What Value Investing Really Means

A detailed study by O’Shaughnessy Asset Management, paints an interesting picture of how value investing plays out. Basically, value stocks have bad prospects and the market gets that direction right, on average. However, as we’ll see the strategy still has the potential to make money for investors.

For example, maybe  a value company is losing share to competitors or maybe rising prices are hurting their margins. However, though the market is correct that the prospects for value companies are dim, and hence earnings will decline, they are often too pessimistic on just how bad those prospects will turn out to be. The result is that stock prices can, on average, move up. Not because value stocks hit it out of the park in terms of performance, but because they beat meager expectations. 

So value investments tend to show weaker operating results, but the market often forecasts catastrophe ahead. Making money as an investor is often about the gap between expectation and reality. Value investments don’t have much baked into their share price, so it can be easier to beat expectations. Even pretty bad results can be ahead of expectations. That’s the key.

The Importance Of Expectations

It’s like if all companies were students sitting for exams, the market expects value companies to get an E, but they actually tend to get Ds. It’s not a great performance, but it’s a better performance than the market expects. That difference is what matters. In the market, these expectations matter, and coming in ahead of expectations causes the market to be willing to pay a little more for a dollar of the company’s earnings. 

This growth in the market’s valuation of these companies more than offset the earning decline, that’s less bad than expected. As such it’s not that value companies turn around and find everything to be back to the good old days, but that it’s typically never quite as bad as the market anticipates.

The other thing we should look for with any investment strategy is, does it make sense? For example, buying companies that start with the letter ‘A’ might beat the market, but that could easily be data-mining.

Alternate Arguments

With value investing we have reason to believe that the strategy may work, even before we see any data. This is is for a few reasons. First off, cheaper is often better. As Warren Buffett often points out, when socks are on sale, it can be a good time to buy socks rather than run out the store. The same can be true of stocks, if a particular stock is on sale in terms of trading at a cheaper price relative to its earnings, then maybe its a good time to buy it. 

The second argument is one around mean reversion paired with economic theory. If a company is doing really well, then competitors, or maybe even regulators, will enter and compete away the company’s profits. Equally, if a company is doing poorly, competitors may exit the market or not invest, helping margins come back to more attractive levels. Hence value stocks with apparently poor prospects may see mean reversion and economic theory come to their rescue. This is underpinned by research, for example, De Bondt and Thaler have found that poor performing stocks to tend to mean revert, though the process can take as long as five years.

There are behavioral arguments too. It can simply be hard to own the unappealing stock that misses earnings, has a less competent CEO and a strategic plan that’s misguided. Not the kind of thing you want to brag about at cocktail parties. Still there is a price for everything, and if people have a tendency to want to avoid value stocks, then perhaps that price is too low. Maybe the investors willing to hold these grubby, tainted value stocks, will earn a premium for doing so.

Thus there are quite a few reasons why value investing could hold up in addition to simply historic performance. Hence maybe we should be a bit less inclined to give up on value investing. Some patterns in the market are simply the result of looking around in the data and seeing what works, but with value we have a strategy that potentially makes sense, even before any statistical testing.

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