By Arne Kerst,
Fund Manager at DPAM

Value investing has been the playing field of some of the great minds. Every investor has undoubtedly heard of Warren Buffet and the ‘value anomaly’, whose performance has been the subject of countless academic research papers. However, as we know, nothing is ever set in stone when it comes to investing. Investment styles can go in and out of favour, as we have seen with the value style. With every year of underperformance after the GFC, the ‘value is dead’ narrative has gained in strength. Recently, markets have been favouring the value style again, resulting in some remarkable value performances. In this article, we discuss the explanations for this value premium and on which side of the argument we find ourselves.

The reasons behind the existence of the so-called ‘value anomaly’ has two schools of thought: A ‘risk-based’ explanation and a ‘behavioural’ explanation. The risk-based explanation for the value anomaly finds it origin in the Efficient Market Hypothesis (EMH). The EMH states that, as markets reflect all public information and investors are rational, all securities will be fairly priced and outperformance is impossible. There is no free lunch. Therefore, to generate excess return, one must take on more risk. This explains why, under the risk-based explanation for value, the value premium is seen as a compensation for excess risk. However, market participants do not always act rationally. An example of market participants’ irrationality can be seen in times of market excess. Market participants’ irrationality is a tale as old as time, or at least as long as there have been financial markets. There is a great memo written by Howard Marks in 2000 called ‘bubble.com’, where he gives an interesting story on market mania:

“ The South Sea Company was formed in 1711 to help deleverage the British government by assuming some of the government’s debt and paying it off with the proceeds of a stock offering. In exchange for performing this service for the Crown, the company received a monopoly for trading with the Spanish colonies in South America and the exclusive right to sell slaves there. Demand for the company’s stock was strong due to the expectation of great profits from these endeavors, although none ever materialized. In 1720, a speculative mania took flight and the stock soared. Sir Isaac Newton, who was the Master of the Mint at the time, joined many other wealthy Englishmen in investing in the stock. It rose from £128 in January of 1720 to £1,050 in June. Early in this rise, however, Newton realized the speculative nature of the boom and sold his £7,000 worth of stock. When asked about the direction of the market, he is reported to have replied “I can calculate the motions of the heavenly bodies, but not the madness of the people.” By September 1720, the bubble was punctured and the stock price fell below £200, off 80% from its high three months earlier. It turned out, however, that despite having seen through the bubble earlier, Sir Isaac, like so many investors over the years, couldn’t stand the pressure of seeing those around him make vast profits. He bought back the stock at its high and ended up losing £20,000.”

It seems that even one of the world’s smartest men was not immune to irrational behaviour. It’s hardly surprising then that we rather position ourselves in the behavioural camp for the explanation of the value premium

The Behavioral Finance discipline has been able to observe and describe some investor behaviours that have led to persistent anomalies in asset pricing. Investors are indeed irrational at times, influenced by their emotions, and subject to errors as well as non-optimal decision-making processes. As a matter of fact, investors’ overconfidence in their own judgment and their overreliance on established views lead to long-term overreactions and short-term underreactions of stock prices to new information. The value anomaly can consequently be explained by the overreactions caused by behavioural biases. This anomaly is about markets pricing cheap companies slightly too cheap and expensive companies slightly too expensive. As long as investors tend to overestimate and over-extrapolate winners, and underestimate other stocks, this value anomaly can be captured.

This article briefly studied the value premium and tackled why we talk about ‘value stocks’ or ‘cheap-versus-expensive stocks’ as a way to generate performance, instead of ‘timing the style’ or ‘playing the value style’. Our goal was to briefly explain the possible explanations for the value premium. We lean more to the behavioural explanation, as we believe market participants do not always act rationally and are influenced by their emotions. The timing of, misconceptions about, or the implementation of the value style can be a topic for a sequel.


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