If value investing works so well, why isn't everyone using it

Philip Vanstraceele 26 Jul 2011

Many studies prove that value investing works and performs better than other strategies. The premise is simple: there is a difference between price and value. As Warren Buffett said:

"price is what you pay, value is what you get"

The goal is not to buy at fair value because that will only generate an average return. You should purchase your investments with a large margin of safety. This offers protection against being wrong. Value investing is the only form of real risk management that I know of. It protects you against permanent loss of capital, the real risk. Not risk as Markowitz, Sharpe, and other efficient markets zealots define it: the volatility or beta of a stock. Of course, someone who is leveraged does not have the luxury to ignore the volatility of an asset. But value investing is long-term, mostly unleveraged investing! As Warren Buffett said:

"As far as you are concerned, the stock market does not exist. Ignore it!"

So, with less risk, you get more return with value investing? Gee, that's great?

But if it is that simple, why isn't everyone investing this way?

Value investing requires a contrarian investing attitude, but it is not easy to go against the tide! Our emotions and behavior are under the continuous influences of the media (tv, internet, Facebook, etc.) and other people. Friends who know me well can tell that I watch very little TV. For instance, I never watch the CNBC financial news. Their typical "breaking news" flashes make me crazy. These flashes are just as if the world could stop spinning at any moment.

So rather than worry over the last analyst's opinion or the next market crisis (a world without crises isn't possible, you know), a value investor needs to look to the facts, namely the financial statements and value of a company. Like House, the a-typical US doctor (one of the few series I like to watch on TV) refuses to speak to patients because they lie. We need to mistrust the news and other's forecasts. Contrarian investment strategy is workable because of the continuous overreaction of investors to companies they consider to have excellent or mundane prospects. Uncertainty is part of investing, and research in social psychology demonstrates how easily people are drawn together under conditions of uncertainty and even mild anxiety.

Being contrarian also means not to invest in the hype and story stocks of the moment; you need to invest differently from the majority, and you need to buy the unloved stocks and sell the market's darlings.

But going against the tide is hard. The first man, who said the earth was not flat, was considered an idiot. Nobody wants to be considered an idiot! So you need to think independently. It is difficult for a fund manager to say to a client that he/she lost some of the customer's money temporarily on a small, obscure stock that nobody else had bought. It is more accepted to tell that he lost money on Microsoft or GE. "All the others were wrong too", the perfect umbrella. Value investing is dull, boring, and always the same. You can beat the market by ignoring the herd, but it is not easy.

Another reason why not everyone is a value investor is patience. This is inherent to value investing. As Benjamin Graham wrote:

"Undervaluation caused by neglect or prejudice may persist for an inconveniently long time, and the same applies to inflated prices caused by over-enthusiasm or artificial stimulants."

Cheap stocks can always get cheaper, and expensive stocks can always get more expensive. You need to hold stocks for the long term and stick to the selected strategy. Long-term investors are a vanishing species. Modern investors concentrate too much on annual, quarterly valuation.

For many fund managers, there is also pressure from customers and benchmark paranoia. Many funds are judged on whether they can beat the returns of a particular index. A manager who significantly underperforms the market averages for two or three years has a good chance of losing most of his or her investors. The late '90s were such a hard time for value investors, as they had to compete against the internet bubble story stocks. It was just tricky to invest in cold, non-growth industries. Most customers don't wait to figure out if the fund manager has had just bad luck or is doing a flawed investment process. But even the best-performing investors (as even Warren Buffett) go through (long) periods of significant underperformance. There's just nothing in the short term to do about this.

There are also some regularity rules and practical limitations of many fund managers. Most institutional investors must limit their ownership stakes to 5 or 10 percent of the entire company. Purchasing even 5 percent of a company can push the price up, particularly for small and nano-cap companies. So these investors can't invest in cigar butts or small deep value stocks. And these, of course, are the most interesting bargains to buy. Most research analysts from Wall Street or London won't usually cover these smaller companies either. These shares don't trade enough to generate sufficient commissions to justify research coverage.

People also like forecasts and stories. Our 'experts' try to forecast the economy, the interest rate, unemployment rate, sectors that will do well, etc. But most economists don't have a clue what the future will bring. There are just too many variables to build a reliable model on. And analysts are no better; their forecasts are dreadful on short- and long-term issues. According to David Dreman, this is the 'expert' way to lose money) Humans have a difficult time processing all information. There is an information overload (internet, news, tv, etc.), making it almost impossible to make forecasts. But as said, people like stories and forecasts. Value investing is not based on forecasts; it is based on a margin of safety. But that is too dull for most of us.

Conclusion : Value investing is simple, but apparently not for everyone...