All articles
Investors who allocate their capital based on value have had a terrible decade. They have seen the price of some growth assets soar, defying the valuation metric employed by even the most ardent of value-based investors. These gravity defying assets have ridden a wave of technological and social trends, and the expectation (hope!) of strong growth in the future. Many of the companies in the latter group will meet their investors hopes and dreams, but many will not.
Investing trends always go through long periods in which one or another regime holds sway. However, things have changed from previous periods in history when value lost its way. The growth in passive investing has meant that fundamentals are no longer important. As the value of those dominant growth companies increases the narrative reinforces itself driving even more capital to be allocated. Meanwhile, with the cost of capital zero investors have nothing more to hang onto than the narrative, the meme. This has catapulted the share price of bankrupt, and technology backward companies, resurrecting them from the dead.
This article outlines how we got to where we are today, and where – amid financial markets where the facts no longer matter – value-based investing still exists.
The investment risk spectrum
Before we start, it’s important to introduce the three types of investing – growth, income and value.
Growth investing is the pursuit of capital growth by investing in companies that have strong potential for expansion in the future. Typical examples of growth stocks include small-cap stocks (usually very young businesses), businesses involved in technology where the opportunity for non-linear growth is high, and speculative investments like gold exploration companies where one single find can transform the outlook for a company and its asset valuation.
Growth stocks are very difficult to value using conventional metrics. This is because investors are not betting on what the market looks like now, but what it could look like months or even years into the future. Growth investing is perhaps the most aggressive, risk seeking form of investing.
On the other end of the risk scale is income investing. Income investors will invest in a company or asset that provides a regular dividend or income stream. This type of company tends to be well established with strong and stable cash flows. Income investing tends to do well when investors become fearful. They seek the safety of a reliable company with the promise of a steady payout.
The third style of investing is known as value investing, and while it sits between growth and income it can overlap too.
Value investing involves deriving the intrinsic value of an asset independent of its market price. For example, the intrinsic value of the equity of a company can be calculated by analysing a company's assets, earnings, and dividend payouts.
If the intrinsic value of the asset is more than the current price, it is undervalued by the market and can be described as a value stock. Value investing suggests that an investor should buy and hold until mean reversion occurs, i.e., over time the market price and the intrinsic price will converge, and the asset price will reflect its true value.
A brief history of value investing
The economist Benjamin Graham is known as the father of value investing. However, the approach has been made famous by his greatest disciple, Warren Buffet, the chairman and CEO of Berkshire Hathaway. Value investing is central to Buffett’s approach, coupled with the existence of a moat to protect against competition, the uniqueness of the product and low debt levels.
Not everyone can be as good as Buffett when it comes to analysing companies. That’s why Graham advocated for an investing approach that includes a “margin of safety” to account for the very real risk of human error. For example, Graham typically only purchased stocks that were trading at two-thirds of its net current assets.
The fundamental tenet of value investing is that value matters. Value matters in the eyes of investors that adopt this approach because they believe that, in the end, value ultimately determines asset prices.
The job of analysts on Wall Street and in the City of London was to seek out assets below their intrinsic worth. A task paid handsomely for by active orientated investors eager to seek out value before the hordes piled in. Once the asset had started to find new-found appreciation by the wider investor universe, the price would rise, and at some stage, reach or even exceed fair value. At which point the value orientated investor would look to deploy their capital elsewhere.
For bettors schooled in expected value betting this will sound very familiar. Seeking out value, extracting every cent out of value you can before the bookies and the competition find out. But in the world of investing this approach is now quaint, from another era even.
The growth in passive investing
Over the past 25 years there has been an unprecedented growth in passive investing. Passive investing is a strategy that seeks to track or mirror a market index (such as the S&P 500 or the Euro Stoxx 50). In contrast, active management is all about trying to beat the performance of the broader market by seeking to uncover value propositions in the market, especially those with asymmetric return profiles.
The argument for passive investment is based on the Efficient Market Hypothesis (EMH). According to the economist Eugene Fama who came up with the theory, in “an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value.” The theory was popularised by Burton Malkiel in his 1973 book, A Random Walk Down Wall Street. According to the author the price of a stock or any other asset resembles a drunkard’s walk – meandering, erratic and unpredictable. Malkiel made the conclusion that since it was impossible for a money manager to predict unpredictable markets then it was better for investors to put their money in diversified, passive funds.
In the US, assets invested in passive mutual funds and ETFs account for between 40-50% of all assets under management depending on how it is defined. The market share of passive investment has doubled over the past ten years. Europe has seen similar growth with passive instruments accounting for one-fifth of assets. In the US, assets invested in passive mutual funds and ETFs account for between 40-50% of all assets under management depending on how it is defined. The market share of passive investment has doubled over the past ten years. Europe has seen similar growth with passive instruments accounting for one-fifth of assets.
The growth in passive investment has been a win-win for investors. Low fees and strong performance relative to active managed funds has drawn more capital into the passive investment umbrella.
Passive instruments mirror the composition of the benchmark they track, making frequent changes, typically based on the market capitalisation of the companies within the benchmark. This means that the larger the value of a particular stock, the larger its weighting in the index. This means more buying demand for that stock, pushing the share price higher, which tends to lead to an even larger market cap. This then draws in more capital, and so on and so on…
The unintended consequences of the surge in passive investment
But there’s a problem. Passive investment is backward looking. As investment funds are required to hold equities in proportion to the overall market cap the status quo becomes exaggerated. Funds must invest in stocks that form a large component of sector and national benchmarks because that is what their performance is measured against. They become must own stocks for reasons completely unrelated to their earning potential. The fund does not care about what could be, only what is. Even if the growth potential of an underappreciated small cap company looks explosive. It. Does. Not. Matter.
In a world where fundamentals do not matter anymore, the incentive to research begins to decline. For the remaining active investors, it becomes more and more difficult to hold conviction in an investment. The secret to success in active investment is recognising value and being recognised by the market later. But what if later never comes?
As discussed, a passive investment fund has a mandate to buy or sell when instructed to do so – when funds are provided or requested to be taken away. Instead of liquidity being a function of investors belief in the value of an asset, liquidity is a function of capital flow, and the latter can disappear as quickly as it appears.
Paradoxically then there is a lack of liquidity in the market. Coupled with a lack of conviction on fundamental value this means that asset values can be a lot more volatile than you would normally expect given the size of the asset. In contrast, active investors give the market depth, i.e., there is diversity of opinion, valuation, and capital to deploy both to buy and to sell. With passive investment, capital flow is everything.
Meme stocks
Zero cost of credit has prevailed across the globe for what seems like a permanent state. This coupled with the rising dominance of passive investment flows and the increased use of leverage has resulted in grotesque distortions in capital allocation. In this world the most solid underpinning to any investment is the narrative. Nowhere is this more vividly shown than in the memes that drive speculation.
According to Wikipedia a meme (pronounced meem) is, “an idea, behavior, or style that spreads from person to person within a culture—often with the aim of conveying a particular phenomenon, theme, or meaning represented by the meme.” The word first dates from the 1920’s when the biologist Richard Semon used the term “mnemes” to describe biologically inheritable memory. The meme has become a peculiarity of the social media age. Now anyone can copy and make small variations to funny images, videos or text and stand a chance that it might go viral.
If the meme is the most visible vehicle by which our narratives are carried and spread through the market, then they also tell you much about the stories that investors are thinking about right now. While those that fail to reflect the investment zeitgeist wither and die, those that do grow reinforce the zeitgeist by growing stronger. A viral meme in today’s investment world is a story that sticks.
In their book, Made To Stick: Why Some Ideas Survive and Others Die the authors, Chip and Dan Heath outline the 6 principles that makes a story a SUCCESS:
- 1. Simple: There is a reason proverbs stick; they are simple and profound.
- 2. Unexpected: Ideas that stick violate our expectations. They generate interest and curiosity.
- 3. Concreteness: Sticky ideas are often encoded in concrete language. Think of the proverb, “A bird in hand is worth two in the bush.”
- 4. Credibility: Sticky ideas force people to question themselves or others around them.
- 5. Emotion: You and I only care about an idea once it makes us feel a certain way.
- 6. Stories: Stories, whether true or false engage us. They take us on a journey, while the best captivate us.
“Stonks!”, “buy the dip”, “diamond hands, “to the moon”, “hold the line” or “YOLO”. Each of them has the 6 attributes that make them successful memes. In the absence of fundamentals, the narrative is all that matters.
One of those compelling narratives involves the arc of a protagonist (the hero) that takes on the world with his or her vision, and although experiences obstacles on the way, eventually succeeds. Elon Musk’s vision for the future of EV’s is one example. Individual investors taking on the hedge funds – the establishment – and winning is another. It’s a battle between the hero, and the villain. To buy into a meme stock and hold it with “diamond hands” is to become part of a movement, the culture that underpins the investor community.
While the internet has always been a hotbed of discussion for investment in stocks, the medium has gone into overdrive over the past year with WallStreetBets at the heart. Social media (Twitter and TikTok) combine to create FinTwit and FinTok, a place where retail investors can pump or dump whatever meme stock they take a fancy to.
In a world of low information and even less care about ‘fundamentals’, greed and fear become the dominant emotions driving markets. The meme is how it manifests itself. But it’s not just about the meme - it’s how the crowd thinks the crowd will react to the meme.
The meme beauty contest
The Keynesian beauty contest is a concept developed by economist John Maynard Keynes. It describes a beauty contest in which participants are asked to choose the 6 most attractive faces from 100 photos. The winners are those who pick out the top 6. But here’s where it gets complicated. As Keynes outlines, picking out your top 6 is not the winning strategy:
"It is not a case of choosing those [faces] that, to the best of one's judgment, are really the prettiest, nor even those that the average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees."
An investor in meme stocks must do more than stick their money in the stock whose meme they find most engaging. No, he or she must ask what everyone else is likely to pick as the next meme stock to soar “to the moon”. They then require “diamond hands” to ride the wave, cashing out before the narrative turns and another meme stock takes its place.
When will value investing come back from the dead?
As so often happens, the rest of the world are likely to follow the lead set by the US. That means the trend towards passive investment, in which the fundamentals do not matter, is likely to accelerate over the next few years. Whereas previously, an active investor may have been able to develop some alpha in an obscure frontier market, that will become increasingly difficult in the future.
Remember that passive investment has only really been a thing for the past 20 years - a microcosm of time in the history of markets. Could a seismic event force the mechanics of the market, one that is currently carried out in the shadows, to be thrust into the light?
Historically, at least one particular investment style tends to perform better than another for long periods of time – cycling between growth > value > growth > value, and so on. A change in style tends to happen near the end of an economic cycle. Over the past decade growth has outperformed value, but since the covid induced recession that regime change may be getting closer.
However, one factor that has supported the growth of the markets and passive investment has been central bank intervention – money printing, quantitative easing, etc. – and it may serve to prolong the death sentence for value investing. The actions of central banks have dampened volatility in the real world, creating the illusion of prosperity. Instead, the actions of central banks have kept various sectors of the economy on life support, neither living nor dying. A zombie economy.
Central banks have no choice. The level of debt that has built up across the economy is too large for it to do anything else. This means that there is likely to be even more central bank interference in the months and years ahead – MMT (technically “Modern Monetary Theory”, but really “More Money Today”), yield control, central bank digital currencies…
The market and the economy will eventually eat itself. That day could be a long way off, or it could be tomorrow. We do not know when it will happen, or what the aftermath will look like. What to do before the day of reckoning arrives?
Where fundamentals still live
Many of the same factors that have affected equity valuations (zero cost of capital, passive investment flows, meme’s) are also present in other more esoteric markets. They are increasingly hard to escape. Even real assets such as commodities lose their tether to the real physical world.
When the cost of capital is zero, companies can issue shares infinitum and the money printer at the central banks goes ‘brrrrrr’, investors have increasingly focused on the finite. And so, whether it is bitcoin, rare trading cards, or Non-Fungible Token (NFT) of Jack Dorsey’s first tweet or digital art, the focus of many investors has been on bidding up the value of scarce assets.
However, like any good idea it can always be taken too far, everything – even scarcity - has its price. At the peak of the Japanese asset bubble in the late 1980’s and early 1990’s prices in central Tokyo were such that the Tokyo Imperial Palace grounds were estimated to be worth more than all the land in California. The Imperial Palace was, and still is scarce, after all there is only one, but that doesn’t mean it’s value should go to the moon. Fast forward to 2021 and the narrative has evolved to the point where scarcity has never been more abundant.
There are markets where fundamentals still live undisturbed by outside forces. Sports betting is one such market.
Sports betting is arguably the only asset in which fundamentals matter. At the end of a match, game or race, a result has been declared. There is a winner, and a loser. Depending on the sport, skill and luck play a different part in the outcome. Shock results do happen every day, but over time the best players and teams tend to win.
Sports betting requires a laser like focus on value. Narratives, memes, or verbal and financial intervention by central banks - none of that matters. For the investor schooled in the principles of value investing it’s good to know that there are markets still available that haven’t lost track of fundamental value.Sports betting requires a laser like focus on value. Narratives, memes, or verbal and financial intervention by central banks - none of that matters. For the investor schooled in the principles of value investing it’s good to know that there are markets still available that haven’t lost track of fundamental value.
Value investing is dead, long live value betting.
