Easter special on value investing

Since it's Easter Monday up here in Canada, a statutory holiday for us Canadians, The Verdict wasn't shown tonight. So, I've prepared a brief intro to "value investing," the investment philosophy followed by the typical institution that invested in Hollinger International back in the days when Conrad Black was its CEO. (The same company, now named Sun-Times Media Group, is now a turnaround stock.)

Many institutional investors follow an investment model called "Modern Portfolio Theory" (MPT.) The Wikipedia explanation of it will probably seem like gobbledygook to anyone without a background in statistics, but its conceptual underpinnings are fairly straightforward. The two theories that underpin MPT are: the Random Walk hypothesis, which claims that stock prices do not move according to any predictable pattern because changes in those prices are random; and, the Efficient Market Hypothesis, which claims that the present price of a stock accurately reflects all that is presently known about its value. Put the two together, and you come up with the conclusion that it's impossible to predict a stock's future value by simply plowing through its, or perhaps the underlying company's, performance in the past. All that can be done is to rate a stock by the extent of a downturn (or upturn) in its price over a given time period, or its price-volatility over time, as compared with the price-volatility of the market in general. (This is called "the beta coefficient."). Before investing, the investor has to decide how much risk he or she is willing to put up with by investing in stocks at all, in exchange for a return higher than that offered by a risk-free investment like Treasury bills. The beta coefficient is then used to find stocks that are less risky, as risky, or riskier than the general stock market, with a corresponding damping, tracking or amplification of the expected gain when the stock in question increases in price. Once again, the investor's own risk tolerance determines what "beta-weighting" a portfolio will have, just as the investor's tolerance for overall "market risk" will determine how much of his or her portfolio is in stocks at all. An investor can also use diversification, or putting money in more than one stock, to ease the risk that has to be faced. This is MPT in a nutshell; the complexification largely involves specification of risk level and implementation of its principles, including the diversification principle. An MPT investor follows this three-stage procedure: first of all, deciding what percentage of funds should be in the equity market at all; secondly, deciding how much stock-specific risk to take on with the equity part of the portfolio; and finally, deciding how much diversification is desired - how many individual stocks with the appropriate beta coefficient should be bought or kept.

Value investing is explicitly at odds with MPT, or any strategy that uses an MPT-like investment philosophy. Value investors believe that equity markets are not efficient, because some companies are below security analysts' radar and/or because of analysts' biases that are psychological in origin. One famous value investor, David Dreman, rebutted Modern Portfolio Theory in Appendix A (pp. 399-404, hc.) of his 1998 book, Contrarian Investment Strategies: The Next Generation.

Like all forms of investing, value investing carries risk with it - specifically, the risk that an ostensibly undervalued company has something subtly wrong with its prospects. Thus, value investors consider it sensible to diversify; the recommended number of stocks to hold in a value portfolio typically varies from 10 to 20. A value fund often holds the shares of more than twenty different undervalued companies in its portfolio.

In the criminal trial of Conrad Black, Peter Atkinson, Jack Boultbee and Mark Kipnis, the aggrieved shareholders in question, such as Christopher Browne of Tweedy, Browne, believe that the reason why the regular common stock of Hollinger International sold at a discount to its net asset value, and stayed at a discount for an unreasonably long time, was because Conrad Black and the other three defendants swindled Hollinger Int'l, and thus swindled its shareholders. The defendants, of course, deny this allegation.