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?
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."
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...
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.
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.
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.
If you take a look at any stocks in the stock market, you will see at least a 50% percent move for every stock between the 52-week-low and the 52-week-high. Especially during 2021 - 2022, Chinese ADRs traded on New York Stock were going through a real rollercoaster ride. For e.g. $PDD dropped over 80% in 13 months and made a 3-fold from the very low in the next 12 months. You really not gonna believe that the value of the company was really that volatile. Value investors took advantage of those stocks, invested with a margin of safety, and made a fortune. But there were also many value investors who got scared and dumped $BABA during the drop. Some factors that scared them:
- a military confrontation between China and USA / Taiwan
- Crackdown of Chinese companies by Xi
- Covid etc.
But most of them were either unjustified and temporary headwinds
An excerpt from Buffett's 1987 annual letter already discussed it:
Ben Graham, my friend and teacher, long ago described the
mental attitude toward market fluctuations that I believe to be
most conducive to investment success. He said that you should
imagine market quotations as coming from a remarkably
accommodating fellow named **Mr. Market** who is your partner in a
private business. Without fail, Mr. Market appears daily and
names a price at which he will either buy your interest or sell
Even though the business that the two of you own may have
economic characteristics that are stable, Mr. Market's quotations
will be anything but. For, sad to say, the poor fellow has
incurable emotional problems. At times he feels euphoric and can
see only the favorable factors affecting the business. When in
that mood, he names a very high buy-sell price because he fears
that you will snap up his interest and rob him of imminent gains.
At other times he is depressed and can see nothing but trouble
ahead for both the business and the world. On these occasions he
will name a very low price, since he is terrified that you will
unload your interest on him.
Mr. Market has another endearing characteristic: He doesn't
mind being ignored. If his quotation is uninteresting to you
today, he will be back with a new one tomorrow. Transactions are
strictly at your option. Under these conditions, the more manic-
depressive his behavior, the better for you.
But, like Cinderella at the ball, you must heed one warning or everything
will turn into pumpkins and mice:
Mr. Market is there to serve you, not to guide you.
It is his pocketbook, not his wisdom, that you will find useful.
If he shows up some day in a particularly foolish mood,
you are free to either ignore him or to take advantage of him,
but it will be disastrous if you fall under his influence.
Indeed, if you aren't certain that you understand
and can value your business far better than Mr. Market,
you don't belong in the game.
As they say in poker, "If you've been in the game 30 minutes
and you don't know who the patsy is, you're the patsy."
The existence of Mr. Marekt is the most important reason why value investors like Buffett can compound money over 80 years with a CAGR of over 20%. Watch my channel or other value investing channels that show you how everyone can be a value investor and beat the market consistently, then you'll learn more (channel in profile description)