Value investing evidence roundup

The past week or so, Greenbackd has been collecting evidence for the outperformance of value investing, use of the magic formula, and the use of other ratios to outperform the market.  It's great stuff.

I had planned to write a post this weekend with links to all, but I just checked google reader and another excellent blog, Alpha Vulture, already did that in this post.

Here's the blogger known as Alpha Vulture, with his master - an unlikely looking older woman.  Alpha Vulture is about to scan the pink sheets for prey, and report back on his blog.  I may then select the tastiest morsels to invest in.

So now I don't have to find all the links and try to put them into html, just click on the link above.

Venture capital returns

The hilariously named and always good to read Felix Salmon has a great post on How venture capital is broken.

Here's a picture of Felix's face.

This is one of those times where I could summarise his post, but it's really good anyway and already summarises a larger report.  Basically, he's got data for venture capital returns (which there was very limited data on before) showing that there aren't insanely high returns to limited partners (ie, investors).  In fact, the marginal investor is earning a negative return, and probably has been since about 1995.  

I like this because I once sat in a meeting with a senior government official who glibly told the 8 or so attendees that "what happens is off shore private equity [of which venture capital is a subset] borrows overseas at 4%, and invests here earning 25%, and leverages up even more to make three digit returns".  I didn't even know what to say and so said nothing.  (I could have said this, or this, but no one else seemed shocked so I just blinked as loudly as possible).

I like confirmation of the fact that he was almost certainly wrong, and had probably been to too many meetings with people like this.

Pure magic, or just an illusion?

Doesn't look like 30.8% to me

Greenbackd has an excellent round up of recent evidence on the outperformance of Joel Greenblatt's so called "magic formula".

I won't repeat his post - just go and read it.  But basically, it outperforms, but nowhere near the 30.8% cumulative annual growth rate that Greenblatt reported in his book.  Wes Gray has elsewhere noted that Greenblatt has dropped that number from his speeches.  Gray suspects that Greenblatt made an error in his backtesting.

Regression to the mean, or why second albums suck

I'm currently reading Daniel Kahneman's Thinking, fast and slow.  It's excellent.  It's taking me a while to get through, because the book is long and has lots of great insights that take a while to digest.

He looks like he's thinking at a medium pace here.

One such insight is the oft-quoted but less understood "regression to the mean".  Kahneman gives the clearest explanation I've ever read.  Put simply, he says that many outcomes are a result of a combination of what we might call "skill" and "luck".  (If you don't like the word "luck", just substitute "randomness").

Because many outcomes are the result of skill + luck, when there is a particularly good outcome (say an investment manager's portfolio return in a year), it is likely that the next year will be less impressive.

For argument's sake, let's be generous to investment managers and say that their portfolio return for a single year is a result of 30% skill and 70% luck.  If they are a skilled manager, who gets lucky, they will have a very high return that year.  Let's say they were in the top 10% of luckiness that year.  The next year, they are still highly skilled (their skill transports over time), but the 70% luck outcome resets every year (of course, it resets every nanosecond, but for our purposes we can think of it resetting each year as that is our measurement period).

When the random number generator called life rolls the investment manager's portfolio dice, the probability that they repeat their good luck or receives better luck is 10%.  The probability that their luck "reverts to the mean" is whatever's left - 90%.

God rolling the dice of life, and determining your investment results. 

That's why it's interesting for the purposes of investments (and of course it applies to individual stock picks, yearly results, and all sorts of decisions that need to be made).

But it occurred to me there's another area where it goes a long way to explain (and to my mind probably completely explains) a commonly debated and observed pattern - bands' second albums are almost always worse than their first.

The Strokes - it wasn't because Julian got a long term girlfriend, it was a statistical artifact called regression to the mean!

So the first thing you have to realise is that the only reason you have heard of a band's first album is because it was excellent, right?  There are a lot of bands making first albums in the world, and you hear a miniscule fraction of a tenth of a hundredth of one percent of those albums.  For that to happen, the band has to be skilled, but of course there are lots of skilled bands.  On top of that, the band has to get lucky - not a bit lucky, but massively lucky.  For whatever reason, be it coincidence of time and space, the music they make has to resonate with the public, and probably with you, for you to think the band is good and to worry about the band's second album.  Right time, right place, whatever - the band got a bit lucky.

So we know that luck played a large part in determining the outcome of their first album (this does not undermine the skill/taste/coolness of the band, it just notes that there is an aspect of luck to their success).  When luck is reset for their second album, the chances of them repeating their outstanding skill + luck combo are tiny!  Of course it's going to be a worse album!  The only reason you heard of them in the first place was their crazy luck to make it out of the swamp of average debut albums.

So next time someone at a party starts talking about bands with disappointing second albums, impress them by talking about regression to the mean.  If that doesn't impress them, really wow them by bringing up this blog post on your iphone or android device!