Could the unfortunate fate of the three blind mice – specifically the loss of their tails by way of a carving knife – be explained away by the farmer’s wife being a keen student of Vietnamese history? For once, when Hanoi was suffering from a particularly severe rat problem, its French colonial rulers offered a bounty for every rodent killed – payable on the production of a rat’s tail.
Even though many bounties were paid out, however, the city’s problem did not improve and the reason for this eventually dawned on officials as they started to notice an increasing number of tailless rats scampering about. It turned out the locals were cutting off the tails of the rats they caught and then releasing them so they could breed and therefore grow the pool of potential revenue.
Something similar happened in colonial India where a bounty on killer cobras led to the locals breeding more snakes to pocket more cash and thus to a higher cobra population – particularly when the bounty system was ended and the cobra-breeders released their now-worthless charges. As it happens, this idea of an attempted solution making a problem worse is known, among other things, as the ‘cobra effect’.
Both of these anecdotes came to our attention courtesy of the interesting Investor’s Field Guide blog When measures become targets: flow index investing changes indexes , which makes the point that whatever you choose as a measure of performance is what you end up getting – and that holds true for fund managers as much as it does for colonial officials striving to deal with a rat or snake problem.
As the blog puts it: “Tell a portfolio manager that they will get paid on Sharpe Ratio, and you can bet that their Sharpe will improve, relative to other measures of investing success. This can become a problem.” This state of affairs is summed up by something apparently known as Goodhart’s Law, which holds: “When a measure becomes a target, it ceases to be a good measure.”
The blog touches on the huge rise in the popularity of index-tracking funds before – the point where we began to get really interested – focusing in on value. The author observes, for example, they would rather pay 100 basis points for an S&P 500 index fund trading at 12x normalised earnings than five basis points for the same market trading at 25x earnings, which is where it stood in March 2016.
Tying together the two strands of value and performance metrics, the blog then points out the price-to-book ratio, which has historically been one of the most common measures of valuation, “became the target around which hundreds of billions in assets built value portfolios and indexes, and along the way has decoupled from other major value factors” – for example, EBITDA, free cashflow and total yield.
Defining value factor
Metrics such as these have proved better indicators of value since price-to-book was first seen as the defining value factor, suggests the blog, continuing: “Interestingly, if price-to-book value goes fully out of favour – don’t think we are there yet – it may finally make price-to-book a good measure of value again! Watch for big names to change their definition of value from price-to-book to something else.”
We are, in other words (and despite the blog primarily focusing on US data), back on familiar territory for The Value Perspective – the dangers of following the crowd and, in particular, the distortions that can be created when everyone is doing the same thing – so it was interesting to see the Investor’s Field Guide going on to quote one of our favourite investors, Seth Klarman.
Writing back in 1991 about indexing in general, says the blog, the Baupost Group founder observed: “I believe that indexing will turn out to be just another Wall Street fad. When it passes, the prices of securities included in popular indexes will almost certainly decline relative to those that have been excluded.”
Noting a Barron’s line that “a self-reinforcing feedback loop has been created, where the success of indexing has bolstered the performance of the index itself, which in turn promotes more indexing,” he went on: “When the market trend reverses, matching the market will not seem so attractive, the selling will then adversely affect the performance of the indexers and further exacerbate the rush for the exits.”
A quarter of a century after Klarman offered that warning, it is debatable how close we are to seeing his words coming to pass. More certainly, however – and as we discussed in Sleep loss – there is now a growing body of evidence to suggest a primary consideration for investors over the years since the credit crisis has been avoiding volatility.
This only enhances what we might term the ‘bond proxy paradox’ – the hunt for supposedly safe and stable stocks since the credit crisis pushing up the valuations of these stocks to a point where they can really no longer be considered safe or stable. As ever, such things tend to move in cycles and what was once considered an advantage will, after a certain critical mass is reached, become a disadvantage.
As we never tire of pointing out, here on The Value Perspective, a value strategy has outperformed the market over 130 years of history so it is perhaps understandable investors should try to tap into this by tracking a value-oriented index. It would, however, be ironic should mean reversion – one of the fundamental pillars of value – end up being instrumental in thwarting these ambitions.
With today’s valuations, the only way investors stand any chance of achieving portfolios that are attractively valued by historical standards is if they are willing to diverge significantly from benchmark indices. As the wider market continues its hunt for supposed safety and stability, that is where the real investment opportunities are now going to be found.