Why value investing still works in markets
Reams are being written about the death of value investing or in defence of it. Michael Mauboussin, one of the best investment strategists around, in this piece for the FT, helps bring clarity around this debate. He says “Value investing, defined as buying or selling securities at prices different than their true value, is alive and well”. But in recent times, value investing became synonymous with buying stocks with low P/E or P/B multiples. Mauboussin blames this is on the flawed use of the Capital Asset Pricing Model or CAPM (see here for Marcellus’ own views on why CAPM hurts investors).
CAPM’s postulation that higher the risk, higher the returns were questioned when in practice researchers showed that low risk stocks performed better than high risk ones (when risk was measured as Beta or relative volatility to that of the market).
“In 1992, Eugene Fama and Kenneth French, professors of finance, published a much-cited paper which showed that adding measures of size and value to beta righted the relationship between risk and reward. The size factor documented that the stocks of small capitalisation companies earned higher average returns than those with large capitalisations. The value factor, measured as a multiple of priceto-book value per share, revealed that stocks with low multiples did better than those with high ones.
Consistent with the CAPM, Profs Fama and French saw these as risk factors and argued their tests did not confirm that markets were inefficient. Value investing suddenly became synonymous with buying stocks with low multiples and avoiding or shorting those with high multiples.
Years later, many investors and market observers still unfortunately conflate value investing with the value factor. Value investing is buying something for less than it is worth. The value factor is an ersatz measure of gaps between price and value. Worse, the relevance of the value factor is fading.
Earnings and book value no longer mean what they used to. Tangible assets, such as factories, were the foundation of business value in Graham’s time. Yet intangible spending, such as research and development, has been on the rise for decades. Indeed, companies in developed countries started spending more on intangibles than they did on tangibles shortly after the Fama and French paper was published.
Investments are outlays today in the expectation of higher cash flows tomorrow. Intangible investments are treated as an expense on the income statement. Tangible investments are recorded as assets on the balance sheet. That means a company that invests in intangible assets will have lower earnings and book value than one that invests an equivalent amount in tangible assets, even if their cash flows are identical. Earnings and book value are losing their ability to represent economic value.
Fundamental value investors should focus on gaps between price and value for individual securities. The present value of future cash flows, not misleading multiples, are the source of value. As Charlie Munger, Warren Buffett’s partner at Berkshire Hathaway, has said: “All good investing is value investing.” The value factor may be floundering, but value investing remains as relevant and useful as ever.”