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Does value investing work? More specifically, I've taken Dr. Damodaran's course on valuation (available online at his website) and have read parts of his textbook "Investment Valuation", and am coming from a dcf vantage point. The fundamental ideas behind it (that you are buying a real company whose value is the future cash flows discounted by its risk) seems to make sense (at least, if I was buying a business next door that's what I would do). On the other hand it's common knowledge that it is notoriously difficult if not impossible to consistently beat the market (Malkiel, Fogle etc.) and it's better to buy index funds. So my question is, is there any evidence that value investing actually beats the market? Is the whole field a waste of time (applied to the stock market, it would presumably be useful in actual buy outs)? As an aside, why does it seem to be difficult to get a conclusive answer to this question?

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    It is very difficult to get a conclusive answer to this question because everyone has a different bias towards the market. Even in value investing, different analysts will give the same company a different value, because the value is based on future cashflows, so one analyst will make different assumptions from the information they have at hand to get to a valuation different from other analysts. And lastly it is not impossible to consistantly beat the market, I have seen some beat it cosistantly each year for more than 20 years, and not by a couple of % point but by more than double. – user9722 Jan 14 '16 at 5:45
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    You are aware that one way an index fund saves money is that they use the research done by another group to make decisions. Thus there can be a value index fund. – mhoran_psprep Jan 14 '16 at 10:23
  • Define "work" here. Fama and French's study would be my initial thought on value investing working but it depends a great deal on how precisely can you define your terms here without being wishy washy or having grand ideas, e.g. that value investing is a silver bullet is a bit of a myth. – JB King Jan 14 '16 at 15:32
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    @JackSwayzeSr I agree completely that professionals have more time, information and skill, but now the problem becomes how good are you at finding a manager that is good at value investing. In the end is that worth 75bps in fees? The data is much more clear here a pretty strong no. Here is a great review article papers.ssrn.com/sol3/papers.cfm?abstract_id=955807 – rhaskett Jan 15 '16 at 20:46
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    My combined index fund investment has been beating the market over the long term, at moderately low risk... but its design goal was just to deliver market rate of return. If there was an easy way to beat the market, people would be using it and market rate of return would adjust itself accordingly. – keshlam Jan 15 '16 at 23:34
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As an aside, why does it seem to be difficult to get a conclusive answer to this question?

I'm going to start by trying to answer this question and I think the answer here will help answer the other questions. Here is a incomplete list of the challenges involved:

  • Defining value investing: Mr. Damodaran has one method, but there are thousands of thoughts on the matter. For instance, Fama/French and Warren Buffet both have methods of determining "value" that are very different from Damodaran.
  • Turning signals into portfolios: how much do you buy of each? Only U.S. stocks? How long do you hold to see if your signal works? These questions can make a huge difference.
  • Testing: What time period? Do you control for risk? What do you define as "the market."
  • Persistance Even on average how certain are you that things that worked in the past will continue to work? Especially if a bunch of people are trying to do the same thing now that it is famous and bidding the prices up...
  • Randomness: You can find the perfect value investment and it could be an Enron or the whole market could tank.

So my question is, is there any evidence that value investing actually beats the market?

Yes there is a lot of evidence that it works and there is a lot of evidence that it does not. timday's has a great link on this. Some rules/methods work over some periods some work during others. The most famous evidence for value investing probably comes from Fama and French who were very careful and clever in solving many of the above problems and had a large persistent data set, but their idea is very different from Damodaran's, for instance, and hard to implement though getting easier.

Is the whole field a waste of time?

Because of the above problems this is a hard question. Some people like Warren Buffet have clearly made a lot of money doing this. Though it is worth remembering a good amount of the money these famous investors make is off of fees for investing other peoples' money.

If you understand fundamental analysis well you can get a job making a lot of money doing it for a company investing other peoples' money. The markets are very random that it is very hard for people to tell if you are good at it and since markets generally go up it is easy to claim you are making money for people, but clearly banks and hedge funds see significant value in good analysts so it is likely not entirely random. Especially if you are a good writer you can make a more money here than most other jobs.

Is it worth it for the average investor saving for retirement? Very, very hard to say. Your time might be better spent on your day job if you have one. Remember because of the fees and added risk involved over say index investing more "Trading is Hazardous to Your Wealth."

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The June 2014 issue of Barclays Wealth's Compass magazine had a very nice succinct article on this topic: "Value investing – does a rules-based approach work?". It examines the performance of value and growth styles of investment in the MSCI World and S&P500 arenas for a few decades back, and reveals a surprisingly complicated picture, depending on sector, region and time-period.

Their summary is basically:

A closer look however shows that the overall success of value strategies derives mainly from the 1970s and 1980s. ... in the US, value has underperformed growth for over 25 years since peaking in July 1988. Globally, value experienced a 30% setback in the late 1990s so that there are now periods with a length of nearly 13 years over which growth has outperformed.

So the answer to "does it beat the market?" is "it depends...".

Update in response to comment below: the question of risk adjusted returns is interesting. To quote another couple of fragments from the piece:

Since December 1974, [MSCI world] value has outperformed growth by 2.6% annually, with lower risk. This outperformance on a risk-adjusted basis is the so-called value premium that Eugene Fama and Kenneth French first identified in 1992...

and

That outperformance has, however, come with more risk. Historical volatility of the pure style indices has been 21-22% compared to 16% for the market. ... From a maximum drawdown perspective, the 69% drop of pure value during the financial crisis exceeded the 51% drop of the overall market.

  • Are these numbers quoted on risk adjusted or absolute return figures? – SMeznaric Jan 23 '16 at 2:51
  • @SMeznaric: Article does mention risk in a couple of places (will update answer above to quote them) but is more interested in total return. I have seen it claimed elsewhere that value style should have less potential downside because... well, if cheap stuff got any cheaper it'd be snapped up. No idea how true that is though. – timday Jan 23 '16 at 20:22
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One aspect of this - no matter which valuation method you choose - is that there are limited shares available to buy.

Other people already know those valuation methods and have decided to buy those shares, paying higher than the previous person to notice this and take a risk.

So this means that even after you have calculated the company's assets and future growth, you will be possibly buying shares that are way more expensive and overvalued than they will be in the future. You have to consider that, or you may be stuck with a loss for decades. And during that time, the company will get new management or their industry will change, completely undermining whatever fundamentals you originally considered.

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The Investment Entertainment Pricing Theory (INEPT) has this bit to note:

The returns of small growth stocks are ridiculously low—just 2.18 percent per year since 1927 (versus 17.47 percent for small value, 10.06 percent for large growth, and 13.99 percent for large value).

Where the S & P 500 would be a blend of large-cap growth and value so does that meet your "beat the market over the long term" as 1927-1999 would be long for most people.

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    This may be biased by the current trend of investors demanding that small companies be managed for dividend rather than growth. – keshlam Jan 18 '16 at 0:32

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