There is a simple heuristic for gauging the investment style adopted by a fund manager; it is based on how you feel when looking at the holdings in their portfolio. If you feel comfortable – they are a quality investor, if you feel excitement – they are a growth investor, and if you recoil in horror – they are a value investor.

Last year, the value investment team at Schroders highlighted a significant investor bias towards growth stocks amongst managers in a certain peer group.  This tendency was not surprising – in the majority of major equity markets growth has trounced value in recent years (2016 being an exception), and through this period many value managers will have lost assets and jobs.  For those managers with more malleable investment philosophies, their portfolios will have inexorably become growth orientated as the style delivered excess returns.

However, what is perhaps even more diverting than these relatively short-term factors is the longer-term dynamic.  The value premium is one of the most robust and consistent phenomena in academic investment research (Fama & French, 1998, Asness, Moskowitz, Pedersen, 2013), yet as an investment style it appears to exist at the periphery.  Despite a considerable weight of evidence to suggest that value outperforms growth over the long-term; it is the latter that seems to dominate the investment landscape – the siren song of barriers to entry, nascent demand, earning upgrades and secular tailwinds is seemingly irresistible.

It is important to clarify what is meant by value – it is a nebulous concept and few fund managers admit to owning expensive stocks.  The traditionally favoured metric is price/book, which has characteristics that are ideal for academic research, but may be too narrow for our purposes. Instead, I will define a value approach as such:

Investment in a stock trading at a discount to the market or peers in relative terms across a range of metrics and / or below its intrinsic value; where there is no expectation for the underlying business to produce operational results (sales growth / margins / earnings growth) in excess of their historic average or the norms for their industry.

Although admittedly convoluted, the crucial point is that value stocks should be observably cheap across a number of metrics and not require abnormal operational results to justify investment.  There is no obligation for a value investor to hold companies that are demonstrably high quality or that possess superior growth prospects; rather they seek companies where the share price unfairly represents the operational realities of the business.

From a behavioural perspective, a value approach is difficult for a fund manager to consistently apply and demanding for a fund investor to hold, and these issues contribute significantly to the paucity of genuine value strategies available, despite the compelling empirical evidence.   There are myriad of behavioural pitfalls that blight value investing, and rather than produce an exhaustive list, I will highlight those I perceive to be the most material:

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–  Narratives: We have an overwhelming desire to construct, and believe, coherent, simple narratives. Walter Fisher (1978) first posited the narrative paradigm theory, which argued for the pre-eminence of storytelling in human communication – compelling tales outweigh robust argumentation. Growth stocks often benefit from beguiling narratives, which we inextricably link to positive share price performance, whereas value stocks suffer from the reverse –‘cheap for a reason’ is the common slight aimed at undervalued stocks. As investors strive for consistency, it is hard to reconcile the typically negative narrative that accompanies a depressed value stock with the potential for strong future performance.

– Recency: Even if we define our approach as long-term, we are inevitably biased toward current events and overweight the importance of the recent, compared to history.  This is a major headwind for a value style, as it is often predicated on the reverse – ignoring the short-term noise and focusing on the longer-term attributes of an investment.

– Availability: A closely related concept is the availability heuristic (Tversky & Kahneman, 1973), whereby the perceived frequency or probability of an event is driven by what is available – or what easily comes to mind. This create a number of problems for value investors – notably, we are more likely to recall prominent examples of companies that experienced difficulties and failed (so called value traps) rather than those which have undergone problems and staged solid, yet unremarkable, recoveries.  Thus, our bias is likely to be towards overstating the worst case outcome. Furthermore, when assessing an individual company, we are likely to overweight current and readily available information, which is typically negative in regard to value stocks.

– Salience: Griffin & Tversky (1992) argue that we struggle to differentiate between the strength of evidence and its weight – that is the salience of evidence often supersedes its credibility.  Information that is distinctive or prominent will tend to dominate our thinking, and in the case of value stocks the arresting information is likely to unfavourable and therefore prone to exaggeration.

– Affect:  A plethora of studies have highlighted that decision making is often driven by how we ‘feel’, rather than cognitive evaluations (including: Lowenstein, Weber, Hsee & Welch, 2001), and value investing is undoubtedly emotionally taxing.  A value investor often has to invest counter to ‘common wisdom’ and the prevailing market narrative for sustained periods. Furthermore, on a significant minority of their investments (if they are skilful) they will be proved wrong and the market negativity justified. Making a mistake when the market ‘knew’ the problems faced by a company and the negative narrative was ‘obvious’ is far more damaging to ego and reputation, than the failure of a consensus growth stock where the positive narrative does not result in robust returns.

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Given that there are substantial behavioural impediments to running, or investing in, a value fund, the obvious solution is to employ systematic strategies (active or passive), which not only nullify the problems of human behaviour, but seek to exploit them. Whilst this is certainly a viable route to accessing the value premium, it is likely that there remains an advantage for those select, traditional active fund managers able to filter genuine value opportunities from the aforementioned traps. However, perhaps the sternest question for systematic value strategies is whether fund investors have the fortitude to maintain positions in such approaches for the long-term.  We struggle with owning value stocks with negative narratives, and this challenge is exacerbated when we hold a systematic fund and perceive it to be ‘blindly’ buying into ailing or out of favour companies.  Thus, there are no simple solutions.

Whilst in its basic form a value approach may be considered elementary compared to other investment styles, it is the most exacting behaviourally; this is a key reason why a long-term premium exists for owning value stocks and why both active managers and fund investors struggle to embrace the discipline.

Key Reading:

Asness, C. S., Moskowitz, T. J., & Pedersen, L. H. (2013). Value and momentum everywhere. The Journal of Finance, 68(3), 929-985.

Fama, E. F., & French, K. R. (1998). Value versus growth: The international evidence. The journal of finance, 53(6), 1975-1999.

Fisher, W. R. (1978). Toward a logic of good reasons. Quarterly Journal of Speech, 64(4), 376-384.

Griffin, D., & Tversky, A. (1992). The weighing of evidence and the determinants of confidence. Cognitive psychology, 24(3), 411-435.

Loewenstein, G. F., Weber, E. U., Hsee, C. K., & Welch, N. (2001). Risk as feelings. Psychological bulletin, 127(2), 267.

Tversky, A., & Kahneman, D. (1973). Availability: A heuristic for judging frequency and probability. Cognitive psychology, 5(2), 207-232.