Berkshire Ruminations

Thursday, January 22, 2009

RBP Investing Update

Back in June I mentioned on this blog that I had started working for a company called Transparent Value, which developed the Dow Jones RBP Indexes based on their proprietary methodology called "Required Business Performance," and that I had been writing a blog for them.

While I realize it may sound like I am just trying to sell the company, I seriously think anyone with an appreciation for value ought to give this methodology a look because it looks like the guys at Transparent Value really are on to something. This is evidenced by the performance of the indexes in 2008. If you had used their methodology to construct a long/short market neutral portfolio you would have beaten the market handily (and actually earned a positive return in 2008!). Granted we only have one year of performance history, but what a year it was to test an idea like this!

For an academic and value investor like me, their methodology is the perfect blend of empirics and fundamental value. Basically they take each company determine what assumptions one would have to make about it in order to make a DCF valuation yield whatever the current stock price is. Then based on historical performance the assign each company a probability that they will be able to deliver up to those assumptions. The indexes simply select stocks based on this probability.

I am always looking for empirically solid but economically logical investing strategies (in fact my other blog, Empirical Finance Research, is devoted to this idea alone) and RBP fits in perfectly. If any readers of this blog have questions about it, let me know because its sometimes hard to understand at first. But once you get the gist of it it's pretty rockin.

Friday, January 09, 2009

Fundamental Value Investors: Characteristics and Performance

My good friend Wes Gray and I recently wrote an academic paper about value investors. Wes is a fellow coauthor mine over at the Empirical Finance Research blog. In our paper we analyze the investment recommendations on the website Value Investors Club, which in my opinion has some of the highest quality research accessible by the general public.

VIC started about nine years ago and today has more than 3000 very high quality research reports written and published by its members. Most, though not all, VIC members are professional money managers and membership in the club is limited and coveted. Wes and I wondered (from an academic point of view) if these people were actually able to beat the market given that, in an efficient market, we would expect them to not.

Our results indicate they do beat the market and can produce substantial alpha over one-year holding periods. They do best picking small cap stocks, but for horizons longer than one year they fail to beat the market. From this we conclude that there is more inefficiency in small caps and that the broader market recognizes these inefficiencies if you give it a year. This was an exciting finding for us since it logical and makes economic sense and also means we aren’t wasting our time reading VIC write-ups!

Anyway we posted the paper at SSRN yesterday and Guru Focus has already republished it themselves, although I am keeping an updated version on my personal webspace. We would love getting feedback on it as we are looking to improve it and prepare it for academic publication.