Professor Richard Thaler is the current president of the American Economic Association. That may look to be a remarkably uninteresting piece of information but it isn't.
You see, 40 years ago, Thaler's branch of economics simply didn't exist. All economic and financial theory assumed that people are rational beings who consistently behave in the way that is best for them as individuals. This made learning anything about economics excruciatingly boring (which is why I changed to history half way through my own degree). It also made it mostly wrong.
Enter Thaler, who, along with a few others, introduced the then heretical and now pretty mainstream idea that people are all a little bit crazy. We are utterly incapable of making consistently good decisions based on the available information. We are irrational and endlessly biased, and any models based on the idea that we are not is almost entirely useless.
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Earlier this year, Thaler published a memoir, Misbehaving, The Making of Behavioural Economics. In it, he describeshow he has played part in moving behavourial finance from a time in which it was referred to as "wackonomics" to a time in which its chief cheerleader can be made president of the American Economic Association.
Most books on economics or finance are almost entirely unreadable (which is fine given that they are full of nonsense anyway) and I put most of them down after a speed-read of the first few chapters and a skim of the last (getting together the reading list I give you at the beginning of most summers is no easy task). But this one is well written and rather fun.
I'll leave you to read about the biases that have us eating too many nuts before dinner and then having to leave the lobster that comes next (even when we know there is lobster next), and have us mowing our own lawns rather than paying a kid £10 to do it for us, but then not accepting £20 to mow our neighbour's lawn (if we will mow a lawn for the sake of £10, why not £20?).
I want to focus on the bit in the book in which Thaler writes about value investing a subject I also discussed with him when we met for an interview earlier this week. There are hordes of studies that show that, over most reasonable periods of time, investing in cheap stocks is a better idea than investing in expensive stocks.
The original investment guru, Benjamin Graham, told us this was so back in The Intelligent Investor in 1949. Some stocks, he said, traded below their intrinsic value thanks to "neglect or prejudice." They might continue to do so for an "inconveniently long time," but those with a longish time frame could and should just buy these low p/e stocks (stocks with low price/earnings ratios) and wait.
Graham's studies showed that this worked perfectly well. From 1937 to 1969, $10,000 invested in the expensive stocks in the Dow Jones would have ended up worth $25,300. But $10,000 in the cheap stocks would have ended up worth $66,900.
James P O'Shaughnessy gave us some even more stunning numbers in What Works on Wall Street. If you had put $10,000 into high p/e stocks at the beginning of the 52 years leading up to 2003 it would have grown to $793,558. That's nice. But had you put the money into low p/e stocks, your returns would have been way more than nice: you'd have had $8,189,182.
You'd have done even better had you looked at some other measures of value, perhaps price/book (a measure of the price of the shares relative to the value of the assets of the company). Buying shares on a low price/book ratio would have seen you end 2003 with $22m plus change in the bank. Really nice.
Those who believe in efficient markets (and hence remain convinced that nothing is ever the wrong price) would have us believe that this huge outperformance is simply because buying cheap stocks is a riskier business than buying expensive stocks "cheap" can easily turn to "bust." And if investors put their money into risky stuff they naturally demand higher rates of return. This is nonsense.
We all know how quickly expensive stocks can go bust (hello every bank in the Western world) and Thaler proves pretty emphatically in various papers that "value" investing is no more risky than "growth" investing (the same by the way goes for small companies).
So why then, given these numbers, hasn't every long-term investor in the world been buying value for the last 50 years, thus (eventually) eroding the advantage in doing so? The answer is simple: because they are crazy. They stereotype businesses as either "good businesses" or "bad businesses" and then extrapolate endless (and unnecessary) pessimism for the latter. It's an irrational over-reaction.
So there you have it. If you want to be the one to make the money, all you have to be is slightly less crazy than most other people. Be sane enough to look for value, to buy value, and then to wait for that value to come good and your long term profits are as good as in the bank. That's the good news.
The bad news is that there isn't much value around at the moment: Socit Gnrale's Andrew Lapthorne notes that in the US at least "EV/Ebitda ratios have rarely been this high"in the last 20 years.
So where do you go?
You can invest with Thaler himself if you are in the US. Fuller & Thaler Asset Management advises on a fund in the US (theUndiscovered Managers Behavioral Value Fund)that "capitalises on the market's over-reaction to negative information regarding a company's future prospects" and has outperformed the index by around three percentage points a year after fees for the last ten years.
Otherwise, you could look to the few cheap markets in the world (I recommended Vietnam last month) or find a UK-based manager who will do it for you.
I met with an old friend and sometime colleague this week Tim Price who is hoping to end up the go to guy' in this space. His new fund, The VT Price Value Portfolio, has super-strict rules on investing. At a time when the best-known retail funds in the market are running portfolios with average p/e ratios of 20 times plus, and average price/ book ratios of well over seven, his portfolio has an average p/e of 13 times and an average price to book ratio of 1.3 times. It is a little too expensive the total expense ratio is 1.8% but this should come down as the fund grows and, assuming there are at least some sane investors still knocking around, it should grow.
A version of this article was first published in the Financial Times
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