Around 1.5 years ago, I read a piece of fascinating research from O’Shaughnessy Asset Management (OSAM) and the pseudonymous financial blogger, Jesse Livermore. The research provided insights on why value investing (essentially investing in stocks with low valuations) has worked in the stock market over long periods of time but has struggled in the last decade or so.
I want to share the paper’s main findings and my takeaways, because value investing is popular among many stock market participants.
Value’s success
The research found that stocks in the value category saw their earnings fall in the short run. The market was somewhat correct in giving such stocks a low valuation in the first place. I say “somewhat correct” because the market was excessively pessimistic. Value stocks eventually outperformed the market because their earnings recovered to a point where their initial purchase prices looked cheap – it was the initial excessively-pessimistic pricing and subsequent recovery in earnings that led to the value factor’s ability to deliver market-beating returns.
So the market was right in the short run, in the sense that value stocks will see a downturn in their businesses. But the market was also wrong in the sense that it was too pessimistic on the long-run ability of the businesses of value stocks to eventually recover. OSAM and Livermore’s research also showed that the value factor’s poor performance in the last decade or so can be attributed to the disappearance of the subsequent recovery in earnings of value stocks. The reason for the disappearance of the earnings-recovery was not covered in the paper.
My takeaways
First, investors can gain an enormous and lasting edge over the market simply by adopting a longer time horizon and having the courage and optimism to see past dark clouds on the horizon. The Motley Fool’s co-founder and chairman, David Gardner, spoke about the concept of “Dark Clouds I Can See Through” in an insightful podcast of his. The idea behind seeing past dark clouds on the horizon is that if you’re able to look past the prevailing pessimism about a situation, and if you’re right in your optimism, there’s success to be found on the other side when the clouds clear. OSAM and Livermore showed this empirically when they broke down the exact drivers behind the past successes of the value factor – investors who had the ability to “see” the subsequent recovery in earnings of value stocks were able to profit from the market’s short-term pessimism.
Second, I think it’s now more important than ever for investors to not buy value stocks blindly. The underlying mechanism behind the value factor’s past successes has been shown to be the initial overly-pessimistic pricing and the subsequent earnings recovery of value stocks. The recent struggles of the value factor, however, has been due to the inability of value stocks to produce an earnings recovery. To succeed with value stocks, I think investors should have a robust framework for analysing companies in the value category and think carefully about the probability of their businesses’ abilities to produce growth in the future.
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