Value Investing Isn’t Dead Yet, Just Wounded
Value investing, which is often traced back to Ben Graham in the 1940s, is among the most influential trends in finance in recent decades. Value investing is based on the idea that lots of stocks are out of investors’ favor because of myriad of reasons, such as recent losses, management upheaval (think GE), product failures, etc. Investors beat down the share prices of these companies, resulting in low market-to-book ratios (market value of company divided by its book, or equity (net assets) value reported on the balance sheet). These are the “value stocks.”
At the other extreme, are the glamour (growth) companies―think Apple, Amazon and Netflix―whose recent success leads investors to believe in an unending growth, or permanent prosperity. Investors bid up the shares of these companies, resulting in high market-to-book ratios.
And here is the essence of the value theory: Many investors make systematic mistakes; they over-emphasize recent evidence (a phenomenon termed by behaviorists―the “recency effect”) namely, they are convinced that 2-3 quarters of losses are harbingers of long-term corporate decline, or that a short streak of sales increases portend long-term expansion. That’s the reason they bid down the former and up the latter. In reality, though, many of the out-of-favor “losers” recover soon (that’s the reason they are called “value”), and at the other extreme, many of the seemingly permanent growth companies falter. Growth is notoriously ephemeral.
Under this scenario of investors’ systemic misvaluations, investing in value (beaten up) stocks pays off, because their share prices subsequently rise, and selling short growth (inflated) stocks is a winner, because these shares are soon to decline. And, indeed, historically, such value investing was a very successful strategy, as the following figure demonstrates.