Music to a value investor’s ears:
You shouldn’t buy this stock at any price.
Ben Graham advocated that we should always follow a cardinal rule if we truly believe in the value investing philosophy: buy cheap.
Why is it that this simple piece of wisdom has withstood the test of time?
The answer may be that it is psychologically difficult to buy cheap stocks (since we believe they may be cheap for a reason), which means not many people can do it. Yet, the historical evidence suggests that those who are able to follow the value investing discipline, and buy cheap consistently, end up with good value and beat the markets.
Quant investing rock star Cliff Asness provides additional insight:
A lot of what we trade [is]…value based, trying to buy cheap things…value tends to win over the long term…[it’s] one of the classic quantitative strategies. We’ve been working on trying to make ours better, for twenty-some odd years, but it’s still about trying buy cheap things….[based] on some things you’d recognize. All else equal, if a company has a low price to earnings ratio we like it a little better. It’s about that complicated. It’s just a whole bunch of stuff like that…Put together a portfolio that’s long the 200 cheapest stocks in the market…on simple measures. Long the stocks with the lowest average of the price to earnings, price to book, price to sales…When you look at the portfolio you own, you’re going to throw up a little bit. You’re going to go “I own this stuff?! I can’t believe it, these are the worst stocks!” Because markets might not be perfect, but they are not complete idiots…Markets work long term.
Value investing has worked not because cheap companies are generally much better companies than expensive. It has worked because they get a little too cheap. Buying a bad company can be a good idea if the price is too low…Great non-quantitative managers can hold themselves to this…they can hold this discipline in their head, and not get caught up. A lot of investors get caught up in the hype, and we think this is part of why things like value investing work. They end up paying too much for things…that had good times over the last four or five years.
Two interesting items within these remarks are worth highlighting. First, Asness points out that you’re going to throw up a little when you see what’s in a value portfolio. Second, he observes that value investing has worked because companies can sometimes get a little too cheap.
To a value investor, there is a clear connection here: the reason why stocks become a little too cheap is precisely because they make you want to throw up.
So what, exactly, is it about these stocks that makes Asness want to throw up?
One reason this reaction is triggered is because it is very easy to imagine bad outcomes for value stocks. The reasons why we believe things could go badly for our value stock portfolio is because these potential bad outcomes are highly available to us.
In their paper, “Judgment Under Uncertainty: Heuristics and Biases,” Amos Tversky and Daniel Kahneman describe the availability bias:
There are situations in which people assess…the probability of an event by the ease with which instances or occurrences can be brought to mind. For example…one may evaluate the probability that a given business venture will fail by imagining various difficulties it could encounter. This judgmental heuristic is called availability…Lifelong experience has taught us that, in general… likely occurrences are easier to imagine than unlikely ones. As a result, man has at his disposal a procedure (the availability heuristic) for estimating the…the likelihood of an event…by the ease with which the relevant mental operations of retrieval, construction, or association can be performed. However…this valuable estimation procedure results in systematic errors.
Cass Sunstein has used the term “probability neglect” when referring to how we overreact to perceived potential harm. This has an evolutionary basis: we have evolved to avoid threats, and can be prone to overweight perceived risk even when such concern may be misplaced.
Since potential bad outcomes to our value stocks come to mind very easily, based on our immediate, visceral reactions to how these firms make money and the markets they are in, we ignore the laws of probability and place too much emphasis on our fears rather than on the objective reality. This is why stocks can become too cheap – we overreact to our fears, which are highly available.
How Availability Bias Affects Decisions
Consider some generic categories of cheap stocks you might find in a typical value stock portfolio, and how our views of them can be affected by the availability bias:
The Software Maker
Technology is fickle. A once dominant franchise is being destroyed by competition and is now in permanent decline. This company is a dinosaur. Don’t touch it with a ten foot pole, you shouldn’t buy this stock at any price.
The PC Maker
The PC industry has a simple dynamic: the market for PCs is shrinking at double digit rates. Why would you want to be long any company whose primary product is sold in a rapidly shrinking market? You are crazy for even thinking about buying this company. You shouldn’t buy this stock at any price.
The Satellite TV provider
Subscriber growth is slowing, cable is a superior technology, and TV will soon be available over the internet anyway. These threats represent a clear and present danger to the business. With these terrible industry dynamics, you shouldn’t buy this stock at any price.
The Newspaper Company
We all know that no one, and I mean NO ONE, reads newspapers any more. All news is delivered over the internet these days. You shouldn’t buy this stock at any price.
The Defense Contractor
In times where government budgets are under increasing scrutiny, it would be madness to invest in a defense contractor, since their projects are on the firing line. Defense cuts will probably hurt this stock, so you shouldn’t buy this stock at any price.
Office Supplies company
Everything is moving to mobile computing and tablets, which are gradually replacing the traditional physical office supply market. With its markets being so heavily pressured by technology, you shouldn’t buy this stock at any price.
The Book Store
Book stores are dead. Anyone who has bought online from Amazon knows that. When there are so many quickly growing companies out there to choose from, you are taking a big risk in buying a bricks-and-mortar book seller. You shouldn’t buy this stock at any price.
Wireline Telecom Company
Copper wire networks can’t compete with cable, and require huge capital expenditures to upgrade and achieve the faster download speeds offered by competitors. With this outdated business model, you shouldn’t buy this stock at any price.
We believe the stories about these stocks because they are highly available to us. And they may be true. But the key is not necessarily whether the bearish views are accurate, but what is the price you pay. As Warren Buffett has said, “Price is what you pay, value is what you get.”
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