Firm as our convictions may be about the advantages of value investing, and which the academic evidence proves, we are still aware of some pitfalls that can catch out the unwary. For example, it is possible to buy a company too early – if we buy a business we think is valued too cheaply and it becomes cheaper still then, in the short term, we could be made to look silly. However, in the longer term, if the decision to buy that company was sound, it will ultimately have been the correct decision.
The risk value investors are perhaps most taken to task on revolves around ‘value traps’ – where people buy cheap companies but these are cheap for a reason – so that is what we spend most of our time trying to protect ourselves against. There are plenty of cheap businesses out there that deserve to be cheap. As such, focusing on the drivers of every investment, understanding why the company is cheap, and whether or not a business is of sufficient quality to be able to grow profits over time is hugely important. Ensuring our investments are not value-trap businesses is a key part of what we do.
A final consideration for investors is there is at times a price to be paid for the pattern of performance value offers. Since value investors obviously only seek out value and they do not mind what other people are doing, they typically have portfolios that look different to the benchmark, and consequently perform very differently to a benchmark index. To perform better than the average, your portfolio must look different to the average portfolio. Over time the different portfolio that value investing brings tends to translate into good performance. But, over shorter periods, performance can look weak when compared to the benchmark; particularly in frothy or momentum driven markets.
Value investors have no real control over this short term volatility but – perhaps understandably – some investors do not like it. It is that dislike which creates the opportunity in value stocks, and we would simply say that short term volatility is the price we have to pay for our longer-term performance.