The idea behind value investing is very simple for most people. It is essentially about buying a business cheaper than how much it is worth. However, most find it extremely difficult to implement this simple logic in practice. Many may conclude that deep value investing does not work.
Instead of buying low and selling high, they land into many psychological pitfalls in the market and end up doing the converse. Needless to say, their returns are probably nowhere near spectacular but yet, these are the very investors that make the most noise in the market.
If not value, then what?
Many hedge funds and trading desks come up with fancy proprietary strategies aiming to beat the market in the shortest time possible. Their empirical research focuses on discovering the factors that generate highest returns in the shortest time possible.
This mechanical way of investing reflects one ugly psychological trait that we possess – impatience. We desire quick returns.
But this search for immediate gratification has proven repeatedly to be toxic for our portfolio since the beginning of time.
Warren Buffett, the legendary value investor, issued a challenge 10 years ago to the hedge fund industry – a $1 million bet that they could not put together a portfolio of hedge funds that would outperform an S&P 500 index fund over 10 years. He strongly believes that active stock-picking along its high costs associated will lead to less than desirable results over the long run.
So how were the results? It is summarized clearly in the table below:
Average Hedge Fund Returns of 22% over 9 years amount to a measly 2.2% annualized return per year while the S&P index provided a much better 7.1% annualized return.
What this shows is that counterintuitively, by taking the long-term value approach, you are much more likely to generate a much performance than the average stock-picker.
This isn’t just true for investing. The ability of an individual to accept delayed gratification has shown to correlate with the probability of his or her future success.
If it works so well, why not the value approach then?
Investors tend to underestimate the importance of psychology and historical events. Just a word of caution before we begin, we aren’t using historical data to predict future trends of stock prices. That would be the so-called technical analysis that is widely used in the trading realm.
An understanding of historical events is essential to learn about the dynamics of the industry and the business. You have to know how the gears work and how the cycles behave before making judgement about the business. Looking at numbers without having any regard for the fundamentals will cause your analysis to be nothing short of being superficial.
The technical aspects of value investing are simple and easy to learn. With sufficient time and effort, most investors can learn how to read the financial statements, value the assets and calculate ratios. They can even make sound judgement about how expensive or cheap the stock currently is solely based on the price and figures provided in the annual report.
However, that is certainly not all there is to investing and this is where most investors fall short.
Beyond learning how to read financial statements, which is what every investor is minimally expected to know, you must understand how psychology comes into the picture.
In The Intelligent Investor by Benjamin Graham, he personified the financial market and named it Mr. Market. Mr. Market is portrayed as a partner who offers investors investments opportunities at varying prices every day. Sometimes when Mr. Market is feeling good, prices are sky-high. Other times, prices can become ridiculously cheap.
But Mr. Market’s mood is very contagious too. When prices are high, the typical investor tend to go along and feel great too, buying up whatever stocks that seem to have made Mr. Market’s day. When prices are depressed, most steer clear from these unwanted stocks instead.
Having a solid understanding about how these opportunities arise as a result of such recurring mistakes will value-add your judgement when you analyze stocks.
While industries change rapidly, and businesses evolve, one aspect of the financial market will never change – investors’ psychology. Some may argue that algorithm and automated trading are taking over the industry but ask yourself, who created these algorithms? These formulae are designed to profit from the short run, reflecting the greed and fear of the very investors that created them. Commonly used terms in the industry such as target price and stop losses stem from such a philosophy.
Crux of successful value investing
In the level playing field where everyone possesses the same amount of information and able to acquire the same skills, what truly matters would be your judgement. Yes, you can crunch impressive numbers and derive some fancy valuation number but if you do not complement this with any qualitative reasoning, the numbers will be meaningless.
Look, if you are looking to generate market-beating performance year after year, you have to think on a deeper level than most. You have to cut loose of any psychological burden that is pulling you back too. With self-discipline and careful thought, your efforts will inevitably pay off.