In my early 20s, I became an almost overnight believer in value investing after reading Benjamin Graham’s seminal work, The Intelligent Investor.
The logic of Graham’s investment philosophy was so elegantly simple that it was hard to deny: By purchasing shares of companies that are trading at discounts to their intrinsic values, investors can outperform the broader market over the long run.
But despite how common value investing has since become, Graham’s approach is still not without its detractors. It runs counter to two widely held beliefs that continue to pervade the world of finance to this day.
The first belief is the notion that market prices always accurately reflect a stock’s true value. Proponents of this idea – which is also known as the efficient market hypothesis – argue that all relevant information about a company is quickly incorporated into its share price, making it impossible for a stock to consistently trade at a discount to its intrinsic worth.
The second is that broad diversification, rather than concentrated bets on individual stocks, is the surest path to investment success. This approach, called modern portfolio theory, holds that investors can maximize their returns based on a given level of risk by spreading their bets across a wide range of assets.
These two beliefs have been pillars of the financial world for decades. But the long-term success of famous value investors like Warren Buffett, Seth Klarman and Joel Greenblatt has bolstered the case against them – and proven that the crowd is often wrong.
So why don’t more people embrace value investing?
Part of the answer lies in the strategy’s demand for patience – a virtue that’s in short supply in today’s fast-paced world. When Graham first published his book, the average holding period for stocks was measured in years. Today, it’s mere months.
The internet has undoubtedly contributed to this shift. Armed with real-time data and the ability to trade with the click of a button, many investors now focus more on a company’s near-term earnings fluctuations than its long-term prospects.
Yet it is precisely the willingness to go against the crowd that gives value investing its edge. Value investors recognize that markets are not always efficient and that sentiment and short-term noise can cause stock prices to diverge significantly from where they should be based on underlying business fundamentals.
By focusing on a company’s long-term earnings power and buying only when there is a substantial margin of safety, value investors position themselves to profit from the market’s mistakes. That’s why some of the most fertile hunting grounds for value investors are areas of the market where most people aren’t looking and where information is scarce.
Small cap stocks, for example, often have little to no analyst coverage, which creates opportunities for diligent investors to find mispriced gems. They also sport the lowest price multiples in the market currently, followed by midcap stocks.
With the S&P 500 now trading at a hefty premium to small cap stocks, value investors may once again have the odds in their favor. History suggests that buying solid small companies at attractive valuations tends to yield market-beating returns over time.
Ultimately, while many investors chase hot stocks and short-term performance, value investing offers a time-tested approach grounded in logic and discipline. By focusing on the difference between price and value, investing thoughtfully rather than emotionally, and being willing to go against the crowd, patient investors can outperform over the long haul.