Why Does Value Investing Work?

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Abnormal Returns

It seems like a silly question to ask on a site devoted to value investing. Of course, value investing works. All of the academic studies say so! Which might very well be true, but there is unfortunately a gap between what happens in theory and in practice.

Aswath Damodaran in a recent paper examined the actual results of value fund managers and noted a gap between the performance of those managers and underlying value indices. I recommend you visit Greenbackd who in a series of posts takes a much closer look at the Damodaran paper. Damodaran concludes:

“If you are an individual value investor, you can attribute this poor performance to the pressures that mutual funds managers operate under, to deliver results quickly, an expectation that may be at odds with classic value investing. That may be the case, but it points to the need for discipline and consistency in value investing and to the very real fact that beating the market is always difficult to do, even for a good value investor.”

As I write in my book, Abnormal Returns: Winning Strategies From the Frontlines of the Investment Blogosphere, “Investing is hard.” Value investing is not exempt. In fact I argue that value investing works, to the degree that it does, because it is in fact very difficult to do in practice. (One could argue the same for momentum investing as well.)

Don’t take my word for it. In my book I quote two much more accomplished investors on the topic. David Swensen, head of the Yale University endowment wrote in his book Pioneering Portfolio Management:

“In many instances, value investing proves fundamentally uncomfortable, as the most attractive opportunities frequently lurk in unattractive or even frightening places.”

This is why active value investors often underperform. By their nature they are unwilling to buy those stocks that are the most ugly, which by definition provide the greatest opportunity. Howard Marks weighed in on this topic of why value investing works in his recent book The Most Important Thing:

“To boil it all down to just one sentence, I’d say the necessary condition for the existence of bargains is that perception has to be considerably worse than reality. That means the best opportunities are usually found among things most others won’t do.”

The fact is that most people don’t want to be value investors. Even value investors find it difficult to invest in those situations that are the “ugliest” and therefore the most ripe with opportunity. Hence the under-peformance of value fund managers.

Therefore aspiring value investors need to decide whether they are going to simply embrace some sort of quantitative discipline or tread carefully into “frightening” territory on their own.

About the Author

Tadas Viskanta is the founder and Editor of Abnormal Returns. Tadas is a private investor with over 20 years of experience in the financial markets. He is the co-author of over a dozen investment-related papers that have appeared in publications like the Financial Analysts Journal, Journal of Portfolio Management among others. Tadas is also the author of the forthcoming book: Abnormal Returns: Winning Strategies from the Frontlines of the Investment Blogosphere* which culls lessons learned from his time blogging.

Reference Links

Damodran: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2042657

Greenbackd: http://bit.ly/JkzcTF

Amazon: http://amzn.to/wdjuru

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