The evidence that value outperforms long term is compelling, but the question is why. And why do most professionals continue to ignore value strategies?
The more I research value investing, the simpler its concepts appear. It is the simplicity behind a value-based investment strategy that helps explain its success.
To really commit to a value strategy, you have understand why value will continue to work into the future. As dissected in our letter to The Broken Leg Investment Letter subscribers, correlation rarely equals causation and countless investment strategies have ended in disaster because they were based on data mining and erroneous correlations.
Value, however, works and there are endless studies, and the extraordinary track records of some of Wall Street’s biggest names, to prove it. Value’s outperformance is due to causation, not just correlation, and rests on a simple truism - value stocks are hard to buy and require the right temperament, so offer up outstanding investment opportunities.
Even in this market, pockets of investor irrationality offer up great bargains if you know where to look. Over the course of the previous 12 months, we have found 36 great value stocks and have watched some of those rise rapidly in just a few months. As John Templeton said, the stock market is really just a market of stocks.
Warren Buffett (Trades, Portfolio), of course, understands the role of temperament and whenever he imparts his wisdom, it is usually in this area:
"The most important quality for an investor is temperament, not intellect”
There are so many examples of Buffett talking about temperament. I bet if you took all he has publicly said over his 60-plus years on what it takes to be a great investor, he will refer to temperament more than anything else.
Value investors have the temperament to buy what everyone else does not. You only get big dislocations in a market (on the downside) when investors hate something -- when they can no longer stand the pain and give up. It is this basic equation of oversupply and an absence of demand for a stock that drives value’s success as a strategy.
It is rare to see this in growth stocks. Rather, if a stock is loved, you have the opposite problem as few holders want to sell and leave money on the table. Growth stocks are sexy; they have a great story, represent the future and have enormous promise.
The value stock landscape - especially the top deep value strategies we track - is a graveyard of hopes and dreams. Glorious prospects (or fantasies) have turned sour, and stockholders, wanting the pain to end, sell at nearly any price. When you are dealing with emotional sellers in pain, you can scoop up some serious bargains. As Buffett said in a May 2015 CNBC Interview:
“If you’re not going to kick a man when he's down, well, when are you going to kick him?”
Another way to look at this phenomena is through the theory of mean reversion. Mean reversion (where a trend will eventually revert back to a mean) is prevalent right through the natural world. In their 1988 paper “Mean Reversion in Stock Prices, Evidence and Implications,” James Poterba and Lawrence Summers, professors at MIT and Harvard, examined U.S. stock market returns from 1926 through 1985, annual New York Stock Exchange returns from 1981 to 1985 and monthly returns for 17 stock markets outside the U.S. from 1957 through 1986 (which included Austria, France, the Netherlands, Spain, Belgium, Germany, Norway, Sweden, Canada, India, the Philippines, Switzerland, Colombia, Japan, South Africa, the United Kingdom and Finland).
The pair concluded returns for all markets revert to the mean over the long term. Today’s high-return stock tends to be tomorrow’s dog, and today’s poorly performing stock tends to be tomorrow’s champion. Other studies by Tweedy Browne (Trades, Portfolio) come to a similar conclusion - the market mean reverts over the long term.
Whichever way you look at it, either through the neat mathematical and natural phenomena of mean reversion or through temperament, when something is cheap, it is more likely to outperform. And when you find the right sort of cheap stocks, back up the truck.
But will the market continue to undervalue some stocks in the future? Or will market participants pounce on any slight undervaluation, destroying the excess returns of value stocks and killing value investing as a strategy?
Why value will never die
I firmly believe the answer is no and here is why: most money managers look to the wrong metrics to determine risk.
Money managers live by the terms “alpha” and “beta.” Alpha just measures a stock’s outperformance versus the market given the same volatility. Beta is assumed to be a measure of a stock’s “risk” and - incredibly - only takes into account its volatility. Volatility is easy to measure -- you find a stock’s mean return over a period of time and then calculate the variance from that mean for each day's trading. The greater the variance, the greater the volatility and, therefore, the greater the supposed risk. To academics and most money managers, risk has nothing to do with the chance you will lose your money.
On this measure, value stocks will often be judged as being riskier. Value stocks initially underperform versus the market, having had some bad announcement hammer their stock price. The market often takes the stairs up and the elevator down - stocks fall more sharply on bad news than they rise on good news. Having experienced sharper falls and greater volatility, value stocks are therefore seen by much of the market as being more risky.
Buffett usually puts it best:
“The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more...Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people that think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it's riskier to buy $400 million worth of properties for $40 million than $80 million..."
You cannot make this stuff up. When you watch a fund manager on TV, they will talk about alpha and beta. They are operating in a dream world; a world learned through a few finance textbooks at university, where the market can be defined through elegant mathematics. Yet, as Buffett explains, the mathematics behind this is that of Alice in Wonderland. Volatility does not equal risk, yet this is how trillions of dollars are allocated within the market.
The danger of elegant mathematics
Value investing legend Mohnish Pabrai (Trades, Portfolio) puts it this way in his book, "The Dhandho Investor":
“If it (the strategy) requires a spreadsheet, it's a big red flag.”Â
Again, value investing’s power is its simplicity. After nearly 100 years of outperformance, you would think the world would have figured this out. Instead, it is continually fooled by elegant theories such as beta, alpha, modern portfolio theory or discounted cash flow analysis.
From where I stand, the case for value stocks has only become stronger over time. More than ever before, company boards and management today are further removed from accountability by their true owners, the stockholder, as large pension funds account for an ever-growing percentage of the market. Institutional money is nearly always allocated based on all these overly-elegant, questionable measures of risk, leaving major opportunities open to intelligent investors.
Similarly, growth stocks are more popular than ever and real assets (such as real estate, cash, securities, etc.) on balance sheets are mostly ignored, leaving ample opportunity for value investors. Yes - even in this market.
Capital intensive businesses with thin profit margins are being ignored now more than ever. Which institutional investor can withstand the pressure to buy hot stocks versus the market's ugliest of ducklings?
Fund managers can’t afford to be different
“Better to be conventionally wrong than unconventionally right.” - John Maynard Keynes
Fund managers, who make up an ever growing percentage of the market, know it is best to hug the index to ensure a long career. If they fail, after all, so will everyone else. In other cases, fiduciary duty requires fund managers to invest according to the questionable principles laid out above. The biggest (and growing) players in the market (funds) want to invest similarly to each other, and to stay away from “risky” stocks.
No. Deep-value stocks are unloved now more than ever. The fundamental principles of value developed by Benjamin Graham and David Dodd are still set for large market outperformance for the same old reasons - they are ugly, unloved stocks investors mistakenly label as risky. Deep-value stocks are just waiting for a shrewd, patient investor like you to buy them.
