Value in Bonds

As I'm in the midst of a job search I haven't dedicated as much time as I would have liked to getting this blog started. I'm hoping to increase the frequency of posts as I am able. In the meantime you may consider subscribing to the RSS feed so that you automatically receive new posts.

---------------

Market prices for fixed income securities can be volatile just like those for equities, especially for those bonds with longer maturities. As you may be aware, Benjamin Graham describes bargain issues as those stocks and bonds particularly worthy of a security analyst's investigation. In terms of bonds these bargain issues are bonds that are deemed to be safe investments but which still sell at so low a price "as to offer a chance of considerable enhancement in market value". This is why we want to find bonds of a higher quality which are trading at a discount to bonds of a lower quality. In most cases bonds would be trading cheaply because their safety is questionable but this is not always the case. As in equities, there are always a small number of cases where a security may be trading at a discount while still meeting strict investment standards. Fundamentals still reign supreme in fixed income though, so not only do you want a company that may have been battered by the market and investor sentiment (even if correlated with a higher yield on the fixed income security), but you want to be confident that your contrarian views are correct. The bonds are only valuable so long as the company is still in existence!

The concept of finding value in fixed income securities is relatively straightforward, but where do we begin to look for these bargains? If the equities of certain companies may have been negatively affected, creating value opportunities within the equity market, then perhaps the fixed income securities of these companies may be a good place to start. As there is no apparent systematic way to segment corporate bonds into value and growth categories, The Brandes Institute went back to a study they conducted on equities and then studied the bonds that the companies in the study had issued. Their main findings were as follows:

• There were more issuers with debt outstanding within the value companies.
• The bonds issued by companies within the value group delivered a better total return than the bonds issued by the growth companies over subsequent 3 year periods from 1990 to 2007.

What is interesting from the findings of the study is that one would assume the difference in total return to be merely due to the value bonds' lower average credit rating and subsequently higher average spread. As such, The Brandes Institute compared the Lehman Brothers U.S. Aggregate Corporate A Index (a proxy for bonds of the growth companies which had a credit rating of "A" on average) to the Lehman Brothers U.S. Aggregate Corporate BAA Index (a proxy for bonds of the value companies which had a credit rating of "BBB+" on average). Over the same period as the study, these indices showed a difference in total returns of 14 basis points versus the approximately 69 basis point annualized total return difference between the value and growth bonds in the Brandes Institute study. The total return advantage for bonds of value companies therefore can not be fully explained by credit quality or yield spread.

It's difficult, if not impossible, for a retail investor to build a bond portfolio with adequate diversification. Perhaps there would be demand for a fixed income ETF that invests solely in the fixed income of the low price-to-earnings universe of stocks, which is commonly used as a generalization for the universe of value stocks.

Ups and Downs of the Business Cycle

I do not recommend trying to time the market. Once again - I do NOT recommend timing the market. That being said there are benefits to knowing where we are in the business cycle.

From a value perspective what I look for first and foremost is the discount to a company's intrinsic value that their stock is trading at. This card trumps all as the company that leaves you the greatest margin for error should outperform in the long-run. Assuming all else being equal, including the discount to intrinsic value, there are times when I would select one investment over another. Look at today's markets for instance, we are most definitely somewhere around the trough of the business cycle. As the markets begin to improve we can expect a resurgence of inflation as demand returns and rates (which are now at historic lows) revert to the long-run average. At a time like this I would rather hold resource producers that will benefit from commodity price inflation. On the other hand, I would stay away from consumer goods manufacturers who will be susceptible to the rising input prices and may have competitive pressures which will keep them from raising prices to compensate. Financial companies would also perform poorly in an inflationary environment as rates rise and cut into their profits.

As mentioned before, this is only one of the many considerations that would go into comparing one investment option to another. If one company looks like the greater value play and has comparable long term prospects then the short term implications of the business cycle would not play a major part of the decision. This brings me to the next implication for this topic on value investing. When valuing a company it is a good idea to normalize earnings over an entire business cycle. As value investors we take a long term horizon and the value of a company relies in large part on profits that are expected many years into the future. As such, the next few years in the business cycle should not play much importance in the investment decision. It is important to make sure that you don't "anchor" your future expectations on recent boom or bust years. By normalizing profits over an entire business cycle we enable our valuation to take a realistic long-term view of the profits a company can be expected to make without incorporating a bias from the most recent reporting periods. As long term investors we are concerned with the long-term path of the economy and not the short term booms and busts that give rise to great investment opportunities.

First Post - Recommended Reading

It's pouring rain outside as I sit here and listen to the thunder and the occasional wail of sirens passing by... what better time for my first post! To introduce myself; I am a 25 year old student of value investing and, while I will surely get older and more knowledgeable, I will also always remain a student of this investment philosophy. Having been only formally introduced to value investing within the past year, at MBA school, I am already a devout follower in and believer of the philosophy. During the past year I have read countless journal articles and research papers on value investing - I have even valued a company or two (quite the understatement). The goal of this inaugural post is to start you, the reader, on the path of enlightenment. Following are a list of journal articles and working papers that I recommend you read in order to help you pursue a value investment methodology with the discipline that is required. If you are currently enrolled in a post-secondary institution then you can likely access the journal articles through your school's library. The working papers listed can be found via the Social Science Research Network (SSRN).

1. Abhyankar, A., Ho, K., Zhao, H., Value versus Growth: Stochastic Dominance Criteria, Working Paper, 2006.
2. Arshanapalli, B., and Nelson, W.B., Small Cap and Value Investing Offer both High Returns and a Hedge, The Journal of Wealth Management, Spring 2007.
3. Athanassakos, G., Portfolio Rebalancing and the January Effect in Canada, Financial Analysts Journal, Vol. 48, No. 6, Nov. – Dec., 1992, pp. 67-78.
4. Athanassakos, G., Value vs. Growth Stock Returns and the Value Premium: The Canadian Experience 1985-2002, Working Paper, 2006.
5. Bauman, W.S., and Miller, R.E., Investor Expectations and the Performance of Value Stocks versus Growth Stocks, Journal of Portfolio Management, Spring 1997.
6. Capaul, C., Rowley, I., Sharpe, W.F., International Value and Growth Stock Returns, Financial Analysts Journal, Vol. 49, No. 1, Jan. – Feb., 1993, pp. 27-36.
7. Chan, L.K.C., and Lakonishok, J., Value and Growth Investing: Review and Update, Financial Analysts Journal, January/February 2004.
8. Fama, E.F., and French, K.R., Value versus Growth: The International Evidence, The Journal of Finance, Vol. 53, No. 6, Dec. 1998, pp. 1975-1999.
9. Kao, D., and Shumaker, R.D., Equity Style Timing, Financial Analysts Journal, Vol. 55, No. 1, Jan. – Feb., 1999, pp. 37-48.
10. Lakonishok, J., Shleifer, A., Vishny, R.W., Contrarian Investment, Extrapolation, and Risk, The Journal of Finance, Vol. 49, No. 5, Dec. 1994, pp. 1541-1578.