What is Value?
Investing styles nomenclature has a history going back to the 1920s. Though Graham and Dodd never used the phrase, "value investing”, they are credited for the same. The term was coined later to help describe their ideas. The Graham approach was to recommend low-risk entry inexpensive (cheap) stocks. They advocated a systematic approach to selection (bargains). They sought to buy businesses trading at a discount to net current asset values, what has been referred to as intrinsic value rather than price momentum.
I wrote about the history of value investing in my 2015 paper, “What is Value?” and explained why Value was a statistical idea before it was fundamental.
What is underperformance?
Underperformance vs. market refers to a situation where an investment or a portfolio of investments performs worse than the overall market or benchmark.
For example, if the S&P 500 index has a return of 10% over a given period, and an investor's portfolio has a return of 8%, the portfolio is said to have underperformed the market by 2%.
Underperformance can occur due to a variety of factors, such as poor stock selection, higher fees, and expenses, market conditions, or unforeseen events.
However, rarely do we look at underperformance related to Value investing style. Asset management strategies have little chance to survive in an inflationary world without understanding outperformance and their connection to investing styles.
Who are the big Value investors and did they outperform the S&P500?
Benjamin Graham: Considered the "father of value investing," Graham was active in the investment world from the 1920s to the 1970s. His investment philosophy was based on buying stocks that were undervalued by the market, and he famously advocated for a "margin of safety" approach to investing. Graham's returns are not publicly available, but he is widely regarded as one of the most successful investors of all time.
Despite a harrowing loss of nearly 70% during the Great Crash of 1929–1932, Graham survived and thrived in its aftermath, harvesting bargains from the wreckage of the bull market. There is no exact record of Graham’s earliest returns, but from 1936 until he retired in 1956, his Graham-Newman Corp. gained at least 14.7% annually, versus 12.2% for the stock market as a whole—one of the best long-term track records on Wall Street history.
Warren Buffett: Buffett has been active in the investment world since the 1950s and is widely considered one of the greatest investors of all time. Berkshire Hathaway under him has delivered an average annual return of around 20% since 1965. This compares to the S&P 500's average annual return of around 10% over the same period, meaning Buffett has outperformed the index by a significant margin over many decades.
Seth Klarman: Klarman founded Baupost Group in 1982 and has been actively investing for nearly four decades. Baupost's returns are not publicly available, but it is estimated that the firm has delivered an average annual return of around 20%, compared to the S&P 500's average annual return of around 10% over the same period.
Peter Lynch: Lynch managed the Fidelity Magellan Fund from 1977 to 1990 and delivered an average annual return of around 29%. This compares to the S&P 500's average annual return of around 16% over the same period, meaning Lynch outperformed the index by a significant margin.
Joel Greenblatt: Greenblatt founded Gotham Asset Management in 1985, and his investment strategy has delivered strong returns for many years. His Gotham Enhanced Return Fund has delivered an average annual return of around 16%, compared to the S&P 500's average annual return of around 10% over the same period.
Were they following Value investing?
Peter Lynch was not a pure value investor like Benjamin Graham and David Dodd, but his investment approach incorporated several key principles of value investing, as well as growth-oriented strategies. His investment philosophy was based on fundamental analysis, and he had a keen eye for identifying undervalued companies with strong growth potential. He famously coined the phrase "buy what you know," encouraging investors to look for opportunities in their areas of expertise.
Lynch's approach could be described as a blend of value and growth investing, as he looked for undervalued companies with the potential for future growth. He was also known for his long-term perspective and patience in holding onto investments that he believed had strong potential. One key aspect of Lynch's approach was the concept of "stalwarts," established companies with strong fundamentals that had proven themselves to be reliable performers over time.
Overall, while Lynch was not a pure value investor, his investment approach incorporated elements of value investing, growth-oriented strategies, and a focus on high-quality companies with strong fundamentals.
Warren Buffett has made several successful investments during market downturns, including during the 1973-1974 bear market, the 1987 crash, and the 2008 financial crisis. In each of these cases, Buffett took advantage of market dislocations to purchase high-quality companies at attractive prices.
While Buffett is often associated with value investing, his approach to investing is broader than just traditional value investing. He has emphasized the importance of investing in high-quality companies with strong competitive advantages, and he has also been known to invest in companies with growth potential, even if they don't necessarily appear undervalued.
Overall, Buffett's approach to investing can be summarized as a focus on long-term value creation, with an emphasis on identifying high-quality companies with strong competitive advantages and sustainable growth potential. While his approach shares many similarities with traditional value investing, it also incorporates elements of growth investing and a focus on risk management and capital preservation.
While Seth Klarman's investment approach is often described as value investing, there are some key differences between his approach and the traditional Graham and Dodd value investing philosophy.
One major difference is that Klarman focuses heavily on risk management, which is not emphasized as much in the traditional Graham and Dodd approach. Klarman believes that preserving capital is just as important as generating returns, and he is willing to hold cash or invest in more conservative assets when he believes that the market is overvalued.
Another difference is that Klarman is more willing to invest in distressed or special situation opportunities than Graham and Dodd, who primarily focused on investing in companies that were trading at a discount to their intrinsic value. Klarman believes that there are opportunities to generate significant returns by investing in companies that are facing short-term challenges or are undervalued due to special circumstances.
Finally, Klarman is more willing to deviate from traditional value metrics, such as price-to-earnings ratios or price-to-book ratios, to find opportunities. He is known for his deep research and analysis, and he looks for companies that have strong competitive advantages, durable business models, and the potential for long-term growth.
Joel Greenblatt's investment style is often considered a variation of value investing, but it differs from Graham and Dodd's traditional value investing in a few key ways.
One of the major differences is that Greenblatt's approach emphasizes the use of quantitative metrics, specifically the use of earnings yield and return on invested capital (ROIC). These metrics are used to identify companies that are trading at a discount to their intrinsic value and have strong underlying fundamentals. In contrast, Graham and Dodd focused more on qualitative analysis and looked for companies with a margin of safety based on their overall financial position.
Another key difference is that Greenblatt's approach incorporates a focus on special situations, such as spin-offs or restructurings. He believes that these situations can provide opportunities for outsized returns if the market is mispricing the underlying assets or undermining their growth potential.
Additionally, Greenblatt places a greater emphasis on the importance of diversification in his portfolio construction. He believes that diversification can help to mitigate risk and reduce the impact of individual stock performance on the overall portfolio.
The Graham and Dodd Value Investing
Momentum crash was not articulated as a term in the intelligent investor, but the masterwork is replete with examples that point to investing in large discounts after a bear market as a period that can create an appreciation for the active risk taker. Premiums or buying into exuberance was the antithesis of the intelligent investor.
“Hence under conditions of late-1971, the enterprising investors can probably get from good-grade bonds selling at a large discount all that he should reasonably desire in the form of both income and chance of appreciation.”
“But there is an underlying tendency for a market decline in this field to be overdone; consequently the group as a whole offers an especially rewarding invitation to careful and courageous analysis.”
“In the decade ending in 1948, the billion-dollar group of defaulted railroad bonds presented numerous and spectacular opportunities in this area. Such opportunities have been quite scarce since then, but they seem likely to return in the 1970s.”
“If you want to put money in investment funds, buy a group of closed-end shares at a discount of, say, 10% to 15% from asset value, instead of paying a premium of about 9% above asset value for shares of an open-end company.”
“Hence it is very unlikely that you will obtain a lower overall return from a (representative) closed-end company, bought at a discount, if its investment performance is about equal to that of a representative mutual fund.”
“If we consider the three domestic companies selling above asset value, we find that the average of their ten-year overall returns was somewhat better than that of ten discount funds, but the opposite was true in the last five years.”
“Experience teaches that the time to buy preferred stocks is when their price is unduly depressed by temporary adversity. (At such times they may be well suited to the aggressive investor but too unconventional for the defensive investor.)”
“Large profits were made by people who, a few years previously, had bought these issues when they were friendless and sold at low prices.”
“There were fairly important setbacks between 1949 and 1968 (especially in 1956–57 and 1961–62), but the recoveries there-from were so rapid that they had to be denominated as recessions in a single bull market, rather than as separate market cycles. Between the low level of 162 for “the Dow” in mid-1949 and the high of 995 in early 1966, the advance had been more than sixfold in 17 years—which is at the average compounded rate of 11% per year, not counting dividends of, say, 31⁄2% per annum.”
“The investor’s choice between 50% or a lower figure in stocks may well rest mainly on his own temperament and attitude. If he can act as a cold-blooded weigher of the odds, he would be likely to favor the low 25% stock component at this time. As the financial markets heave and crash their way up and down day after day, the defensive investor can take control of the chaos. Your very refusal to be active, your renunciation of any pretended ability to predict the future, can become your most powerful weapons. By putting every investment decision on autopilot, you drop any self-delusion that you know where stocks are headed, and you take away the market’s power to upset you no matter how bizarrely it bounces.“
The Discretionary Value Investor
If discretionary value investing involves capitalizing on momentum crash, significant Graham and Dodd discounts, active tactical risk-taking during crashes, a combination of value and growth investing, or simply growth investing with quality as done by the famous investors, then it is not the value investing a normal street investor can do. The investing style is for the elite, the geniuses, with an army of researchers. It is nearly impossible for a discretionary individual value investor to emulate such an out-performance. Even if they would have the gift of tactical timing, idiosyncratic risks are stacked against them and the exuberant 2010s and now the 2020s are a lot different than the 1970s.
The Systematic Value Investor
The individual value investor’s incapability is a part of the value underperformance. The quantitative value investor [QVI] is not far behind. The story of the QVI could be understood by Revisiting Bondt and Thaler, who in their paper “ Can Investors add and subtract?” Illustrated the reversion in 3 years' worst performers portfolio and best performers portfolio. The worst portfolio did better than the best portfolio. There was a natural reversion that saw laggards outperform the winners. Statistically, value regressed to mediocrity, a concept first used by Francis Galton in 1896. Fundamental Index was a systematic rule-based application elucidating the idea of systematic value using a smart beta approach.
The Middling Performance
Leave outperformance, both discretionary value investing and systematic value over the last 5 decades have produced middling performance. Individual investors did not make any record books, behavioural finance which was a close investing style to value investing failed to get noticed for its stellar performance track record, and fundamental index creators admitted that there were more factors rather than Value. And if this was not enough, Berkshire Hathaway has long periods, where it barely tracked the S&P 500 performance.
Qualitative Reasons Why Value Underperforms!
Statistically, Value should have reasonable odds to beat Growth or any other combination of actively chosen factors or naively assorted factors, but still, Value unlike many other factors is more prone to underperformance. Because of the singular nature of understanding and looking at value, i.e. fundamentally, we miss out on its idiosyncraticity, its uniqueness, and its atypical character. Value is not just fundamental, it is also relatively inexpensive. And something inexpensive can behave unexpectedly because of the following reasons.
Structural Issues: If an asset is undervalued due to structural issues, such as poor management, a flawed business model, or unfavorable industry dynamics, then the idiosyncratic nature of its value or cheapness would be tied to these specific issues. For example, a company that is struggling to compete in a declining industry may be undervalued due to structural issues, and the idiosyncratic nature of its value or cheapness would be linked to the specific challenges it faces in that industry.
Lack of Interest: If an asset is undervalued due to a lack of interest from investors, then the idiosyncratic nature of its value or cheapness would be tied to the specific reasons why investors are not interested in it. This could be due to a lack of awareness of the asset, poor investor relations, or a negative reputation. For example, a small company with a strong growth story may be undervalued due to a lack of interest from investors who are not aware of its potential.
Misperception: If an asset is undervalued due to misperceptions about its value or prospects, then the idiosyncratic nature of its value or cheapness would be tied to these specific misperceptions. For example, a company with a strong competitive position may be undervalued due to misperceptions about its ability to sustain that position, leading investors to underestimate its long-term value.
Temporal Structure: If an asset is undervalued or overvalued due to temporary factors, such as short-term market trends or a cyclical downturn in the industry, then the idiosyncratic nature of its value or cheapness would be tied to these specific temporal factors. For example, a company that is undervalued due to a temporary downturn in the industry may be considered cheap in the short term, but the idiosyncratic nature of its value would be tied to its ability to overcome the downturn and return to growth in the long term.
But at the heart of all these issues are the measuring metrics. The idiosyncratic nature of value or cheapness can also be influenced by the specific measuring metrics used to evaluate the asset's fundamental value. For example, if a stock is undervalued based on traditional metrics such as price-to-earnings ratio, but is actually fairly valued based on other metrics such as price-to-sales ratio, then the idiosyncratic nature of its value or cheapness would be tied to the specific metrics used to evaluate it. Similarly, if an asset is undervalued or overvalued due to a unique characteristic that is not reflected in traditional metrics, such as a strong brand or unique technology, then the idiosyncratic nature of its value or cheapness would be tied to these unique characteristics. Simply put it is hard to understand the unique characteristics of Value, even if it is laid out fundamentally.
Quantitative Reasons Why Value Underperforms!
There are many quantitative reasons to explain the probabilistic drag on Value, if we look at it statistically rather than fundamentally. Statistical Value can be defined as relative losers with a certain look-back period.
First; tactical timing looks exciting when it becomes a popular cult but it is hard to implement. Second; Value is an active investing style, which will always have more risk than naive factor allocation, which is more passive. Third; Regression of Value from its discounted state is not a strategy, it is extrapolation. Fourth; negative fat tails of statistical value can be as prominent as positive tails. And when companies get stuck in the Value trap, they drag the overall performance of the portfolio. Fifth; Value returns have on average higher excess volatility compared to Growth returns. This might seem counterintuitive, but the base effect could contribute significantly to statistical volatility. Sixth; Lower Kurtosis isn’t enough for a Value strategy to deliver outperformance. Seventh; Fundamental screening is not enough to give a positive skew to a Value strategy. Eight; Over a long period, fundamental metrics like PE ratios may have shown a negative regression slope, but such behavioral patterns don’t lend themselves to systematic outperformance. Ninth; the level of dispersion in a Value group of stocks is always going to be higher than Growth because, greed is a more converging phenomenon, compared to lackluster Value. Tenth; It’s an impossibility to predict how low will a Value stock take to become a Growth stock. Even if Value investors are not seeking a complete reversal of fortunes, systematic exiting out of a Value position is not a sure-shot way of delivering outperformance.
Conclusion
We have run many simulations and studied them over years to understand investing styles. And Value has lagged when it came to alpha (outperforming the market).
Value portfolio built from bottom quintile performers of the S&P500 deliver excess returns at a higher excess volatility (2016-2022)
Value portfolio built from bottom quintile performers of the S&P 500 has negatively skewed Information ratio and excess returns (2016-2022)
Value portfolio built from bottom quintile performers from the S&P 500 has more than 70% of data points under 0.5 Information Ratio and 64% data showing postive excess volatility fom 2016-2022
It’s not difficult to prove that Value underperforms. Value’s popularity is married to human overconfidence to be able to pick stocks. Value investing may have an opportunity to deliver absolute returns, but it does not have the statistical character to deliver outperformance to beat Growth over a decade-long investing rolling period. And even if Value beats Growth in some time windows, it can not do it consistently. We need a secular bear market to better understand Value outperformance.
The idea of an intelligent investor that can buy discounted value and beat the market is connected to periods of momentum crashes. Without the momentum horse, Value has a hard time finishing the outperformance race. There are geniuses out there who can do the magic consistently, but such cerebral work is an extreme competency for the rare mind, not for the lay mind. And that genius who can do Value investing may still end up beating everything in the long term, but he/she definitely won’t give sustained outperformance, year after year.