The answer is simple but not obvious to all. Value investing works because it “forces” investors to do what’s unnatural: buy low and sell high.
Investing titans including Warren Buffett, Benjamin Graham, John Templeton, and others amassed their fortunes following this principle. They only bought stocks when they were undervalued and sold or reduced positions when they became overvalued.
The Empirical Data
Morningstar and Dalbar among others provide empirical data showing that individual investors underperform the stock market because they buy and sell at the wrong time. The data demonstrate that individual investors buy more when their confidence is highest near market peaks and sell when their faith is lowest, near market bottoms. Benjamin Graham warned about this behavior when he created his story of Mr. Market.
This behavior was seen implicitly by following the flow of money for retail investors before the dot com and real estate bubbles and after the stock market collapse of each. Not only did individual investors “lose their shirts” during the collapse they also missed out on the incredible recoveries by staying out of the market during the ensuing recovery.
One of the best ways to illustrate this is by using the famous Magellan Stock Fund as an example. During the tenure of Peter Lynch heading the fund from 1977 to 1990, the fund averaged an incredible 29% annual return. It’s impossible to lose money in a stock fund like that, right?
What Peter Lynch observed is that quite a few investors (the myth is that it was 50%, but no one has ever confirmed this) lost money in his fund during that time because they often bought at peaks and sold at dips.
In other words, many investors bought the fund when they were psychologically most confident because the fund was performing well and sold when they had psychologically lost confidence because the fund was doing poorly. They did the opposite of what they should have done to maximize their returns.
These poor choices were the natural by-products of human nature- greed and fear. Let’s face it; it’s challenging to sit on your hands and do nothing in hot markets. And it’s even harder to jump in and invest when the market is down and all the news doom and gloom. But that’s precisely what it takes to be ultra successful in the markets.
That’s why value investing works. If “forces” you to buy stocks after stock corrections and during market downturns when it is psychologically the hardest to do so and to sell them when they become overvalued.
Other supporting examples include the groundbreaking study done by Morningstar that showed that investors trailed the average fund by 1.5 percentage points over the last decade.
How the Cycle Plays Out
Let’s look at how the cycle plays out. A bull market comes along. There are stories everywhere of people making huge money buying stocks; it becomes easy. Remember the dot com and real estate bubbles?
You couldn’t attend a social function without hearing a story about how someone was making a small fortune.
Not wanting to be left out, people jump on the bandwagon and join the “in” crowd. As prices continue to soar higher, investors convince themselves that this time is different. They’re blinded by the money they’re making and start ignoring history, market valuations and the risk they are taking on. As the song says “The futures so bright I gotta wear shades”.
At its worst, this tunnel vision leads to market manias; pockets of time where fortunes are made and then lost even quicker. In the1950’s there was the electronics boom. That was followed by the nifty fifty stocks of the ’70s. More recently we had the dot com boom of the 1990s and the real estate bubble.
But eventually, all market manias come to an end. The market prices come crashing down, and emotions once again take over. Fortunes are lost faster than they were made in the ensuing panic selling. What inevitably happens is that stock market participants overreact and send prices lower than they should be which creates a second mistake.
The Second Mistake
With the pain of losses still fresh in their mind investors treat the stock market like the plague and stay as far away as possible. They’ve lost trust in the financial community and the stock market in general. This line of thinking compounds losses as they miss out on incredible recoveries such as those that occurred in 2003 and 2009.
Good value investors approach the market differently. They don’t chase recent performance. In fact, they’ll invest even more after market corrections.
Value Investors know to stand down while they listen to friends and co-workers brag about how much money they’re making. They know to stand down even as they’re called foolish for not getting in on the action, for not investing in a sure thing.
Warren Buffett himself was ridiculed for not participating in the dot com boom. People called him old and out of touch. But Warren Buffett knew what he didn’t know. He didn’t understand tech stocks or why they were priced so high. More importantly, as a wise and experienced value investor Warren Buffett knew better than to get caught up in their hype. He was vindicated in the ensuing dot com crash and still sits near the top of the world’s wealthiest people.
When everyone was talking doom and gloom, what did Warren Buffett and other savvy value investors do after the dot com and real estate market crashes? They took advantage of the carnage and enjoyed banner years in 2003 and 2009.
Personally, we’re looking forward to the next market correction so we can invest more heavily and continue to outperform the market indexes.
The Definition of Value Investing
Before we finish here, we have to define our version of value investing for you. When we refer to value investing, we are not using the typical definition. In the conventional definition, value stocks are those characterized by selling below liquidation or book value, at historically low price-to-earnings levels or depressed price to cash flow levels.
When we refer to value stocks, we mean stocks that are below their intrinsic value compared to future growth potential. Warren Buffet provides further clarification on this. In his 2000 letter to shareholders he had the following to say;
“Market commentators and investment managers who glibly refer to growth and value styles as contrasting approaches to investment are displaying their ignorance, not their sophistication.”
If you buy stocks solely for the reason that they have low price-to-book or price-to-earnings ratios your results can be very disappointing. The stocks can remain undervalued for long periods because they lack the catalysts to grow earnings per share or sales which attract investors and push stock prices up.
Therefore it’s essential to have a more holistic view of stocks when using a value stock investing approach. That’s why we follow a more balanced approach that takes into consideration both the stocks current value and its intrinsic value based on economic cycles, catalysts and growth opportunities.
Remember this; what is often hardest to do is what makes you the most successful in the stock market. Value Investing will help you make the best investment decisions.