Countless academic studies support the notion that over time you will substantially increase your odds of out-performing the stock market by employing a simple value investing strategy - buying stocks with relatively low price-to-earnings, price-to-book and/or price-to sales ratios. However, if value investing really works, why do so many "value investors" fail to achieve the payoffs suggested by academic studies? A recently published paper explored why active value investors underperform and offered some tips on how to improve your value investing process.
Dr. Aswath Damodaran, a world-renowned valuation expert and Professor of Finance at NYU Stern School of Business, recently researched the depths of value investing in his April 2012 paper titled "Value Investing: Investing for Grown Ups?" In the paper, he explored the various reasons why active value investors underperform and examined what he considers the three basic strands of value investors - screeners, contrarians and activists.
- "Screeners" search for stocks that trade at low multiples relative to fundamentals like earnings, book value or revenues, with the belief that stocks with certain fundamental qualities will earn higher than average returns over long periods of time.
- "Contrarians" look for value in the most abandoned stocks with the belief that these stocks are likely to be irrationally punished by investors and will eventually (over years, not months) reverse course.
- "Activists" acquire large stakes in undervalued or poorly managed companies, and use their position as a large stakeholder to push for changes that they believe will eventually unlock shareholder value.
Although the three types of value investors mentioned in Damodaran's paper use different approaches, they often wrestle with similar challenges. A few of the common challenges that value investors face are the need for a long time horizon, employing the right amount of diversification, minimizing taxes and transaction costs, and possessing the discipline required to invest against the grain. Are these challenges, which are somewhat elementary to investing, so great, that even professional value investors cannot overcome them? According to recent mutual fund performance data, the answer is "yes."
The Value of Active Value Investing
To test the merits of active value investing, Damodaran collected U.S. mutual fund performance data from 2007 to 2011. He then classified the mutual funds into value, blend and growth categories, and measured their returns relative to an appropriate passively managed investment option, or index fund. The actively managed value funds were measured relative to an index fund consisting of only value stocks (low price-to-book and low price-to-earnings stocks) and the actively managed growth funds were measured relative to an index fund consisting of only growth stocks (high price-to-book and high price-to-earnings stocks). The results from this simple study were not encouraging for value fund managers or their investors.
On average, actively managed value funds lagged their comparable index funds by more than any other mutual fund category measured. This was particularly true when considering mutual funds that invest in large-cap stocks. The only funds that beat their passively managed counterparts across all three market cap classes were growth funds.
Time horizon conflicts are likely one of the biggest challenges hindering value fund manager performance. Mutual fund managers face short-term performance pressures and the prospect of "hot money" investor redemptions. In sharp contrast to these industry pressures, the academic studies that support value investing strategies illustrate that they work best over long time horizons. Consequently, value fund managers are constantly at odds with the academic studies that support their investing philosophy.
An Art and a Science
The evidence in Damodaran's paper illustrates that active value investing is a challenging endeavor - a balance between art and science. Although it's hard to argue with decades of academic research and the track records of high-profile value investors like Benjamin Graham and Warren Buffett, it is apparent that active value investors will not be successful if they do not follow certain disciplines. If you consider yourself a true value investor, then here are a few suggestions that will help you in your pursuit of successful active value investing:
Stick to Your Guns:
Negative price action and unflattering media reports can make value investors second guess their decisions. On the other hand, the academic studies that argue in favor of value investing are generally measured over long time periods (five or more years). Research has demonstrated that, because of factors like short-term price momentum, value investing strategies are less reliable over shorter time horizons. If you are going to attempt value investing, you need to have the long time horizon and the discipline required to stick with it. After all, a cheap stock can get even cheaper and stay that way for years.
Watch For Value Traps:
Weak fundamentals can make certain stocks cheap for a reason. For example, a stock may deserve a lower price-to-earnings ratio if the company's business is riskier, it has less attractive growth prospects, or it has a lower dividend payout ratio. Company specific accounting issues can also make stocks look artificially cheap.
Many popular valuation metrics like price-to-book and price-to-earnings ratios include accounting numbers in the denominator. These numbers can be temporarily inflated or misleading and may require adjustment. For example, most value investors will adjust a company's book value lower by subtracting intangible assets like goodwill. Having a deep understanding of the fundamental factors and accounting issues that affect relative valuations will help you separate a value stock from a value trap.
Diversify, but Don't Over Do It:
Value investors can become so focused on their individual stock ideas that they end up concentrating too much of their capital in a particular "cheap" sector or stock. In contrast, most of the academic studies that support value investing pull from a universe of thousands of stocks, across many different industry sectors.
The art of proper diversification is a balancing act between investment strategy, risk tolerance, time horizon, transaction costs and the degree of certainty surrounding an investments value. Simple diversification will complement a value-driven, margin-of-safety investing principle and help you smooth out the effects of changes in stock price momentum.
The Bottom Line
In conclusion, the cut and dry value investing methods used in the confines of academic studies can quickly become soiled by real world constraints. Before you decide to get your hands dirty with active value investing you may want to take a cue from Benjamin Graham's 1949 classic best-seller on value investing, "The Intelligent Investor":
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks."
The merits of active versus passive value investing will always be up for debate. Whether active value investing is right for you has more to do with your own investing philosophy, constraints and preferences than anything else.
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