Is Value Investing Any Better Than Gambling?

This is a great article by James Mackintosh that I read last week comparing the rise and fall of “value” vs. “momentum” investing strategies based on a new study by Joseph Kushner, an associate at Goldman Sachs Asset Management. The study was published in the latest issue of the Journal of Portfolio Management. It looks at 30 years of historical data comparing the two strategies against the market.

In general, speculators treat stocks as a short term trade, constantly exchanging based on small price differences driven by “momentum”. Value investors tend to stay in a company for a long time, waiting for the fundamentals to improve and raise the price of the stock.

The author suggests that value investing, as in studying a company’s underlying fundamentals, is no better than gambling. The value investor’s returns come from a rising market lifting all boats, raising the price of the stock absent any improvement in the company’s fundamentals. In the study, Kushner notes that the stock price would indeed rise to meet its “intrinsic” valuation, but it would fall back once a year to a cheap price relative to book value. Kushner believes that the fundamentals of the company did not change, but other people were simply more willing to pay a premium for the stock based on a changing valuation.

Whereas Kushner notes that the momentum investor, in the very process of realising gains based on a directional trend, has utilised a price gain (or drop) based largely on company fundamentals. The momentum investor bets that there is always someone willing to pay a higher price (or lower in the case of short selling), and the range of human emotions is long and varied, giving the investor room to manoeuvre.

The value investor waits for the momentum investors to either overprice or underprice a security relative to its book value, using this difference as an arbitrage opportunity (taking into consideration a margin of safety and other better opportunities in the market).

On a personal note, I disagree with Kushner’s theory that simply because there are price swings in a one year time frame, that this implies the company’s fundamentals did not improve. It often takes years for company fundamentals to be accurately priced into the stock, and the in-between period includes lots of price swings due to the mood (and “momentum”) of short term traders. I think the study should have taken a longer holding period into consideration to test the strength of company fundamentals and value investing.

The way I see it, the value investor needs the momentum investors as liquidity to drive the price to its intrinsic valuation. And the momentum investors need changes in valuation (conducted by due diligence from value investors and based on changing fundamentals) to obtain a directional play. Its a virtuous circle that few people in the investing community mention.

Both strategies have worked historically, but are now undergoing a period of doubt due to the winner-take-all environment of the tech stocks (arguably now largely being driven by momentum). Kushner notes that value investors missed out on the rise of large growth companies in recent years. Momentum strategies had difficulty keeping up with the sharp ups and downs that occurred several years ago, and the huge increase in money chasing the same types of returns.

I believe value and momentum strategies will hold up in the coming decade, and if investor psychology is any key, it’s more than probable.

Its a well written article from the Wall Street Journal by James Mackintosh:

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