Against The Tide: Value Investing in a Climate of Quantitative Easing

Last Friday, November 18, The Wall Street Journal reported that asset management titan Bill Miller had decided to hand over the reins of managing the Legg Mason Value Trust fund to a successor.  During his tenure as manager of the fund, he had the distinction of outperforming the S&P 500 index for 15 consecutive years, from 1991 to 2005. At its peak the fund swelled in size to $19.7, at the end of 2005.  Since then, funds under management have dwindled to $2.8 billion, as Miller’s knack for outperforming the benchmark deserted him. From 2006 through to 2008 the fund underperformed the benchmark, and  lost 55.1% of its value in 2008 when it was also deserted by some hefty investors.  He did claw back a substantial portion of the losses though with a gain of 40.6% in 2009, in the process outperforming the benchmark by 1400 basis points.

This year at any rate Miller has certainly not been alone in finding returns elusive. He joins such stellar names as Bill Goss of Pimco, Anthony Bolton of Fidelity and John Paulson who have all had difficult years in failing to match their benchmarks  and/or posting losses.  Notable value fund investors Bruce Berkowitz (Fairholme Fund) and Whitney Tilson (Tilson Focus) have also struggled and posted losses this year.

The Smartest Guy in the Room

As a former investor in the fund – fortunately during the good years – I met Bill Miller on a few occasions.  Apart from his investment nous, I recall that he had some interest in and involvement with complexity theory and the institute of complexity theory in Santa Fe. Also, early on in his career, he trained as a pastor for a short while. Neither of these activities is mentioned in the Wikipedia entry so I am going purely on memory here.

Bill Miller has always defined himself as a value investor, somewhat controversially so. Some, competitors especially, expressed the view during the fund’s long winning streak that he wasn’t deploying true value principles in selecting stocks for the fund and that the fund should be reclassified as something other than a value fund. But, much more importantly, he in fact helped to redefine what was thought of as value investing. As a result of inspiring a new approach to value investing, he was the first high profile value investor to arrive at the very important conclusion that technology stocks can offer value, and to back this call by amassing large stakes in certain dominant media and technology companies such as Microsoft and Amazon. Surely, value investing is doomed if application of its principles leads investors to eschew investments in companies that put innovation centre-stage, which is often the defining characteristic of a technology company!

Certain of his investments have also exposed what some tend to regard as the soft underbelly of value investing; it can give rise to a proclivity for financials. Financials tend to have historically strong underlying fundamentals, while macro investors are much more wary of them, even when the stocks are trading below book value, as currently. For example Warren Buffet, on whose investment process Miller built much of his thinking, took a $5 billion stake in Bank of America on 25 August this year. Although the share price shot up initially on news of his purchase, since then it has fallen back again from $7.65 to $5.14. This has not though prevented the Berkshire Hathaway share price appreciating from $103491 to $110525 over the same period.

Following an appraisal of what could have been done better, the approach to managing the Legg Mason Value Trust Fund has been modified to ensure that it always holds at least a market weighting in any sector that drops into the bottom decile of historic valuation ranges. Such sectors are currently healthcare, technology, and financials.  This is in response to an error committed in 2002 in not overweighting energy stocks then, which decision harmed the performance of the fund, particularly in 2006.  Other than that the worst call he believes he made was to take a big stake in Eastman Kodak, where the business environment moved against the company and did not recover.  

In interviews, Miller partly attributed the fading of his funds’ performance to the big rise of index tracking funds which has tended to render equities much more highly correlated with one another, and rendered the relative discipline of picking individual stocks less rewarding. When investors purchase an index tracking fund, all shares in the index are bought, which tends to lead to an increase in the degree of co-movements.  Indeed, high correlations between asset classes are thought to be a feature of the fear and loathing currently permeating financial markets. For example, according to the Financial Times, November 23, p33, drawing on something Bill Miller said, “...movements in shares prices have become increasingly correlated with one another, a trend that has been dubbed ‘risk on, risk off’ since the financial crisis...risk on, risk off has been the name of the game for the past two years.”       

That correlations have in fact increased is disputed by The Wall Street Journal’s Jason Zweig. He contended in an article November 12, 2011 that the increase in correlation is more apparent than real.  The article points out that “(a)ccording to data from MSCI, which tracks stock indexes around the globe, the average monthly correlation of the U.S. with the other countries in the MSCI World Index is 0.80—not far from the maximum 1.0. But at the end of April, days before most stock markets peaked world-wide, that relationship stood at 0.81. At the end of last year, it was 0.82; in March 2009, it was 0.87. Over the past 10 years, it has averaged 0.78. So, while U.S. stocks are moving very much in tandem with those of other markets, they are less linked than they have been in the recent past”.  The article also points out that the correlation with emerging-market equities has been falling lately. Zweig contends that there is a neuro-biological phenomenon at work here, in that during turbulent times the visceral response is to perceive correlations as increasing.  

Country indices may not be any more highly correlated with one another presently than at other times, but there is some evidence that asset classes that don’t normally move together, such as the gold price and particular currencies, have been moving in tandem.  It seems unlikely that a number of star managers could all have lost their touch at the same time – it is probably more the case that the investing environment has changed in ways that has undermined their investment methodologies.  The sophisticated quantitative work that would be required to establish to what extent share price movements have become more correlated, and different assets that don’t have a similar underlying rationale have exhibited co-movements, is beyond the scope of this article, but I do think there is a sense in which the investing environment has changed in ways that may be undermining careful investment disciplines, particularly that of individual share selection. 

That has been one of my concerns with the love affair central banks presently seem to have with quantitative easing (QE). They are being spurred on by a coterie of influential columnists, some of whom have very distinguished track records indeed, who appear to be inordinately impressed with the ability of central banks to create money. Now I don’t for one minute think that a return to a gold standard is warranted – why should the stock of money be arbitrarily fixed by the availability of a commodity when the availability of real goods and services is increasing all the time owing to advances in technology, additions to the capital stock, the advance of human ingenuity, increases in the labour supply etc etc?  But don’t textbook accounts of elementary monetary theory also, in addition to the lender of last resort function of central banks, also refer to money’s role as a store of value, or unit of account? In many countries, for example the UK, which has significantly negative real rates of interest on savings deposits owing to a persistent inflation overshoot, money certainly is not fulfilling its function as a store of value.

Of course, the Value Trust’s really awful year was in 2008, before central banks applied QE in earnest as a solution to economic mayhem. But even before this, as the acumen of highly skilled investors seemed to wane, the Fed had had acquired a predisposition for extremely accommodative monetary policies.

There are also those who will contend that Miller’s 15 year streak constitutes nothing more than luck, that consistently outperforming efficient markets is impossible, and that some sort of reversion to the mean is inevitable. I think it is unlikely though; Michael Mauboussin estimated the probability of his winning streak occurring through sheer chance at 1 in 23 million.  I’m not entirely convinced by the arguments presented in a letter to the Financial Times, November 26, 2011, pg 12, in which Marcin Przybyla of the European Central Bank suggests that with so many thousands of people engaged in trying to beat the markets, the odds of at least one of them consistently doing so through sheer chance is far higher, at around 75 percent. There are also those who have sought to establish whether an investor who held the fund from inception would have outperformed the S&P500 overall. This is near-to-irrelevant though – most investors would have held the fund for a much shorter duration.          

An early (classical), sophisticated, monetary theorists was Wicksell, who drew an important distinction between the money, real, and natural rates of interest. The money rate of interest is the interest rate one observes in the market, the real rate of interest is the money rate of interest minus the expected inflation rate over the period applicable to that rate of interest, and the natural rate of interest is unobservable but determined by the marginal productivity of capital. Although the central bank can’t determine this exactly, it is vitally important for the stability of the economy that the central bank endeavour to set the money rate of interest so that it is aligned with the natural rate of interest. Set it too low and the economy will experience an investment boom and eventual inflation; too high and the economy enters a deflationary spiral. 

Now, in recent decades we have witnessed instances of economies, first and foremost of which is Japan, that have combined very low interest rates with very sluggish or non-existent economic growth. The overwhelming consensus among economists is that when economic growth is slow, this implies that interest rates should be set at low levels, since savings and investment won’t be aligned except at very low rates of interest, although they don’t often couch their remarks in terms of the natural rate and the productivity of capital.

But I have sometimes wondered; what if there is causality operating in the opposite direction too?  What if establishing a very low money rate of interest diverts flows of capital in such a way that capital becomes misallocated, lowering the productivity of capital, the natural rate of interest, and contributing to slow growth in the economy? What if maintaining a perpetually low money rate of interest erodes the income of savers to such an extent that a short-fall of aggregate demand opens up that exerts a brake on the secular growth rate of the economy, opposite to what is intended?

It would be beyond the scope of this article to construct a model to attempt to explore the possibly of reverse causality, or perform tests such as Granger causality on a well-specified econometric model in order to try to determine the direction of causality. But it would seem to follow that under circumstances in which the monetary policy regime does contribute to a misallocation of capital, then this would also contribute to a lowering of investment returns.

One aspect to developed country efforts to add to the monetary base of their economies through QE is soaring levels of cash balances at corporations. On 28 May 2011, The Wall Street Journal contended that  “(t)here is a cash crisis in corporate America – although it comes not from a shortage of the stuff but from a surplus”. Cash held on balance sheets by the companies that constitute the S&P500 at that stage amounted to a record $960 billion. Against this, the dividend payout ratio at 28.9% was the lowest since 1936! To set this in context, legendary value investor and thinker Benjamin Graham believed that a good rule of thumb would be for companies to return around 2/3 of surplus cash balances to investors in the shape of dividends.

Allowing for the fact that the scope of the operations of many of today’s corporations are global, and that repatriating cash balances from abroad might incur tax payments that might otherwise be avoided, the payout ratio that then prevailed is well below the payout ratio of just below 50 percent that has tended to prevail over a long sweep of time.

The trouble with companies accumulating such large cash piles is that it tends to be poorly spent. The WSJ article referred to above cites the Microsoft purchase of Skype for $8.5 billion as a possible example of poorly deployed corporate cash. However, for Microsoft the sum of money spent accounted for merely the cash raked in over one quarter. Assuming it continues to amass cash at the same rate, it will be under pressure to make further such acquisitions. This is just one mechanism by which QE, by fostering a very low interest rate regime and contributing to a build-up of corporate cash balances, and an overall abundance of cash, might lead to a misallocation of capital over time. 

For traditional value investors, the dividend yield is a crucial metric. If its role becomes diminished, this removes an important tool from the toolbox of the value investor.  Not only that but long-term studies of stockmarket returns have tended to show that investors set too much store by anticipated capital appreciation; that a surprisingly large portion of returns garnered from stockmarket investments over time have accrued from dividends as opposed to capital appreciation.       

But, recent years have brought a new dimension to bear in the shape of activist monetary policy.  Whenever markets have wobbled to some extent, investors and commentators have with increasing stridency agitated for a further burst of QE that becomes ever more vociferous until the relevant Central Bank has capitulated and given in to market demands. The latest target of such attention is of course, the ECB.

Patterns of alternatively rising and falling markets punctuated by bursts of QE are indeed, very macro driven market environments.  If, on every occasion that markets wobble and become cheap this is counteracted through a burst of monetary stimulus, this pattern works to the advantage of certain types of investors, but to the detriment of others.  If all the world’s tennis tournaments were suddenly to be played on clay courts, certain tennis players would thrive while others presently thought of as great players would drop out of the top ten altogether.

Likewise, in order to prosper value investors need markets that for a time are overall cheap and undervalued and dominated more by stockpicking considerations than macro and political developments. And value investors fulfil a very important role in markets. They tend to have longer time horizons than other investors, and their trades tend to counteract the pressures towards short-termism in markets and companies that are often bemoaned by policy makers. They help to keep markets honest through their relatively labour intensive approach to investing. They fulfil a social good in contributing to the diversion of capital to the companies that can put it to best use.

Even at the best of times, value investing is not for the faint hearted though. It tends to produce greater volatility of investment returns than other styles, such as growth and momentum approaches to investing. Value investors have to learn to live with extended periods of underperformance as a necessary price to be paid for ultimately superior long-run returns. It’s a difficult business model for a fund management company to deploy; there is the continual risk that investors with shorter time horizons than the fund will withdraw their investments during periods of underperformance.           

Index tracking, investing in index funds, and riding waves of momentum may all be more appropriate investment styles for a market environment of which a major feature is extremely low interest rates and QE. But, while there is a compelling logic behind index tracking, it has to be acknowledged at the same time that index trackers are free-riding off the knowledge gathering efforts of others.  Index tracking works off the efficient markets assumption that all important information has already been uncovered and captured in market prices so that there is little if any benefit to be derived from doing stock analysis oneself, or paying for research from a reputable firm.

There is another, more pernicious effect of an investment climate dominated by monetary policy.  Instead of conducting research to generate profitable investment opportunities, it then becomes very important to establish contacts with people in positions of authority, who may then drop hints about the future intended actions of the monetary authority. Investment success becomes predicated more on who you know rather than what you know. An article on November 24 in the Wall Street Journal recounts how Nancy Lazar of top-ranked economics firm ISI discerned from an August 15 meeting with Fed Chairman Ben Bernanke that the Fed was about to embark on a new version of the old idea of “operation twist”, of purchasing long-dated treasury bonds and selling short-dated treasury bills in an endeavour to lower long-term rates in relation to short-term rates. She placed a call to clients and a profitable five-week window of opportunity was opened-up during which time investors were able to participate in the renewed impetus to the bull market in long-term bonds. By the time the operation of the Fed was announced on September 21 and became public knowledge, the opportunity to garner profits had largely evaporated as the market had anticipated the Fed’s move. Others reportedly privy to the impending policy shift were Richard Tang of the Royal Bank of Scotland and Jan Hatzius of Goldman Sachs. Small wonder then that Bill Goss’s shortening of the duration of the bond exposure of his fund earlier in the year on the basis of fundamental analysis was overwhelmed by such developments and led to lame returns for the funds he managed[1].                            

The conclusions I draw from this is that while the fashion for QE has created a difficult environment for fundamental investors of all stripes, and particularly for value investors, and this has contributed to the difficulties Bill Miller and others of his ilk have experienced, it is not right to call time on value perspectives in investment strategy and fund management. The FTSE for instance has delivered its longest losing streak since January 2003. During this time value has underperformed the major indices, for an extended period of time in the US. I recall that Tiger Asset management closed its doors and returned to funds to investors in late 1999, when the fund managers determined that they could no longer make sense of the ruling investment climate. With hindsight, this marked what proved to be almost the pinnacle of the ascendency of growth styles of investing over value for many years.  While the debt crisis of the Eurozone continues to brew and the likelihood of markets being swamped by an influx of cheap money remains, it will continue to be a difficult trading environment for value investors. However, when the losing streak ends and markets rebound on a sustained basis, it is likely that value styles of investing will return to the fore and outperform on the way up. Meanwhile, the discipline introduced into the Value Trust fund, of having holdings of at least market weight in any sector at the extreme low end of the historical valuation range appears to be a good one, although judgement, especially in the case of financials, should always be allowed to override purely mechanistic approaches.  Technology stocks and healthcare appear to be of particular interest currently. The best businesses in both sectors tend to be driven by innovation, which is also a characteristic of our principle interest; renewable energy.              

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[1] Lest the reader get the wrong impression, conversations between Fed officials and prominent market participants are legal; the Fed is entitled to attempt to discern from market participants the likely market reaction to policies under consideration