“We already see resurgent the age-old frailty of the investor – that his money burns a hole in his pocket.” Thus wrote Benjamin Graham in his seminal work on value investing, Security Analysis, written in 1934. Yet those words are just as relevant in today’s investment climate where many once again think that all they need to do to succeed in investing is to buy stocks of glamorous, high-growth companies. Valuation is once again perceived to be only of passing interest, a topic focused on by those unsophisticates that have not evolved to a higher level of understanding, one that allows the true investing gurus to pinpoint the future of rapidly growing companies 15+ years out.
If you have been paying any attention to the rising stock market in the last couple of years, you might be tempted to succumb to this siren-song and relax your investment criteria in order to join those appearing to make money quarter after quarter in high-expectation growth stocks. Don’t… at least not until you read this article.
Value Investing Works…
- Statistically inexpensive “value” stocks have on average outperformed statistically expensive “glamour” stocks across the board over the long-term
- The cheapest decile of stocks has outperformed the median stock by ~ 2% per year
… But Value Investing Does Not Work All the Time
Fifteen years ago, as a young analyst, I attended a conference at Harvard on Behavioral Finance. During one of the sessions, a well-known value investor presented evidence that value investing has produced superior returns over all rolling 10-year periods during the timeframe that he studied. I came up to him after his talk, and asked – if value investing works so well, why doesn’t everyone do it? He smiled at me knowingly and explained that while value investing works over most long-term periods, it frequently doesn’t always work in the short-term. There are plenty of 3-year periods when value investing produces inferior returns, and most market participants don’t or can’t have the time horizon that is sufficiently long to be able to look through that. They will either get fired, lose their clients, or if they are investing their own capital, lose the confidence in their process while they wait for the period of underperformance to end.
In other words: Value investing works over the long-term exactly because it doesn’t work all the time. If it worked all the time, it would have been arbitraged away long ago by people programming computers to invest large amounts of money based on its principles. However, because of intermediate-length periods when value investing doesn’t work, and most investors’ lack of a long-term time horizon, this hasn’t happened and value investing remains one of the few constants in a changing investment landscape. Most people just can’t stomach periods of underperformance. (For more on this topic, see How and Why to Be a Long-Term Investor).
The Math of Waiting for Attractive Opportunities is Very Forgiving
We are frequently told not to time the market. I believe that is right for those whose only equity investing option is the market. So if you are pursuing a dollar-cost-averaging approach using low-cost index funds (something I think many would benefit from as I wrote in Why Passive Investing Is an Excellent Default Choice – an Active Investor’s View), by all means continue with that approach. However, if, like me, your goal is to find individual under-valued securities in which you invest only when they offer a large margin of safety, then the following analysis is highly relevant.
Hypothetical Scenario #1
- Option A: Invest in the market immediately. Assume 8% long-term (70-year) nominal annual returns (might be generous from the current starting point)
- Option B: Hold cash for 3 years, then invest in an attractive investment with an IRR typical of ones that I seek (13%)
- Internal Rates of Return (IRRs): Option A: 8%; Option B: ~ 10%
Hypothetical Scenario #2
- Option A: Invest in the market immediately. Assume 7% nominal annual returns for 8 years (a generous estimate from the current starting point)
- Option B: Hold cash for 3 years, then invest in a security with a Price/Value ratio of 65%. Assume that it takes 5 years for the Price/Value gap to close, with value growing at the discount rate I use to estimate value (10%)
- Internal Rates of Return (IRRs): Option A: 7%; Option B: ~ 12%
The Current Opportunity Set Is Not Attractive
There are two ways to look at the attractiveness of the market: bottom-up and top-down. To a concentrated value investor such as me, the former approach is much more relevant because even if the whole market were grossly overvalued, it could be quite possible that enough attractive opportunities exist to put together a portfolio offering excellent potential returns with a large margin of safety. An example is the Tech bubble of 1999-2000, when overall valuations were very high, but there existed many opportunities in “old-world” industries that didn’t get caught up in the speculative craze that affected technology, telecommunications and media stocks.
The most relevant measure of bottom-up investment opportunities is what each investor can find that fits their process. However, I thought as a broader measure I would present recent data from Morningstar, which:
- Takes an intrinsic value approach to valuing stocks, just as we do
- Is focused on analyzing business quality and each company’s competitive advantage
- Has done this for a large, 1,800+ universe of companies which should be reasonably representative of the broad opportunity set