Content provided by Rusty Vanneman, CLS Chief Investment Officer
Why does value investing work? Simply put, the expected return for any investment is determined by the price you pay. For example, a great company could still be a bad investment if the price paid is too high. Conversely, a sub-par company could be a good investment if the price paid is low enough. Or, to put it yet in another, though perhaps a bit simplistic, way, if you pay $10 for $1 of dividends, then that obviously should provide a better return than paying $10 for $0.50 of dividends.
There is plenty of academic research supporting value investing, including the well-known Fama & French study from 1992. Money managers like David Dreman have also published considerable research on why value investing works. A Google search will find numerous studies supporting value investing.
Perhaps more importantly, the proof isn’t just in academic studies, but in the actual results of great value-oriented money managers, past and present, including Warren Buffett, Bill Nygren, and the late Sir John Templeton. The list of great growth-oriented investors is a lot shorter, but names like David L. Babson, T. Rowe Price, and Peter Lynch were still very conscious of value.
Intuitively, we know that investors tend to underperform the market, and this underperformance is often referred to as the “behavior gap.” Arguably, the biggest reasons for the behavior gap is that investors follow the crowd and chase performance. However, value investors, by definition are not chasing performance, nor are they following the crowd.
A security only becomes a value when prices are down – and they are usually down for a reason. And bad news flow follows lower prices. So to buy an ideal “value” investment, the security in question is not going to look that attractive in the context of the current market narrative. This is why value investing can be so hard to do. It is often seen as too risky, but not in the traditional sense of risk as tied to price volatility. Instead, value investing runs the risk of making the decision-maker look wrong. To buy such a security – and to see it continue to underperform – can be seen as a threat to credibility. In short, being a value investor runs the risk of looking foolish. Not many PMs want that risk.
Value investing is also hard because the data doesn’t change every day. This isn’t reassuring to people who crave constant information or action. More importantly, this isn’t very useful for traders (who need action items to spur volatility), or the financial media (who need to write stories). It takes a while for valuations to change, and the daily barrage of noise and chatter does little to change it. The daily noise might seem important – it’s always used to explain performance AFTER it happened – but it just doesn’t materially move the important needle of valuations.
The pipeline of daily noise includes a lot of forecasts and commentary, of course, but there is also a steady supply of economic data talked about each day. Again, the daily economic data might explain some short-term price volatility, but it’s also rare when any single data point is truly that significant when it comes to changing valuations.
This doesn’t just apply to the stock market either. It also applies to fixed income, which is why there is such a fascination in the daily wiggles in interest rates when arguably the more significant risk – credit risk – isn’t talked about as much (because credit spreads and default rates don’t change as much).
Being a successful investor isn’t necessarily about collecting and processing a vast amount of information and responding to news flow each and every day. Instead, successful investing is typically about discipline and patience. It’s also about having thick skin, because instead of going with the herd, you might be fighting the herd!