What about Value Investing?


This question came at the end of a presentation I gave at the Michigan Radiological Society Resident/Fellow annual meeting.  Although I provided an answer then, I felt it wasn't as complete as it could have been for as good of a question as it was.  I had just finished presenting a fair amount of data indicating that index fund investing was far superior to picking your own stocks or using actively managed mutual funds.  There are really a couple of different ways to be a value investor.

Tilt to Value

The first way is to simply add a value tilt to your portfolio of index funds.  I already do this as I have a 5% slice of large value stocks and a 5% slice of small value stocks in my portfolio.  The data shows that value stocks (those with a low price to book value, a low price to earnings ratio) over the long run generally have higher returns.  While some have speculated this is a free lunch due to the glamor effect of growth stocks like Apple, Microsoft and Wal-mart, most academics agree it is simply because these stocks are riskier.  Kmart is simply more likely to go out of business than Wal-mart, so investors are rewarded with higher returns for buying Kmart stock.  Index funds already contain all of the value stocks, but by slicing and dicing a total market index fund with a value index fund, you can overweight those stocks with a higher expected return.  This comes at the cost of a small amount of diversification, of course.   Putting a chunk of your portfolio specifically into a value fund is a pretty easy way to “value invest.”

Graham and Doddsville

But when most people are talking about “Value Investing” they're thinking in terms of the writings of Benjamin Graham and Warren Buffett.  To them, value investing means buying something for less than it is worth, then holding on to it for a long time, hoping the market finally realizes the true worth of the investment.  Value investing is not only a method of security selection, but also a method of market timing.  You buy more of a good company when it's price goes on sale.  You got a better deal on Coca-cola by buying it in Fall 2008 than in Spring 2008 before it went on sale.  It was the same company in the Fall as it was in the Spring.  There are dozens of books in the financial books section of the library describing various ways to do this.  Does it work?  Of course…if you do it right.  Unfortunately, it turns out it is a lot harder to do it right than it at first appears.

Are you Warren Buffett?

The record for actively managed value fund managers isn't any better than it is for active managers as a whole.  If the professionals can't do it, what makes you think you can?  If you decide to go your own way, a la Warren Buffett, and pick individual stocks you decrease your diversification and add uncompensated risk to your portfolio.

Give it a try

I don't see anything wrong with someone who wants to do this dedicating a small portion (say 5-10%) of your portfolio and going for it.  You might even want to do “paper trades” for a while (like a couple of years) before committing your retirement stash to your stock picking prowess.  It's probably best to get this urge out early in your investing career, while your nest egg is still small compared to your future earnings.

Calculate your return

If you want to do it, I suggest you keep meticulous records of your returns, including fees, commissions, and extra taxes due.  In my experience, it is a rare stock-picker that even knows how to calculate his return.  Most likely, you'll soon realize you're putting in a ton of effort and still underperforming the indexes. But if it turns out you have some talent for it, be sure to calculate out the hourly rate your efforts are providing for you.  An extra 1% return on a $100K portfolio is worth $1K.  How many hours of effort did it take for you to make that $1K?  It might have been a lot easier to put in another day at work and make the same $1K than to have spent 50 hours over the course of a year eking out another 1% in investment returns.

What do you think?  What does “Value Investing” mean to you?  How do you incorporate it into your portfolio?