Is Value Investing Dead?
Day traders, swing traders, and Hedge Fund managers would all have you believe that Value Investing is dead, but we argue that Value Investing is very much alive and kicking because the core principles of value investing are still valid.
Some classic value investing strategies and tactics, however, are dead. These strategies no longer work because the markets they were designed for no longer exist. Some of Benjamin Graham’s strategies could be partially obsolete.
Graham designed his classic value investing system when tech stocks and most modern institutional investors did not exist. In Graham’s day, investors could only buy stocks in the United States, Europe, and the British Empire.
There was no NASDAQ when Graham was trading. All the trades Graham made were on paper because electronic trading did not begin until after his retirement. Another difference is that there were no Japanese or Chinese companies trading in the American stock market in Graham’s day.
Is Value Investing Dead? No, It Lives On.
Despite all the market changes, the principles and philosophy Graham created are still valid in the stock market today.
Graham’s advice of always asking “does it make money” is still the best lesson any investor can learn. Both the Dot-com bubble of 2000; and the Mortgage Crisis of 2007 and 2008, if investors and speculators had heeded Graham’s advice.
The Dot-com bubble and the Mortgage Bubble crashed because people were investing in instruments that did not make money. Investors who do not check if companies are making money will lose money.
Buy Businesses and Not Stocks
A value investor who lives by Graham’s advice; Warren Buffett, has made vast amounts of money in the 21st Century.
Buffett built his Berkshire Hathaway (NYSE: BRK.B) empire through the strategy of “buying businesses instead of stocks.” Buffett made his $79.8 billion fortune by assembling a stable of good companies that make a lot of money.
Berkshire Hathaway’s market capitalization grew from $135.89 billion in April 2000 to $509.10 billion in September 2019. In fact, Buffett manages to beat the market through value investing averaging a compound rate of return of over 23%.
Buffett spends his time searching for good businesses the market overlooks while ignoring most investment news. Those businesses are often in sectors Buffett loves, such as insurance, heavy industry, media, and transportation.
One Buffett strategy that still holds up is to seek companies with management teams he likes and respects. According to Buffett himself, he only works with “people he can see himself working with forever.”
This is Buffett’s way of employing the classic strategy value strategy of only buying well-managed companies. Buffett famously does not try to manage the companies Berkshire buys because he trusts the management teams. In fact, Berkshire Hathaway reputedly only employs 20 people at its Omaha headquarters.
Another famous Buffett quote goes further by saying:
“I try to invest in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will.”
An excellent insight into the fact that many businesses begin to fail when the third generation of family owners take over. So a business that is so simple any idiot can run it is a maxim that reminds to of the risks.
Berkshire Hathaway makes money by locating well-managed companies that make a lot of money and investing in them.
Is Value Investing Dead Because of Automated Trading?
The short answer is no, in fact, trading automation is moving towards more sophisticated value investing strategies.
According to the Economist & Deutsche Bank, “90% of equity-futures trades and 80% of cash-equity trades are executed by algorithms without any human input. Equity-derivative markets are also dominated by electronic execution according to Larry Tabb of the Tabb Group, a research firm.”
Essentially this means that the vast majority of trading in the market is run by computers. More and more the computer algorithms are not just using arbitrage strategies to scrape a few tenths of a cent per trade, but increasingly employing value investing strategies. A new force in the market is Robo Advisors, let’s take a close look.
Are Robo Advisors Using Value Investing
The rapid rise of Robo Advisors, which essentially automate the building and maintenance of a portfolio around your specific investing needs, is leading to something new. Many Robo Advisors will simply recommend a selection of ETFs for you to invest in. But there are few that actually implement a value investing strategy as a core part of the investing methodology.
Having reviewed and research over 20 different Robo Advisors, I found that most simply offer different ETFs to match the client’s risk profile. Many do however rely on accruing dividends.
What many investors have forgotten is that value and dividends make a huge difference to the compounded returns of your investment over the long-term.
Does Trading Beat Value Investing?
The short answer is no, there is no evidence to support the notions that Hedge Fund Traders beat the underlying stock market index over any single 5 year period.
In fact, according to our research Buffett manages to beat the market through value investing averaging a compound rate of return of over 24.7%. This is not through trading this money is earned by investing real capital in real businesses.
There is, in fact, no evidence to support the fact that trading stocks out-performs a well-structured value portfolio. As shown in our stock market statistics research
Actively managed fund (Mutual Fund) performance is looked at here, fund managers seem to be excellent at making profits for themselves but not so good at making profits for their clients.
- Over 1 year 60.49% of fund managers failed to beat the market index.
- Over 3 years 92.91% of fund managers failed to beat the market index.
- Over 15 years 82.23% of fund managers failed to beat the market index.
- 21.22% of actively managed funds are closed down after 5 years
- 42.87% of actively managed funds are closed down with 10 years
As the vast majority of mutual funds do not beat the underlying index and they incur much higher costs than passive index-tracking funds, we can assume that at least 2% less compounding of your wealth will occur.
[Related Article: The Ultimate Guide To Value Investing, Graham, Buffett And Beyond]
Ignoring Stock Market Volatility Still Works
Berkshire Hathaway bought no tech or Dot-com stocks, the market darlings, and came through 2000 unscathed. This does not mean Buffett hates tech.
Berkshire Hathaway is buying both Amazon (NASDAQ: AMZN) and Apple (NASDAQ: AAPL) now that those stocks make money. Ignoring the market cost Berkshire some money from share growth but allowed the company to avoid years of losses.
The key advantage to ignoring the market is that it simplifies investing. Investors who ignore the market will not waste time, effort, and money selling stocks each time an index moves. Buffett’s experience shows value investors can make money by concentrating on a few good stocks they like.
The Margin of Safety has Changed
Graham’s fundamental concept of the margin of safety is still valid. The margin of safety, however, is different in today’s world.
Berkshire Hathaway’s experience shows Graham’s strategy of diversified buying of good but low-cost stocks no longer produces a high margin of safety. The margin of safety is low because that strategy no longer produces enough cash.
Companies and investors need more cash because today’s markets are more complex and volatile than in the 20th Century. There were two US major market corrections in the first decade of the 20th Century, for example. There was one US major correction the 1987 Black Monday Crash, in the last half of the 20th Century.
Berkshire Hathaway’s portfolio now includes cash-rich companies; including Bank of America (NYSE: BAC), Wells Fargo (NYSE: WFC), and Apple (NASDAQ: AAPL). Apple had $94.61 billion in cash and equivalents on June 30, 2019. Bank of America had $180.09 billion in cash, and Wells Fargo had $430.41 billion in cash and equivalents in June 2019.
Another Buffett response to the higher level of volatility is to concentrate investment in good stocks Warren likes. Buffett’s belief is that good companies make money in bad times.
Buffett maintains a high margin of safety by keeping a lot of money invested in the Berkshire Hathaway Stock portfolio of cash-rich companies he trusts. This strategy runs counter to Graham’s bargain hunting.
Graham’s method of stock picking was to identify low-priced stocks and carefully investigate the companies. The aim of this method is to find moneymaking or high-growth companies that the market undervalues.
The danger from this method today is that many low-priced companies have a low margin of safety. Many companies with low stock prices have small amounts of cash.
Many investors like low-share price companies because they often issue big dividends. Management has the money to issue those dividends because it maintains no cash reserves.
Why Small Companies and Small-Cap Stocks are no Longer safe
This dividend yield contributes to the investor’s margin of safety but not to the company’s. Companies with high dividend yields and low-stock prices still generate income, but they are no longer safe because they may struggle to maintain the high dividend payout.
Technology increased international competition, and the consolidation of many industries is destroying the market share of many smaller companies. Amazon (NASDAQ: AMZN) is gobbling up the customer base of many smaller retailers and the high street.
New communications technologies like social media, streaming video, and the internet are taking the audience of once-lucrative media businesses. Even lifelong newspaper junkie Warren Buffett admits digital technology dooms newspapers.
“No one except The Wall Street Journal, The New York Times and now probably The Washington Post has come up with a digital product; that really in any significant way will replace the revenue that is being lost as print newspapers lose both circulation and advertising,” Buffett said. Buffett made the statement at Berkshire’s 2018 shareholder question-and-answer session, The Wrap reports.
Buffett is saying that smaller media companies; like smaller retailers, cannot capture enough market share to survive. Thus, Buffett thinks newspapers, and many smaller companies, are no longer value investments. These companies are no longer value investments because they can no longer make a lot of money.
The first lesson value investors need to learn from Buffett is to stay away from smaller companies that do not have a sustainable competitive advantage. The second lesson Buffett teaches is that you need to be ready to dump any stock that faces business annihilation in today’s market. A third lesson is that investors need to keep a lot of cash on hand to survive and make money in today’s market.
Value investing principles are still valid, but value investors need to change their strategies and use the power of modern stock screeners to find great value investments and great dividend investment strategies to generate income over the long-term.