The carnage that ripped through the capital markets last year imparts many lessons, including one people forget when times are flush: Value matters.
One important reason-maybe the main reason-many investors are grieving today over their battered portfolios is that they ignored this sage advice in the bull market that preceded last autumn's collapse. Using company valuation as a guide to managing asset allocation isn't a silver bullet, or course. But if you neglect it, you're almost surely an accident waiting to happen.
Fundamental valuation separates investing from speculation. This is an old idea in the money game, but it's rare that the case is so convincing as now-a time when market history, finance theory and even common sense speak clearly about putting valuation first no matter what the times are, good or bad.
Of course, there's not much appeal in it for those seeking a short-term trading strategy. Indeed, a value-oriented asset allocation framework is likely to shine, instead, over the long haul, as a risk-management tool rather than a return booster. Still, these days that proposition might sound very attractive to a lot of people. Investors have rediscovered that it's essential to smooth out rough edges in the volatility of their investments over a business cycle or two if there's any hope of achieving their long-term financial goals.
The modern incarnation of value investing traces its roots to Benjamin Graham and David Dodd's 1934 Security Analysis, currently in its sixth edition. The book, widely hailed as the value investor's bible, preaches that market prices can (and do) deviate from a security's "intrinsic value" and investors should exploit the gap when the opportunity arises. Buying at a "margin of safety" improves the odds of capturing relatively higher expected returns, the book advises. Meanwhile, it's also critical for the investor to cast a wary eye on assets trading at rich multiples.
Value investing was originally conceived for those picking individual securities, and Warren Buffett and other Graham disciples have put it to good use over the years. Applying those lessons to markets overall, however, is no less compelling these days, in part because of the proliferation of mutual funds and ETFs that target asset classes in broad and narrow terms. Academic literature has also supported transplanting a value-oriented view of investing to asset allocation, and has been moving ever closer to Graham's views since the 1980s.
From a 21st century perspective, modern portfolio theory (MPT) and value investing now share a fair amount of common ground. It's easy to think otherwise, since these two concepts of money management as originally conceived stood in opposition to each other and seemed like natural adversaries.
Modern portfolio theory, after all, spawned index funds and the view that market prices are the best estimate of a security's worth. This idea has always seemed to contradict Graham's value strategy, which asserts that market prices are wrong at times and thus give enlightened investors a chance to second-guess the market and profit from their insight.
What seems to keep the two theories apart is the popular notion of MPT, which remains stuck in the 1960s and 1970s, bogged down by earlier interpretations of the efficient market hypothesis and indexing. By the earlier standards, markets were assumed to be completely unpredictable, according to a strict interpretation of the random walk theory for describing market behavior. In turn, that implied that asset allocation should generally remain static and unchanging, come hell or high water.
But that rift has closed, and a growing body of research in financial economics has more closely seen modern portfolio theory dovetail with the value camp. The two now share some basic assumptions, thanks to the evolution of MPT over the years. It raises the possibility that something akin to a grand unifying theory of investing is at hand.
Should financial advisors care? Absolutely. If the classic strategies of active and passive investing are more closely aligned in favor of value investing than previously recognized, the union lends more authority to a value-informed view of investing strategies generally. This is true for both stock pickers and those using index mutual funds and ETFs to build portfolios.
In other words, we're all value investors now, or at least we all should be. That's the message in the financial literature. A more practical-minded review of market history only strengthens the case.
Consider, for instance, the Boston-based GMO LLC, a value-oriented investment firm that's been warning clients for several years that high market valuations threatened the outlook for equities. Its long-term forecast for ten asset classes published a decade ago now looks unusually prescient. GMO's ten-year outlook for U.S. stocks in 1998 called for a roughly 1% annual loss for the S&P 500 for 1998-2008. The actual performance was essentially flat.
Sage insight, or just dumb luck? No one can say for sure either way, of course. But this much is clear: GMO and other like-minded value shops had been advising clients for several years ahead of 2008 that lofty valuations and unattractive investment prospects were a clear and present danger. So it was hardly rank speculation. Rather, the increasingly cautious outlook among value investors was driven by a pragmatic reading of the fundamentals.
True, the warnings came too early for some investors. Anybody who followed the advice would have had to turn cautious and sacrifice some return at the height of the most recent bull market, one that ran on longer than many thought possible. But in hindsight, it looked like a small price when you consider what happened to the perma-bulls.