What is value investing and how does it work?
Simply put, value investing is a strategy where you buy stocks believed to be undervalued.
Value investors believe the stocks they select are trading below their intrinsic values; and thus try to capture such opportunities to generate returns. They believe that the market overreacted to news which resulted in stock price movements that do not correspond with a company’s long-term fundamentals, thus giving these investors an opportunity to generate returns when the price is deflated.
Value investing is practised by many familiar faces in the world of finance – successful figures such as Warren Buffet and Seth Klarman.The investment strategy is considered one of the most successful ways to invest in equity. Eugene Fama – the developer of the Efficient Markets Theory – himself points out that
value stocks outperform growth stocks over time.
He called this occurrence as the value premium – the excess returns gained from implementing a value based approach. The analysis he conducted spread between the years 1926 and 1963, and results for this analysis were replicated over the years using both different time frames and different markets. The research shows that value investing outperformed growth investing in 12 out of 13 markets between 1975 and 1995.
Value investors believe the stocks they select are trading below their intrinsic values; and thus try to capture such opportunities to generate returns.
Why does value investing work?
To understand why value investing works as an investments strategy, let’s first consider the Efficient Market Hypothesis. The idea behind this hypothesis focuses on the fact that a stock price should always reflect its fair value.
As publicly listed companies are required to provide shareholder information to the public, all investors would have access to this information. The stock price then should ultimately incorporate and reflect all this information that is available, which would then ensure that the stock price reflected is consistently fair (termed ‘fair value’). According to this theory then, it would be impossible for investors to purchase either undervalued or sell overvalued stocks.
As such, it shouldn’t be possible to outperform the overall market through expert stock selection or market timing, and the only way an investor can obtain higher returns is by purchasing riskier investments.
But if the hypothesis of market efficiency is correct – then why would we invest at all? It would be foolish to do so because you will never be able to beat the market.
Are markets efficient though? There are quite a few reasons for why markets may not be efficient. The following are just some of the more popular ones:
Human behaviour is sophisticated and fallible
Behavioural economics discovered, time and time again, that human beings are not completely rational and that such a trait plays out in different fields, with one of them being financial markets – as evidenced by herding behaviour, speculation and mania.
Trends are real
Researchers have witnessed many types of trends in financial markets and, quite often, such trends repeat themselves over time. Provided below are some examples of these trends:
“The January Effect”
is one example of such a trend – describing the general seasonal increase in stock prices during the month of January. Analysts generally attribute this occurrence to an increase in buying after the low prices of December when investors, typically engaging in tax-loss harvesting to offset realized capital gains, prompt a sell-off. Another explanation is that investors often use their year-end cash bonuses to purchase investments for the following months.
“The Size Effect”
– the relative advantage the size of a company has on returns -is another example of a trend. Some analysts suggest investing in a small company may lead to higher potential returns than investing in larger companies, even after accounting for unsystematic risk. They believe that companies with smaller market caps tend to outperform those with larger market caps.
“The Momentum Effect”
– the rate of acceleration of a security’s price or volume – is yet another example. In investments, momentum refers to the rate of change in price movements of a particular asset i.e. the speed at which the price is changing. It has been well researched that companies that had performed best in the past (6-12 months ago) tend to perform better in the future than firms that performed worse over the same period. Reasons for this effect are debated, but they can most likely be attributed to investor psychology – people would like to invest in something trendy and ‘hot’.
When an investor sees a growing trend in a stock’s price, earnings or revenues, they are often enticed to take a long or short position in the stock in the hope that this momentum or ‘trend’ will continue in a way that will benefit them.
Such examples may then lead to the view that markets are, in fact, inefficient.
Value investing, then, works because it encourages investors to go against market momentum, buying when markets are down and selling when markets are high.
It sounds simple, but you’d be surprised at how often investors misinterpret and do not follow this strategy. Morningstar, Dalbar and others provide empirical data on this concept, showcasing that individual investors do in fact underperform the stock market because they buy and sell at the wrong time. Dates, time periods and volume demonstrate that individual investors tend to buy more when their confidence is highest – i.e. near market peaks, bullish – and sell when their confidence is lowest – i.e. near market bottoms, bearish.
In his article on value investing Shailesh Kumar mentions the speech of Cliff Asness, billionaire and co-founder of AQR Capital Management and his viewpoints on two main reasons for why value investing works:
(1) Cheap stocks are often overlooked because investors prefer the glamour growth stocks. This is the behavioral argument that says investors prefer a company with a narrative about the future as opposed to one that’s undervalued or beaten down in price.
2) Value stocks compensate you for higher levels of risk because the companies can become distressed. This is more of an efficient market argument that says higher expected risk should lead to higher expected returns.
It can be seen then that good value investors approach the market differently. They don’t chase recent performance. In fact, they’ll invest even more in aftermarket corrections. An investor who practices value investing would not buy an overpriced stock even from a really good company. This is because buying a good business at an overpriced price would constitute as a bad investment.
Is value investing fundamentally different from stocks trading?
Yes. Stock trading generally focuses more on price movements and other such indicators. Value investing, on the other hand, focuses more on analysing business fundamentals of the stocks and buying stocks below their intrinsic value (when they are undervalued). Further, value investing generally employs a longer time span than other forms of investing as it employs a buy and hold strategy until the value of the investment generates successful returns.
What risks are associated with value investing?
Value investing, like every other investment, comes with its own risks. When buying significantly under-priced stocks, personal assumptions and judgements of future performance will most likely come into play as well. These carry some risk with them as we cannot assume our judgement is always correct.
Some of the risks associated with value investing include the following;
One of the biggest risks in value investing is overpaying for a stock. Since the strategy focuses on buying undervalued stocks low and selling high, overpaying for a stock is a primary risk. The closer an investor pays to the stock’s fair market value – or over it – the bigger his risk of not earning enough (or even losing) becomes. As a rule of thumb, value investing incorporates purchasing stocks at a price of around two-thirds or less of their intrinsic value to reduce risk over the long term.
Another risk would be to not diversify your assets. Diversifying your assets allows you to spread your risks across different industries and sectors, so as to minimise it. Some value investors suggest that you can have a diversified portfolio even if investing in only a small number of stocks as long as those stocks represent different industries and different sectors. Others may suggest to own a minimum of 10 to 30 stocks to achieve adequate diversification.
Listening to your emotions
Shutting down your emotions can be difficult when your hard-earned money is on the line. Once you start investing, it is often tempting to sell your assets once their price rapidly drops. Value investing focuses on avoiding the herd mentality – which means keeping or buying a stock when its price is falling. It means going against the trend and saying ‘no’ when others say ‘yes’. It is therefore important to approach your investments with a certain level of detachment.