Tuesday, January 13, 2009

Stock Picking Ability and Value Investing

Andy Kern and Welsey Gray are two finance doctoral student who also run the blog Empirical Finance Research. They've just put a study up on SSRN titled "Fundamental Value Investors: Characteristics and Performance." In it, they examine the investment recommendations of a fairly large and sophisticated community of fundamental value investors (the folks at Valueinvestorclub.com):
The data in this study are collected from a private internet community called
Valueinvestorsclub.com (VIC), proclaimed by the founders to be an “exclusive online
investment club where top investors share their best ideas.”1 The site has been heralded in many business publications as a top-notch resource for anyone who can attain membership (Financial Times, Barron’s, Business Week, and Forbes among others). The site was founded by Joel Greenblatt and John Petry, both successful value investors and managers of the large hedge fund Gotham Capital. It was created with $400,000 of start-up capital to be the site with “the best-quality ideas on the Web” (Barker (2001)).

The investment ideas submitted on the club’s site are broad, but are best described as fundamental value plays.
What do they find? Here are their conclusions:
We find that value investors are not focused on high book-to-value stocks, but instead focus on intrinsic value (discounted value of after-tax free cash flows generated by a business) and signaling factors in the market (e.g. open market repurchases, insider buying, activist activity). These investors also tend to favor smaller stocks with a value bias for long positions and small growth stocks for short positions. We also determine that value investors are fairly one dimensional and utilize only a few tools when making their investment decisions. This suggests that professional investors may suffer from limited attention and resource deficiency.

Our analysis of value investors’ investments suggests that value investors do have
stock picking skills. Utilizing the BHAR and the calendar-time portfolio regression
approaches, we find evidence that value investors reliably outperform the market.
A very nice paper, and well worth a read. While you're at it, check out the Valueinvestorsclub site - as a guest you can read the recommendations with a three-month lag. Some of them are pretty interesting.