The value investing process is commonly not well known or understood. This happens because universities do not incorporate the investing strategies as a part of the lecture programs. The underlying reason is that universities always consider that markets are efficient. It is based on this notion that modern portfolio theory (MPT) has dominated the academic field of portfolio management lectures. MPT and value investing could not be more different from each other.
The value investing philosophy was first developed by Benjamin Graham during the 1930s and compiled in his book “The intelligent investor” which has been the basis for all future development in the field ever since. The strategy is all about finding undervalued companies by choosing stocks with low price-to-earnings ratio (P/E), price-to-book ratio (P/B) and other valuation metrics. An investment decision is based on whether the stock is valued over or under the intrinsic value.
The strategy of value investing works. Academic research has shown that in bad and good times, value investing beats the market (Fama & French, 1998). Since researchers can’t know what stocks that value investors buy, they look instead on groups of stocks with low P/E and P/B ratios. A significant factor for value investing strategies is that there is no focus on a requirement of diversification, which stands in direct contrast to MPT. Instead, the portfolio of a value investor focuses on a small group of stocks. This investment style is coherent with ideas of economist Keynes and maybe more famously Warren Buffett.
“ACADEMIC RESEARCH HAS SHOWN THAT IN BAD AND GOOD TIMES, VALUE INVESTING BEATS THE MARKET” (FAMA & FRENCH, 1998)
The opposite style of value investing is following the principles of Modern portfolio theory, developed by Harry Markowitz, first published in the Journal of Finance in 1952. The theory is familiar to any university student majoring in finance: there is an optimal amount of risk to take on for achieving the maximum return from a portfolio. The key is to utilize the benefit of diversification by adding stocks whose stock price movements are uncorrelated, thus eliminating unsystematic risk. Then the portfolio is protected and, regardless of how the market moves, will have a positive outcome. MPT strategies are widely implemented by portfolio managers. The drawbacks of the theory are that the underlying assumptions are not applicable in real life, markets are not efficient and there is no evidence for individual stocks being completely uncorrelated from other stocks. In times of market uncertainty, investors tend to sell stocks as if they were correlated, investors are not rational.
So why is MPT the most used strategy by industry professionals when research shows that value investing has been more profitable and not necessarily involving more risk? One explanation is derived from basic human nature: we are irrational and act like a herd. Portfolio managers do not want to act too different from their colleagues due to the risk of being wrong alone and losing their jobs. As Keynes said, “It is better to fail conventionally than succeed unconventionally”. It is not portfolio managers lacking the ability to pick stocks that levee them over diversifying their portfolios, but rather institutional factors and the will to protect their jobs and assets under management.
Article published in our May Newsletter
Max Römbo, MSc in Finance