Porfolio Risk and Value Investing

I read a provocative blog post at http://bit.ly/9hmslP where the author Andrew Redleaf discusses risk in the context of modern portfolio theory (MPT) in what would be described in the investment industry as asset allocation or perhaps more simply described as "suitability". Inherent in Mr. Redleaf's argument is that risk can be diversified away. MPT suggests that only non-systematic risk can be diversified away and that ultimately the inherent risk exposure in a diversified portfolio is systematic risk. Systematic risk differs across asset classes and engaging that risk is the core concept of asset allocation.

From his post, Mr. Redleaf seems to suggest that all risk can be reduced and that the work/theories of Benjamin Graham and Warren Buffet supports his theory. Mr. Graham, the father of value investing (of whose work I am a great admirer and have studied and continue to study in great depth), theorized that extra-ordinary returns can be achieved by investing in securities that are priced below their intrinsic value. According to MPT, stocks don't trade below their intrinsic value because all information on securities is reflected in their current prices. We know that this is not true-- otherwise, credit default swaps on sub-prime loans would have been priced much differently. Experience suggests that the market mis-interprets or mis-understands security valuation fairly frequently. However, the market tends to be right more often then not, and only truly skilled technicians can identify and exploit undervalued securities. Mr. Graham recognized that the difficulty with exploiting undervalued securities (which are inherently difficult to identify--it requires expertise in fundamental analysis) is that the market may take years to recognize the inherent value of the security. As such, timing presents a risk to exploiting that value.

There are a large number of asset managers who ultimately put their pencils down and accept MPT. Even Benjamin Graham in his later years suggested that given the enormous amounts of analysis being conducted throughout the world that investors would likely concede to MPT. However, there is a small number of asset managers that will not concede to MPT because they will find and exploit undervalued assets. This is the very essence of why I'm in pursuit of value!

While MPT suggests that systematic risk cannot be diversified away, the relentless pursuit of value can render systematic risk irrelevant. Just ask Michael Burry who took low calculated risks that yielded extra-ordinary returns during a time of systematic failure. Ultimately, realizing true value is not correlated to systematic rises and falls-- I believe that this is the salient point of this entire argument.

How to find which securities to evaluate under a top-down approach

If you start with the top-down approach you can find desirable industries/sectors. But what is next-- how do you maximize efficiency to conduct in-depth fundamental analysis only on securities who have a greater statistical likelihood of being good investments? The following are filtration tools that can be applied:

• Valuation and Fundamental Stock Screens: Multiple tools provide scale and can eliminate less desirable securities. An example is the PEG ratio. If you applied a PEG ratio to the companies within a particular sector you could eliminate large percentages of prospective securities based on their PEG ratio multiple and how that ratio compares to the industry mean. Other examples: P/B ratios, P/S ratios, P/CF, EV/EBITDA, etc.
  
• Insider Analysis: When a company insider buys or sells their company stocks they have to disclose their transactions to the SEC. If an insider is buying their own stock for their personal holdings-- it certainly makes sense that further evaluation of their company may be in order. I believe that insider analysis has merit particularly when considering long positions.

In theory you could apply all of these filters to a particular sector and arrive at a cross-section of possible companies that are most likely to be undervalued. This does not imply that such a cross-section are undervalued, but it certainly assists to come-up with a much more workable list of companies to evaluate.