My F&M

Why Value Investing Works

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In an article last June, we reviewed the history of value investing.  A value tilt, which is a significant part of our investment approach, involves selecting stocks of companies that are priced more cheaply than the average stock on parameters such as revenues, earnings, cash flow, and dividend yield.  We presented historical return data showing that over long periods of time the value approach has produced significantly higher investment returns than both the overall market and growth stock investing.  We also showed that the value approach requires patience because, while it is very effective in the long run, there can be relatively long periods when it trails the overall market.  We’ve been in such a period since 2008. To read the June 2018 Value Investing article, click here!

This article will build on the foundation laid in Mark’s piece by examining why value investing has worked and should continue to work.  Furthermore, if these “cheaper” stocks outperform the market over time, then “expensive” stocks must underperform the market over time.  So why would investors commonly overpay for those stocks?  “Human nature” is the short answer to these questions.

Value investing demands two traits that are often in short supply for investors: patience and discipline.  Because it has periods where it trails the market and many investors are short term focused, impatience can easily cause them to abandon the approach during one of these periods.  This guarantees that impatient investors will have disappointing results from the strategy, but ultimately increases the opportunity for those who persist.  

Perhaps even more challenging is to have the discipline to avoid overpaying for companies with rosy outlooks.  Faster growing companies generally warrant higher valuations, but the market frequently overprices these companies.  At the same time, slower growing companies tend to be underpriced.  The most important underlying behavior at work in both cases is “herding”.   Humans instinctively recognize that there’s safety in numbers, i.e. the herd offers protection.  Indeed, this instinct has worked in providing physical protection for centuries.  However, it’s dangerous behavior in the investment world.  Resisting the impulse to follow the herd is rewarded in investing, but it requires discipline that many investors don’t possess.

Investors are often drawn to the excitement and potential of the fastest growing companies, and herding behavior can quickly cause these companies to be excessively priced as investors chase into the same stocks.  Simultaneously, this herding in the direction of the fastest growers means moving away from slower growing companies, which leads to underpricing them.  Twenty years ago, the herd created the tech bubble.  Fifty years ago, the stock market darlings were called “glamour” stocks or “one decision” stocks, because the herd hoped their growth would make up for overpaying.  It didn’t work out that way then and it doesn’t now.

In fact, there are several barriers to that happy outcome.  It’s exceedingly difficult to accurately predict long-term growth rates for companies, and the mistake is almost always over-optimism.  The default expectation is to project recent growth rates well into the future.  Reality seldom lives up to those extrapolations.  One of the reasons it doesn’t is because economics is working against the growth stocks and in favor of the value stocks.  In a free market, capital is drawn to fast growing areas and away from slower growing areas, so competition inevitably multiplies over time for fast growing companies and frequently declines for slower growers.  Compounding this headwind is the challenging math of maintaining a high growth rate as the size of a business increases.  For a company to continue growing at a 20% rate for the next five years, it must generate more than twice as much in profits in year 5 as it did it in year 1.

So, while there is a strong statistical case built on many decades of investment returns for using a value tilt for investing, it is the enduring nature of the human behavior that underlies those results, and further buttresses that conclusion.  It also adds to one’s confidence to stay the course through periods when value is underperforming.