Value Investing: Where is the beef?

In my first post in this series on value investing, I noted that value investing is a broad brush that covers a range of different approaches, ranging from screening for cheap stocks to looking for bargains in the "loser" bin to being catalysts for change in poorly managed, mispriced companies. There is one characteristic that some value investors seem to share, which is that they are the grown-ups in the investing world, and that investors with different views of the world (a belief in momentum, hope for growth or that markets are efficient) are deluded. Implicit in this view is also the belief that value investors are the long term winners in markets, but is this a belief that is backed up by the evidence? Or as one of my favorite commercials of all time would put it:

Does spending more time researching a company’s fundamentals generate higher returns for investors? More generally, does active value investing create value? A simple test of the payoff to the "active" component of value investing is to look at the returns earned by active value investors, relative to a passive value investment option. In the figure below, I compute the excess returns generated for all US mutual funds, classifed into small cap value, mid cap value and large cap value, relative to index funds for each category. Thus, the returns on small cap value mutual funds are compared to the returns on index fund of just small cap, value stocks (low price to book and low price to earnings stocks).

While the average returns earned by small cap and large cap value funds did beat their respective indices over a 5 year period, the active value funds underperformed the indices in every other comparison, with small cap value funds delivering almost 2% less than the small cap value index over the last ten years. These results are not due to negative returns at a few really bad funds, either, since 55% of large cap value fund managers, 64% of mid cap value fund managers and 56% of small cap value fund managers  under performed their respective indices between 2002 and 2011. In fact, even over the 2007-2011 period (the most favorable period in the comparison), using the median return rather than the average return across value funds makes the excess returns negative. Lest you attribute this to the time period of the analysis, you can look at this study from 1992-2001 and this one from 1971 to 1991 to see that the findings apply over time.

If you are an individual value investor, you may attribute this poor performance to the pressures that mutual funds managers operate under to deliver results quickly and their tendency to drift from their core philosophies, and argue that disciplined individual value investors do better. Since it is difficult to track the performance of individual investors, the question of whether individual value investors deliver better results than mutual funds has no clear empirical answer. However, there are some intriguing findings in the literature.

1. In a study of the brokerage records of a large discount brokerage service between 1991 and 1996, Barber and Odean concluded that while the average individual investor under performed the S&P 500 by about 1% and that the degree of under performance increased with trading activity, the top-performing quartile outperformed the market by about 6%.
2.  Another study of 16,668 individual trader accounts at a large discount brokerage house finds that the top 10 percent of traders in this group outperform the bottom 10 percent by about 8 percent per year over a long period.
3. Studies of individual investors find that they generate relatively high returns when they invest in companies close to their homes compared to the stocks of distant companies, and that investors with more concentrated portfolios outperform those with more diversified portfolios.

While none of these studies of individual investors classify superior investors by investment philosophy, the collective finding that these investors tend not to trade much and have concentrated portfolios can be viewed as evidence (albeit weak) that they are more likely to be value investors.

Faced with this evidence, some value investors fall back on the old standby, which is that we should draw our cues from the most successful of the value investors, not the average (or the median). Arguing that value investing works because Warren Buffett and Seth Klarman have beaten the market is a sign of weaknesss, not strength. After all, every investment philosophy (including technical analysis and charting) has its winners and its losers. A more telling test would be to take the subset of value investors, who come closest to the meeting the purity standards of value investing, and see if they collectively beat the market. Have those investors who have read Ben Graham's investment tomes generated higher returns, relative to the market, than those who just watch CNBC? Do investors who trek to the Berkshire Hathaway annual meeting every year have superior track records to those who buy index funds?

I don't think we will ever know the answers to those questions, but I am willing to hazard a guess. I don't think that value investors as a group, no matter how tightly that group is defined, beat the market. I also think that some value investors do beat the market consistently, and that their success cannot be attributed to luck. I would go further and argue that they share some common characteristics:

1. Core investment philosophy:  A good value investor has a well thought through view of how markets work and how they correct themselves, honed not only through experience but backed up with empirical evidence. 
2. Competitive edge: At the risk of repeating myself, you do need a competitive edge to succeed over the long term. Since that edge can no longer be access to data or analytical tools (both of which have been democratized), it may have to come from you having a longer time horizon, a lower need for liquidity or a different tax status than the typical investor. It could also come from your capacity to deal with information overload or use information across different markets (globally and in terms of asset classes) better than the typical investor.  
3. Discipline: If there is a finding that studies have in common, it is that too much activity, even with the best of intentions and by the smartest of investors, is damaging to portfolio returns. Having the discipline to not deviate from your core philosophy (based upon whims or emotion) seems to be a key component in long term success.
4. Lack of hubris: There is no reason why value investors cannot borrow and adapt pieces of momentum and growth investing or even from academia to augment their returns. To do so, they have to be open to the possibility that every investment philosophy has its strengths and weaknesses, and that no group of investors has a monopoly on investment virtue (and success).

This is the last in a series of posts that I have on value investing. You can read the paper that I have on value investing (see link below) and I did make many of these points in a presentation (Warning: It is a little caustic...) in Omaha this year at a value investing conference, just before the Berkshire Hathaway meeting.

The Value Investing Series

Where is the value in value investing? (Downloadable paper on value investing)

Blog post 1: Value Investing: An Identity Crisis?

Blog post 2: Value Investing I: Screening for bargains

Blog post 3: Value Investing II: Contrarian Investing

Blog post 4: Value Investing III: Activist Value Investing

Blog post 5: Value Investing: Where's the beef?