One of the most discussed phenomenons in recent years has been how value stocks are underperforming vs growth stocks. Indeed, the return of value stocks is now at the lowest level compared to growth stocks at any time in history.
Inspired by Warren Buffett’s amazing miracle, there are millions of value investors globally. These value investors look to profit by buying undervalued stocks and selling them when they are at (fairly valued) or above their intrinsic value (overvalued). This mechanism resembles a situation where the a pendulum swings from one end to the equilibrium position, then to the other end.
In fact, the underlying rationale of value investing is mean reversion. As sound as the rationale is, both economically and mathematically, value investors are clearly struggling of late.
The two questions to ask are:
- What if it never reverts to its mean?
- What if it takes forever to revert to its mean?
On the first one, I remain a believer of mean reversion. But one common misconception investors have is that the mean is static, which is not true. The mean is not constant and will change over time. Therefore, the intrinsic value of a stock will also change over time, along with the fundamentals. As a stock’s intrinsic value decreases, the margin of safety also decreases if the stock price remains unchanged. And in most cases, stock price also decreases as investors require higher margin of safety, sometimes to a even bigger extent because decrease in intrinsic value is a result of deteriorated business fundamentals. In addition, analysts who are looking to buy a stock tend to overestimate in their forecasts while ignoring the fact that a company’s book value is to be eroded by reported net losses, such that an apparently cheap stock may no longer look cheap after a period of ongoing losses. Therefore, unless you foresee an imminent turnaround in business fundamentals, by that I mean actual financial results, otherwise the above vicious cycle could cause a lot of pain and for a lengthy period, despite you are theoretically correct about the concept of mean reversion.
As for growth stocks, the idea is similar but tricky. If the underlying business fundamentals keep improving, why should we expect stock prices not to continue rising? Likewise, as the underlying business fundamentals of many value stocks kept deteriorating these days, their stock prices kept falling. While it’s true that many growth stocks trade above their intrinsic value, but we should also understand that their mean, i.e. intrinsic value, is also rising over the period. As such, even though the stock price keeps rising, the actual disparity between stock price and intrinsic value may not be widening as much as it seems.
On the second question, it’s a tough one asked by millions of value investors who are about to lose faith in what they are doing. Certainly it’s taking longer than it used to be for mean reversion to take place in recent years. However, we should understand that investing is more an art than a science. There’s no reason to expect when exactly mean reversion will happen.
The Market Can Remain Irrational Longer Than You Can Remain Solvent. — John Maynard Keynes
To deal with this phenomenon, there are a few optimizations that I have made in recent years:
- Invest in quality companies rather than bad but cheap companies
- Overweight growth stocks, although the world is changing at a quicker pace than ever, many winners keep winning
- Be very selective on value stocks, and stay away from those with gloomy outlook
- Avoid turnaround plays, they seldom turn
- Sit on my ass on quality companies
“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” — Warren Buffett
“Turnarounds seldom turn.” — Warren Buffett
“The big money is not in the buying or selling, but in the waiting.” — Charlie Munger
Don’t get me wrong, I am still a firm believer in value investing. But my point is, the ability to adapt and adjust to put yourself in the best position to thrive, is one of the crucial factors to be a successful investor.
All roads lead to Rome, and value investing is one of them.
