Just as about everything in life, value investing too has certain advantages and disadvantages from my perspective. I’m saying from my perspective, because investors or portfolio managers with different approaches might view some pros as cons and vice versa. Of course, the advantages significantly outweigh the disadvantages (if it were otherwise, why do it?), but it is important to address the downsides nonetheless. Let’s dig right in.
Making money while you sleepValue investing is extremely simple to understand. Does it mean it is easy to do? Of course not, but simple and easy isn’t the same. To say value investing is simple refers to the logic behind it- buying excellent, undervalued companies for a good price. That’s it. If you compare it to other investing styles, and I’m using investing in an extremely loose sense, i.e. even speculations, trading etc., I believe value investing comes on top.
I am not saying these approaches don’t work or they’re stupid, but they really aren’t for the average person without deeper finance knowledge or interest in them. On the other hand, value investing as already mentioned is very simple to understand and although accounting knowledge certainly helps, you don’t have to be a certified auditor to understand that a lot of debt is bad, making a lot of cash is good and having a strong brand and good managers in the company is also good.
Why should you care? I believe you should always understand what and why you are buying something. Therefore, if you are long term oriented, prefer quality companies for a discount but don’t have background in finance, value investing is your best shot to understand the underlying principles and decision-making process to buy a particular company.
It makes sense
And I would even argue it makes the most sense. I don’t want to belittle other investment strategies and portray it like value investing is the only way to go, certainly not. But I think the underlying logic behind value investing is extremely logical and intuitive. By underlying logic I mean how value investing makes money, i.e. buying companies whose price is under their value and relying on the market to recognize this value over time and push the price higher to reach it.
A very fair question is “and why should the price chase after the value”? When the father of value investing Benjamin Graham was asked this question, he replied that it is a mystery of his business and that he doesn’t know. I don’t know either, but I think it’s human nature to even out any imbalances and to behave economically, i.e. trying to buy something “in a discount”.
Why is this important? When buying stocks of companies, I stress out it is crucial to understand how the company makes money and understand the business model. This is no different– if I invest in a certain style, it’s important to understand why and how the strategy makes money. If you are able to make money trading charts, random picking or market anomalies (if you want to have fun, take a look at the Sell in May and go away or Monday/Weekend effect), it’s absolutely alright, I simply feel more comfortable knowing how and why my stock picks made money.
“If you don’t find a way to make money while you sleep, you’ll work until you die”
– Warren Buffett
Value investing is definitely the winner in maintenance. That means once you buy a company, you want to hold it for a very long time- ideally forever. Does that mean we can’t sell the stock? Certainly not, but the point is, by definition, we search companies that will grow and create value forever.
That’s a great advantage because once you build your portfolio of 10-20 super high quality stocks, you only check on them every once in a while, but otherwise let them work their magic and grow. This literally means you let your money work for you while you sleep.
If we compare it to other approaches, for example day trading, Forex trading, chart trading or others which hold stocks only for a few days or months, you have to constantly watch the market closely, be quick on your feet and most importantly, once you sell the stock, you have to find a new one which will make you money. Don’t get me wrong- all this can be very rewarding in returns, but I just prefer making money by not doing much with stocks I own than moving the money around constantly. That also means if you’re a value investor, your journey to wealth will be much less stressful and hectic.
Imagine you bought a very profitable restaurant in the city center for a good price after a recession. Would you sell the restaurant just because it suddenly made a lot of money and tables are always full? Would you try to find another restaurant on which you could make a quick buck? Probably not. You would most likely keep the restaurant, since you know it will continue being profitable in the 5, 10, or 30 years in the future and that people will always come. This is what Warren Buffett means when he says you should think like a business owner, because by purchasing stocks, you become one.
As I described, we buy companies sporadically and hold them for a very long time, therefore our transaction costs are going to be marginal or almost none. Even if you invest by dollar-cost averaging, i.e. buying periodically every month, your costs are going to be very low.
Now compare that to a trader who buys and sells 12 times a day. Their transaction costs are going to be astronomical. Of course it depends on their strategy, broker, country etc., but it isn’t rocket science to know someone who trades often will have higher transaction costs than someone who buys just once in a while.
If you think that transaction costs aren’t such a big deal, think again. There are quite a lot of academic papers examining various investing strategies. What these papers find is that a lot of the strategies are quite profitable– until you introduce transaction costs.
I actually learned this the hard way- I used to trade stock options with around 3000€ I had saved up. I was trading for around 6 months and according to my Excel spreadsheet, I should have had around 300€ more in my account. 10% in 6 months, not bad I though to myself. But my account was barely above the 3000€. What the hell? Did I forget to record some big losing trade? I didn’t. What I had forgotten, however, were the trading costs. When I looked at the account statement from my broker, it was right then and there- around 300€ in transaction costs.
I didn’t pay much attention when opening the trades, my costs added up and diminished all returns I had made. To put an end to transaction costs, there is a study from Sweden mentioned in the book by Daniel Crosby “The Behavioral Investor” which states, that portfolio managers lose 4% a year on transaction costs on average. Let that sink in. It means that if I make 10% return a year with no transaction costs, an average trader with high transaction costs has to make 14% a year just to be even.
I won’t ever forget the words of my professor in one of my classes: “the tax impact is significant for this strategy, but I will show you how to get around it and reduce some of these taxes”. Typically Swiss.
Jokes aside now, tax impact really is a huge factor and you cannot omit it. Depending on where you live, the tax rate for trading gains will differ, but it will most likely be somewhere around 10-30%. If it were 20% and you made 10% a year, you are suddenly left only with 8%.
Maybe that doesn’t hurt enough because it’s in percent, which is quite abstract, so imagine you made $100’000 a year. Now the regulator comes and takes $20’000 from that. That’s a few nice holidays, maybe a new car or reconstructing your kitchen.
Why am I telling you this? To illustrate why long-term investing comes on top- there are little or no taxes on long-term capital gains. Now before you send your lawyers because you had made a profit and had to pay taxes, hold up. It again depends on where you live, how long you hold etc. In the US, Uncle Sam is more strict about it, but in many European countries, if you hold long enough there are no taxes or they are very small. (Once again, each tax jurisdiction is unique).
What world would it be if everything was only great and full of advantages, right? Let’s face the truth and address the disadvantages of value investing.
Hard to measure
Golden standard of the portfolio management industry is using statistical methods for investing, which is very quantitative and precise. Based on regression models, it tells you how big of a return you can expect in a given year (for example 10%) and how much the returns will deviate (if deviation is high, you could get +20% or 0% returns, if it is low, it will be more concentrated around the 10%).
Well, value investing lacks this precision. True, we estimate by how much the company is undervalued (margin of safety) or yearly return based on PE/ROE method, but that’s still only estimation. When you start out you are in the blue and have no idea how much you are going to make in the next 1, 3 or 5 years, but since we invest for the long-term, it shouldn’t matter that much. Still, investors don’t like uncertainty and this is one you have to learn to live with.
Interestingly enough, psychology is one of the biggest caveats when it comes to value investing and it is one of the hardest things to learn. That seems extremely counter-intuitive, because we discussed how logical value investing is and why it makes sense. Let’s break down psychology into more specific categories.
Adhering to the rules
As I said, I think value investing is very logical and so are the rules– investing in profitable companies with good outlook for the future, managed by excellent people, with low debt levels etc. Most people understand this on paper- until they enter the financial markets. Suddenly, all these rules get thrown out of the window and people start buying the latest hype companies everybody is buying, just because they have grown substantially lately. Suddenly, it doesn’t matter they are vastly indebted, report huge losses and are in overall bad financial shape.
What’s even more surprising, this happens to people who made their fortune in business ventures and thus should have certain business acumen, or even professional portfolio managers. But why? There is just something about the capital markets, the high liquidity and ever-flashing price changes that actives the inner gambler in us. In order to be successful as a value investor, you have to learn to ignore all this and focus on what’s important. (Great books about this are “The Intelligent Investor” by Benjamin Graham and “The Behavioral Investor” by Daniel Crosby.)
Being a contrarian means you go against the current and buy what everybody is selling, relying on their herd mentality and them over-selling the stock, thus making it undervalued (behavioral finance studies this closer). This actually happens often and when some stock or industry falls into disdain of the market, it gets beaten up pretty badly, which makes it an interesting opportunity for you.
But beware if you’re thinking you’ll just go and buy all the stocks that have been falling to make juicy returns. I will once again cite my professor: “people are stupid, but they are not stupid all the time”.
What he meant by that, is that sure, sometimes people behave irrationally and oversell the stock, but sometimes the selling is justified and happens for a reason. Therefore, as a value investor, you have to distinguish which companies fall because of irrationality and which fall because there is something fundamentally wrong with them.
Now comes the difficult psychology part: even if you master your mind, it is very difficult to shut of you herd-mentality. When you find a beaten down stock, which is still extremely high quality, you will fight thoughts like “If so many people are selling the stock, there must be something wrong with it!” or “what if there’s something I am missing?”. There is no simple answer for these problems and you have to slowly learn how to be as detached and objective as possible in order to focus on the companies themselves and not people trading them.
Sitting on your hands
The last psychological caveat I struggle with personally as well is “sitting on your hands” to restrain them for clicking on “Buy” and “Sell” buttons. As I explained, value investing is very low maintenance where we buy sporadically. That can be also a disadvantage compared to investing styles where you get signals more often, because you feel like you’re missing out on the market moves by not being fully invested. Then, because of this feeling, you make erratic, unwise decisions “just to put the money somewhere”, which yields bad investments in the end. Bottom line is: don’t buy a stocks just because you haven’t done so in a while, but only when it is truly undervalued.
Investors and portfolio managers, who have more-or-less stable portfolio have years, when they don’t buy or sell a single stock. Can you imagine? Researching and analyzing companies the whole year, just to do nothing with it in the end. It can be very draining psychologically and you have to learn to be slightly lazy about buying companies.
One solution is to buy companies which are so undervalued (which we do by definition), that if you have a year when you don’t find anything new, you just buy more stock of the company you already own. You can also think about it this way- you want to buy as much as you can from undervalued companies of high quality.
I hope I was able to illuminate the world of value investing a little closer to you and explain, why I think value investing is great while also addressing the disadvantages. The bottom line is, if you can master your psychology and adhere to the rules, anybody can become successful value investor.
If you have any question regarding this article or any other topic related to value investing, do not hesitate to contact me, I’ll be happy to chat with you. Until then, stay vigilant.