Why value investing works – in a single chart

Why does value investing work? The answer can be found in one chart – and here is a thousand or so words on what that picture is worth to value investors



Nick Kirrage
Co-head Global Value Team

New visitors to The Value Perspective might, reasonably enough, be wondering why they should adopt a value approach to investing and, greeted by an initial response of, say, ‘Because over the longer term it works’, might then equally reasonably enquire: ‘So why does it work?’ At which point, we would direct their attention to the following chart, which is, in essence, the North Star of value investing.

10 year annualised return by starting cyclically adjusted P/E (CAPE)


Past performance is not a guide to future performance and may not be repeated.

*Source: Stock market data used in "Irrational Exuberance" Princeton University Press, 2017, updated. Robert J. Shiller. Based on US Equity market – since 1871

Using data going back to the late 1800s, this shows the 10-year annualised returns of US equities, grouped by valuation, and as such is the visual embodiment of the basic principle of value investing – that if you buy cheap companies then, on average and over the longer term, you will make money and, if you buy expensive companies then, on average and over the longer term, you will not.

The thing that is so enduring and powerful about this chart is that it talks about nothing other than the price you pay – no macroeconomics, thematics, politics, profits or anything else.

That is an important lesson but one that so many people manage to look past – possibly because the more problematic aspect of the chart is that, while it makes it very clear where you ought to invest, that is far, far easier said than done.

In fact, humans are pretty much hardwired to do the opposite of what the chart advises because the companies that live on the right-hand side seem exciting and attractive while those on the left look dull and scary.

In Lord of the Rings terms, it is akin to choosing between staying in The Shire or taking a trip to Mordor – most would pick The Shire but, of course, if Frodo had stayed home, the story could have had an unhappy ending.

Ultimately, here on The Value Perspective, the way we make money is not by looking to forecast any of the factors that matter so much to other investors – those macroeconomics, thematics, politics, profits and so on.

No, it is by counting on the one thing we believe will not change over time – the only aspect of investing that we can see has remained consistent over the last 150 or so years.

And that is human behaviour.

We may like to think we are more sophisticated than we were 150 years ago but the evidence would suggest otherwise – that, in effect, in the short term, we learn a lot; in the medium term we learn a bit; and, in the long term, we learn almost nothing.

Yes, that is pretty depressing but it also contains a hugely important lesson that can help us make money for our investors.

The reality is that most investors behave in a very consistent pattern – a predictable cycle of emotional responses, any of which we are likely to witness on an almost daily basis. And it is perhaps the everyday nature of these emotions that mean they can lose their resonance in articles such as this – so let’s talk through the emotional cycle of a stock using the power of the internet to liven things up a bit.



We will start with the ‘euphoria’ phase. Say, you already own a stock. You are convinced it is a great business. The technicals are amazing, the model is fantastic, the company management are illustrious and, when it comes to potential new competitors, it has a metaphorical ‘moat’ you could park a metaphorical superyacht in. It is wonderful. The valuation? Well, it will grow into the valuation but as things stand …

That is the place you are in – and it is a great place to be – but then, of course, something goes wrong. It is only a little something – a profit warning of some sort perhaps – and you will initially get a little anxious. But then you will remember, ‘No, no – I have done the analysis. This is a quality business and, actually, this is a buying opportunity. Back the truck up. Buy more for the portfolio. Mr Market, I reject your concerns …’



So you conclude this is a buying opportunity … only … what if it isn’t? ‘Why is the stock still going down? What don’t I know that everyone else in the market apparently does? Why is the company’s share price still falling? I really do not understand this. Hang on … now I’m actually getting a bit nervous. Maybe I have got it wrong after all…’



‘What if …? Oh no. I’ve just bought more of this – in fact, I’ve just doubled my position. People are going to be calling to ask why I’m the biggest holder of this stock. I’m the biggest holder of this stock! And it’s falling …’ That is when the wheels typically come off. The business may have had this wonderful moat but that superyacht is now looking a lot more like a dinghy – and, what is more, a dinghy that is starting to sink …



And this is when you start to give in to despair. You become very concerned about the world and suddenly realise, ‘Oh no, I’ve made a terrible mistake. But OK … look – it could happen to anyone, right? It’s not really my fault. And this is a portfolio – things can and do go wrong. It’s OK. I’m just going to get out but I will do it quietly. Shhh – nobody will notice. This never happened …’



So you cut the stock from the portfolio. ‘Let’s never talk about this stock again. I do not want to know what’s going on with it. Why? What’s going on with it? Nothing? Good. Don’t. Want. To. Know. But the stock does seem to be doing a little better. Why? I know the business could never have fixed all its problems in the time the shares have been recovering. So you know what? I’m going to ignore it – people are getting spoofed …’



‘No. This is not happening. Nothing to see here. Although …now I look at it again … and markets do seem to be improving … and the management do appear to be back into their stride … they really are talking a compelling game. And, actually, they do seem to have fixed a lot of things with that massive acquisition they did in Indonesia that everyone liked. So maybe I have got this wrong …’



‘Maybe this is a really good business after all. You know what? I should have stuck to my guns and, while we’re on that sort of subject, I need to bite the bullet. I need to toughen up, get back on the horse and dive right back in and I need to do all that right now.’ So you do and the stock continues to tick back up and, before you know it, we are right back to …



‘Happy times are here again. I’m going to make all those losses back. This is a great place to be and this is a great company. The technicals are amazing, the business model is fantastic, the company management are illustrious and when it comes to potential new competitors, I have never seen a metaphorical moat like it. It is all just wonderful. The valuation? Well, it will grow into the valuation … won’t it?’


That cycle is very typical of humans and, while that again may sound depressing, it is also something value investors can trade off.

Amid all the change of the last century and more, one thing has stayed the same. Us. Human beings are the constant – markets are cheap when we are fearful; and they are expensive when we are greedy.

We are what is underpinning value’s ‘North Star’ chart and we are systematically exploitable.

And value investing is the system.


Nick Kirrage
Co-head Global Value Team


Behavioural finance
The Value Perspective
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