Value investing was introduced in the previous article. Let’s now turn to a critical question; does value investing work? We’ll look at three studies that answer the question over a sufficiently long investment horizon.
The first is from the Brandes Institute with a mission to expand the investment community’s understanding. Second, is Tweedy Browne Company, with a 99-year history of value investing. And, the third is one of the most successful investors in the world who uses a value approach; Warren Buffett.
The Brandes Institute’s Answer to Does Value Investing Work?
The Brandes Institute built on an original study by three academics; Dr. Lakonishok, Dr. Vishny, and Dr. Shleifer (LVS) that compares the performance of “value stocks” to “glamour stocks.”
Value stocks are companies going through difficult times, operating in mature industries, or facing adverse circumstances. Glamour stocks are typically fast-growing companies, often from dynamic industries and in favor of investors.
Their studies focused on the difference in the performance of the top glamour stocks compare to the top value stocks to determine if one of the strategies performed better.
LVS’s methodology involved two basic steps. First, they divided the sample of companies into deciles based on one of the following criteria.
- Sales growth over the preceding five years
- Select pairings of the variables above
They then tracked the aggregate performance of each decile every year for the next five years. And, repeated this in each subsequent year from 1969 through 1989.
Averaging the performance data across the decile groups enables comparison of value and glamour. LVS found the performance of best decile value stocks outpaced the performance of the best decile of glamour stocks.
For instance, using price-to-book ratios (P/B), the average annualized five-year return for decile one glamour stocks (the highest P/B ratios) was 9.3%, while the return for the decile ten value stocks (the lowest P/B ratios) was 19.8%.
Using data from 1980 to 2014, the Brandes Institute’s found that over the long term, a value premium was evident across valuation metrics, regions, and market capitalizations.
In Exhibit 1 below, they subtracted the returns of decile one glamour stocks from decile ten value stocks. Value stocks outperformed glamour stocks in all segments.
In Exhibit 2, they used the same approach and subtracted decile one returns from decile ten returns. It shows value stocks outperformed glamour stocks in more periods and longer stretches.
Brandes then adjusted the study and extended it to markets outside the United States using 4,577 companies. And, again, they found value outperformed glamour regardless of valuation metric (Price to Book, Price to Earnings, Price to Cash Flow), region (US, Non-US, Emerging Markets) or market capitalization.
Value stocks consistently outperformed glamour stocks across the data, although the value premium did vary.
Brandes Concludes (emphasis added):
“If we assume that it is the habit of the market to overvalue common stocks which have been showing excellent growth or are glamorous for some other reason, it is logical to expect that it will undervalue—relatively, at least—companies that are out of favor because of unsatisfactory developments of a temporary nature. This may be set down as a fundamental law of the stock market, and it suggests an investment approach (value investing) that should prove both conservative and promising.“
Tweedy, Browne & Company Answer to Does Value Investing Work?
Tweedy, Browne’s 99-year history in value investing traces directly back to Benjamin Graham. For example, Graham was one of Tweedy, Browne Company’s primary clients for decades.
Through Graham, the original partners did business with investment legends Walter Schloss and Warren Buffett. Their investment approach came from Benjamin Graham and David Dodd’s first textbook on investment research, “Security Analysis” and “The Intelligent Investor.”
Tweedy, Browne Company’s publication “[What Has Worked in Investing]” is a compilation of 50 different studies conducted on what works in investing. The studies tested different value investing parameters against other investment strategies and indices. Here they graciously share their knowledge of historically successful investment characteristics and approaches. The compiled results in “What Works in Investing are impressive.”
Tweedy, Browne’s Conclusion in Part:
“…contrary to some proponents of the efficient market theory, it is possible to invest in publicly traded companies at prices which are significantly less than the underlying value of the companies’ assets or business….It can only be stated with certainty that many studies have repeatedly shown investment in numerous groups of bargain securities over very long multi-year periods has produced excess returns.”
For those looking for empirical evidence that value investing works well, you are encouraged to review the studies in “What Works in Investing.” They provide an excellent source of other information in investing, and you are also invited to browse through their website here.
Warren Buffett’s Answer to Does Value Investing Work?
Warren Buffett made his case for value investing at the Columbia Business School. It was the fiftieth anniversary of the publication of Graham and Dodd’s “Security Analysis.”
Superinvestors of Graham-and-Doddsville
He makes the case with a story of how an unusually large group of successful investors came from the same very small intellectual village. And, then names this hypothetical village Graham-and-Doddsville. In addition, the village has a concentration of investment winners that cannot be explained by chance.
A Common Strategy
Their common intellectual patriot is Benjamin Graham, the father of value investing. For instance, they all exploit the difference between the (value) of a business and the (price) of the business.
“Essentially, they exploit those discrepancies without the efficient market theorist’s concern as to whether the stocks are bought on Monday or Thursday, or whether it is January or July, etc.”
“Our Graham & Dodd investors, needless to say, do not discuss beta, the capital asset pricing model, or covariance in returns among securities. These are not subjects of any interest to them. In fact, most of them would have difficulty defining those terms. The investors simply focus on two variables: price and value.”
Buffett goes on to say the many studies of price and volume are extraordinary. The reason is, of course, there is unlimited data available for computers and mathematicians to analyze. And, “it seems sinful not to use them, even if the usage has no utility or negative utility.”
“I think the group that we have identified by a common intellectual home is worthy of study. Incidentally, despite all the academic studies of the influence of such variables as price, volume, seasonality, capitalization, size, etc. upon stock performance, no interest has been evidenced in studying the methods of this unusual concentration of value-oriented winners.”
Buffett cites specific examples (including Tom Knapp, a founder of Tweedy Browne) and illustrates their decades of investment success in tables of data.
Buffet Concludes With:
“It’s very important to understand that this group has assumed far less risk than average. Note their record in years when the general market was weak. While they differ greatly in style, these investors are, mentally, always buying the business, not buying the stock. A few of them sometimes buy whole businesses. Far more often, they simply buy small pieces of business. Their attitude, whether buying all or a tiny piece of a business, is the same. Some of them hold portfolios with dozens of stocks; others concentrate on a handful. But all exploit the difference between the market price of a business and its intrinsic value.”
Better Returns and Lower Risk
How can these Graham-and-Doddsville investors exploit the gaps between price and value over such long periods? And, how can they do it with less risk? “When the price of a stock can be influenced by a ‘herd’ on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person. It is hard to argue that the market always prices rationally. In fact, market prices are frequently nonsensical.”
The Efficient Market Theory says a positive correlation exists between risk and reward. Buffet explains how in fact, the opposite is true in value investing.
“If you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is.”
The Superinvestors of Graham-and-Doddsville is available in its entirety at The Columbia Business School website here.
What We Learned:
- Does value investing work? Certainly, over a long period of time.
- In addition, the value investing premium can make a huge difference in your long term performance.
- Also, some of the most successful investors in the world use a value investing strategy.
- Further, they willingly share how they do it creating a huge advantage for the individual investor wishing to learn value investing from the best.
Hopefully, these three sources make a sufficiently strong case for value investing to capture your interest. However, to do it successfully requires discipline, work, and analysis that we’ll discuss further in this series of articles.
In the meantime value investing provides great mentors to guide the way. Read and listen to Warren Buffett, Charlie Munger, Bruce Flatt, and Howard Marks. In other words, it’s like having a billionaire money manager advising you on how to invest for free! Equally surprising, however, is how few seem to listen.