According to popular belief, value investors would like to buy shares in companies that trade at low price-to-earnings (P/E) and/or price-book value of equity (P/B) ratios. This so-called “naive” value investing approach assumes investors buy all low-priced (in relation to fundamentals) stocks irrespective of whether they meet the margin of safety requirement—a key requirement by professional value investors.
Despite the underperformance of the naive value investing strategy over the last 10 years, in the long run such a value strategy has, on average, outperformed a growth strategy (that is, stocks that trade at high P/E and/or P/B ratios). For example, the average U.S. value premium (value stock returns minus growth stock returns) from 1926 to 2018 was 4.7%. A positive value premium is also observed in Canada and around the world. Additionally, my own research shows that the value strategy has lower risk than the growth strategy in terms of beta, performance over different states of the world, and when companies report unexpectedly good or bad earnings. In other words, it is not risk that drives this long-term outperformance.
Academic studies examining the frequency with which the term “book-to-market” appears in the corpus of books scanned by Google show that investor interest in value investing has trended up over the last 90 years. If this is the case, and given that value stocks outperform growth stocks, on average, in the long run around the world and with lower risk, two questions come to mind: (a) why isn’t everyone a value investor; and (b) if so, why doesn’t this mis-pricing disappear?
Let us look at these questions from an individual investor’s point of view. As we all know the evidence on the outperformance of value stocks in the long run, why do not we do the right thing and invest in value stocks? The reason is that our own human nature prevents us from doing the right thing. We are not rational. We are not patient and disciplined. We panic and we get exuberant. We tend to invest a lot when the market rises, and disinvest when the market falls. A recent study by BlackRock showed that while the average equity mutual fund in the U.S. returned about 8% over the last 30 years, individuals investing in these funds made only 2%. Why? Because they tried to time the market. Rather than looking for opportunities to buy when everybody was fearful, they were selling—and then buying when everyone was exuberant about the market direction. They were panic stricken at the bottom of the market and ebullient at the top. In other words, in investing, humans’ worst enemy is our own temperament.
Okay, you may say, individuals are vulnerable to the weaknesses of human nature. How about professionals who are well-trained and well-paid? Why don’t they do the right thing? It is simply because, in general, they do not care about doing the right thing. They are more worried about career risk (losing their job) or business risk (losing funds under management). Value investing does not work all the time. In fact, the last 10 years it has not worked very well. If you are a portfolio manager, managing money along with other portfolio managers in a mutual fund company and you go on a limb investing heavily in value stocks and you underperform for a few quarters, what will happen to you is that you probably lose your job. Therefore, the safest thing for a portfolio manager to do is gravitate more towards index funds rather than focusing on what works. That is why about 40% of equity funds in North America tend to be closet indexers. At university, most people learn that the average equity fund underperforms. How can it outperform, if, say, 40% of the funds in the sample chosen for the study are closet indexers? But if one looks at recent studies that followed a more refined methodology and focused on narrow portfolios, they do show that such funds tend to outperform. Therefore, in my opinion, mutual fund managers do poorly, not due to lack of stock-picking abilities but rather due to institutional factors that encourage them to over-diversify.
So there you have it. Weaknesses in human nature and the conflicts of interest that portfolio managers have when they manage other peoples’ money interact to bias stock prices and give an opportunity to value investors to outperform. Professional value investors, typically those working for themselves or in small shops structured as partnerships, overcome these biases as they have honed their character and are investing their own wealth along with their clients’ money. (This does not include professional investors working under the umbrella of a mutual fund; it is difficult to be a value investor in a mutual fund setting, as you are driven by these conflicts/biases.)
Because weaknesses in human nature and conflicts of interest of portfolio managers are not going away any time soon, value investing will continue to outperform over long time periods.