Are The Lessons Of The Past Still Relevant?

{ Euclidean Q2 2012 Letter }


Today, and for some time now, share price fluctuations are being driven by anxieties concerning the state of the world.  Individual companies’ shares are making large moves, even when there is no news directly related to the companies themselves.  A Greek politician speaks, a Spanish minister makes a declaration, and the market value of a company in Tennessee that manufactures towing equipment moves by 10% or more in a single day.  In this context, Euclidean’s YTD performance is now just marginally positive after a strong start to the year, and our monthly returns have had unpleasant swings. 

What should you make of this?  Should you take direction from the volatility of market prices?   Or, should you use the volatility to find disconnects between prices and fundamentals, and buy good companies at bargain prices?  As you know, we choose the second option.  We will not waver in this choice because we believe it persistently carries the day. 

Our Perspective

We are living in unsettling times, and so it is worthwhile to ask, “Are the lessons of the past still relevant today?”  When we consider this question, we reflect on how we might have felt during other unsettling times.  Certainly, during the past hundred years, equity investors have not always had an easy ride.  They have had to endure two world wars, treasury yields fluctuating between 0% and 17%, the emergence of radio, television, computers, and the Internet, and more than 100 sovereign debt defaults and restructurings worldwide (including more than 20 in Europe). [1]

To navigate these volatile and sometimes very scary periods, would an investor have had to evolve his investment philosophy to do well over time?  We think the answer to this question is: no.  To explain why, we will examine a very simple, “value-oriented” approach to investing that ignores external macroeconomic and political developments, and also refrains from making predictions about how a company might grow.  Instead, this method involves purchasing shares in companies at very low prices in relation to those companies’ intrinsic values.  We will look at this approach through both top-down analyses of stock market history and the results of certain well-known investors who have employed it. 

Fama and French

An extraordinary amount of research has been conducted by academics showing that value-based equity strategies have outperformed the market by meaningful margins over long-term periods. One of the most well-known studies is that of Eugene Fama and Kenneth French, whose “Cross Section of Expected Stock Returns”, published in the Journal of Finance in 1992, examines (among other things) the ratio of a company's book value to market value as a source of above-average expected returns. 

Fama and French’s study covered 1963 to 1990 – a period that included the Vietnam War, two oil shocks, treasury yields spiking above 17%, and sovereign debt defaults in Brazil, Argentina, Chile, Mexico, India, and Turkey.  The researchers sorted the domestic equity universe into deciles.  On one end of the spectrum were companies selling at the greatest premiums to book value.  Some refer to these expensive companies as “growth” companies, as it is assumed that the premium market price reflects a belief that those companies are likely to grow at above-average rates.  On the other end of the spectrum were “value” companies.  These companies are selling at the biggest discounts to book value, presumably because the market expects those companies to do less well in the future than they have in the past.

What did Fama and French find?  They noted that stocks in the top “value” decile had an average annual return of 19.6% over the period, whereas an investor concentrated in the top “growth” decile had an average annual return of 7.7%.  This is a stunning difference.  Purchasing companies’ shares at pessimistic prices seems to have been a much better approach than betting on companies priced at a premium. 

Fama and French used this analysis to make certain statements about the tradeoffs between risk and reward, but we note a few other powerful takeaways:

  1. The ratio of a company’s book value to market value is a remarkably crude measure for assessing whether a company’s shares are being offered for more or less than they are worth. It is therefore amazing that one can do well across long periods simply by buying shares of companies on the inexpensive side of the equity universe when segmented by book value.  The big lesson here is that by focusing on something knowable and intrinsic to a business, you can do better than by making predictions of how a company might evolve or how extrinsic factors may impact the business.
  2. It is noteworthy that it would have been a costly distraction if an investor’s concerns about macroeconomic developments caused him to deviate from an investment program focused solely on this very crude measure of value.  Surely most investors did not compound their wealth at a 19% annualized rate across those three decades (doing so would have turned $1M into $100M).  It sounds so simple.  But, during the more volatile times included in this study’s period, imagine how difficult it would have been to stay the course.  Imagine when the market dropped by 40% during the early 1970s.  Remember when the market fell more than 20% in one day during October 1987.  These and many other periods are times when one might have wondered, “Is this time so different that the old rules no longer apply?”
  3. Lastly, and this takeaway is at the core of why we started Euclidean, we note that if you could have done this well with such a simple approach, perhaps there is an opportunity to do even better with a more robust process for evaluating the intrinsic worth of individual companies.

Wall Street Journal & The Brandes Institute

Last month, we shared with our investors an article from the WSJ that presented results from a study by the Brandes Institute.  This study’s timeline overlaps a bit with Fama and French in the 1980s but then continues forward also covering 1990–2010.  So, unlike the first, this study’s measurement period includes the Russian debt default, the collapse of Long Term Capital Management, the September 11th terrorist attacks, and the emergence of the Internet and the associated dot-com boom and bust.  Again, these are all times when it would have been tremendously difficult to adhere to an investment process that focused on buying companies at discounts to intrinsic value and ignored everything extrinsic to those businesses. 

An excerpt from the WSJ article states: 

 “.. a great mystery of investing – a free lunch of sorts has persisted in the form of value investing.  For example, the Brandes Institute sliced US stocks into 10 deciles by value characteristics, from 1980 to 2010, the cheapest outperformed the dearest by 575%.  Such an opportunity shouldn’t persist, but it does.  That is probably because there are bad periods for value stocks of three or more years interspersed among the good ones.” [2]

When we sent out this article, one of our investors wrote us a note stating that he thought the article was interesting but added, “All of this depends on how you define value!” 

We thought this was a fair point but we then referenced research we had done back in 2008, prior to launching our fund in August of that year.  The following simulated portfolios show three very simple approaches for systematically adhering to “value” principles.  Each simulated portfolio was constructed to hold 100 positions and to rebalance annually.  Please review them closely, as well as the additional detail on the simulations provided in the footnote. 

These simple simulations [3] seem to indicate that if your goal is to realize above-average returns, you have a wide range of options for how you define value.  They also suggest that what matters most is that you define a process – however simplistic – that attempts to buy companies’ shares for less than some intrinsically grounded estimate of what they are worth and you adhere to this process, even during uncertain times. 

These findings have been corroborated by numerous researchers. If you’re interested in exploring this further, please consider reading David Dreman’s book titled Contrarian Investment Strategies and Tweedy Brown’s paper titled What Has Worked In Investing.    

Individual Value Investors and Evidence From Earlier Parts Of The 20th Century

Although there is good evidence that value principles withstood the trials and tribulations of the past 40–50 years, what about even more volatile periods including world wars and the Great Depression?  Some argue that to find any real precedent for the state of the world today, you need to look at the 1930s for guidance. 

The reason most of the quantitative research starts in the second half of the 20th century is that reliable financial data on all but the largest public companies is hard to get prior to the 1950s and 1960s.  So, to evaluate how well these same principles might have held prior to those periods, you need to look at the track records of individuals who deployed a value approach in their investment operations.  Fortunately, there are quite a few well-documented examples to choose from.      

For the 1950s, you can point to Walter Schloss, who outperformed the market by more than 8% annually beginning then and continuing through the 1980s.  Walter invested simply by screening for stocks of companies selling for less than their value to a private owner. [4] For the 1940s, you can look to Sir John Templeton who developed great conviction that the best time to buy equities was when people were the most scared.  This conviction, and his success in demonstrating that value principles also worked when investing on a global basis, earned him a great fortune over the succeeding decades.  However, to explore how value principles carried the day even in the 1930s, you can read Benjamin Graham’s writings [5] from that period or you can turn to an unlikely place – to the father of macroeconomics, John Keynes. 

It is relevant to think about Keynes today, given that macro concerns are currently driving market prices for all assets.  What is less known about Keynes, but well documented this year in a paper by Chambers & Dimson of the University of Cambridge, is that the father of macroeconomics had a mixed track record as an investor until he committed to ignoring the macro picture in his investment activity and, beginning in the early 1930s, focused solely on value principles.

From the paper, we learn that in the 1920s, Keynes’ approach: 

“. . . advocated a close monitoring of monetary and economic indicators necessary to decide on a switch between equities, fixed income, and cash. . . He therefore not surprisingly started out with a top-down investment philosophy.  He believed that his skill in interpreting the latest economic statistics – he was also a founder of the London and Cambridge Economic Service – would enable him to time entry into and exit from the stock and bond markets.” [6]

Unfortunately for Keynes, it turned out that even this great macro thinker, who presumably had access to information on monetary developments not accessible to most investors, performed worse than average through the 1920s and up through 1932.  In that year, however, Keynes changed his investment approach.  He decided to ignore the macro picture, trade less, and concentrate his investments in companies that were cheap in relation to their earning power.  His transformation into a value investor was a radical change.  Once it occurred, he commenced a period, lasting from 1932 to 1945, where he outperformed the market by more than 10% a year.  It is also notable that in 1938, he stayed the course even as the market value of his portfolio fell by more than 20%, which was more than twice the decline of the UK equity market. 

Keynes’ experience highlights that having the right investment process (one that seeks to buy things for less than their intrinsic worth) is half the game.  The other half is having uncommon discipline in adhering to that process, even when it is most difficult to do so. 

Relating This Back To Euclidean 

We find the research and examples of the individual investors described above to be compelling because they complement each other.  On one hand you have simple quantitative research suggesting that buying companies at pessimistic prices in relation to very simple measures, like book value or last 12-months earnings, would have been a successful approach to investing.  On the other hand, you have professional investors who, to varying degrees, conducted rigorous assessments of individual companies to understand the true character of their businesses.  In both cases, the approach was the same: to ignore potentially costly distractions and to focus solely on buying shares in companies at large discounts to conservative estimates of their inherent worth. 

This is also Euclidean’s approach.  Like the first camp, we are using quantitative research and a systematic approach.  Like the legends of value investing, we believe that there are better ways of assessing a company’s value than crude measures such as price-to-book or price-to-earnings, and we attempt to develop a nuanced view of a company’s true character by analyzing its entire operating history.  Like both camps, our investment process ignores the uncertain macroeconomic picture and makes no modification in response to volatility caused by other investors’ risk-on, risk-off behavior.  We adhere to this process and take no direction from short-term performance swings – be they for better or worse – with the knowledge that across the volatile times of the past, this approach has persistently carried the day. 

*****

Please let us know if you have any thoughts or comments on this letter.  We look forward to connecting with you in the weeks ahead.

Best Regards,

John & Mike

[1] This Time is Different: A Panoramic View of Eight Centuries of Financial Crises, by Carmen M. Reinhart and Kenneth S. Rogoff.  2008.

[2] Wall Street Journal, Timing Isn’t Everything For Value Investors”, by Spencer Jakab.  2012.

[3] In the simulations, Standard & Poor’s COMPUSTAT database was used as a source for all information about companies and securities for the entire simulated time period.  S&P 500 return is the total return of the S&P 500, which refers to the Standard & Poor's 500 Index with dividends reinvested.  Simulated returns also include the reinvestment of all income. The simulation performance does not reflect the deduction of any investment advisory fees or the impact of trading costs. In each simulation, all NYSE and NASDAQ companies were ranked according the stated criteria such as Price to Tangible Book Value or Price to Earnings.  In the Low Price to Earnings & High Returns On Capital simulation, companies were ranked on each metric, and then the sum of a company’s respective ranks was used to sort the universe of potential investments in order of attractiveness.  Non-US-based companies and companies with a 2007 adjusted market capitalization of less than $100M were excluded from the ranking. Portfolios were constructed by investing equal amounts of capital in the top-ranked companies and holding positions for one year. For the three simulations, portfolios of 100 companies were constructed.  The purchase and sale prices for a security were the average closing prices for the security over a 30-day period from the date on which buying or selling began. The amount of shares of a security bought in a month was limited to no more than 20% of the monthly volume for a security. Historical simulated results presented herein are for illustrative purposes only and are not based on actual performance results. Historical simulated results are not indicative of future performance.

[4] The Superinvestors Of Graham and Doddsville, by Warren Buffett.  1984.

[5] “In 1900 none of us had any inkling of what the next fifty years were to do to the world.  Now, in 1949, we have deeper apprehensions but no more knowledge of the future.  Yet if we confine our attention to American investment experience there is some comfort to be gleaned from the last half-century.  Through all its vicissitudes and casualties, as earth-shaking as they were unforeseen, it remained true that sound investment principles produced generally sound results.  We must act on the assumption that they will continue to do so.”  Excerpt from The Intelligent Investor, by Benjamin Graham.  1949. 

[6] Keynes the Stock Market Investor, by David Chambers & Elroy Dimson.  2012.


We share these numbers because they are easy-to-communicate measures that show the results of our systematic process for buying shares in historically sound companies when their earnings are on sale. [7] [8]

It is important to note that Euclidean uses similar concepts but different measures to assess individual companies as potential investments. Our models look at certain metrics over longer periods and seek to understand their volatility and rate of growth. Our process also makes a series of adjustments to company financial statements that our research has found to more accurately assess results, makes complex trade- offs between measures, and so on. These numbers should, however, give you a sense of what you own as a Euclidean Investor. In general, higher numbers for these measures are more attractive. The key measures are:

  1. Earnings Yield – This measures how inexpensive a company is in relation to its demonstrated ability to generate cash for its owners. A company with twice the earnings yield as another is half as expensive; therefore, all else being equal, we seek companies with very high Earnings Yields. Earnings Yield reflects a company’s past four-year average earnings before interest and tax, divided by its current enterprise value (enterprise value = market value + debt – cash).
  2. Return on Capital – This measures how well a company has historically generated cash for its owners in relation to how much capital has been invested (equity and long-term debt) in the business. At its highest level, this measure reflects two important things. First, it is an indicator of whether a company’s business is efficient at deploying capital in a way that generates additional income for its shareholders. Second, it indicates whether management has good discipline in deciding what to do with the cash it generates. For example, all else being equal, companies that overpay for acquisitions, or retain more capital than they can productively deploy, will show lower returns on capital than businesses that do the opposite. Return on Capital reflects a company’s four- year average earnings before interest and tax, divided by its current equity + long-term debt.
  3. Equity / Assets – This measures how much of a company’s assets can be claimed by its common shareholders versus being claimed by others. High numbers here imply that the company owns a large portion of its figurative “house” and, all else being equal, indicates a better readiness to weather tough times.
  4. Revenue Growth Rate – This is the annualized rate a company has grown over the past four years.

[7] All Euclidean measures are formed by summing the values of Euclidean’s pro-rata share of each portfolio company’s financials.  That is, if Euclidean owns 1% of a company’s shares, it first calculates 1% of that company’s market value, revenue, debt, assets, earnings, and so on.  Then, it sums those numbers with its pro-rata share of all other portfolio companies.  This provides the total revenue, assets, earnings, etc. across the portfolio that are used to calculate the portfolio’s aggregate measures presented here. 

[8] The S&P 500 measures are calculated in a similar way as described above.  The market values, revenue, debt, assets, earnings, etc., for each company in the S&P 500 are added together.  Those aggregate numbers are then used to calculate the metrics above.  For example, the earnings yield of the S&P 500 is calculated as the total average four-year earnings before interest and taxes across all 500 companies divided by those companies’ collective enterprise values (all 500 companies’ market values + cash – debt).