Why Value Investing Works (II)

Maverick Lin

Published in

The Compounding

5 min readMar 11, 2020

Dear Mr. Market,

I was recently wondering about why value investing works. After poking around a bit, here’s what I have come up with.

What is Value Investing?

Value investing is a rational, disciplined approach to help navigate the investment world ruled by speculation, unjust emotions, confusion and momentum. The core value is very simple: the underlying value of financial security is measurable and stable regardless of what Mr. Market does to it. The goal is to purchase securities when their market prices differ significantly from their fundamental or intrinsic value.

The success of value investing has been known for many years since Benjamin Graham and David Dodd’s book in the 1930s- the successful track records of superinvestors like Warren Buffett, Tom Knapp, Bill Ruane, Charlie Munger, and Walter Schloss aren’t exactly secret. So why hasn’t the market arbitraged away this anomaly? Why isn’t everyone a value investor? As Warren Buffet aptly puts it:

I have seen no trend toward value investing in the 35 years that I’ve practiced it.

There are a few reasons:

It goes against human nature/behavior. Stocks or assets trading for 50 cents on the dollar usually have many troubles- potential bankruptcies, regulatory threats, lawsuits, negative earnings, industry problems, boring, etc… In short, these companies are extremely depressing and very few people would want to touch them. We tend to invest a lot when the market rises, and disinvest when the market falls.
It can take a very long time for cheaply priced value stocks to return to fair value. It is hard to remain patient for the gap between price and value to converge- it might happen tomorrow or 2 years from now. It’s even harder to remain patient when people around you are making money. Patience is certainly a virtue. The lack of patience for investors who don’t stick with a long-term horizon presents opportunity to those with a long-term perspective.
It doesn’t always work. The stock market and investing are faddish, and investing styles cycle through value as well as growth phases. It takes discipline to not panic when things go against us. For example, value over the past 10 years has underperformed growth- however, in the long run, such a value strategy has, on average, outperformed a growth strategy.

In addition, the plethora of studies that support value investing is astounding. Study after study show that value works. Even more astounding is the fact that despite the overwhelming evidence, people still find it hard to adopt value investing.

Tweedy, Browne, a value-oriented global and U.S. equity manager founded in 1920, has nicely summarized most of these studies (50+) into a nice booklet. Here’s a blurb:

Dr. Josef Lakonishok (University of Illinois), Dr. Robert W. Vishny (University of Chicago) and Dr. Andrei Shleifer (Harvard University) presented a paper funded by the National Bureau of Economic Research entitled, “Contrarian Investment, Extrapolation and Risk,” May 1993, which examined investment returns from all companies listed on the New York Stock Exchange (NYSE) and American Stock Exchange (AMEX) in relation to ratios of price-to-book value, price-to-earnings and price-to-cash flow between 1968 and 1990. In their abstract, the authors state:

“This paper provides evidence that value strategies yield higher returns because these strategies exploit the mistakes of the typical investor and not because these strategies are fundamentally riskier.”

A subsequent paper, interestingly co-authored by Burton G. Malkiel, the Princeton Professor and author of A Random Walk Down Wall Street, which argues against the efficacy of actively managed investment strategies in favor of index funds, investigated whether the predictable return advantages associated with contrarian strategies set forth in previous empirical studies was persistent and exploitable by investment managers.
In this study entitled, “The Predictability of Stock Returns: A Cross-Sectional Simulation,” Zsuzsanna Fluck (New York University), Burton G. Malkiel (Princeton) and Richard E. Quandt (Princeton) examined the performance of 1,000 large-company stocks ranked by price/earnings ratios and price- to-book value ratios from 1979 through 1995, and confirmed the findings of the previous Lakonishok, Shleifer and Vishny study, “Contrarian Investment, Extrapolation and Risk,” finding that,
On a sample of large companies that is free from selection bias, we have concluded that the superior performance of contrarian strategies, documented by earlier studies is not simply an artifact of selection bias. We have also found that the result is robust with respect to transaction costs.
The papers by Fluck, Malkiel and Quandt, and by Lakonishok, Shliefer and Vishny, together with similar studies described in the “Assets Bought Cheap” and “Earnings Bought Cheap” sections of What Has Worked In Investing demonstrate that, at the extreme, investors overvalue and undervalue individual stocks, and that the best returns come from buying stocks at the extreme end of the value spectrum.

As Bruce Greenwald, professor at Columbia University’s Graduate School of Business and an advisor at First Eagle Investment Management, puts it in his 2005–2008 lectures on value investing:

Nonetheless, study after study proves value works.
When we talk about value investing there is a lot of evidence that value investors have been on the right side of the trade. The statistical studies that run against or contradict market efficiency almost all of them show that cheap portfolios — low market-to-book, low price-to-book — outperform the markets by significant amounts in all periods in all countries — that is a statistical, historical basis for believing that this is one of the approaches where people are predominantly on the right side of the trade.
Those studies were first done in the early 1930s; they were done again in the early 1950s. And the ones done in the 1990s got all the attention because the academic caught on. There is statistical evidence that the value approaches — buy cheap securities — have historically outperformed the market. Buying cheap works.

Well, there you have it. We have presented the case why value investing works, namely because of three reasons:

Value investing goes against human nature.
We are not patient enough to wait for price and value to converge.
Value investing doesn’t always work.

In addition, we have discovered that there is an abundant amount of empirical/statistical evidence showing that value investing works over the long run but not the short run.

Until next time. Vale.