When teaching graduate courses in investments, I always try to integrate books written by practitioners to provide a more pragmatic perspective on investments. One book I’ve used is James Montier’s Value Investing: Tools and Techniques for Intelligent Investment. My review of the book is provided below.
James Montier’s book is a solid read for individual and institutional investors alike. Montier is currently a member of the asset allocation team at GMO, a Boston-based investment manager co-founded by Jeremy Grantham. The book is a collection of articles Montier wrote for institutional investors while serving as Global Strategist for Dresdner Kleinwort and Société Générale.
In the book, Montier discusses some of the problems of classical finance theory and offers insights derived from behavioral finance and value investing. In Part 1 (Why Everything You Learned in Business School Is Wrong), he describes the flaws inherent in the Efficient Market Hypothesis, Capital Asset Pricing Model (CAPM), and Discounted Cash Flow (DCF) models. With chapter titles like CAPM is Crap, Pseudoscience and Finance: The Tyranny of numbers and the Fallacy of Safety, and The Dangers of DCF, James makes no attempt to hide his disdain for the financial theories espoused at most B schools. While not new, his discussion of the pitfalls of the terminal value calculation – specifically, the interaction between the growth rate and cost of capital – is very well written in my opinion. As part of the discussion (some might say assault), he provides the following example: “If the perpetual growth rate is 5% and the future cost of capital is 9%, then the terminal value multiple is 25x. If the estimates are off by only 1% in either direction for the cost of capital, the growth rate, or both, the terminal value multiple can range from 16x to 50x. Given that the terminal value is often the biggest contributor to the DCF valuation, these issues are non-negligible.” Examples like this resonated with me and underscored the importance of triangulating on valuation using multiple methods.
In Part 2 (The Behavioral Foundations of Value Investing), Montier outlines the institutional structures and behavioral traps that derail so many investors and offers suggestions of how best to avoid these them in an attempt to think and act differently from the herd. In his discussion of behavioral stumbling blocks, he notes that “investing is probabilistic, so losses will occur. However, given our tendency to be loss averse, strategies that sometimes see short-term losses will be shunned.” While subtle, I think this is an important point: While value investing will result in losses – absolute and relative – from time to time, no other strategy provides better results over time. This sentiment is echoed by Robert Olstein in The Art of Value Investing, who notes “Changing investment styles to the latest fad produces the same results as changing lanes during rush-hour traffic jams. You increase the risk of an accident with little chance of achieving better results.” Montier also notes that “the stories associated with value stocks are generally going to be poor,” which makes owning them a tough to buy. As value investors, however, our focus shouldn’t be on whether the story is good or poor, but whether the bad news is already reflected in the stock price (perhaps overly so). He uses a lot of great analogies throughout the book. When discussing investors’ – particularly growth investors – bullish bias, Montier notes that “if we jump on the scales in the morning and they give us a reading that we don’t like, we tend to get off and have another go – just to make sure we weren’t standing in an odd manner. However, if the scales have delivered a number under our expectations, we hop off the scales into the shower, feeling very good about life. This is a classic example of motivated reasoning, and underscores the point that “we are very good at accepting information that agrees with us and questioning any information that disagrees with us.” Montier argues that the best way to address motivated reasoning is to deploy what he calls empirical skepticism; that is to say, “if you believe something is true, then test those beliefs against wide-ranging empirical data (ie., try to prove its false using whatever data you can get your hands on).”
Parts 3 (The Philosophy of Value Investing) and 4 (Empirical Evidence) aren’t to be skipped. Here, Montier describes the importance of: 1) a sound investment process, 2) focusing on the key drives of a stock, and 3) being contrarian. When discussing a sound process, he uses the casino analogy; that is “all casino games have a winning process – the odds are stacked in the favor of the house. That doesn’t mean they win every single hand or every roll of the dice, but they do win more often than not. In investments, we have no control over the outcomes. The only thing we can control is the process, so it makes sense to concentrate on that.” When scrutinizing your process, Montier argues that “too much time is spent trying to find out more and more about less and less…, but the simple truth is that our brains aren’t supercomputers with limitless computational power. So, rather than collecting endless amounts of information, we should spend more time working out what is actually important, and focusing on that.” Stated different, we should focus on the 2-3 key drivers of stock performance over the intermediate-to-long-term. Everything else is largely noise.
Contrary to comments from other readers, I thought Value Investing: Tools and Techniques for Intelligent Investment did offer solid tools to improve investment performance. For instance, Part 5 (The ‘Dark Side’ of Value Investing), includes Joining the Dark Side: Pirates, Spies, and Short Sellers, which is the subject of a second post on the book. In this chapter, he offers a 3-factor model for identifying short candidates by isolating on expensive stocks with deteriorating fundamentals and poor capital discipline. Montier provides the logic of combining the three factors in a screen and also back-tests the performance of screen over multi-year periods to demonstrate the efficacy of the screen in identifying short candidates in different markets. He uses a similar approach in the follow-on chapter, Cooking the Books, to support his “C Score,” a metric that can be used to evaluate a firm’s potential earnings manipulation.
As a collection of articles written for institutional investors, the book lacks sufficient structure for the average retail investor. In fact, it reads more like a compendium of articles used in a graduate investments course. That said, I found Value Investing: Tools and Techniques for Intelligent Investment to be insightful and thought-provoking and would recommend it to institutional investors interested in refining their investment process.
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