The challenges of value investing

Unlike some people out there I am not a value investor in the true sense of the word. That is I don’t go looking for individual stocks which through the use of valuation metrics appear under priced. I would more class myself as a pseudo value investor. My strategy is to be either under weight or over weight equities depending on whether the market appears over or under valued using the cyclically adjusted PE ratio (CAPE or PE10). I now track this for 3 markets:
- The UK FTSE 100 CAPE
- The US S&P 500 CAPE
- The Australian ASX 200 CAPE

I am currently reading the book “The Greatest Trade Ever” by Gregory Zuckerman. This is the story of John Paulson who looks to have been one of the few who successfully bet against the US sub-prime housing bubble making $15 billion for his fund and $4 billion for himself in a single year. The book also describes others who also spotted that it was a bubble but for various reasons including being short to early and getting burnt or not successfully figuring out how to trade the bubble had their fingers burnt.

An interesting read however it was just a couple of paragraphs discussing two famous people, which I’ll detail later, that made me start thinking about the challenges of value investing. There seem to be two very obvious ones:
- The market can remain irrational for a long time, and
- The pull of the herd mentality can be very strong indeed

Let’s look at an example from my own investing world. Chart one shows my latest data for the cyclically adjusted PE for the S&P 500. Now picture a person value investing using this metric to time when they are in or out of the market (slightly different to me as I only vary the investment weightings meaning I am always invested to some level). Now put yourself in July of 1997. The monthly (I don’t track anything more regularly than monthly) S&P 500 price is 925 and the CAPE is 32.8.

Now you look back over history and realise that the market has only had this level of boom valuation once in the last 116 years and that was just prior to the great depression. So let’s say you decide that the market is overvalued and you sell out deciding to start buying back in when the market reaches a fair value of about 16.0 (close to the long run average). You are therefore sitting on the sidelines while the price goes to 1485 (missing potential capital gains of over 60% if you timed the market perfectly) in August of 2000 meaning you have for 3 years watched irrational exuberance bid up the market resulting in massive over valuations. Do you still feel the market is overvalued and will correct or have we reached a new paradigm? I’d like to think I could hold on however as I will mention in a minute it could be very difficult.

So in 2000 the market starts to correct and you start to breathe a little easier. The CAPE however never gets to 16.0 bottoming at 22.4 in September of 2002 with a price of 867 which is only 6% or so below where you sold out in the first place. You are then still on the sidelines though another boom where the S&P 500 price peaked at 1520 in 2007 before you can finally start buying in November of 2008 with the price at 883 which is only 5% (thanks partly due to the damage even “low” inflation can do over a long period) or so below where you first sold out more than 11 years ago! Sure you may have made money in other markets by being in bonds etc but it would take nerves of steel. Could I have held out? Again, I’d like to think so however two paragraphs in “The Greatest Trade Ever” make me wonder.

Firstly, in the early 18th century Sir Isaac Newton “decried the growing passion for shares of the South Sea Oil Company, a British company that gained a monopoly on trade in South America”. Newton surely saw the over valuation and sold his holdings for £7,000 for a 100 percent profit. So far so good. However as the buying continued at a frenzied pace even the extremely intelligent Newton couldn’t resist the pull of the herd and bought back in. The final result? A loss of £20,000. Now I know that I am nowhere near as intelligent as Newton and even he couldn’t resist the herd mentality.

Secondly, we jump to the 1920’s and Benjamin Graham. Any value investor will know the name Benjamin Graham. I think it would be fair to say for a value investor he is considered one of the greats of value investing. Well in the roaring market of the 1920’s even Graham “embraced the fast-trading lifestyle of his day, taking up residence in the luxury Beresford Apartments on Central Park, hiring a manservant, and borrowing money to expand his investment portfolio”. Graham failed to spot the irrational exuberance and his “investments lost roughly two-thirds of their value between 1929 and 1931”.

If one of the most intelligent people of all time and one of the greatest value investors of all time can get it wrong, by succumbing to the herd and not spotting the market irrationality, do you think that you could stay the course and follow your value investing principles?

As always do your own research.