Toward a Theory of Value Investing: A Behavioral Perspective Mohammad Moniruzzaman Siddiquee MBA (UNB Fredericton, 2012) MBA (Jahangirnagar University, 2002) BBA (Jahangirnagar University, 2000) A Dissertation Submitted in Partial Fulfilment of the Requirements for the Degree of Doctor of Philosophy In the Graduate Academic Unit of Interdisciplinary Studies Supervisor: Eben Otuteye, Ph.D., Faculty of Business Administration Examining Board: Gopalan Srinivasan, Ph.D., Faculty of Business Administration Francis Tapon, Ph.D., College of Business and Economics, University of Guelph Michael Bradley, Ph.D., Department of Psychology Donglei Du, Ph.D., Faculty of Business Administration External Examiner: George Ye, Ph.D., Sobeys School of Business, Saint Mary’s University This Dissertation is accepted by the Dean of Graduate Studies THE UNIVERSITY OF NEW BRUNSWICK April, 2017 © Mohammad Moniruzzaman Siddiquee, 2017 Abstract We hear a lot about value investing, an investing approach introduced by Benjamin Graham in the 1930s and championed by Warren Buffett, but we know very little about why it works so consistently. Academia has considered the consistent performance of value investors as a statistical anomaly, but given that it has persisted for more than eighty years, it warrants further investigation. Currently, the higher yields obtained through value investing, which entails finding and buying stocks at a discount to their intrinsic value, is not explained by a body of theory. Furthermore, the complete works of Ben Graham have never been summarized in a systematic and analytical framework. This dissertation addresses both gaps. It summarizes the contribution of Ben Graham to the investment world; and, drawing on tools and concepts at the confluence of behavioral finance and the practice of value investing, my analysis and empirical studies contribute to building a formal theory of value investing. To provide context, the dissertation first focuses on the concept of rationality and explains the rationale of Prospect Theory as an alternative model of decision-making under risk, before tracing the evolution of value investing while highlighting the contribution of Ben Graham to security analysis. Additional literature reviews why value premium exists, mainly focusing on behavioral explanations. The theoretical aspects of value investing are then applied to two empirical examples. The first investigates the extent to which a value investing heuristic that is designed to minimize ‘gut’ decision- making and maximize analytical thinking can outperform other investment systems. The ii second demonstrates that over short holding periods, T-Bills and T-Bonds are safe assets in the sense that they always yield positive returns, however, over holding of periods five years or more, common stocks are just as safe and far exceed returns on T-Bills and T-Bonds. The major contribution of my dissertation is to lay a foundation for the theory behind value investing and to illustrate the reasons for its success through a careful and comprehensive review of the work of Ben Graham and the literature on behavioral finance. Lastly, the dissertation provides individual investors with a useful heuristic that reflects a value investing approach. iii Dedication To my late father, Mohammad Siddiqur Rahman who would be the proudest father today and to my mother, Mrs. Helena Rahman, who has been waiting for the last five years to see her son finishing his studies. To Benjamin Graham, Warren Buffett and Charlie Munger, for letting me to stand on their giant shoulders. Isaac Newton once said: “If I have seen further it is by standing on ye shoulders of Giants.”1 1 This quote is from a letter written by Isaac Newton to a fellow scientist, Robert Hooke on February 5, 1675. See Turnbull, H.W. (Ed.). (1959). The Correspondence of Isaac Newton, Vol I 1661-1675 (pp. 416- 417). Cambridge: Cambridge University Press. iv Acknowledgement I am grateful to my supervisor, Dr. Eben Otuteye for his generosity, without which this dissertation would not have come to fruition. Dr. Otuteye went above and beyond the call of duty. He designed my program of study, starting from developing course works to supervising the dissertation as it unfolded. He introduced me to the world of value investing – he is my Ben Graham. I would like to thank my other committee members: Dr. Francis Tapon (University of Guelph); and Dr. Gopalan Srinivasan (UNB Fredericton) for their time and valuable advices. I am also grateful to my colleague and mentor, Dr. Fazley Siddiq, Dean of Faculty of Business, UNB Saint John for his help and support of my studies. My colleagues Dr. Saiful Huq and Dr. Shelley Rinehart have constantly reminded me to finish my studies. Thanks a lot. I would like to thank the Centre for Financial Studies and Alim Mirza (Government of New Brunswick) for helping me with access to Bloomberg databases. My colleague at the Faculty, Dr. Natalie Folster who carefully read the entire manuscript and provided copyediting services. Jacqueline Seely of the School of Graduate Studies carefully reviewed the formatting of the manuscript. Finally, I am indebted to my beloved spouse, Sanjida Afroz who provided the much needed mental support from faraway. v Table of Contents Abstract ................................................................................................................................................................... ii Dedication ............................................................................................................................................................. iv Acknowledgement ............................................................................................................................................... v Chapter 1 Introduction: Toward a Theory of Value Investing - A Behavioral Perspective ..................................................................................................................................................................................... 1 Introduction and Context ................................................................................................................................ 2 The Research Problem ..................................................................................................................................... 6 Specific Research Questions .......................................................................................................................... 8 Empirical Components .................................................................................................................................. 13 Empirical Study I: Examining the Performance of a Value Investing Heuristic ............... 13 Empirical Study II: Perception of Time Horizon and Performance of Common Stock Portfolios ............................................................................................................................................................. 16 Chapter 2 Literature Review Part I: Alternatives to the Rational Model and Cognitive Biases Culminating in Prospect Theory ................................................................................................ 22 Decision Theory: Introduction .................................................................................................................. 23 Decision Theory: Historical Context ...................................................................................................... 24 Cognitive Biases Culminating in Prospect Theory ........................................................................... 33 List of Cognitive Biases ................................................................................................................................. 38 Debiasing ............................................................................................................................................................. 66 Chapter 3 Literature Review Part II: Benjamin Graham and the Evolution of Value Investing .............................................................................................................................................................. 71 Introduction ....................................................................................................................................................... 72 Before Ben Graham ....................................................................................................................................... 77 Early Era: 1917 to 1934 ................................................................................................................................ 81 Founding Era: 1934 to 1976 ...................................................................................................................... 82 Post-Graham Era: 1976 to Present .......................................................................................................... 89 Thematic Review of Ben Graham’s Ideas ............................................................................................ 93 Conclusion ....................................................................................................................................................... 152 Appendix A: Benjamin Graham’s Works in Chronological Order ........................................ 154 Chapter 4 Theoretical Framework: Why Value Investing Works .......................................... 160 Investment vs. Speculation ......................................................................................................................