The New Value Investing: How to Apply Behavioral Finance to Stock Valuation Techniques and Build a Winning Portfolio

The New Value Investing

Applying Behavioral Finance to

Stock Valuation Techniques

C. Thomas Howard

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First published in Great Britain in 2015

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The right of C. Thomas Howard to be identified as the Author has been asserted in accordance with the Copyright, Designs and Patents Act 1988.

Paperback ISBN: 9780857193933

eBook ISBN: 9780857193971

British Library Cataloguing in Publication Data

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Praise for Behavioral Portfolio Management by C. Thomas Howard

Professional money managers and investment advisers alike will find Tom Howard’s thought-provoking exploration of the practical implications of investing in a world where emotional crowds dominate the determination of prices to be an interesting and engaging read.

Jim Peterson, Chief Investment Officer, Charles Schwab Investment Advisory, Inc.

By rethinking the basic challenges of equity investing from a behavioral viewpoint, Professor Howard has arrived at some totally fresh insights into what it takes to be an outstanding long-term investor. Though aimed at professionals in the field of investment management, many of the ideas presented in this highly readable book will be invaluable to a wider audience.

Andrew Cox, Director, Janus Capital Group

Tom Howard masterfully bridges the gap between the insights of behavioral finance and the demands of portfolio management, and he explains behavioral data investing in a forthright and engaging style. Advisors and investors alike stand to benefit from this book.

Philip Lawton, Ph.D., CFA, Research Affiliates, LLC

"There has been a glaring hole in the study of behavioral finance, namely, how to incorporate its caveats and principles into successful investment management. Behavioral Portfolio Management helps to fill the gap left behind by theorists with its creation of a unique framework for investment managers."

Jason A. Voss, CFA Institute Behavioral Finance Content Director, author of The Intuitive Investor, retired investment manager

Tom Howard was the most inspirational and influential professor in my master’s programme. His proven ability to harness behavioral factors and rigorously apply them to the portfolio management process makes this book a fascinating read!

George Spentzos, Managing Director, Société Générale, London, UK

Tom Howard demonstrates how the traditional tools of the investment industry, like modern portfolio theory and investment style boxes, combine with investor emotions to distort portfolios and asset prices. This book can teach you the proper strategy, consistency, and conviction to harness these distortions in your portfolio for higher returns and avoid the Cult of Emotion.

John Nofsinger, Ph.D., Seward Chair in Finance, University of Alaska, author of The Psychology of Investing

This book is a game-changer; as early adopters of Behavioral Portfolio Management, we found this to be an oasis in the desert of Modern Portfolio Theory. I know of no better way to beat the market then to do what this book tells me to do; and no book says it better than this. The reasons for our outperformance transcend time and trump the competition, ‘rational’ or otherwise. Of course we are emotional investors – now we can profit from that!

Karl Frank MA, MBA, MSF, CFP, President, A&I Financial Services LLC

"Dr. Tom Howard has taken the principles of Behavioral Theory and applied them to investing in his new book Behavioral Portfolio Management. Beyond theory he has applied these precepts to actual portfolios with considerable success. He examines ‘What If’ we take advantage of human behavior and use that knowledge to enhance portfolio returns. An excellent read that takes us to the next stage in the investing arena."

Philip Hartwell, CFP, Royal Alliance

Traditional finance assumes that investors are rational. Behavioral finance rejects that notion and studies how emotions and psychology affect investors and the financial markets. Most academics have rejected behavioral finance because of the perceived lack of practical applications. In this book, Dr. Howard shows how his methodologies can incorporate behavioral finance concepts into a very successful investment strategy. His evidence may give behavioral finance the academic credibility it deserves.

Maclyn Clouse, Ph.D., Professor of Finance, Daniels College of Business, University of Denver

Contents

About the author

Acknowledgements

Preface

Chapter 1 – Mastering Your Emotions

Summary

The Impact of Emotion When Investing

Basic Concepts in Emotional Control

Chapter 2 – Managing Your Stock Portfolio

Summary

Sound Portfolio Decisions

Company and Industry Diversification

International Diversification

Diversifying Larger Portfolios

Trading Activity

Portfolio Versus Individual Stock Performance

Measuring Performance

Chapter 3 – Tilting The Market In Your Favor

Summary

The Time Structure of Market Returns

Deep Behavioral Currents

Catching the Trade Winds of the Market

Chapter 4 – Where To Find Investment Ideas

Summary

The Universe of Ideas

Your Broker or Your Barber or Your Brother

Stock Screening

Chapter 5 – Value Investing Framework

Summary

Identifying Undervalued Stocks

Value Investing versus Future Growth Investing

Value Analysis

Estimating a Value Range

The Art of Selling

Performance Expectations

The Holding Period

Chapter 6 – Making Sense Of The Economy And The Market

Summary

The Relationship Between the Market and the Economy

The Business Cycle

The Federal Deficit and Money

Market-wide Valuations

Chapter 7 – Untangling Financial Statements

Summary

The Company’s Flows

The Balance Sheet

Making Financial Statements Useful: Ratio Analysis

Lies, Damn Lies and Financial Statements

Chapter 8 – In Search Of Value

Summary

The Idea Behind Valuation

Dividend Valuation

Earnings and Other Valuation Techniques

Chapter 9 – Conducting A Value Analysis

Valuation Example 1

Valuation Example 2

Chapter 10 – A Closer Look At Earnings

Summary

Accounting Issues in Reported EPS

Company 7 Example

Chapter 11 – How The Pros Implement A Valuation Strategy

Mutual Fund Research

Impact of Elements

Putting it All Together

Some Final Thoughts

The Art and Science of Value Investing

The Three Secrets of Value Investing: Patience, Patience and More Patience!

Don’t Fall into the Popularity Trap

About the author

Dr. Howard is co-founder of AthenaInvest, a Greenwood Village-based SEC Registered Investment Advisor. He led the research project that resulted in Strategy Based Investing, the methodology which underlies AthenaInvest’s investment approach. He oversees Athena’s ongoing research, which has led to a number of industry publications and conference presentations. Dr. Howard currently serves as CEO, Director of Research, and Chief Investment Officer at Athena.

Dr. Howard is a Professor Emeritus at the Reiman School of Finance, Daniels College of Business, University of Denver, where for over 30 years he taught courses and published articles in the areas of investment management and international finance. For many years he presented stock analysis seminars throughout the US for the American Association of Individual Investors, a national investment education organization headquartered in Chicago. Dr. Howard has been a guest lecturer at SDA Bocconi, Italy’s leading business school and at Handelsho/jskole Syd in Denmark and was a 2004 Summer lecturer in international finance at EMLYON in France.

He acted as a consultant for a number of firms, most recently First Data Corp and Janus Capital Group, and served for 10 years on the Board of Directors for AMG National Trust Bank N.A., a financial counseling and investment management firm headquartered in Denver.

After receiving his BS in Mechanical Engineering at the University of Idaho, Dr. Howard worked for Proctor Gamble as a production and warehouse manager for three years. He then entered Oregon State University, where he received an MS in Management Science. He then received a Ph.D. in Finance from the University of Washington.

Acknowledgements

Three books provided me with important foundational ideas: Daniel Kahneman’s Thinking, Fast and Slow, Nassim Taleb’s Fooled by Randomness, and Hersh Shefrin’s Behavioralizing Finance.

Kahneman, winner of the 2002 Nobel Memorial Prize in Economic Sciences, does a masterful job of presenting the major conclusions of behavioral science, providing numerous insights into how individuals actually make decisions using shortcuts and heuristics. The rational model it is not. Behavioral science came of age during the same time period over which MPT became the de facto standard in the investment management industry. With the benefit of 20/20 hindsight, I wish my own education and early experience would have included much more behavioral science and much less MPT. But it is better to be late than never as they say.

Taleb provides an eminently readable exposition on the challenge facing individuals in mastering one of the most difficult real world realities: the random nature of events and markets. He contends that the complex and random nature of the investing world we face has outrun our own brain’s evolutionary hardwiring. To be successful, an investor must think of the world in terms of probabilities and previously unobserved events (black swans in his parlance). This requires a dose of heavy duty analytic thinking – what Kahneman refers to as System 2 thinking.

Shefrin, in Behavioralizing Finance, provides a systematic analysis of how behavioral assumptions impact various aspects of modern finance theory. Shefrin believes that the future of finance will combine realistic assumptions from behavioral finance and rigorous analysis from neoclassical finance.

I can’t go without mentioning Robert Haugen and his book The Inefficient Stock Market. In the mid-90s, as I was actively questioning the validity of MPT, I came across this excellent book which confirmed many of the things I was thinking at the time. He essentially posited a behavioral market in which pricing distortions were common. I used his book in my Securities classes at Daniels for nearly 20 years. Haugen provided an important stepping stone on my journey to behavioral investing, and for that I thank him.

I would like to thank Craig Callahan, friend and colleague, for posing the initial questions and providing support for the research project which has produced one surprising result after another and led to us cofounding AthenaInvest. For many years I have enjoyed and benefited from my conversations with my friend and industry veteran Andrew Cox. Academic colleagues Russ Wermers, Levon Goukasian, Hersh Shefrin, Oliver Boguth, Russ Goyenko, Randy Cohen, Malcolm Baker and Gene Fama have provided useful insights over the years. This book would not have been possible without the support and infrastructure development provided by my colleagues at AthenaInvest: Andy Howard, Joel Coppin and Lambert Bunker.

And most importantly, the unwavering love and support of my wife Mitch has been indispensable. She has stood by me for 40 years, through the trying years of the PhD program and now through the testing times of launching a new business. To her I dedicate this book with love.

Preface

It probably doesn’t surprise you that the stock market is the most studied institution in history. Out of all this intellectual horsepower comes a very clear and simple message: if you consistently pursue a value investing strategy you will earn an above average return on your portfolio. This may mean hundreds of thousands, if not millions, of extra dollars in your portfolio at the end of your investment horizon.

The aim of value investing is to identify those stocks that are undervalued and which can be expected to produce above average returns in the future. The idea has been around for a long time. Very early on in happenings such as the Tulip Bulb craze of the 1600s and the South Sea Bubble of the 1700s, and more recently in the stock market crash of 2008, investors have noticed that markets, being a human institution, make valuation mistakes. Helping you identify these valuation mistakes is the goal of this book. I draw from my own experience as well as from the extensive research that surrounds this area.

Value investing is within everyone’s reach. So why doesn’t everyone use it? The key is patience. Value investing does not work all of the time, nor does it work with every stock, but it works over the long term if you stick with it through thick and thin. Many investors are unwilling to wait out the dry spells, so they abandon the approach and move on to something else.

I draw much of my material from my 1996 book A Vest Pocket Guide to Value Investing, which in turn was based on my American Association of Individual Investors’ Stock Analysis seminar that I presented throughout the US for over 15 years. Since writing that book nearly 20 years ago much has changed.

In particular, the evidence has turned decidedly against the concept of an efficient stock market in which stocks are correctly priced. Instead we now realize stock prices are largely determined by the actions of the many emotional crowds that rampage about the market. This strengthens the case for value investing. My success in managing the Athena Pure portfolio, using a value investing strategy over the last 12 years, provides further support for this contention.

Another significant change over the last 20 years has been the widespread recognition that investors do not make rational decisions, as is clearly demonstrated by 40 years of behavioral science research. Driven by this result, along with the mounting evidence against the foundations of Modern Portfolio Theory, I recently wrote Behavioral Portfolio Management. It challenges much of the academic and industry conventional wisdom on how to build and manage successful portfolios. I draw material from Behavioral Portfolio Management and weave it into the discussions of valuation techniques.

Over the last ten years, my company AthenaInvest has conducted extensive research on US and international active equity mutual funds domiciled in the US. It has produced a number of interesting results that challenge conventional wisdom. The most startling is that active equity managers are superior stock pickers but not so good at portfolio management, as evidenced by their poor average fund performance.

In order to better understand how these managers make decisions, AthenaInvest organizes the active equity universe around ten equity strategies. The valuation strategy, the focus of this book, is one of these strategies and represents one of several approaches to implementing Behavioral Portfolio Management. Our research reveals that delivering superior returns is not limited to those pursuing a valuation strategy. Instead we have found that there are many, many ways to build superior equity portfolios. Future books will focus on other successful strategies.

About this book

The first ten chapters in this book deal with the techniques you can use to build a successful value investing strategy. The techniques