Value investors exploit the systematic behavioural weaknesses that the vast majority of investors succumb to when making investment decisions. These biases can be exploited by implementing the “margin-of-safety” principle: Described in Benjamin Graham iconic work The Intelligent Investor (1949). While most investors are too optimistic about the future operating results, Graham advises to invest in stocks that have a substantial fundamental safety margin. The margin of safety protects the investor against unexpected negative evolutions in the (business) economic environment and minimizes the risk of “a permanent loss of capital”.
- The financial strength of a company should protect against a Permanent Impairment of Capital: A company should dispose of sufficient financial power at all times. This financial power will become extremely important in times of economic crisis and/or industry distress.
- A company should be acquired at an attractive valuation: When estimating the valuation of a company Graham mainly makes use of traditional valuation multiples such as a price-to-book, price-to-sales, and price-to-earnings ratio. Stocks with high valuation multiples are termed growth stocks; stocks with low valuation multiples are called value stocks or bargain issues.
- All forecasts are considered to be speculative.
Numerous studies have demonstrated the outperformance of value stocks: e.g. Graham, 1976; Basu, 1977; Chan, Hamao and Lakonishok, 1991; Davis, 1994; Fama and French, 1992, 1998; Lakonishok, Shleifer and Vishny, 1994; Haugen and Baker, 1996, 2008; Brouwer, van der Put and Veld, 1996; Bauman, Conover and Miller, 1998; Chan and Lakonishok, 2004; Anderson and Brooks, 2006; de Groot, Pang and Swinkels, 2010
In light of the robust historical evidence in favour of value investing over extended periods of time it is particularly interesting why this well-researched market inefficiency isn’t exploited by more investors. More importantly; why doesn’t the opportunity disappear as more investors embrace the idea and the opportunity disappears with increased market efficiency?
Whilst the value investing approach is conceptually easy to understand it is very hard to practice. The Value Investing opportunity is firmly rooted in behavioural biases that are ingrained in the human psyche. The main reason is for its existence is Career Risk, as explained by Haugen (2010) in The New Finance. Stock prices are predominantly influenced by institutional investors (like pension funds, insurance companies, trusts and endowment funds). For their stock investments the performance is usually measured relative to a stock index like the S&P 500. These indexes are typically dominated by expensive growth stocks. The performance of the institutional investors is evaluated over relatively short time periods of typically of less than three to five years. Consequently these institutional investors have very short horizons.
Value investing is a long-term investment strategy that focuses on avoiding a ‘permanent loss of capital’ and may (temporarily) underperform the market. This is particularly relevant during investment bubbles (e.g. the TMT stock market bubble in the late 90’s when most value investors underperformed relative to the market). Because institutional investors are likely to be severely penalized or even fired for underperformance relative to these indexes they hold portfolios with more expensive growth stocks rather than cheaper value stocks, even though some know this brings underperformance in the long term.
The conclusion is that most institutional investors are unable to take advantage of the Value Investing opportunity despite a greater awareness of the outperformance. This is supported by the surprising fact that there is no evidence of the Value Investing opportunity fading away.