In looking for a free lunch many long-term investors gravitate towards value investing where the evidence is that so-called value stocks offer excess returns over medium term periods. This approach, however, brings with it a range of issues of mental discipline that can cause all sorts of strange behaviours, including an unreasoning attachment to stocks that have no merits whatsoever, apart from their consistent appearance on stock filters of a certain kind. Over and above this, though, there's a problem with the way that value investing is conceived. To the extent that it offers improved returns the general belief is that it does so by ensuring that the investor takes on more risk. This is exactly the wrong way for most investors to proceed: we want more returns for less risk. And done properly that's exactly what value investing can achieve for us.

Value Metrics

Value investing relies on looking for stocks with a certain set of attributes that hopefully provide the investor with a margin of safety. Typical metrics include a low book to price ratio, so that the company is trading at a discount to its tangible assets, a low price-earnings ratio and a high dividend. There are a range of other possible value filters, but in all cases the aim is to find companies on a lowly rating compared to their peers, with some safety net in case things go wrong.

The market isn't entirely dumb so stocks on low ratings are often there because they deserve to be. They may be in declining industries or have a history of terrible management or simply be in areas that are wildly unpopular due to wider sentiment in society. Often all three. Whatever the reason, the aim of the value investor is to find these stocks and then bet on them, usually on a portfolio basis, although there are deep value investors who aim to find very undervalued stocks and then go all-in.

Excess Returns

The numbers show that value investing tends to provide good returns over a reasonable period of time – although the short-term pain can be extreme as poorly performing stocks have a tendency to continue to perform poorly, the downside of the momentum effect. So value investors need deep pockets of liquidity and nerves of steel to plough their furrow through thick and thin.

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