The human psychology behind value investing

This article is part of
Understanding ‘Value Investing’ - August 2013

This is because universities have accepted the notion that markets are efficient and, as a result, teach modern portfolio theory, which cannot be more different than value investing.

Value investing is a style developed in the early 1930s by Ben Graham at Columbia University. It involves a three-step process – though most people believe the process is limited to only the first step.

First, identify possibly undervalued stocks by choosing stocks with low price-to-earnings (p/e), price-to-book (p/b) or other valuation-related metrics. Second, value in depth the stocks that pass the screening process to estimate their intrinsic value. And third, make an investment decision to buy only if the stock price is below the intrinsic value by a predetermined margin of safety – value investors are very careful of valuation risk, which is paying too much. Value investors are contrarian (bottom-up) stockpickers with long-term perspective.

Does value investing work?

In answering this, academic research focused primarily on the first step of screening as academics do not know what stocks value investors actually buy, but they do know that they tend to buy from the low p/e or p/b group of stocks.

Such research showed that thus defined value investing works. Value stocks (low p/e or p/b) outperform growth stocks (high p/e, p/b) in Canada, in the US and global markets. They outperform when the markets go down and up, and when news is good and when it is bad. And they do all this without having higher risk, as measured by beta or standard deviation or adverse states of the world.

Other research, better focused on what value investors do, also showed that value investing works. Studies of 1,700 actively managed US funds from 1984-99 and 1993-2002 found that the more concentrated a fund was – in other words, the less diversified – the better it did. The outperformance resulted from selecting the right sectors or stocks, not from market timing.

Additionally, the studies found that the lower the reliance on public information and the greater the reliance on portfolio manager’s own skill, the greater the outperformance. Value investing is all about concentrating a portfolio to a few selected truly undervalued stocks. And as Keynes once said “once you attain competence, diversification is undesirable”.

Warren Buffett echoes this view.

The first direct study of value investors – Do Value Investors Add Value? published in the Journal of Investing – examined whether value investors add value over and above a simple rule that dictates they invest only in stocks with low p/e and low p/b ratios.

The author found that value investors do add value, in the sense that their three-step process of selecting truly undervalued stocks produced significantly positive excess returns over and above the naive approach of simply selecting stocks with low p/e and low p/b ratios.

As noted investor Sir John Templeton said: “It is impossible to produce a superior performance unless you do something different from the majority”.