Approximately 60 members of CFA Society Chicago and their guests gathered at the University Club on August 18, 2021, for the latest event in the Distinguished Speaker Series. An additional 190 people participated virtually, by live streaming. This was the first event held in-person by the Society since March 2020, due to COVID-19 restrictions. The guest speaker was Josef Lakonishok, chief executive officer, chief investment officer, and a founding partner of LSV Asset Management LLC (LSV). Lakonishok, formerly a professor of finance at the University of Illinois at Urbana-Champaign, co-founded LSV in 1994 along with two other academics whose collective research forms the core of the firm’s management process. He remains the only founder still engaged in the business.
LSV Asset Management specializes in value equity management for institutional investors. Assets under management totaled approximately $112 billion at June 30, 2021. The firm’s investment philosophy asserts that achieving superior long-term returns depends on systematically exploiting the judgmental biases and behavioral weaknesses that influence the decisions of many investors. These include such tendencies as:
- extrapolating the past too far into the future,
- wrongly equating a good company with a good investment, irrespective of price,
- ignoring statistical evidence, and
- developing a “mindset” about a company.
LSV uses a quantitative investment model to choose out-of-favor (undervalued) stocks that exhibit good potential for near-term appreciation. Because the market has such low expectations for these securities, LSV believes they are more likely to produce superior future returns if their growth exceeds those low expectations. This process produces portfolios with a deep value orientation.
Chris Vincent, CFA, CEO of the Society, opened the event by welcoming all attendees, participating in person or by virtual format. Robert Knezevic, CFA, co-chair of the Distinguished Speaker Series Advisory Group then introduced Lakonishok. He began with a description of LSV’s investment process, which is decidedly quantitative using half a century of quarterly financial data reaching back to 1970. Their universe is the 1,000 largest publicly traded companies in the U.S. They focus on the per-share growth rates of six metrics:
- Gross Profit
- Operating Earnings
- Forecasted FY1 Earnings
Lakonishok presented data for Nonfinancial firms which showed that, over the history of his database, these metrics averaged about 4-5% without dividends included, and 7-8% including dividends (which themselves average 2.81%). The growth rates presented represented actual real growth rates plus 2% inflation. When viewed by sector, the data showed, somewhat surprisingly, that the technology sector did not generate the best returns during the past half century. Healthcare was the best, followed by consumer staples. Both were aided by fairly generous dividends compared to technology. The weakest sectors were telecommunications, and utilities which, despite their high dividends, were unable to generate sufficient growth to achieve a higher ranking.
The basis of LSV’s investment process depends on a ranking of the universe by valuation using the earnings/price ratio (not P/E) and book to market value. They divide the universe into deciles from most expensive to cheapest. Their thesis posits that the most expensive stocks, despite being the fastest growing, rarely generate enough growth to compensate for their rich starting valuations. In effect, their high valuations are too high a hurdle to clear and act as an impediment to future performance. LSV prefers to focus on the cheaper deciles (8, 9 & 10) where low valuations provide an advantageous starting point. Additionally, companies in the cheaper groups tend to pay dividends, which gives them another advantage. The combination of the dividend yield plus the opportunity for expansion of their multiples, more than offsets the lower growth in sales, EBITDA, gross profits, etc.
Lakonishok went on to address questions attendees had submitted in advance.
Does LSV make any changes to the usual definition of “value” in order to make its method work best?
A: The book value of assets must be written down whenever necessary to reflect economic values, and similarly, intangible assets must be valued realistically.
Isn’t value just a cyclical determinant of beta rather than a reliable source of alpha?
A: Definitely not.
What is your position on the debate between active and passive management?
A: At least at the present time, there are far too many expensive stocks in the market that will hold back index returns in the future. This gives active managers a good opportunity to outperform by screening these names out of portfolios.
Are you concerned about inflation?
A: It is definitely a concern for bonds which he would consider richly valued even if the ten-year treasury rose to 2% (from about 1.25% currently). If inflation pushes rates even higher, returns will be impaired further.
Comment on the increased impact of “rate directionality” on stock market returns.
A: Low rates are not positive for future economic growth, so they provide little long-term benefit to the stock market. Their impact is very short-lived.
Can you comment on the Reddit Meme trading craze?
A: The situation is similar to the tech bubble in 1999. The values are not to be trusted. He added that he thinks big tech companies need more regulation. They are too big and powerful.