LSV Asset Management was founded in 1994 by, and named after, Messrs. Josef Lakonishok, Andrei Shleifer and Robert Vishny. The Chicago based firm today is run by Mr. Lakonishok and twenty equity partners with strong academic backgrounds similar to the original founders. LSV Asset Management (LSV) is a mostly employee owned firm with an AUM of just under sixty billion dollars. The firm uses quantitative value equity managers in providing active management for institutional investors through the application of proprietary investment models.
The Three Musketeers of Quantitative and Behavioral Finance:
The founders of the firm are accomplished and reputed academics, especially for their work in behavioral finance. The cornerstone of the firm’s investment philosophy is the trio’s combined quarter century of research and some odd two hundred plus research papers they have produced. As a matter of fact, LSV originated from the founding fathers’ academic desk: Contrarian Investment, Extrapolation, and Risk (updated in 2009 by The Brandeis Institute). The 1994 landmark study, for which the trio was bestowed the prestigious Roger F. Murray Award, became the de facto manifesto on the basis of which LSV was established.
As mentioned before, Mr. Lakonishok is the CEO, Chief Investment and Founding Partner. He obtained his BA in Economics and Statistics from the University of Tel Aviv in 1970. In 1972, he obtained his MBA from the same university. In 1974, he had obtained another degree this time an MS in Statistics from the prestigious Cornell University. He later pursued his PhD. in Finance from Cornell University as well. With an almost perfect combination of statistics and economics, he began his career as an academic and wrote numerous papers on those subjects.
He started his career at Tel Aviv University, where he was appointed as Professor for Economics and Accounting. He continued teaching there for nine years for the period 1976-1987. Meanwhile, he began his US career as visiting faculty at the Johnson Graduate School for Management at Cornell. In 1987, he moved to Chicago and became the William G. Karnes Professor of Finance at the University of Illinois at the Urbana-Champaign campus. He has also been acting as a visiting faculty for University of North Carolina, Chapel Hill and University of British Columbia, Canada.
The other two co-founders, Mr. Andrei Shleifer and Mr. Robert Vishny, although no longer with the firm, have left an enduring influence on the philosophy and strategies used by LSV even till this day. The Russian, or Soviet at the time, Mr. Shleifer is a highly acclaimed economic academic. He held tenure in Department of Economics at Harvard University for a decade (1991-2001) and then for the next five years was the Whipple V. N. Jones Professor of Economics. He has been awarded the John Bates Clark Award for most promising economist under forty.
Mr. Robert Vishny is also a highly renowned economist. He graduated from the University of Michigan with an AB in Economics, Mathematics and Philosophy and later acquired his PhD. in Economics from MIT in 1985. He is also a former Eric J. Gleacher Professor of Finance at the University of Chicago.
Investment Philosophy and Process:
The fundamental framework of LSV’s investment philosophy is founded in the exploitation of judgmental biases and behavioral weaknesses encompassing investment decisions to achieve superior long-term gains. Traditional financial theory purports that investors are “wealth maximizers” but are distracted by emotional and psychological factors causing them to make unpredictable and irrational decisions. Behavioral finance, on the other hand, explores the reasons behind these “anomalous” financial decisions. Even though conventional, and modern, finance is based upon logical theories, such as capital asset pricing model (CAPM) and efficient market hypothesis (EMH), there are instances in which these theories fail to account for, and explain, investors’ decisions.
These anomalies are beyond the scope of logical and rational explanation. For example, even knowing the extraordinary odds of winning the lottery does not deter a person from purchasing a lottery ticket. This tendency to overlook statistical evidence and form a “mindset” is the locus of the contrarians at LSV. However, behavioral finance has its detractors, notably Eugene Fama, who believes that market efficiency cannot be completely ignored and that these anomalies are ultimately corrected over time.
LSV is a deep-value investor that uses a quantitative investment model to select undervalued stock with a potential for near-term growth, believing that these out- of-favor stocks will produce superior returns if their future growth surpasses the market’s low expectations. To begin with LSV differentiates between a “value” stock, a poor performer with poor future potential, and a “glamour” stock, a good performer with good future potential. The stocks are classified as such, value or glamour, based on four metrics: book-to-market (B/M, the opposite of price-to-book), cash flow-to-price (C/P), earnings-to-price (E/P), and 5-year average growth rate of sales (GS).
LSV’s argument, as mentioned before outlined in their 1994 study, is that value strategies produce superior returns because investors do not fully understand the phenomenon of mean reversion and hence, guides them to ”extrapolate past performance too far into the future.” To exploit this behavioral weakness, or intuitive forecast, LSV’s counter-intuitive strategy is that contrarian investors should buy “value” stock and sell “glamour” stock. This adds an extra dimension to each one of the four aforementioned metrics to further fine tune the selection process. This Two-Dimensional Classification defines LSV’s “value strategy “as “buying stocks that have low prices relative to earnings, dividends, book assets, or other measures of fundamental value.”
LSV’s investment process involves quantitative techniques with a bottom-up approach for stock selection. Although the investment process is uniform for each of the investment strategies it is divided into capitalization ranges or regions, LSV has thirteen value equity strategies in all. LSV uses a proprietary investment model to rank stocks on a variety of factors contributing to the predictability of future stock returns. The process is continuously and diligently improved by the LSV investment team while maintaining a basic combination of the rudimentary forces that propel markets: value and momentum factors.
To complete the process, LSV employs strict risk controls that limit the exposure of the portfolio to industry and sector concentrations. Individual stocks are limited to exposure as well to further control risk. Portfolio turnover is about 30% per strategy.
“We are quantitative value money managers. There are more and more quantitative money managers today, but I think that when we started, you didn’t really have that many active value money managers.”
“I always believed that if people are getting too excited about a performance of a company that is doing well for a prolonged time period, as did Cisco, Microsoft, etc., investors extrapolate past performance too far into the future and push prices up too high. Eventually these companies will disappoint investors.”
“We like to buy value stocks, stocks that are out of favor, that have disappointed investors for quite some time. Investors will eventually be rewarded not because the companies are great, but because they bought the stock at a cheap price.”
“I never could understand why anybody would buy a company and pay huge multiples for it. You need a lot of luck to be able to justify such prices, because markets are competitive. If you have a good product, you will attract competition.”
“The efficient market theory tells you that prices more or less reflect the value of the company.”
“We are quantitative value money managers. There are more and more quantitative money managers today, but I think that when we started, which was about seven years ago, you didn’t really have that many active value money managers. We probably were relatively early in this game. A lot of things that we do came out of academia. The company was founded by Rob Vishny, a professor at the University of Chicago, Andrei Shleifer, a professor at Harvard University, and myself. We tried to incorporate a lot of ideas from behavioral finance, and all sorts of inefficiencies and anomalies that we saw in the literature.”
“I always believed that if people are getting too excited about a performance of a company that is doing well for a prolonged time period, as did Cisco, Microsoft, etc., investors extrapolate past performance too far into the future and push prices up too high. Eventually these companies will disappoint investors. We like to buy value stocks, stocks that are out of favor, that have disappointed investors for quite some time. Investors will eventually be rewarded not because the companies are great, but because they bought the stock at a cheap price. I never could understand why anybody would buy a company and pay huge multiples for it. You need a lot of luck to be able to justify such prices, because markets are competitive. If you have a good product, you will attract competition. It’s very difficult to sustain your edge and continue to grow at high rates. Therefore, it made a lot of sense for me to be a contrarian investor and stay away from companies where there is too much optimism.”
“The efficient market theory tells you that prices more or less reflect the value of the company”
“The Internet bubble, the media telecom bubble, how can you explain in a rational way valuations that made absolutely no sense?”