The Evaluation of Common Stocks
by David Merkel, Aleph Blog
Today, Tom Brakke of the Research Puzzle wrote:
“Go to it then. The field is wide open. The old masters have confessed their inability to determine value objectively. More investors than ever before are committing their capital to stocks. Very little has as yet been done in the field of stock evaluation by statistical organizations — and I say this with full awareness of our own efforts in the past 21 years. Here in the field of stock evaluation you will find a worthy challenge to your intelligence, and exciting adventure too.”
— Arnold Bernhard, founder and editor of the Value Line Investment Survey.
The above excerpt is the last paragraph of Bernhard’s 1959 book, The Evaluation of Common Stocks. It is interesting to consider the changes since that time and to ponder the opportunities (or lack thereof) that exist now as a result of those changes.
Is the field still “wide open” for the enterprising investor?
When I was writing my Master's Thesis at Johns Hopkins at the tender age of 21, I did a significant study on what did and didn't work in stock investing. My unpublished Master's thesis anticipated momentum investing, but I did not get it at the time. It also showed that value effects could make money, as well as tracking insider trading.
My life might have been quite different if I had started a hedge fund in my 20s off of my thesis... might have been richer, but my knowledge of of business was enriched by being an actuary for so many years... admittedly, I was not your normal actuary, but having to solve practical business problems does shape your views of many other things.
But Value Line, as created by Samuel Eisenstadt, discovered quantitative growth investing -- price momentum, earnings momentum, and earnings surprise long before the rest of Wall Street caught on. Once Wall Street caught on in the 90s, a lot of the excess profits got squeezed out, and Value Line lost its mojo.
As an aside, when I was running a set of multiple manager funds that did pretty well in the 90s, one manager had its methods and they were price momentum, earnings momentum, and earnings surprise. I said to them, "Oh, you do what Value Line does." They were as offended as they could be without poisoning the possibility of being hired by us.
In another situation, I ended up hiring a value plus momentum manager in the mid-90s. Very reliable outperformance.
But let's go back a little further. After the Great Depression, a lot of companies sold for considerably less than their net assets. This diminished but held true until the 60s. Ben Graham earned his living from arbitrage and net-net value investing. Buffett, getting started later, did much the same, but being younger, reached a point where the easy opportunities were largely gone, but he had a lot of his investing life in front of him, unlike Graham, who picked that time to retire.
Value investing I do not think is tapped-out, though beating value indexes is difficult.
In the 80s, quantitative value came into existence, along with momentum and size as factors. But throughout the 90s insider trading, net operating assets, distress and other factors began to be modeled. Now there are many quantitative factors, and it is hard to tell which are redundant.
With Graham, and Buffett and Eisenstadt in their early years, financial data did not flow easily... those who put in the hard work of gathering scarce data earned exceptional returns. Today, with the internet, mere quantitative investing yields less of an advantage. In order to do anything worthwhile some qualitative knowledge must be mixed in, or, proprietary data that few have.
Tom asks if the field is wide open. I don't know. We've had a lot of discoveries over the past 50+ years, but discoveries are sometimes "forgotten" when they lose their punch. There may be future discoveries, whether from technical or accounting measures. I am reluctant to say everything that can be discovered is discovered, but I don't want to say that there will be some earthshattering theory in the future... that may not happen.
What might happen is an economic disaster like the Great Depression that makes many flee stocks. Then some of the older theories will work again for a time. So I would answer Tom -- is the field wide open? No, but it is open somewhat, and with a lot of application and intelligence, it's possible but not likely that you will do something amazing.
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