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In William Bernstein’s excellent book The Intelligent Asset Allocator, he really gets into minutiae on a host of market issues.

Almost every aspect of portfolio theory is inspected, weighed, run through models, graphed, and dissected.

You had me at “inspected” Dr. Bernstein.

One section which I particularly enjoyed was his discussion of value investing.

In my post the value of value, I gave a brief introduction to the idea of the value factor as a source of increased expected returns in the stock market.

Value companies strike a chord with me. They can be recognized by their cheapness relative to their actual book value or earnings. And their performance is surprisingly robust over time.

But Bernstein’s discussion opened my eyes to whole host of juicy new tidbits about the value factor.

1. Although there’s increased standard deviation in the stock prices of value companies, this actually stems from more extreme price movements upwards, rather than a greater likelihood of loss (value stocks are actually the least likely to have losses of greater than 10% in any given year). In other words the value play may actually be less risky than the market as a whole. Another free lunch?

2. Value companies are essentially companies that are universally recognized as “bad companies”.

Bad management, poor growth potential, poor positioning in the market.

This is why they are so cheap.

But the paradox is this: stock pricing is all about expected earnings growth. So when a company is a poor one, negative performance does not really impact the stock price going forward. The price is already cheap. Poor performance is baked into the cake.

Conversely if a bad company company has even modest growth or earnings, there can be a rapid increase in valuation (stock price.)

Or what if the bad companies management changes and it transforms into a good company? Overtime it’s price will go up and will it become a “growth stock.” What was once cheap will have become expensive. At which point the value investor will sell it and buy a few more “bad companies.”

It’s kind of a “no place to go but up” phenomenon.


These English blokes should have called themselves “Good Investment”

3. The reason why value investing still works even after it’s efficacy has been well documented is that people just don’t want to buy “bad companies.” This all too human bias leads to a persistent market inefficiency. One that can be exploited by the value investor.

4. Although growth companies do, in fact, grow faster than value companies, they are so expensive that the persistence of the growth required for them to outperform value companies over time becomes exceedingly unlikely.

Bernstein makes the argument that a company growing 5% faster than the rest of the market will be twice as expensive as the market.  Thus it will take 14 years of equivalent 5% outperformance in order to adequately compensate its shareholders for the increased cost of  initially purchasing the stock.

Simply stated: growth is way overrated.

And value is definitely undervalued.

When I squint my eyes I can see a certain symmetry here between stocks and people.

Imagine some dude driving a 14-year-old Volvo, his house smaller than all of his coworkers, his clothes less than fashionable. He’s a total underdog.

If people are anything like stocks, we should put probably put our money on that guy. He’s probably salting away a good portion of his salary, as we speak ,and investing it in value stocks.

His net worth is growing even as we overlook him.

He’s not far from being financially independent.

I aspire to be that guy.

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