Monday, January 23, 2006

Value Investors as Market Timers

A very interesting debate is taking place among fellow value bloggers, Geoff Gannon of Gannon on Investing and Bill R. of Absolutely No Doodahs. Involved as well are Shai Dardashti and Arpit Ranka. The debate centers on one primary issue, the usefulness (or otherwise) of technical analysis and whether value investors can be both.

Here are the relevant links:

Geoff Gannon: On Value Investors as Market Timers

Bill R The Problem(s) with Value Investing
Technical Analysis and Value Investing

Shai Dardashti Is there Value in Technical Analysis?

Arpit Ranka Is There Time for Timing?
Lessons Taught by a Coin

I will share a little of my own perspective, but I am afraid, little incremental value to this debate. If what I suspect is true, I may well be the ancient amongst this group of bloggers, having been a portfolio manager since 1980 and an analyst and investor for five years prior thereto!. Consequently, I may have the dubious distinction of having made more investment mistakes than anyone else here and have tried many approaches to finding an investment nirvana. As Buffett says, there are many ways to get to heaven, and I believe that a blending of disciplines is conceivable and in fact beneficial.

Efficient Markets Hypothesis, as Bill points out, tends to dismiss technical analysis out of hand. Historically, so did I. When EMH died, largely due to what academic finance refers to as anomalies, the weak form of EMH which dismisses technical analysis seemed to be the only remaining tenet. I must confess that in my zeal for fundamental analysis I too dismissed technical analysis. After all, how many chartists do you see on the Forbes 400 list?

My fundamental approach to valuation is similar to that of Geoff, I do attempt to seek intrinsic value primarily through DCF analysis. Such valuation models produce a theoretical value of a company based on your own set of assumptions, in my case, using estimated operating margins, working capital and fixed investment needs, tax rates, and growth rates. The result is calculated for my estimate of a competitive advantage period, the toughest estimate of all. After all, competitive strategies and the competitive landscape will change. I adjust my discount rate according to the variability of the cash flow stream. This is the art in fundamental analysis…a DCF is nothing more than a calculator…it will produce a value based solely on your inputs, garbage in, garbage out. It is the underlying analysis and judgment that brings value to a calculation of a DCF. Bear in mind that there are other sources of value beyond what you see in the cash flow stream. Patents and other intellectual property, licenses, ownership rights, investments in minority held subsidiaries, real estate, etc…the value of these in a DCF is zero! I frequently need to remind myself of the value of these non DCF inputs.

Arpit’s coin toss experiment has been used to ridicule technical analysis and is available on several websites. Arpit’s use of behavioral finance axioms develops some excellent arguments against technical analysis and for a single-minded approach. His logic is irrefutable. But let me tell you about my own experimentation.

Back in the early 1990’s, I spent a great deal of time back-testing Berkshire’s portfolios to see if I could decipher what it was that WEB was doing. I felt, and continue to believe that one can replicate or at least approach his results. (This is an experiment that Shai is currently undertaking.) The advantage that Buffett has on me, beyond wisdom, brilliance, and all-around intelligence, is a negative cost of capital created by insurance float. His ability to assess long term returns on capital and appropriate discount rates in assessing them is the key to understanding value investing. I believe that WEB’s rate of return, without the benefit of negative cost of capital, is about 14%...still outstanding, EMH defying returns.

I believe that through discipline, any of us can achieve such returns but with one proviso…I learned that using some relative strength or momentum measures as an adjunct to determination of return on capital would add about 1.5% to 2% to the back-tested results. As a fundamentalist down to my toenails, I was shocked by this finding. Yet backtest after backtest, it came through.

Even some academic studies have endorsed the “serial correlation” or sustainability of momentum. (Hope this appeals to your superb statistical understanding, Bill!)

Grundy & Martin

I do NOT suggest that WEB in any way uses such a method. Negative cost of capital provides a far better performance than relative strength will. I will accept any help from any methodology that I can get!

My advice:

  1. Find a discipline in which you can excel. If fundamental analysis seems too rigorous, find a technical approach and learn it well. Though most academic research refutes it, some people, especially using cyclical stocks, have been terrific investors.

  2. Use and appreciate a DCF model. Understand what it captures in your assumptions, and what it misses and dismisses.

  3. Add to your core fundamental performance incrementally using relative strength approaches.

  4. Understand behavioral biases. Identify and understand the biases of managements as well as those of the masses. Control your own.
So where do I stand? I believe that a successful approach to investment can incorporate several methodologies. My primary approach is entirely fundamental and is the basis for any investment I make. I am a great believer in behavioral finance and having an understanding of where opportunities can arise or where short-circuited thinking can fail me. This is always a subsequent test of my fundamental modelling. Finally, I have learned to incorporate some momentum measures into my thinking and entry points. I did it reluctantly, but the backtests demonstrated incremental return.


At 3:37 PM, Blogger NO DooDahs said...

"After all, how many chartists do you see on the Forbes 400 list?" I didn't see too many pure stock market value investors there, either, folks. Most of the people I saw there got there by starting (or inheriting) a business - which oddly enough is how most of the millionaires in the U.S. get made. But I digress ...
See the 9th paper down, post was made Jan 1 2006. It's a good paper.

Thanks for the props! I appreciate all the traffic I can get!

At 3:52 PM, Blogger Rick said...

Thnx for the comment Bill. In the top 100 of the Forbes 400, I counted 17 people who, though they may have developed a business successfully, preserved and grew their wealth through fundamental investing. Still looking for the technician in that list. I do appreciate the list of papers regarding momentum investing. Is the only form of technical analysis that works momentum and relative strength? In my opinion, this is the only successful technical discipline. Do you agree?
Thanks for your comments and your posts!

At 6:03 PM, Blogger NO DooDahs said...

"Preserved and grew" is much different from "gained" is it not? You also probably don't know to what extent most of those 17 considered technical factors as an adjunct to their selection or timing of purchases.

While momentum and relative strength are the most-tested and robust TA disciplines, I do believe there is merit in the concepts of support, resistance, overhead supply, and sentiment. It's just much harder to document them in a published paper, in part because it's harder to get the data. For example, where do you get put and call volume on stocks from 1950?

I also think that candlecharts give an excellent visual clue to short term changes in sentiment.

Lastly, I think changes in volume and trend that correspond give a fine clue to stock movements. Take a look at this.

At 9:54 PM, Blogger Rick said...

Thnx again for your thoughts. I agree that momentum and relative strength are the most "proven" and demonstrated of technical disciplines which is why I have availed myself of them. I also believe that many behavioral finance concepts are generally academic "speak" for "sentiment." But honestly, at least in my realm of experience in working with some ultra-wealthy people, only one has ever given charting any open consideration. This gentleman had made a fortune in commodities and currency trading employing primarily TA but wanted to have his capital redeployed in value strategies. He viewed his technical prowess as something that was useful to him in trending inflationary commodity markets. He caught the wrong side of the deflationary 80's and came to me in 1990 to preserve and grow his capital. We both gained! Sample
The traditional tests that dismissed technical analysis I believe were ill-conceived. I do believe that serial correlation does exist and some filter rules may work. However, demonstrating quantitatively what a resistance or a support line represents is subject to much gray interpretation. That's not to say it isn't useful to some. Just hasn't been for me. I remain open-minded and agnostic as far as broader interpretation of TA. It's been a fun trail of posts!


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