Do you know why value investing and value stock analysis go together like and hand and glove?
It is because every time you buy stocks and shares in a company you are betting on its future. And predicting the future, be it the future of people, companies or the economy, is not a trivial matter.
In fact, looking at a study carried out by ETX Capital using Government statistics, all predictions regarding the future of the UK economy were different from what happened. To be precise, the industry average accuracy when predicting the UK GDP growth and CPI Inflation rate in 2016 was 0.47% of actual figures.
(In case you are curious, according to the ETX Capital study, the City forecasters closest to what happened in the UK economy, in different years, were Morgan Stanley, Commerzbank and Capital Economics. Three non-City forecasters whose economic predictions were close to reality were the Centre for Economics and Business Research (CEBR), the Oxford University-run, Oxford Economics, and PricewaterhouseCoopers (PWC). I’m digressing, though.)
Now, if these giants of economic analysis, that have impressive resources and access to incredible talent and competence, are shooting off target what chance do we have? Or what chance to ‘get it right’ do much smaller operations analysing value stocks have?
Not very good, I’d say. Value stock analysis is no more reliable than these economic forecasts.
To tell you the truth, realising that value stock analysis is unreliable was a major reason I pulled the plug on my value stocks investing portfolio. Value stock analysis is unreliable not because of incompetence or bad intentions; it is unreliable because of the five systemic reasons I’ll tell you about.
Value stock analysis is inherently unreliable and there is not much we can do to change that.
#1. Information deficiency
Information deficiency is another way to say that we don’t know all we need to know about something.
When it comes to value stock analysis, information deficiency is inevitable; after all, analysis is founded on publicly available information (company reports). This make sure that all analysts work from a ‘level playing field’ and that all investors make decisions based on the same information (at least in theory).
This doesn’t mean that this information is sufficient to make ‘future proof’ decisions.
Did you think that the penalties for insider trader are for nothing? (Insiders have, or could get, information the rest of us don’t access to and this distorts market rules of fairness.)
#2. Complexity of object
Yes; the more complex the object of analysis the higher the probability that the model (and analysis) will be inadequate.
Companies are very complex to analyse and modelling them involved very large number of variables – some problematic to quantify and model anyway (like type of management and its effect in different industries).
It is also hard to establish a working, useful hierarchy of factors that may affect company performance. Add to this the influence of factors outside the company and…
…well, you get the picture. Any model to analyse stocks and shares is a proxy and is likely to generate results that can be widely off the mark.
(This is why financial organisations recruit top mathematicians, statisticians and physicists. They still ‘get it roughly right’ only some of the time.)
#3. Unpredictability of group behaviour
An additional complication to the trustworthiness of value stock analysis is that the price of stock depends not only on the value of the company but also on the trust of investors and their behaviour.
Group behaviour is largely unpredictable and reaches ‘tipping’ point so fast understanding and action matter very little.
Much of behavioural finance is about this and while it helps us comprehend the past, it gives little guidance about the future.
#4. Reputation dependent company value
I also believe that a very specific issue with value stock analysis has developed recently because of the changing nature of value of companies.
Many contemporary companies build on reputation to create value. This is probably best illustrated by an example:
Oprah mentions that she is very happy with Weight Watchers and the share rises.
Kylie Jenner mentions she is ‘soooo over Snapchat’ in a tweet and the share drops 8% in a matter of hours.
Go analyse that!
#5. There are ‘black swans’ after all
The notion of ‘black swan’ events was introduced by Nassim Taleb in his book ‘The Black Swan: The Impact of the Highly Improbable’.
The premise of ‘black swan’ event is the following:
We tend to base our expectations for the future (read ‘our value stock analysis and predictions’) on what we know. However, the effects of what we don’t know, and don’t expect, are much larger that these of what we know.
Put simply, analysing the past holds no promise for the future; only an expectation of it.
Finally…
Investing, and value stock investing, is habitually presented as predominantly scientific. Investors are taught to rely on value stock analysis and advised to study company reports in a way of homework.
This is important: after all the scientific, analytical part of investing is what makes it different from most forms of gambling and from games relying on blind luck.
Still, it is wise to take value stock analysis with a large pinch of salt.
It is even better, in my mind, to bypass investing in value stocks altogether and move to more ‘basket’ investing vehicles like online wealth managers, index funds and ETFs.
Do you have value stocks portfolio? How do you select the stocks and shared to buy?
photo credit: SkyFireXII Decisions – January 11th, 2011 (11/365) via photopin (license)