How Can We Be Sure That Value Investing Will Continue To Work?

(Note: This was adapted from an answer to a prospective client’s question that I answered in the Q2 2020 letter to limited partners of Silver Ring Value Partners.)

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Why Value Investing Works?

We cannot be sure that value investing will beat the market. What has worked in the past is not predictive of what will work in the future. However, if we dig deeper into why value investing has worked for a long time, we are likely to get insights into what may or may not continue to work in the future.

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First, what do we mean when we say “value investing?” Historically, most people using this term have referred to the practice of purchasing stocks at a price that is low relative to some fundamental measure such as earnings or book value. The term was used in contrast to “growth investing” which typically involved purchasing stocks at relatively high ratios of earnings or book value based on the expectation that the company’s future growth potential would compensate for that starting disadvantage.

There are a few reasons why over long periods of time such “statistical cheapness” approach to value investing has worked in the past:

  • Behavioral Biases – investors tended to over-extrapolate recent problem of companies into the future far disproportionately to what was rational based on thorough analysis
  • Institutional Constraints – professional investors had or felt that they had asymmetric career/business risk from holding the “ugly ducklings” of the investing universe. On the other hand, mediocre outcomes achieved by following other investors into well-known popular companies was rewarded with disproportionate personal financial gains for professional investors
  • Informational Inefficiency – Up until the last two decades uncovering statistically cheap stocks took significant manual effort
  • Short-term Time Horizon – most investors want or need validation of their approach sooner rather than later, and few are willing to wait for a number of years before seeing their investments work out. The focus of such short-term investors naturally shifts to companies where the current fundamental trends are positive. Value investing on the other hands had many multi-year periods where it performed poorly relative to other approaches, thus pushing away all but a few investors with a long time horizon

Cheap Stocks Tend To Outperform

The result has been that cheap stocks tended to outperform over long periods of time on average as their very low starting valuation more than offset their unexciting fundamental prospects. Conversely, highly priced “growth stocks” tended to underperform over long periods of time on average despite the fact that the underlying companies’ fundamental performance has been far superior to that of “value stocks.”

Of the four reasons that I previously listed for why value investing has worked in the past, Informational Inefficiency clearly no longer applies with the prevalence of sophisticated computers and financial databases.

The next most vulnerable reason for past outperformance is the behavioral bias against companies with poor recent performance. This is only a potential source of future stock outperformance if the problems are on average temporary and the companies tend to recover at least some of their past earnings power to a degree greater than the implied expectations in their low security prices. That does not have to be the case. If low statistical valuation is on average associated with companies that are about to have their profits reduced even further than their stock prices are discounting, or worse yet if it’s the final stopping point on the way to bankruptcy, then what used to be a bias that pointed investors in the wrong direction could become a useful heuristic that can help them avoid disaster. This is not to say that this has happened and will remain so, but rather that cheapness in stocks, even as a group, need not be unwarranted.

The remaining two reasons for the historical success of value investing are structural and will not change. My 15 years at several large mutual fund firms prior to starting Silver Ring Value Partners attest to the fact that Institutional Constraints are just as pervasive as they have ever been. The old adage that it is better to fail conventionally than to succeed unconventionally certainly holds true among professional money managers who are strongly discouraged from straying too far from the herd. On the other hand, the industry’s marketing prowess has translated into large and frequently undeserved excess profits that have allowed for outsized compensations for those money managers who don’t rock the boat and play the game the way their firms want it to be played, even if their clients end up worse off for it. I see no change to this dynamic on the horizon.

Investors' time horizon has not, and is very unlikely to get any longer. The desire for quick gratification is ingrained in both human nature and the business incentives of most professional money managers. It is a rare professional investor who can have horrible 3-year results and survive for long in the business without losing clients or their job.

This analysis leads me to believe that value investing defined as buying groups of statistically cheap stocks should do worse than it has done in the past. How much worse is hard to know. However, there is an argument to be made that the two unchanged factors that led to the strategy’s past success, Institutional Constraints and Short-term Time Horizon, are enough to produce a moderate excess return over time under most conditions.

Statistical cheapness, however, is not the only definition of value investing. An alternative definition is intrinsic value investing. This approach does not rely on below-average multiples of earnings or other fundamental metrics per se. Instead, it aims to value the underlying company based on excess assets and the net present value of future cash flows and then buy the stock at a large margin of safety to that estimate of value. The result can be that a statistically cheap stock may be over-valued and a high multiple stock may be undervalued.

If the valuation analysis performed by an investor who is following an intrinsic value approach is exactly correct, this approach has to work. If. In practice, nobody is ever going to predict the future precisely for any business. Getting the future cash flow stream even approximately right is quite challenging for many companies. So what is at a philosophical level a very sound approach that should work, at a practical level is a difficult discipline to master.

In the hands of the wrong practitioner, the idea of intrinsic value becomes merely a fig leaf to justify paying whatever price they want for a company. Want to buy some glamour company without any profits? Not a problem. Just create a spreadsheet with future forecasts that justify a value today higher than the price, and you can claim to be practicing an intrinsic value approach. By switching from a statistical cheapness to an intrinsic value interpretation of value investing we are trading a less effective but objective approach to a potentially more effective but much more subjective investing system.

An Intrinsic Value Approach

A skilled practitioner practicing an intrinsic value approach with a long-term time horizon and in the absence of institutional constraints is very likely to do better than market over time. However, such a skillset is much more difficult to develop, and few possess it in combination with the temperament required to stay rational during turbulent periods in the market.

Where does that leave us? Value investing, properly understood and implemented is still likely to lead to large outsized excess returns. However, a much smaller percentage of practitioners will be able to achieve this outcome than had in the past, and many investors following a more mechanical approach or subverting the ideas of value investing to stray too far from its real tenets are likely to do no better than the market over time net of fees and expenses.

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Article by Behavioral Value Investing