Value Investing Strategies - The Scientific Evidence
Let's take a look at some data from one of the many academic studies showing compelling evidence of excess long-term returns from basic value investing strategies. University of Chicago professors Kenneth French and Nobel Laureate Eugene Fama performed a retrospective study encompassing 27 years of financial data for each stock trading on major U.S. exchanges. All stocks in the study were divided into ten groups ranked by price/book value ratios, one of the most basic metrics used to estimate whether a company is over or undervalued with respect to the assets it owns. The companies were also divided into ten groups based on market capitalization (the total market value of a company's shares). The very smallest companies are almost totally neglected by Wall Street funds and analysts; as a result, careful analysis of small-cap securities can reveal deeply undervalued investment opportunities that others have neglected, and can provide significant advantages to smaller investors.
As you'll see from the table below, the results couldn't have been more clear. Low price/book ratio stocks had an incredible edge over their high price/book peers; returning on average two to four times as much per year over the study's entire 27-year time horizon. And for the most undervalued companies, a second effect became apparent : the very smallest firms, those almost completely neglected by conventional funds and analysts, consistently outperformed by an even wider margin.
Annual Investment Returns For NYSE/AMEX/NASDAQ Listed Stocks, Ranked by Price/Book Value Ratios and Market Capitalization - July 1963 through December 1990
While proponents of the efficient market theory have not stopped trying to explain away "anomalies" such as these value and size premiums as just another proxy for risk, evidence has continued to grow that value stocks deliver consistently strong outperformance on a risk-adjusted basis. For a readable summary of some of the literally dozens of studies showing the consistent outperformance of value strategies across multiple markets and time periods, see this informative review compiled by the value-oriented management firm Tweedy, Browne and recently updated in 2009. These persistent anomalies are in fact a result of understandable human behavioral biases on the part of the majority of investors, which can allow a patient and disciplined minority of value investors to achieve significant long-term outperformance through an awareness of these facts.
Far from providing any practical benefits for their adherents, many of the models relied upon by the conventional investment community are in fact dangerously divorced from the real world. The capital asset pricing model (CAPM) is based around the core assumption that any excess return is necessarily a compensation for greater risk, which this model equates with price volatility. In reality, there is growing evidence that stocks with lower volatility actually tend to experience higher returns - precisely the opposite of what the core assumption of this model would predict. Dismissing decades of data on securities mispricing as an "anomaly" would be similar to a physicist not checking her assumptions about the theory of gravity if objects were found to fall upwards rather than down.
Proof of a significant value premium in multiple studies provides clear statistical evidence for what history has shown all along -- why the majority of professional fund managers focused on popular growth or glamor stocks perform worse than the market average, and why disciplined value investors like Warren Buffett and Seth Klarman, focused on demonstrably underpriced companies with real business value, have tended to outperform year after year. What the above evidence shows about small company performance is even more compelling. Far from being outclassed by larger professionals, individual and small institutional investors with access to value-based strategies actually have a very powerful advantage. If you start paying attention to the simple, common-sense rules of value investing and begin building your own portfolio of the solid, deeply underpriced stocks neglected by the majority of investors, you'll have a far better chance than any highly-paid money manager at achieving investment returns that strongly surpass the market.
The simple metrics shown above are only two of several objective criteria that have been shown to demonstrate important correlations with future long-term returns. Nevertheless, it can be very dangerous to rely on them blindly. Many purely quantitative funds focused on screening for valuation metrics without further research have often been blindsided into investing in frauds, businesses with corrupt management or genuinely poor long-term economics, or businesses where one-time gains or technical accounting distortions create the superficial appearance of value. Although the experience to perform accurate subjective analysis takes time to develop, careful attention to SEC filings and management behavior can often uncover important company-specific issues, arriving at a clearer picture of genuine business value that can guide investors to even greater risk-adjusted returns than those described above. Review some research reports from past editions of this newsletter to see how fundamental research can reveal opportunities for truly outsized returns, for example by uncovering hidden assets recorded on the balance sheet at historical costs which can be worth substantially more than the reported numbers imply.
For over three decades, a growing body of rigorous studies in quantitative finance and behavioral economics have continued to challenge traditional efficient-markets assumptions with evidence of the remarkable effectiveness of value investing strategies, and has gradually added to the power and sophistication of valuation tools available to those select few investors who actually take the time to study what has worked in the past. As demonstrated by the exceptional historic track records of multiple value investors, and the audited multi-year record of market-beating returns provided on this site, combining quantitative value screening with careful attention to long-term business fundamentals and sustainable profitability can further outperform even these exceptional results. Literally no other investment philosophy can boast such a track record of scientifically and historically verified success.
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