Value investing still works in the long run

Despite proclamations in popular media that value investing is dead, mostly referring to the performance of stocks with low price-to-earnings or price-to-book ratios, the three-step value investing process – searching, valuing and buying only the truly undervalued stocks that meet the margin of safety requirement – works in the long run.

There are two forces that interact to provide opportunity for value investors: Human nature and the conflicts of interest that portfolio managers have when they manage other people’s money. Let’s briefly review how these two factors skew stock prices, helping those who are able to overcome these biases, to outperform.

First, weaknesses in human nature:

• Nobel Prize winner Daniel Kahneman, through experiments, demonstrated that humans are not rational, in the sense that they tend to become risk averse when they win and risk-takers when they lose. The implication of this for investors: They tend to sell their winners too early and hold on to losers for too long.
• Investors use past performance as an indicator of future performance and so they naively extrapolate past trends. In other words, humans are momentum traders, buying winning stocks and selling losing stocks. This behaviour leads to overpricing of winners and the opposite for losers.
• Humans tend to be overoptimistic and overconfident about their abilities. We see this in every aspect of human life – it is part of our DNA – but when this behaviour manifests itself in investing, people tend to become market timers and day traders.
• Investors tend to overreact both on the upside and downside. That is why bull markets tend to be stronger and bear market tend to be weaker than they both should be.
• Investors interpret accidental success to be the result of skill. And when they bet the farm, they lose.
• Humans are social animals and they like to be in groups. So they herd. If the crowd goes in one direction, they think the crowd knows something and they follow suit.

Second, institutional biases:

• Portfolio managers are the worst offenders when it comes to herding, as very few have lost their job because of average performance. Meaning, they herd to protect their jobs.
• Analysts also herd. The low-ability analysts hide in the crowd while the more reputable analysts, who have already made a good name for themselves, are hesitant to take chances.
• Portfolio managers rebalance their portfolios in a systematic way throughout the year. Every January they take riskier positions than their benchmark in an effort to beat it. Later on in the year, as they earn what they think will give them their Christmas bonus, they lock in returns by selling their riskier stocks and load up on safer stocks or go back to benchmark weights.
• Portfolio managers also window-dress. Toward the end of the year, they sell losing and unglamorous stocks and load their portfolios with winning and glamorous stocks in an effort to spruce it up so that when they send their clients their annual reports they see only good and winning stocks held by the portfolio manager.

The interaction of such behaviours causes stock prices to deviate significantly from value, not only over the longer term, but also within a year. For example, portfolio rebalancing is the cause of the “January effect” and “sell in May and go away,” and human nature – of both individual and institutional investors – are behind the causes of bubbles in asset prices.

So you want to be a good investor? First, you need reasonable intelligence; second, you need to understand businesses, have a good analytical framework in making buying/selling decisions, do your homework and have a long term perspective; and third, you need firmness of character – while some people are lucky to be born with it, others need to hone their character and train themselves to overcome human weaknesses.

You can be the best stock screener and best valuator, but if you get greedy, or panic, or get impatient, if you are undisciplined or do not do your own homework, you will never be a good investor.

George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Ivey Business School, Western University.

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