On the Role of Timing in Value Investing, What to Buy?, and a Growing Global Cancer Epidemic!

From: Aditya Rana
Date: Sat, Feb 22, 2014 at 12:41 PM
Subject: On the Role of Timing in Value Investing, What to Buy?, and a Growing Global Cancer Epidemic!

Hi!,

Value investing – i.e. buying undervalued assets which should provide superior returns over time – is a fairly straightforward concept but its implementation is fraught with difficulties, with the most vexing issue being timing. Ben Inker, co-head of Asset Allocation at the famed value manager GMO, provides an interesting analysis of this key issue in their latest quarterly with some helpful practical takeaways (http://www.gmo.com/Asia-Pacific/Research/Letters/default). To summarise:

-Value managers are supposed to buy assets when they are cheap and sell them when they get expensive – but how does one exactly implement this strategy? The answer is simply to invest slowly – both for bottom-up security selectors and asset allocators.

-The technique of "slicing", which bases investment decisions not on just the current "spot" fair value but also takes into account fair value estimates over the last year or so, reduces the impact of temporary changes in data and naturally slows down the investment process.

-A historically very powerful reason for investing slowly is the counter-intuitive fact that buying assets which were the cheapest a year ago (irrespective of their current valuation), has outperformed both buying assets which are currently the cheapest or were on average the cheapest over the past year.

-Their experience in investing in international developed country portfolios clearly demonstrated that buying countries which were cheap a year ago ("lagged value") outperformed buying countries which were cheap today ("spot value") – i.e. buying the two cheapest countries today outperformed the average country by 2.8% over the next year while buying the two cheapest countries a year ago outperformed by 7.4%. This was for the period 1978 until 1999.

-The easy answer is momentum – i.e. that countries have got cheap because they were underperforming and are likely to continue to do so for some time, while waiting a year would allow the negative momentum effect to wane. This is corroborated by the data – the two countries which exhibited the best momentum in the prior year also outperformed by 7.4%, just like the lagged value.

-However, since 1999 both the spot value and momentum investing strategies have actually underperformed the average country by about 0.5% per year, while the lagged value strategy has outperformed by 1.8% per year. While part of the reason is that basing investment decisions on countries (for the developed world) is far less important today than 30 years ago, the outperformance of the lagged strategy continues to be widely prevalent and remains a puzzle.

-Even applying the traditional value criteria for stock selection – the price/book method as suggested by the Fama and French in 1992 – i.e. buying the cheapest 10% of the market would have outperformed the market by 2.5% per year since 1965. However, since 1992 that strategy would have underperformed by 1.6% per year, while the lagged value strategy would have outperformed by 3.5% per since 1965 and 2% per year since 1992.

-While a lagged strategy works well and allows a value manager to capture returns from trading in and out of assets which look cheap, it does not have a well understood (and therefore easily explainable) rationale for investing and there is no solid underlying reason why it will continue to outperform, making it difficult to stick with when it really counts. Slicing is therefore a more practical strategy for value managers as you are almost always moving in the direction of cheap assets today.

-Their experience during the financial crisis was revealing – while they steadily bought falling equities during the November, 2008 – March, 2009 period, they found themselves paralyzed when the market rallied strongly in March and April, 2009, unable to buy more equities which had recently been 20% cheaper, and looking for the proverbial pullback to buy (which never happened!).

-The following table illustrates the performance of four value strategies versus the standard 65(equities)/35(bond) portfolio over the financial crisis.

-Over the three years from 2008-2010, the 65/35 portfolio lost about 2%, initially falling by 34% and then rising by 48%. All the value strategies did better, with the spot value approach performing the worst (saving only 3% on the way down), while the lagged value strategy did the best – initially falling by 19% and then rising by 41% , resulting in a 14% return. The sliced value approach – basically a blend between the spot and lagged value – come in between the two with a gain of 11%. The sliced and then "frozen" portfolio underperformed the sliced strategy by 3%.

-Currently equities look expensive, after having risen from close to normal levels (given the low level of interest rates) a year ago and a slicing strategy warrants selling equities slowly through this year. The selling maybe faster if equities continue to rise and slower if they fall, thereby ending the year with significantly less equity than the 50% at the start of the year (unless equities fall faster than they did during 2013).

Deeply insightful piece with powerful implications for managing an asset portfolio. Clearly, a slicing strategy makes sense and is quite defensible if one is managing third-party money while a lagged value strategy perhaps seems to consist of a value strategy with an overlay of momentum – i.e. buy cheap stocks/assets which have begun to be appreciated by the market. However, the overriding principle is simple – buy (or sell) slowly – i.e. quarterly/semi-annual revaluation and rebalancing with the resulting purchases (sales) spaced out over perhaps three months.

Regarding the current market, a slicing strategy would imply slowly reducing risk positions while a lagged value strategy would imply actually (slowly) increasing risk positions! At this stage, I am more inclined to follow the latter strategy as expected action by the ECB on announcing both a banking union and a QE program would provide powerful support to global risk assets. Regarding the QE program, it is currently rumored that the ECB is finalising a plan involving a size of Euro 400 BN , with government bond purchases linked to the GDP weighting of the respective countries, thus making it a monetary stablisation program aimed at stabilising inflation which would be more in line with the ECB guidelines and therefore make it more acceptable to Germany. Such a program would also provide significant support for gold prices.

Applying the lagged value approach, and using GMO valuations from a year ago, point to being overweight EM, timber and US high quality equities.

A Growing Global Cancer Epidemic?:

An important update on the growing incidence of cancer worldwide from the WHO:

4 February 2014. BBC

-The globe is facing a "tidal wave" of cancer, and restrictions on alcohol and sugar need to be considered, say World Health Organization scientists. It predicts the number of cancer cases will reach 24 million a year by 2035, but half could be prevented.

-The WHO said there was now a "real need" to focus on cancer prevention by tackling smoking, obesity and drinking. The World Cancer Research Fund said there was an "alarming" level of naivety about diet’s role in cancer.

-Fourteen million people a year are diagnosed with cancer, but that is predicted to increase to 19 million by 2025, 22 million by 2030 and 24 million by 2035. The developing world will bear the brunt of the extra cases.

The WHO’s World Cancer Report 2014 said the major sources of preventable cancer included:

-Smoking

-Infections

-Alcohol

-Obesity and inactivity

-Radiation, both from the sun and medical scans

-Air pollution and other environmental factors

-Delayed parenthood, having fewer children and not breastfeeding

-For most countries, breast cancer is the most common cancer in women. However, cervical cancer dominates in large parts of Africa.The human papillomavirus (HPV) is a major cause. It is thought wider use of the HPV and other vaccines could prevent hundreds of thousands of cancers.

-"In relation to alcohol, for example, we’re all aware of the acute effects, whether it’s car accidents or assaults, but there’s a burden of disease that’s not talked about because it’s simply not recognised, specifically involving cancer. The extent to which we modify the availability of alcohol, the labelling of alcohol, the promotion of alcohol and the price of alcohol – those things should be on the agenda." There was a similar argument to be had with sugar fuelling obesity, which in turn affected cancer risk.

-Meanwhile, a survey of 2,046 people in the UK by the World Cancer Research Fund (WCRF) suggested 49% do not know that diet increases the risk of developing cancer. A third of people said cancer was mainly due to family history, but the charity said no more than 10% of cancers were down to inherited genes. "It’s very alarming to see that such a large number of people don’t know that there’s a lot they can do to significantly reduce their risk of getting cancer. "

-"About a third of the most common cancers could be prevented through being a healthy weight, eating a healthy diet and being regularly physically active. These results show that many people still seem to mistakenly accept their chances of getting cancer as a throw of the dice, but by making lifestyle changes today, we can help prevent cancer tomorrow." It advises a diet packed with vegetables, fruit, and wholegrains; cutting down on alcohol and red meat; and junking processed meat completely.

Here’s to a healthier lifestyle and diet as the best preventive medicine!

Regards,

Aditya

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