Thorough analysis, long-term planning and reasonable prices: Value investing is not about buying 'cheap stocks'
A Chinese version of this interview was featured in the 1 September 2019 issue of Zaobao. Below is our original submission in English.
Value investing is when you buy a stock that's priced way below its actual worth, expecting to be rewarded when the price goes up. This concept was first put forward by Benjamin Graham.
However, there was no proper empirical research into value investing until Nobel laureate Eugene Fama and Kenneth French published their seminal 1993 paper, Common Risk Factors in the returns on Stocks and Bonds. Their paper aimed to identify the factors that would explain returns in the stock and bond markets. They found that stocks with high book-to-market ratios (i.e. low relative price) produced greater returns in the long term, which is why value investing worked.
Unfortunately, value investing has been misused and misunderstood by investors. It is not as simple as looking for 'cheap' stocks to buy.
If a company is 'cheap' compared to its peers because no investor wants to buy it, it is probably a distressed company. This means it is a lot more risky, which is also why it should give you a higher expected return. In general, riskier strategies can produce higher returns. As such, a value investing strategy will naturally have a higher volatility.
But a cheap value stock can remain cheap for a long time ("value trap"). In order to receive the returns from the entire universe of relatively cheap stocks, you will need to buy thousands of companies, as shown in the Fama/French paper and other research. Otherwise, you will not be able to realise this value “premium”.
This makes it difficult for retail investors to do value investing. That's because they would not have the ability to screen thousands of companies to identify which are value stocks. Secondly, they would not have enough capital or trading capacity to buy those thousands of stocks. Thirdly, just assembling and monitoring such a huge and complicated portfolio would take an effort that far outweighs the benefits.
Unfortunately, value investors would have suffered over the last 10+ years, as value under-performed growth stocks. That is why we wrote in our book “Simply Invest” (a national bestseller published this year) that retail investors should not focus on just the value premium alone, but to also try and access the other proven factors of returns: such as the size and profitability premiums for stocks, and the term and credit premium for bonds, as detailed in the Fama and French paper. This way, when value under-performs, you still have the other factors working for you.
