Ignore the Theories and Buy Bargains

Ignore the Theories and Buy Bargains


Everything you learn at business school is wrong," says GMO's James Montier in his latest collection of essays, Value Investing: Tools and Techniques for Intelligent Investing.

I didn't go to business school but I think I learnt much the same muck as my husband (who did) on the Swiss Bank Corp (SBC) graduate training course.

There we were taught about 'modern portfolio theory', listened to endless, boring lectures on the 'capital asset pricing model' (CAPM), stared blankly at mathematical explanations of option pricing models and occasionally had to take turns doing incomprehensible sums on the white board at the front of the lecture hall.

I remember it through a haze of confusion. But I did at least come out of the whole thing with a rough understanding of modern portfolio theory – as well as a vague sense that its assumptions (that markets are efficient, that investors are rational and that there is a mathematically definable trade-off between risk and return) didn't really make much sense.

Even then, I knew that nothing much was ever efficient (even SBC – it later turned out I was enrolled on the wrong course). And while I didn't yet know much about the irrationality of investors, the following five years working in Japan's manic-depressive market soon sorted that out.

The truth, as Montier points out, is that the efficient market hypothesis looks completely wrong. The prima facie evidence of this? The existence of bubbles.

The events of the last few years should have made it clear that there is no such thing as an efficient market. But for those still thinking that efficiency might be more resting than dead, Montier points out that there have been 30-plus bubbles since 1925 (a bubble being defined as at least two standard deviations away from a trend). Not much sign of rational investor behavior in that. More like 30-plus signs of gross inefficiency.

The theory being wrong would, in itself, be just fine (it would join a large pile of totally wrong academic theories) but the problem with the efficient market hypothesis is that it has burdened us with a terrible investment legacy.

I haven't space to spell out Montier's entire argument (although I recommend getting the book and reading it), but he blames it – I think, rightly – for pretty much every bad investment experience any of us have ever had with a fund manager. These range from index hugging to ludicrously over-precise forecasting and the industry's obsession with diversification and risk at the expense of what should be the real point of investing – making "maximum real returns after tax".

For bored business school students, this should be excellent news. It means they can chuck out their 1,093-page copies of Principles of Corporate Finance (the business school bible) and start looking for real value in investments instead. And it means that they might actually make some proper money over the long term. Why? Because while most investment strategies show no sign of being able to offer very long-term out performance for investors, value does.

There is plenty of evidence for this but Montier adds to it with a look (from 2008) at global value investing. Here, too, he finds that buying bargains works. If you'd bought the cheapest 20% of all stocks, regardless of industry or geographical location, between 1985 and 2007, he says you would have generated an average return of 18% – a 7% out performance against the index.

Value can even be shown to have worked in Japan: there, post-bubble value strategies have returned around 3% a year (not bad in a deflationary environment) even as the market as a whole has returned -4% a year. Those who have operated a "long value/short glamour" strategy have apparently done even better (12% a year).

So why don't we all invest like this? Fund managers like to say they do. Their marketing material tells us of their propensity to swim against the crowd; their contrarian outlook; their ability to seek out value in sectors that more conventional peers aren't looking at properly. Type "next Warren Buffett" into Google and you'll see what I mean.

It is all nonsense, of course. They just say it because they assume we don't understand how the CAPM works (which we mostly don't). In fact, fund management is generally nothing more than financial groupthink: managers in thrall to the theories they learnt at business school, to the idea that they should be properly diversified, and to the career risk of investing differently to everyone else tend to ignore value and benchmark themselves to everyone else instead.

And the rest of us? Mostly, our failure to buy value and sit on it has got nothing to do with investment theory. We're just impatient and want to see returns now, now, now. So if something doesn't move, we dump it (incurring the fees that doom our portfolios to long- term underperformance). No wonder we never make any money.