In Chapter 2 of Value Investing : From Graham to Buffett and Beyond, Greenwald notes that when stocks are picked based on their price performance over the past three years, rather than last year alone, the results are unexpected. The worse performers do better and the high fliers come back to earth. This is known as reversion to the mean.
Greenwald notes some common variables relating the price of the shares to some fundamental company information, including:
- share price to earnings (P/E)
- share price to cash flow (P/CF)
- share price to book value (P/B)
- share price to sales (P/S)
- share price to dividends (yield)
Those with low prices relative to each of these variables often outperform glamour stocks. In addition, stocks of small companies have outperformed the shares of large companies even when their price-to-book ratios are similar.
Greenwald points out several sources of bias that can lead to value opportunities. There is a systematic bias to cause people to pay too much for winners and too little for losers. There are also institutional biases. Many institutional investment funds are prevented from owning certain kinds of stocks (i.e. social responsibility). Unless there are just as many irresponsible funds as socially responsible funds, shares of the “dirty companies” may be permanently undervalued.
There is also size bias. Many funds cannot invest in small companies, either because their internal rules won’t allow it or they have too much money to manage and small companies can’t absorb enough of it to make it worthwhile. This size bias can have a big impact, especially since small companies have better opportunities to grow faster. Comparing small cap PE stocks to large cap can help you determine the relative value of each of these categories. Spin-offs are often small and dumped by funds that end up owning them. They are worth watching, because they can provide good value opportunities.
Human biases can also create opportunities. Herd mentality can play a large role here. The safest path for fund managers is to look like everyone else. Window dressing by fund managers at the end of the year to make there fund look like everyone else’s creates value opportunities.
Other human psychological biases to look for include the following:
- People remember the recent past better than the distant future. We often predict by extrapolation and do not consider reversion to the mean.
- We dislike risk and losing money. Most importantly, we don’t notice when losers improve.
Greenwald also notes that obscure, small, and boring stocks are great sources of value. In addition, undesirable companies (i.e. financial distress/bankruptcy, companies of industries with overcapacity, industries with import surges, negative legislative or regulatory hits, lawsuits, or long periods of underperformance) are also likely to lead to value opportunities.