Utterly Styleless

As in a number of other disciplines, investors groups themselves according to some (often arbitrary) criteria. It goes with the in/out tribal nature of humanity. Are you a liberal or a conservative, a frequentist or a Bayesian, a value investor or a growth investor?

Value investing means buying stocks that appear cheap on current multiples and growth means buying those that seem cheap on future multiples. Regardless of which so-called “style” an investor follows, the objective of active management – to outperform passive alternatives – remains in tact. So why do investors pitch their tent in one of the two camps?

The origin of the distinction between growth and value can be traced to a paper written over 20 years ago by two of the most respected academics on the topic of asset pricing. Fama (a 2013 Nobel prize recipient) and French argued that the CAPM failed to accurately price the risk on smaller companies (the “size effect”) and those with low price to book (the “value effect”).

This gave a boost to an already-blossoming line of literature examining various anomalies, or breaches of the predictions of the CAPM. Some demonstrated that buying stocks in January and selling in May outperformed, others showed that buying stocks just before they reported results paid off over time. But the most pervasive, from the point of view of the design of the asset management industry as we know it today, is the idea that most stocks fall into one of two categories, value or growth, and managers should behave differently depending on the category they are involved with.

Commentators like James Montier have argued that investor overpay for growth and that value is the only discipline the sensible investor should follow. This line of reasoning extends an approach to investment analysis that can be traced to Graham and Dodd’s Security Analysis textbook. Published in 1934, well before the formulation of the CAPM, the approach advocated by Graham and Dodd has been spliced with the results from Fama and French to give an ostensibly credible lineage to value-investing. But Graham and Dodd neither coined the term “value-investing” nor did they draw a distinction between two styles of investing. Graham and Dodd simply laid out analytical tools for determining whether a stock was cheap given the risks – this is what investing is and should be about, regardless of style.

Value investors expect a specific trajectory in earnings (or cash flows) much the same way as growth investors. Getting this right is more important than being in the right camp to start with. More often stocks don’t fall cleanly into either category and crude criteria such as price to book and price to earnings brush over accounting differences, leverage and the organic sustainability of earnings at the expense of the efficient pricing of risk.

So, there’s nothing fundamental to the style distinction. The two categories exist due to the flaws in a now-debunked theoretical framework, the CAPM. If the theory was better to start with, Fama and French would not have found these exceptions. But we would still stick to the principles laid out by Graham, Dodd, Buffett, Marks and a host of other successful investors – we would just call it “investing” and we would do it without style.

What Investors Don’t Get About Buybacks

Shareholders trust the management teams of companies to make sensible use of the profits generated. Investing those profits wisely can greatly increase future profitability and, hence, shareholder return. Overpaying on an expansion project, for example, will do the opposite. Recently there has been increased focus on companies using their cash stacks to buy their own shares rather than looking for good ways to invest to grow. The question I am going to address is (and it’s an important one) is Does it matter at what price a company buys its own shares?

The intuitive answer, and one that many professional investors and commentators would give, is “of course, buying at a lower price is always better”. The reasoning is that companies that buy their stock before the price goes up get more bang for their buck than those that buy before it goes down. As a result, investors scold companies that buy at or near peak levels in their share prices (this article from Fortune is one of a very large number I found online).

But it actually does not matter. In fact, I can reverse the intuitive answer with two simple arguments:

(1) The shares the company buys get cancelled. The company is not investing in its own shares. Shareholders have no claim on the shares that are bought back and so do not gain or lose if this is done at a high or low price.

(2) When a company buys back its shares, it is buying them from shareholders. Shareholders always prefer to sell shares at a high price and therefore should thank any company that buys from them at such a lofty level.

Argument (1) is pretty solid but I think it’s worth digging into (2) in more detail. Shareholders as a group should prefer the “buy high” approach, but at the individual level those that sell to the company at the peak are better off (following a subsequent fall in price) than those who choose to hang on. That the latter group did not sell at the peak is not the fault of the company or in any way linked to a buyback or lack thereof.

Here’s another way to think about it: if companies had perfect foresight on their share price would they still buy back shares today if they knew the price would be lower in a week?

This is not just a theoretical exercise since companies do have inside information that can give them a sense of the short term trajectory of their share prices.

The answer, again, is that it does not matter. Neither the shareholders nor the company is better off if the buyback is delayed. The company can buy more with a fixed pot of cash if it waits, but the total value of equity following the buyback will be the same regardless of the timing.

However – and here’s where the intuitive answer starts to look (somewhat) good again – the share price will actually be slightly higher in the case when the company delays the buyback (let me know if you want proof of this). Any shareholder who would not sell regardless of when the buyback takes place is better off if the company waits a week. But, shareholders on average will not gain from this “buy low” strategy and, if the company does not buy at today’s higher price, shareholders miss out on the option of cashing in at a better price.

The discussion should not focus on whether timing buybacks in a certain way creates shareholder value (it does not), but how the decisions of individual shareholders to sell or not seem better or worse as a result of the timing. The actions that a subset of the shareholder base might take should not determine the way in which companies divvy out the spoils, so shareholders would be better off redirecting their attention to monitoring the use of the cash that actually stays in the company.

Why Good Luck is a Bad Look

When a combination of skill and luck is what determines whether you win or lose, the skillful tend to win over time. For short periods of time the lucky can imitate the skillful (the signal is blustered by the noise), but there are several reasons why this can’t last. As Michael Mauboussin has been calmly pointing out for years, it’s process, not outcome, that matters.

The best poker players, athletes and investors share a trait: they work on the process and let the outcome follow.

“I should have…” “I knew it…” “Told you so…” All these phrases are red flags that point towards someone overly focused on outcome. Of course, if you can get away with it, it is so much easier to focus on the outcome to justify a decision than the process. But process is what differentiates the skillful from the lucky when making decisions under uncertainty.

In the absence of a unique and unerring strategy on picking the right stocks, getting to the final table at poker tournaments or winning a football match, it is, however, not advisable to ignore the outcome altogether. It is a source of feedback. The crucial point to figure out is how to use the feedback and incorporate it into the process.

This is where having a grasp of the basics of statistical analysis comes in handy. There are rules to bear in mind when drawing inference from the outcomes of random processes. I’d recommend reading The Signal and the Noise (if you haven’t already) for a non-technical and enlightening discussion of this.

Getting to a situation where you win more often than you lose is a typical objective. But, being in a situation where the wins are attributable to skill and the losses are down to bad luck, is a better objective. Relying on good luck is not a good way to get ahead.

The message from the table below has been stuck in my head since first seeing it laid out like this by Michael Mauboussin. While it may not always be clear at first which of the four boxes an outcomes falls into, a combination of good data analysis and a critical sense of why a process should or should not work usually points in the right direction.

Process Table