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The Financialization of Value Investing

When the New York Stock Exchange first set up shop, stocks traded in minimum increments of 1/8 = $0.125 dollars. This system was probably a holdover from the Spanish trading system, whose largest gold coin was valued at eight escudos. If academics in finance would break apart a universe of stocks into eight different groups and rank their performance based on some rigorous filtering criterion, it would tie in nicely with our New York Stock Exchange tradition of shares changing hands in 1/8 increments. Unfortunately, these competitive publish-or-perish types seem to prefer decile categories over pieces of eight. Any last remnants of Wall Street's Spanish roots were given the heave-ho when the SEC mandated decimilization for stock trading on all U.S. exchanges starting in 2001. So ends the pieces-of-eight legacy.

Professors in finance who have a bent toward value investing have also embraced the decile classification system. One of the first scholars to give the Efficient Market Hypothesis a good thrashing using a value-investing rule is Sanjoy Basu. He sorted stocks into multiple pigeon holes based on a price-to-earnings-ratio filtering criterion. Basu's published results from the 1970s showed portfolio returns increasing as the price-to-earnings ratio was reduced. His impressive value investing conclusions could have been left at that, but a last table in his study sliced each of the P/E categories into ten subsets based on stock price performance.[1] I guess the urge to carve up stocks into deciles couldn't be resisted.

Ranking stock deciles by performance using value investing filtering criterion has been the norm in scholarly papers for some time. In the aggregate, value mutual funds have used these academic results to promote their funds to the retail public with wild success. The chart below shows the percentage of all value investing mutual funds in the Morningstar® database that are larger than $500 million, based on assets under management.


Morningstar® database of mutual funds

Of the 2,089 mutual funds in the Morningstar® database that have the word "value" in their title, close to fifty percent of them have an asset size of at least $500 million. More than a third are $1 billion or more in size. With alternatives to equity funds providing returns not much greater than canned goods stored in a basement, there's no stopping the marketing push for more value funds. The ability of these funds to attract ever more capital from a desperate public seems unending.

As in the case of deciles destroying the Spanish pieces-of-eight tradition, have value investing mutual funds abandoned their humble beginnings? The Graham-Newman Corporation founded by Benjamin Graham, the father of value investing, was in business from 1936 to 1956. After picking through some of Graham's annual letters to shareholders, I've put together the table below to show the amount of assets under management at his firm.

  Graham-Newman Corporation Historical Summary
Year Total Market Value of All
Assets at the Graham-
Newman Corp.
Total Market Value of All
Assets at the Graham-
Newman Corp. (Inflation-
Adjusted Year 2013 Dollars)
Percentage of
Total Assets
Allocated to
Common Stocks
1946 $4,172,040.39 $43,745,623.63 10.97%
1947 $3,740,158.00 $38,319,049.76 37.66%
1948 $3,808,176.00 $38,098,682.80 35.89%
1949 $5,242,969.00 $51,248,186.20 51.07%
1950 $5,568,145.00 $53,898,253.49 64.84%
1951 $7,204,634.00 $64,629,641.58 61.86%
1952 $7,470,365.00 $65,580,408.01 63.58%
1953 $7,307,498.00 $63,670,111.48 70.26%
1954 $5,326,213.00 $46,176,612.61 64.66%
1955 $5,058,053.00 $44,015,782.66 60.53%
1956 $5,128,177.00 $43,968,132.80 26.91%
Average Size $5,456,948.04 $50,304,589.55 49.84%

As indicated on the table, Graham managed around $50 million in assets on an inflation-adjusted basis. As shown on the previous chart, more than half of all value mutual funds today exceed $500 million in size. Over the majority of years the Graham-Newman Corporation was open for business, its asset size was approximately one-tenth that of a value mutual fund operating today. On an inflation-adjusted basis, Graham's investment partnership was puny compared to the oversized investment vehicles driven by value fund managers today. Restricting the investments Graham-Newman held in common stocks, the asset size differential compared with its modern contemporaries is even greater. In most years, Graham invested around 60% of clients' money in common stocks. The balance remained in bonds and less volatile preferred stock that paid a steady dividend. Most of the value mutual funds in the Morningstar® database are fully invested in common stocks with a low cash level as a percentage of assets under management. When comparing the reduced common stock exposure of Graham's fund with his modern day intellectual offspring, the size differential in terms of equity exposure is exacerbated even further.

After Graham called it quits and retired to California, one of his former employees, Walter Schloss, decided to hang up a shingle and run his own investment shop. Schloss, who embraced a version of his former employer's value investing philosophy, didn't have anywhere near the asset size that value mutual funds manage today. He was quoted in a Forbes article in 1973 as managing around four million dollars. That comes to around $21 million on an inflation-adjusted basis today. My how times were lean for those glorified value investment gurus of yesteryear!

Thanks to the endless Federal Reserve money printing, there seems to be no end to a financialized America. Not only has there been an explosion in public and private debt, but mutual fund assets have also seen a massive increase in size. I would think it would be quite challenging for today's value fund managers to squeeze such a large amount of capital into some decile of stocks that trade on a relative basis below some stretched measure of Graham's concept of intrinsic value. Given the colossal size of these value mutual funds, drawing management fees off these mega-sized financial products strikes me as a far better business than investing in them.

 


[1] Sanjoy Basu, "The Information Content of Price-Earnings Ratios." Journal of Financial Management (Summer 1975): 60-62

 

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