot button topic within financial circles is whether we are already in a recession, or entering one soon.
In this regard, a few questions come to mind.
Does the economy impact investing performance? Should investors worry about the big picture or should they be economy agnostic?
Long-term investors, such as value investors, believe that it is far more rewarding to focus on valuation and bottom-up analysis than the big picture.
For example, in a Nov. 1999 Fortune magazine article, Warren Buffett mocked those investors who forecast the economy in order to forecast the stock market.
The academic evidence to support this view is plentiful. Researchers at the London Business School found little correlation between real GDP growth and real equity returns during the period of 1900 to 2017 in 19 countries around the globe.
Nevertheless, Ben Graham, the father of value investing, did not advocate that investors abstract from the big picture.
He advised investors to “have an adequate idea of the stock-market history, in terms particularly of the major fluctuations. ... With this background [they] may be in a position to form some worthwhile judgement of the attractiveness or dangers ... of the market”.
In a world dominated by new algorithmic trading and machine learning, Mr. Graham’s writings become all the more important.
It’s vital to recognize that these new processes are driven by models that assign a probability of zero to something, simply because it has never happened and by rocket scientists with computer models that use the past to forecast the future and do so with completely unjustified assurance. In 2008-09, most statistically cheap stocks were sold with the same ferocity as expensive stocks.
This same scenario played out in the recent market sell-off in December 2018. In other words, cheapness protected no stock during these market sell offs. Valuation appeared not to matter. Technology and disrupting innovations are creating a whole new ball game when it comes to investing.
When faced with these new problems - high frequency trading, ETFs, robo-investing, smart beta, artificial intelligence, machine learning, statistical value investing and factor investing - what’s the best solution for value investors?
Do they need new tools and skills to survive in a world of markets that are vastly different than in the past? How can they, at the very least, learn from those who have underappreciated how grievous the impact of systemic flaws can be?
Bill Miller of Legg Mason is a good example.
After beating the S&P 500 every year from 1991-2005, Legg Mason’s Value Trust fund was down 58 per cent in 2008. The collapse wiped out the fund’s brilliant historical record.
“The thing I didn’t do, from Day One, was properly assess the severity of this liquidity crisis,” Mr. Miller said in an interview, adding that, “This is the most serious financial problem since the Depression. It is global, it is systemic, and it is unclear how the financial system is going to (a) be regulated, and (b) behave. So it is very difficult to assess right now.”
No strategy works in all markets, and no strategy works forever. It also seems that we now go from one extreme to another.
Take 2017 and 2018 for example.
2017 was one of the historically least volatile markets since the mid-60s; the last few months of 2018, on the other hand, were some of the most volatile months over the same period. Not only that, but much of the volatility in 2018 was on down days. That is why we need something over and above bottom-up investing.
Value investors address firm specific risk by applying the margin of safety. However, if the stock market is overvalued, then even statistically cheap, Ben Graham worthy stocks, will also fall.
For this reason, macro risk must also be addressed within the value investing approach and, when appropriate, hedged. This is because what will hurt investors is not just things that they do not know (captured by the traditional roulette or coin tossing based measure of risk, namely volatility), but more importantly things that they do not know they do not know (not captured by volatility).
Such risks can be minimized using put options on the market, something that Nassim Nicholas Taleb, author of The Black Swan, is also advocating because it can provide immensely asymmetrical returns in bear markets.
As the popular saying goes, a rising tide lifts all boats; but the opposite is also true. That is why worrying about the market as a whole is also important. In my opinion, investors, even though they should invest bottom up, should also worry top down.
This approach was the focus when developing a new course we are offering at Ivey’s Ben Graham Center for Value Investing titled “Strategic Investing."
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