Historically, value investing has outperformed. It hasn’t done so year in and year out – and it can certainly underperform over shorter periods of time. But over longer multi-year periods, it has outperformed. The evidence in its favor holds across markets, countries, and eras.
Yet value investing has had a terrible period of underperformance the last half decade. It’s been bad enough and long enough to shake value investors to their core.
In a recent letter called “Keeping the Faith,” value investor Ben Inker of asset manager GMO wrote: “With central bankers pushing interest rates down to unimagined lows, ongoing disappointment from the emerging markets that have looked cheaper than the rest of the world, and the continuing outperformance from the U.S. stock market and growth stocks generally, it’s enough to cause even committed long-term value investors to question their faith.”
Inker acknowledges that this difficult period has forced he and his colleagues to question assumptions they’ve held for decades. Yet, as the title of his letter implies, Inker sees no paradigm shift that invalidates value investing. Instead, he affirms that the same conditions that have made value investors prosper in the past still hold.
What are those conditions? Simply for stock prices to be more volatile than their fundamentals justify. We know that company fundamentals – or the ability to generate cash flows — don’t change much from one day to the next. Yet their stock prices can and do because fear, exuberance, behavioral biases, and institutional constraints can push stock prices far higher or lower than makes sense.
Value investing is nothing more than positioning oneself for these excessive price swings to revert over time. When prices get pushed far below where they should be, value investors buy, and when the opposite happens, they sell.
When Inker takes a look at the world today, there is nothing to suggest this strategy still wouldn’t work. What would be worrisome, he says, would be if mispricing ceased to exist. What would be worrisome would be if price volatility declined, or if prices deviated little from their fundamental value.
Yet global stock prices fell 11% in the first six weeks of this year and then rose 13% in the next. That is not a world of pricing efficiency, but of “hyperactive central bankers and jumpy investors unable to decide between reaching for yield or running for safety.”
The difficulty for value investors is – and always has been — that mispricing can sometimes persist for long periods of time and test even the most patient of long-term investors. This is one of those times.
The reality, says Inker, “is that the only way you can get really exciting opportunities for mean reversion is to have misvalued assets become even more misvalued before they revert to fair value. This is the catch-22 of value-driven investing. Your best opportunities will almost always come just at the time your clients are least interested in hearing from you, and might possibly come at the times when you are most likely to be doubting yourself.”