Why Value Investing Works

Here is an article from the Globe Investor magazine (Canada only), where George Athanassakos (I thought I had a long name but I'm not alone I see ;) ) of the Richard Ivey School of Business (Canada) gives some reasons for the so-called value premium. The value premium for those not familiar is the statistically significant mysterious effect of "value" stocks outperforming "growth" stocks over the long run.

Do you know why value strategies beat growth strategies in the long run? It is because human and institutional behaviour cause biases in stock prices that give rise to what is known as the value premium, namely that value stocks beat growth stocks...

Individuals are subject to irrational behaviour. They extrapolate, they are overly optimistic, they overreact and most importantly they herd. They herd to protect their jobs – no one has lost his job from an average performance or being in the same group as their peers. If the group loses and you are in the losing group, there is the insurance that you lost as everyone else – but if you are wrong and others win while you lose, then your job and reputation are at stake.

At the same time, individuals working for institutions have their own agendas that conflict with their clients or investors. They act on these agendas to benefit themselves, rather than those who hired them. They rebalance their portfolios throughout the year to earn their Christmas bonus, they window dress to spruce up their portfolio to look better than they are to their clients and herd to protect their jobs.

All of the above behaviours create biases in the prices of financial securities, such as stocks and bonds, which in turn give rise to the behaviours that value investors exploit. This value premium will continue to exist despite the fact that we all know about it and despite the large body of academic research that has proven it to be the case.

Before I say anything, I should note that the designation of value is quite arbitrary. Some value investors use a hard static defintion that often excludes huge swaths of the investment world. For example, I notice a lot of value investors that think technology stocks can never be considered as value stocks. I'm not sure what one thinks of people like Bill Miller who was loading up on Intel back in the mid-90's when its P/E was under 10 (or something like that). Anything that is "cheap" should be considered value in my opinion. The ultimate investment is one that contains elements of value (cheap) and growth (consistently high profitability).

I personally don't consider myself a value investor (I consider myself a contrarian with a value orientation). I think another reason value investing tends to outperform is that it is tough--especially psychologically! I remember someone once commenting that deep-value investing (which is basically ultimate contrarianism) was the toughest strategy he had attempted. I didn't really realize how tough it was until I actually started following some beaten-down stocks. All the negativity surrounding a cheap stock can start to impact your decisions adversely. It's so easy to flip your opinion after reading the hundreadth article bashing the stock...