Does value investing work?
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Value investing is a distinct investing style that has many famous proponents including Warren Buffett, Charlie Munger and Mohnish Pabrai. The idea is relatively simple: find great businesses with strong fundamentals, whose shares are trading at a discount; then, buy and hold them until the wider market recognises their intrinsic value. Some claim that value investing holds the key to market-beating returns. Yet criticise it for failing to outperform the market in recent years, and argue that it is simply better to “buy the market” over time though “pound cost averaging”.
Does value investing work, and what role might it play in an investor’s portfolio in 2021? In this article, our team at Castlegate (financial advisers in Grantham) offers some answers. We hope you find this content helpful. If you want to discuss your own financial plan with us, please get in touch to arrange a no-obligation financial consultation, at our expense:
01476 855 585
Value investing: overview
The philosophy behind value investing was first developed by investors Benjamin Graham and David Dodd in the 1930s, publicised in the book: The Intelligent Investor. Warren Buffett was a student who went on to become very successful. He summarised value investing as: “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.” Value investing, therefore, is all about bargain-hunting on the stock market.
Many methods are used to find the “fair” (or “intrinsic”) value of a stock (e.g. price-to-earnings ratio). Here, a distinction must be made between value and price. The former is what the stock is reasonably worth; the latter is what you can buy/sell it for (e.g. on an exchange). There are many reasons why stocks may trade at a discount including short-term investor disappointment with profit performance. Value investors assume that their “discounted stock purchases” will, eventually, rise in price when the market comes to recognise their intrinsic value again in the future. At which point, the value investor could sell the stocks and make a huge profit – or, as Buffett propounds, hold them forever.
Does value investing work?
One thing is for certain – value investing can work. Between 1999-2020, for instance, Warren Buffett’s Berkshire Hathaway beat the S&P 500 (a leading US market index) in 12 calendar years. Between 1965-2019, moreover, Buffett achieved 20.3% compounded annual returns whilst the S&P 500 achieved 10%. However, Buffett himself admits he picked many bad stocks, and there were many years when he matched or underperformed the market.
Should I invest in value stocks?
At this point, you may be wondering why you should invest in index funds when the opportunity is there to “beat the market” by picking individual value stocks. However, a hard reality check is needed. First of all, the stock market in 2021 is widely seen as tremendously overvalued. It is very hard to find great companies trading at a discount today. Some “value stocks” can still be found, but many are “value traps” – i.e. they appear to be a great deal but are “cheap” for a good reason (e.g. the stock is in a failing industry).
Secondly, most people simply do not have the emotional discipline to achieve the results of Warren Buffett and his contemporaries. It takes huge resilience to buy an “out-of-favour” stock, continue buying it as it falls and then hold it for the long term. A lot of red, negative percentages appear daily on a value investor’s portfolio. This, bluntly, is too uncomfortable for most people. Thirdly, most people are too busy to research 1,000s of stocks and build a portfolio comprising, say, 20+ value stocks (which then need to be regularly checked and refined).
Why index funds make sense
A small amount of value investing can be a fun experience for some people with the disposition and spare cash. However, most will likely do far better by choosing a healthy range of funds and investing in them gradually over the long term. By pound-cost-averaging like this, you likely end up “buying the market” when it is expensive some months/years, and “cheap” other times. Over many years, however, the market can reasonably be expected to continue growing as a whole, despite various dips and “crashes” along the way.
This takes away much of the urge to look at your portfolio on a daily basis. After all, you do not need the money for 10, 20 or more years and only occasional rebalancing – with your financial adviser – is required to keep things on track, rather than buying/selling stocks every few weeks or months. Indeed, Warren Buffett himself said at the 2020 Berkshire Hathaway shareholder meeting: “for most people, the best thing to do is to own the S&P 500 index fund”; i.e. the 500 biggest publicly-traded US companies.
Conclusion & invitation
If you are interested in discussing your own financial plan or investment strategy with us, please get in touch to arrange a no-commitment financial consultation at our expense:
01476 855 585