Why value investing is for grown-ups
(MoneyWatch) New York University finance professor Aswath Damodaran recently examined whether active management enhanced returns for value investors.
In a April 2012 paper, Damodaran first examines the historical evidence on returns to value strategies, strategies based on simple metrics such as low price-to-earnings or low book-to-market ratios. He then analyzes the three basic types of value investors:
- "Screeners," who use metrics such as price-to-earnings ratios and dividend yields to screen out certain stocks or groups of stocks
- "Contrarians," who take positions in companies whose stocks have performed poorly and/or have acquired reputations as poorly managed or run companies
- "Activists," who take positions in undervalued and/or badly managed companies and then press for changes in corporate policy or management in a bid to unlock value
Damodaran points out that the common theme among the three forms of value investing is that value firms (or firms out of favor with the market) can be good investments. He provides a highly readable analysis of each of the types of value investing. His conclusion:
- Of all of the investment philosophies, value investing comes with the most impressive research backing from both academia and practitioners.
- The excess returns earned by stocks that fit value criteria (low multiples of earnings and book value, high dividends) and the success of some high-profile value investors (such as Warren Buffett) draws investors into the active value investing fold.
He then asks a key question: Does spending more time researching a company's fundamentals generate higher returns for investors? More generally, and the impressive back-testing results notwithstanding, does active value investing pay off?
As a simple test of the returns to the active component of value investing, Damodoran looked at the returns earned by active value investors relative to a passive value investment option. Value mutual funds were compared to an index fund of only value stocks (low price-to-book and low price-to-earnings stocks). The results are not good for value investing. Active value investing funds generally do the worst of any group of funds, and particularly so with large market cap companies.
As further evidence of the difficulty of beating Mr. Market, read my post "In search of the perfect value fund." The conclusion we can draw is that beating the market is always difficult to do, even for a good value investor.
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