Criticism of value investing

January 5, 2016 10:14 AM

I’ve just read “The Intelligent Investor”, which lays out a fairly simple investing philosophy. Warren Buffett describes it as “buying dollar bills for 40 cents”. It seems more reasonable than much of what I read in the financial news, and certainly more reasonable than the way people think about investing in the tech world. But the fact that it seems so sensible to me makes me nervous. Its proponents are very confident and it seems like confident people often lose their money.

So what are the intellectually-rigorous criticisms of value investing? The main complaint I’m aware of is that markets are basically efficient now, so that what worked for Benjamin Graham after the Depression likely won’t work today. There’s also the fact that it’s much harder to make sense of a balance sheet than it used to be.

Surely there must be people who make convincing arguments against this approach? I am comfortable with pretty much any level of math people are likely to use. Or just books you think I ought to read.

(Note: I'm not looking for investment advice, although “buy low-cost index funds” is excellent advice.)

posted by vogon_poet to Work & Money (11 answers total)

so the studies that show value/HML actually works date back to Fama-French who make the argument that value is just simply riskier when volatility is the definition of risk. A counter point to this is Shliefer Vishny, Lakonishok which claims it works due to behavioral bias.

A more recent attempt to challenge value orthodoxy might be seen in the stuff on skewness that Eric Falkenstein's blog focuses on.

There are also a bunch of papers that have come out of AQR (Cliff Asness) that attempts to disaggregate the value factor into quality that challenges the orthodoxy. He's actually a good person in general to read what he says.

There are also critiques that the value and especially size factor excess returns came about due to survivorship bias.

The reality is that over time there are two factors we think we know work - Value and Momentum. There is a pretty facile critique that says Value has been arbitraged away because everyone knows about it, it is intuitive, and easy to implement. The claim is that explains why it has worked in about ten years. None of those things apply to Momentum, so that factor still works. I don't really know the answer to that. Maybe if we haven't had a good value cycle by 2025 I might agree.

Having said all that there is a ton of literature on Value Factors and Factors in general that you can find on-line.

I think that statement about confidence/overconfidence can be applied to weak practitioners of almost every kind of investing.

Feel free to memail if you wish.
posted by JPD at 10:25 AM on January 5, 2016 [2 favorites]

the coherent balance sheet argument is that companies assets are increasingly intangible. However a lot of modern value investors don't use purely P/TBV anymore, and most of the studies that look at the last 40-50 years will show you the cheapest quintile of EV/EBIT is actually the best performing way to capture the value premium.
posted by JPD at 10:29 AM on January 5, 2016

Not so much "criticisms" than different approaches to stock picking: growth and GARP (growth at a reasonable price).

But you could say the implied criticism of value investing in the growth approach is that, for a growth investor, even a relatively expensive-looking stock might be worth picking up for its future growth potential.
posted by mandolin conspiracy at 10:34 AM on January 5, 2016

And the explicit criticism of growth investing is that there is no evidence it works in any sort of systematic way
posted by JPD at 10:36 AM on January 5, 2016 [1 favorite]

Response by poster: Just to be clear, when I said I'm comfortable with math I meant like I'm not afraid of partial derivatives or normal distributions. I still know next-to-nothing about markets or investing.
posted by vogon_poet at 10:40 AM on January 5, 2016

As it happens, there's a recent discussion of this subject over at bogleheads.org.
posted by Short Attention Sp at 11:08 AM on January 5, 2016

My husband works in the finance industry, and I showed him this question. Here was his response:

The efficient market hypothesis is the primary criticism. Its validity is apparent if you go and do the math on a particular company. I would encourage you to try it. Pick a well-known company with a good balance sheet and consistent earnings. Estimate the growth in earnings over 10 years or so. Discount those earnings back at a rate of return that you find acceptable (say 15%). I bet you find that the price of the company is higher than the value you determined.

When Ben Graham was writing The Intelligent Investor, there were companies trading at 40% of book value. They may have been broken businesses, but they were still cheap. Warren Buffet described them as cigar butts. One last puff. Warren Buffet, with Charlie Munger’s influence, has become more focused on great companies at a reasonable price. These are better long-term holds.

The biggest criticism I have and that I find is that value investing requires patience. You may look at 100 different companies for a year and not find the 30%-50% discount you are looking for. So you sit there and accumulate cash and keep researching. Warren Buffet says you should think of stock investing as having a punch list, and you get 20 punches. Basically saying you may find 20 great opportunities in your lifetime. This feels true to me.

What the efficient market hypothesis doesn’t have room for is big market dislocations. In the financial crisis, there were wonderful deals everywhere. There were stocks trading at 3-4 times annual cash flow. I focused on certainty. I found a REIT (LXP) trading around 3x their annual dividend at the time and 2.5x their annual cash flow. I work in real estate, so that was well within my circle of competence. That was a punch on my ticket. They had long-term leases to credit tenants backing their income. I knew their dividend would be cut, and it was, but the stock is now trading at 3x what it was selling for then and has been as high as 4.5x the price I bought it at. That doesn’t count the dividends received along the way. I captured their 33% dividend for a couple of quarters before they cut it back to around 10%. It has an 8% yield today after several increases, but on my basis/cost it is a 27% yield. Oh, if I had had more cash at the time…

That’s value investing. To find a deal today, you likely have to sort through the wreckage in energy and commodities. Maybe manufacturing companies offer some hope. None offer the certainty that could be found in March of 2009 when everyone else was scared and running for the exits. It takes an incredible amount of patience and an incredible amount of discipline. You almost have to build that temperament within yourself to make it work and be successful.
posted by Ostara at 11:26 AM on January 5, 2016 [19 favorites]

I think the evidence that value stocks outpace growth stocks is quite compelling. Probably the strongest case is made by looking at the Russell 3000 data which shows value about 1% better than growth. However, if you are looking at picking individual equities, you run a real risk that the reason your individual stock is undervalued is due to some factor that the market correctly priced that you don't see on the balance sheet. A fair number of equities that would show up on a typical value screen are in fact dogs that are headed nowhere but down. The intellectual argument would be that individual value stocks are more risky, which is why they collectively have better returns because the market prices in a risk premium. This volitility makes value investing something not for the faint of heart. I often think of Buffet's famous maxim that "it's far better to buy a wonderful company at a fair price, than to buy a fair company at a wonderful price."
posted by Lame_username at 12:23 PM on January 5, 2016

The majority of names at anytime in the cheapest quintile of an investment universe will underperform the market, but because the winners in the quintile massively outperformed you end up beating the market.

There is a discussion to be had about whether or not Buffett is still a value investor. That's what some of the AQR papers are about.
posted by JPD at 12:44 PM on January 5, 2016

The problem with value investing is how you define it. What Warren Buffett or Benjamin Graham call value investing is not the same as what Fama and French call value investing. So first you have to explain your criteria for calling a stock a value stock.

In the Graham and Buffet version, they claim that they are reducing risk by buying under-valued stocks (and the secret is how you determine a stock is under-valued). But in the Fama and French version, value stocks pay higher returns because they are inherently riskier.
posted by JackFlash at 4:24 PM on January 5, 2016

Graham didn't realize it but he was just doing high minus low. Buffett of course isn't.

I dont think even gene fama still buys the emh explanation of the value premium
posted by JPD at 5:23 PM on January 5, 2016