Value investing is a style of investing developed in the early 1930s by Ben Graham at Columbia University. It involves a three step process. First, identify possibly undervalued stocks by choosing stocks with low price-to-earnings (P/E), price-to-book (P/B) or other valuation related metrics, second, value in depth the stocks that pass the screening process to estimate their intrinsic value and third, make an investment decision to buy only if the stock price is below the intrinsic value by a predetermined margin of safety.
Unlike modern portfolio theory that emphasizes diversification and de-emphasizes valuing individual securities, value investors focus on valuing individual securities and pay less attention to diversification. As a result, value investors have concentrated portfolios: not because they reject diversification, but rather because they operate within the boundaries of their competence. That means they select only securities they understand; they prefer companies with stable cash flows and a history of steady earnings that can be reliably valued. Value investors choose to hold cash when they can’t find underpriced stocks. A lack of new opportunities is a sign to value investors that the market as a whole may be overvalued.
Does value investing work? In answering this question, early academic research focused primarily on the first step of screening as academics did not know what stocks value investors actually buy, but they did know that they tended to buy from the low P/E or P/B group of stocks. Such research showed that value stocks (low P/E or P/B stocks) outperform growth stocks (high P/E or P/B stocks) in Canada, in the US and Global markets by between 6% and 13%, on average, per year over a number of different time periods ending in 2011. They outperform when the markets go down and when they go up, and in good and bad times and when news is good and when it is bad. And they do all this without having higher risk, as measured by beta or standard deviation or adverse states of the world. Thus defined value investing works.
More recent academic research, better focused on what value investors do, also showed that value investing works. Kacperczyk, Sialm, and Zheng and Kaperczyk and Seru, in two papers they published in the Journal of Finance in 2005 and 2007, respectively examined whether skilled managers exist. The researchers studied about 1,700 actively managed U.S. funds from 1984-99 and 1993-2002. They found that the more concentrated a fund was – in other words, the less diversified – the better it did. The outperformance resulted from selecting the right sectors or stocks, not from market timing. Additionally, the studies found that the lower the reliance on public information and the greater the reliance on portfolio manager’s own skill, the greater the outperformance. Value investing is all about concentrating a portfolio to a few selected truly undervalued stocks. And for Keynes, who switched from being a top down strategist to a bottom up stock picker after 1929, “The right method in investment is to put fairly large sums into enterprises which one thinks one knows something about…”, something that Warren Buffett echoes.
Cremers and Petajisto, in a 2009 Review of Financial Studies paper, introducing a new measure of active portfolio management, referred to as Active Share (i.e., the share of portfolio holdings that differ from the benchmark index holdings), found that between 1968 and 2001 U.S. funds that deviated significantly from the benchmark portfolio outperformed their benchmarks both before and after expenses. Value investing is all about deviating from benchmarks as their low correlations with benchmarks signify. As Sir John Templeton used to say “it is impossible to produce a superior performance unless you do something different from the majority”.
Athanassakos, in a 2011 Journal of Investing paper, in the first direct study of value investors, examined whether value investors add value over and above a simple rule that dictates they invest only in stocks with low price-to-earnings (P/E) and low price-to-book (P/B) ratios. The author, using Canadian data, found that value investors do add value, in the sense that their process of selecting truly undervalued stocks produced significantly positive excess returns over and above the naive approach of simply selecting stocks with low P/E and low P/B ratios.
Finally, a 2012 working paper entitled “On Diversification” by Jacobsen and De Roon concludes that, using U.S. data from 1926-2011, it is difficult to reject stock picking in favour of holding a diversified benchmark portfolio.
If the evidence in favour of value investing is so overwhelming, why isn’t everyone a value investor? Why does a value premium still exist? Shouldn’t it be eliminated? Not necessarily, because the driving forces behind the value premium are human psychology and institutional biases.
Human and institutional behaviour cause biases in stock prices that give rise to what is known as the value premium, namely that value stocks beat growth stocks. Commentators talk about institutions making investment decisions when in fact it is individuals working for financial institutions who make decisions. And these individuals have their own psychologies over which they have little control and their own agendas that may differ significantly from those of the organizations that employ them.
Individuals are subject to irrational behaviour. They extrapolate, they are overly optimistic, they overreact and most importantly they herd. They herd to protect their jobs. If the group loses and a portfolio manager is in the losing group, his job is protected as he lost as everyone else – but if he is wrong and others win while he loses, then his job and reputation are at stake. As john Keynes had indicated “It is better to fail conventionally than succeed unconventionally”.
At the same time, individuals working for institutions have their own agendas that conflict with their clients or investors. They act on these agendas to benefit themselves, rather than those who hired them. They rebalance their portfolios throughout the year to earn their Christmas bonus, they window dress to spruce up their portfolio to look better than they are to their clients and herd to protect their jobs. Moreover, portfolio managers rather than doing the right thing, they are concerned more about losing their jobs and/or losing funds under management. As a result they gravitate towards index funds or becoming closet indexers by over diversifying. It is not that they lack stock picking abilities, but it is rather institutional forces that encourage them to over diversify making them impossible to beat the market.
The above-mentioned biases are best exemplified in the way banks and their executives have behaved over the years. Banks attract the best minds – and yet time and again these intelligent people make poor decisions.
In the early 1980s, banks had excessive involvement in financings of oil and gas companies. In the late 1980s and early 1990s, they were excessively involved in financing of real estate companies. The same was the case for their involvement in making loans to emerging countries, the Asian crisis, Enron and the bursting of the technology bubble, and finally the subprime mess of 2007-2008. They all rushed to make the same loans and expose themselves to the same industries and to the same markets. Together they overbid prices and then had to go after riskier investments. All of the above ended with excessive amounts of writeoffs of bank assets, profit declines and stock price collapses.
Just as bank executives continue to make the same mistakes time and again lured by the fad of the day and the promises of high hanging (and yet very risky) fruit – investors also continue to believe the promises that growth stocks make, overbidding them, and giving rise to the value premium.