Table of Contents Title Page Copyright Page Dedication Preface Part I: Why everything you learned in business school is wrong Part II: The behavioural foundations of value investing Part III: The philosophy of value investing Part IV: The empirical evidence Part V: The ‘Dark Side’ of value investing: Short selling Part VI: Real-time value investing Foreword Part I - Why Everything You Learned in Business School is Wrong Chapter 1 - Six Impossible Things before Breakfast, or, How EMH has Damaged our Industry THE DEAD PARROT OF FINANCE THE QUEEN OF HEARTS AND IMPOSSIBLE BELIEFS SLAVES OF SOME DEFUNCT ECONOMIST PRIMA FACIE CASE AGAINST EMH: FOREVER BLOWING BUBBLES THE EMH ‘NUCLEAR BOMB’ Chapter 2 - CAPM is Crap A BRIEF HISTORY OF TIME CAPM IN PRACTICE WHY DOES CAPM FAIL? CAPM TODAY AND IMPLICATIONS Chapter 3 - Pseudoscience and Finance: The Tyranny of Numbers and the Fallacy BLINDED BY PSEUDOSCIENCE WATCHING TV IMPROVES YOUR MATHS ABILITY SEDUCTIVE DETAILS APPLICATIONS TO FINANCE CONCLUSIONS Chapter 4 - The Dangers of Diversification and Evils of the Relative ON THE DANGERS OF ‘NARROW’ DIVERSIFICATION EQUITY PORTFOLIOS: THE OTHER EXTREME RELATIVE PERFORMANCE DERBY AS A SOURCE OF POOR PERFORMANCE! A (VERY SHORT) PRACTICAL GUIDE TO DIVERSIFICATION Chapter 5 - The Dangers of DCF INTERACTION PROBLEMS ALTERNATIVES Chapter 6 - Is Value Really Riskier than Growth? Dream On RISK I: STANDARD DEVIATION RISK II: CAPM BETA AND CO RISK III: BUSINESS CYCLE RISK Chapter 7 - Deflation, Depressions and Value VALUE AND JAPAN VALUE AND THE GREAT DEPRESSION WHY THE DIFFERENCE BETWEEN THE GREAT DEPRESSION AND JAPAN? Part II - The Behavioural Foundations of Value Investing Chapter 8 - Learn to Love Your Dogs, or, Overpaying for the Hope of Growth (Again!) OF DOGS AND STARS ANALYST EXPECTATIONS AND IMPLIED GROWTH BRINGING IN VALUATION A CASE IN POINT: MINING Chapter 9 - Placebos, Booze and Glamour Stocks PAINKILLERS, PLACEBOS AND PRICE DOES EXPENSIVE WINE TASTE BETTER? GLAMOUR STOCKS BEATING THE BIAS Chapter 10 - Tears before Bedtime BUILT TO LAST ADMIRED OR DESPISED? DON’T BE AN UGLY DEFENDANT ANALYSTS’ VIEWS ON GROWTH CONCLUSIONS Chapter 11 - Clear and Present Danger: The Trinity of Risk VALUATION RISK BUSINESS/EARNINGS RISK BALANCE SHEET/FINANCIAL RISK PUTTING IT ALL TOGETHER Chapter 12 - Maximum Pessimism, Profit Warnings and the Heat of the Moment EMPATHY GAPS PREVENTING EMPATHY GAPS AND THE PERILS OF PROCRASTINATION MAXIMUM PESSIMISM TRADES PROFIT WARNINGS LOCK-INS CONCLUSIONS Chapter 13 - The Psychology of Bear Markets FEAR AND BEAR MARKETS AS TIME GOES PAST THE IMPACT OF BRAIN DRAIN THE BLANK SLATE Chapter 14 - The Behavioural Stumbling Blocks to Value Investing KNOWLEDGE ≠ BEHAVIOUR LOSS AVERSION DELAYED GRATIFICATION AND HARD-WIRING FOR THE SHORT TERM SOCIAL PAIN AND THE HERDING HABIT POOR STORIES OVERCONFIDENCE FUN NO, HONESTLY I WILL BE GOOD Part III - The Philosophy of Value Investing Chapter 15 - The Tao of Investing: The Ten Tenets of My Investment Creed THE AIM OF INVESTING TENET I: VALUE, VALUE, VALUE TENET II: BE CONTRARIAN TENET III: BE PATIENT TENET IV: BE UNCONSTRAINED TENET V: DON’T FORECAST TENET VI: CYCLES MATTER TENET VII: HISTORY MATTERS TENET VIII: BE SCEPTICAL TENET IX: BE TOP-DOWN AND BOTTOM-UP TENET X: TREAT YOUR CLIENTS LIKE YOU WOULD YOURSELF CONCLUSION Chapter 16 - Process not Outcomes: Gambling, Sport and Investment! THE PSYCHOLOGY OF PROCESS CONCLUSIONS Chapter 17 - Beware of Action Man GOALKEEPERS AS ACTION MEN INVESTORS AND ACTION BIAS BUFFETT ON THE FAT PITCH BIAS TO ACTION PARTICULARLY PRONOUNCED AFTER POOR PERFORMANCE CONCLUSIONS Chapter 18 - The Bullish Bias and the Need for Scepticism Or, Am I Clinically Depressed? THE BULLISH BIAS IN FINANCE THE SOURCES OF BULL SCEPTICISM AS A DEFENCE A RATIONALE FOR EVIDENCE-BASED INVESTING DEPRESSIVE REALISM Chapter 19 - Keep it Simple, Stupid IS MORE BETTER? KISS: KEEP IT SIMPLE, STUPID LESSONS FROM HEART ATTACKS WHY? CAN ANYTHING BE DONE? SIMPLICITY IS KEY EXPERTS FOCUS ON THE KEY INFORMATION FROM THE EMERGENCY ROOM TO THE MARKETS Chapter 20 - Confused Contrarians and Dark Days for Deep Value DARK DAYS FOR DEEP VALUE DEEP VALUE WORKS OVER THE LONG TERM VALUE OUT OF VOGUE SHORT-TERM UNDERPERFORMANCE IS A BY-PRODUCT OF A SENSIBLE INVESTMENT PROCESS IS THERE LIGHT AT THE END OF THE TUNNEL FOR VALUE? Part IV - The Empirical Evidence Chapter 21 - Going Global: Value Investing without Boundaries THE EUROPEAN EVIDENCE DEVELOPED MARKETS EVIDENCE BRINGING IN THE EMERGING MARKETS PATIENCE IS STILL A VIRTUE CONCENTRATED PORTFOLIO CURRENT PORTFOLIO STANCES CONCLUSIONS Chapter 22 - Graham’s Net-Nets: Outdated or Outstanding? GOING GLOBAL THE CURRENT NET-NETS PERMANENT LOSS OF CAPITAL CONCLUSION Part V - The ‘Dark Side’ of Value Investing: Short Selling Chapter 23 - Grimm’s Fairy Tales of Investing Chapter 24 - Joining the Dark Side: Pirates, Spies and Short Sellers VALUATION FINANCIAL ANALYSIS CAPITAL DISCIPLINE PUTTING IT ALL TOGETHER Chapter 25 - Cooking the Books, or, More Sailing Under the Black Flag COMPANIES LIE, SHORT SELLERS POLICE: THE EVIDENCE WHO IS COOKING THE BOOKS? THE C-SCORE DOES THE C-SCORE WORK? Chapter 26 - Bad Business: Thoughts on Fundamental Shorting and Value Traps A TAXONOMY OF SHORTS BAD MANAGERS BEHAVIOURAL FOUNDATIONS OF BAD MANAGEMENT BAD COMPANIES BAD STRATEGIES Part VI - Real-Time Value Investing Chapter 27 - Overpaying for the Hope of Growth: The Case Against Emerging Markets THE SORRY TALE OF SIR ROGER EMERGING MARKETS AS THE SIR ROGER OF INVESTMENT CONCLUSIONS Chapter 28 - Financials: Opportunity or Value Trap? SK Telecom Slovic, Paul small cap net-nets, Japan snake attacks social pain See also contrarian strategies; herding Solomon, King Sony South Africa South Korea South Sea Bubble Spain spandrels speculation sport Springsteen, Bruce Standard Chartered standard deviations bubbles definition concepts Starmine stars stop loss uses stories strategy failures M&As short selling candidates stress tests Stroop test style drift successful investors Summers, Larry Sun Microsystems sunk costs, concepts swaps See also dividend swaps, inflation swaps, insurance Sylla, Richard synergies systematic risk See market risk TAA enzyme Taiwan target prices, forecasts Tasker, Peter tax Taylor Wimpey tears before bedtime, growth Templeton, Sir John ten tenets of the author’s investment creed terminal values, DCF Thailand Thain, John Thaler, Richard Tichborne, Sir Roger Tiger, Lionel time series reliance, VaR failings timing issues ‘and this, too, shall pass away’ buy guidelines Coffee Can Portfolio holding periods for stocks optimism stock market moves TIPS TMT bubble top-down and bottom-up investment creed IX total assets Altman’s Z score C-scores total debt total real returns tracking errors See also portfolio management critique definition trailing earnings transaction costs transparent companies treat-your-clients-as-you-would-treat-yourself investment creed X ‘trinity’ aspects of risk See also balance sheet/financial risk, business/earnings risk, valuation risk concepts vulnerable companies Turkey TV, maths ability UBS UK C-scores CDSs deep value opportunities housing market PE ratios uncertainty unconstrained behaviour, be-unconstrained investment creed tenet IV underperformance issues C-scores dark days for deep value ‘unholy’ trinity of characteristics, short selling upside beta US ‘best ideas’ managers bonds C-scores debt/GDP ratio deep value opportunities deflation dividend swaps EPS values forecast errors housing market Japan PE ratios U.S Steel valuation methods See also discounted cash flow bonds dividend swaps earnings power method PE ratios price/sales ratios reverse-engineered DCF revulsion phase of a bubble robustness checks valuation risk concepts definition PE ratios value assessment tests bear market debates behavioural stumbling blocks beta bonds business cycle risk buy guidelines concepts dark days for deep value decision tree deep value opportunities definition dividend swaps value EMH critique empirical evidence fun and excitement good intentions Great Depression homogeneous investors insurance intrinsic value investment creed tenet I Japan net-nets overpayments for growth reviewed positions the road to revulsion schism underperformance issues vogue Value at Risk (VaR) critique reasons for VaR failure value investors bears six key traits value risk, definition value traps, concepts variance mean-variance efficient portfolios risk measures visionary companies, comparator companies vogue, value volatility Wagner, E.J Wason selection task Waste Management Incorporated Whitman, Marty Williams, John Burr Williams, Ted Wilmott, Paul wines ‘Winnie the Pooh’ witch doctors Witter, Dean working capital See also net-nets Altman’s Z score Wright model X-system, brain processes yield curves, recessions zero sum game This article appeared in Mind Matters on 17 June 2009 Copyright © 2009 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication Two economists have written a paper arguing that the NASDAQ bubble might not have been a bubble after all - only an academic with no experience of the real world could ever posit such a thing This article appeared in Global Equity Strategy on 16 January 2007 Copyright © 2007 by Dresdner Kleinwort, a Brand of Commerzbank AG All rights reserved The material discussed was accurate at the time of publication See, for example, Hsu and Campollo (2006) It is worth noting that Harry Markowitz recently wrote an article in the FAJ observing that if one broke the unlimited borrowing assumption of CAPM then the conclusions of the model change drastically, the cap-weighted market is no longer the optimal portfolio and beta is no longer lineally related to return See Markowitz (2005) This article appeared in Mind Matters on 29 April 2008 Copyright © 2008 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication This article appeared in Mind Matters on April 2009 Copyright © 2009 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication This article appeared in Mind Matters on 9 September 2008 Copyright © 2008 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication This article appeared in Mind Matters on 21 April 2008 Copyright © 2008 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication 10 The data I have used come via Ken French’s website http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html 11 This article appeared in Mind Matters on 3 March 2009 Copyright © 2009 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication 12 This article appeared in Mind Matters on 28 May 2008 Copyright © 2008 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication 13 A viewpoint supported by Stickel (2007) and also by my work in Chapter 10 of Behavioural Investing 14 Results for other valuation criteria didn’t alter the findings 15 This article appeared in Mind Matters on 10 March 2008 Copyright © 2008 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication 16 Dan has made a disproportionate number of appearances in my notes as he is one of the keenest observers of human nature I have come across In addition, his research topics are always fascinating He has recently written a book Predictably Irrational, which I suggest that everyone reads It will certainly make my next reading list review Personally I think Predictably Irrational will be the ‘Freakanomics’ of the behavioural psychological world 17 A similar pattern can be found among analyst recommendations See Chapter 10 of Behavioural Investing for more details 18 This article appeared in Global Equity Strategy on 29 March 2007 Copyright © 2007 by Dresdner Kleinwort, a Brand of Commerzbank AG All rights reserved The material discussed was accurate at the time of publication 19 http://www.greektexts.com/library/Herodotus/Melpomene/eng/101.html 20 This article appeared in Mind Matters on 27 January 2009 Copyright © 2009 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication 21 This article appeared in Mind Matters on 22 September 2008 Copyright © 2008 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication 22 This article appeared in Mind Matters on 2 December 2008 Copyright © 2008 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication 23 Technically they have lesions on the orbitofrontal cortex, the amygdala or the right insular or somatosensory cortex - all areas associated with emotional processing in the X-system 24 This test was originally created by Shane Frederik of MIT 25 They used a self-report approach So people were measured on the basis of how much they agreed or disagreed with eight statements such as ‘I tend to use my heart as a guide for my actions’, ‘I like to reply on my intuitive impressions’, ‘I don’t have very good sense of intuition’, etc rather than a more clinical approach such as the CRT 26 This article appeared in Global Equity Strategy on 29 August 2006 Copyright © 2006 by Dresdner Kleinwort, a Brand of Commerzbank AG All rights reserved The material discussed was accurate at the time of publication 27 This article appeared in Mind Matters on 24 February 2008 Copyright © 2008 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication 28 This article appeared in Mind Matters on 1 September 2008 Copyright © 2008 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication 29 This article appeared in Mind Matters on 7 January 2008 Copyright © 2008 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication 30 It is of course only optimal for the goalkeeper to stay in the centre of his goal given the current distribution of kicks If goalkeepers all started staying in the middle of their goals, then the kickers would start shooting left and right exclusively, altering the distribution 31 This article appeared in Mind Matters on 12 February 2008 Copyright © 2008 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication 32 For those unfamiliar with the great man’s ‘Just So’ stories, they are creative tales of how many animals ended up as they have For instance, the elephant in the stories ends up with a long trunk, because he disobeyed his mother, and drank from a river full of crocodiles, one of which grabbed his nose As the elephant pulled back, his trunk was stretched, thus the shape we all know and love today 33 This article appeared in Mind Matters on 3 December 2007 Copyright © 2007 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication 34 See Chapters 2 and 11 of Behavioural Investing (Wiley, 2007) 35 This article appeared in Mind Matters on 30 July 2008 Copyright © 2008 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication 36 Death, Taxed and Short-Term Underperformance (February and July 2007), available from www.brandes.com/institute/BiResearch/ 37 This article appeared in Mind Matters on 16 September 2008 Copyright © 2008 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication 38 This article appeared in Mind Matters on 30 September 2008 Copyright © 2008 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication 39 This article appeared in Global Equity Strategy on April 2007 Copyright © 2007 by Dresdner Kleinwort, a Brand of Commerzbank AG All rights reserved The material discussed was accurate at the time of publication 40 It is perfectly possible that investors might well anchor on the numeric value of more usual valuation measures such as the PE, and thus compare the low price to sales multiple favourably against this incorrect benchmark 41 This article appeared in Mind Matters on 13 May 2008 Copyright © 2008 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication 42 How Companies Spend Their Money: A McKinsey Global Survey, McKinsey Quarterly, June 2007 43 This article appeared in Mind Matters on 30 June 2008 Copyright © 2008 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication 44 Just in case you are wondering about the alternative title for this chapter (More Sailing Under the Black Flag) this refers to the title of Chapter 24, ‘Joining the Dark Side: Pirates, Spies and Short Sellers’ 45 This article appeared in Mind Matters on 12 May 2009 Copyright © 2009 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication 46 Jim suggests reading Clayton Christensen’s ‘The Innovator’s Dilemma’ for a great book on this subject 47 They actually identify seven, but two are very similar, and I have chosen to combine them 48 This article appeared in Mind Matters on 7 May 2008 Copyright © 2008 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication 49 This article appeared in Mind Matters on 13 August 2008 Copyright © 2008 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication 50 http://www.portfolio.com/news-markets/top-5/2008/07/30/RegrettableComments-by-Bank-CEOs?page=1, 51 This article appeared in Mind Matters on 6 January 2009 Copyright © 2009 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication 52 As Stephen Ross once said, to turn a parrot into a learned financial economist it needs to learn just one word: arbitrage To my mind, economists are far too happy to rely on arbitrage assumptions to rule out solutions Indeed, the second chapter of my first book, Behavioural Finance, is spent detailing failures of arbitrage (both causes and consequences thereof, including the ketchup markets!) 53 A rentier is one who lives off rent/income i.e the bond holder 54 This article appeared in Mind Matters on 2 February 2009 Copyright © 2009 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication 55 This article appeared in Mind Matters on 13 October 2008 Copyright © 2008 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication 56 This article appeared in Mind Matters on 25 November 2008 Copyright © 2008 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication 57 It may seem odd for me to talk about DCF valuations given my recent attack on them (see Chapter 5) However, while I am a critic of their use (principally because of huge implementation issues), they do help to highlight the long-term nature of equity investment 58 Thank you very much indeed Christian 59 This article appeared in Mind Matters on 4 March 2009 Copyright © 2009 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication 60 This article appeared in Mind Matters on 12 March 2009 Copyright © 2009 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication 61 This article appeared in Mind Matters on 19 March 2009 Copyright © 2009 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication 62 Available from www.fraser.stlouisfed.org/docs/meltzer/fisdeb33.pdf This is one of few articles published in Econometrica that I have ever read! 63 See Bill Flecksenstein’s excellent book Greenspan’s Bubbles or John Taylor’s insightful paper ‘The Financial Crisis and the Policy Responses: An empirical analysis of what went wrong’, available from www.stanford.edu? ~johntayl/FCPR.pdf, or any of Albert Edwards’ myriad of rants on Greenspan 64 As Stephen Ross once said, to turn a parrot into a learned financial economist it needs to learn just one word: arbitrage To my mind economists are far too happy to rely on arbitrage assumptions to rule out solutions Indeed, the second chapter of my first book, Behavioural Finance, is spent detailing failures of arbitrage (both causes and consequences thereof, including the ketchup markets!) 65 This article appeared in Mind Matters on 28 April 2009 Copyright © 2009 by The Société Générale Group All rights reserved The material discussed was accurate at the time of publication ... Montier, James Value investing : tools and techniques for intelligent investment / James Montier p cm Includes bibliographical references and index eISBN : 978-0-47068518-1 Value investing Investment analysis... EXPERTS FOCUS ON THE KEY INFORMATION FROM THE EMERGENCY ROOM TO THE MARKETS Chapter 20 - Confused Contrarians and Dark Days for Deep Value DARK DAYS FOR DEEP VALUE DEEP VALUE WORKS OVER THE LONG TERM VALUE OUT OF VOGUE... Part II: The behavioural foundations of value investing Part III: The philosophy of value investing Part IV: The empirical evidence Part V: The ‘Dark Side’ of value investing: Short selling Part VI: Real-time value investing Foreword