VALUE INVESTING
Why Value Works

By Stephen Bland (TMFPyad)
April 23, 2004

Why does value work? It's perhaps a daft question for someone like me to ask but I feel like playing devil's advocate this week. Interesting bloke, the devil. Like any supernatural beings from god downwards, he, it, whatever, doesn't exist in my opinion but as a religious or philosophical concept it seems a convenient invention of humans to have someone else around to blame for the ills that we have either created for ourselves or which sometimes just happen and are nobody's fault. The interesting bit is why humans have this need but discussion of that is perhaps marginally off topic for a weekly stock market column.

I still come across people who doubt that the value approach has much merit, attributing any success to luck or anything rather than concede that the style in its various forms has any long-term appeal. It is true in my view that value should not, in theory, exist. There should not be any mispriced shares assuming all available information is public. And since the stock market is a place where information is very rapidly disseminated, especially in these days of electronic communication, all current information is in practice known by all investors about any particular share. That being the case, how can a value investor simply by studying public knowledge of fundamental facts about a share gain any advantage over other investors? This or something similar is usually the kind of argument advanced by those who doubt the value of value.

The reason that value exists is that, although the stock market is one of the nearest things in practice to the economist's theoretically perfect market, the humans who act on this universal knowledge are themselves far from being perfect or rational. People are largely rational but contain a decent streak of irrationality in their psyche because we have not yet evolved to evolutionary perfection. Never mind the stock market, the evidence that people at times act in the most irrational, self-destructive or just plain mad ways is pretty abundant I'd say. So, since the market does not exist in isolation but is actually made up of a large number of human investors, being human they take this situation of publicly available knowledge, of near market perfection, and proceed, to a certain extent, to cock it up, just like we do to many other things on this planet.

The result of the irrationality streak is that gross over or under pricing of shares occurs at times and hence opportunity. That is why value works when it ought not so to do. All because people are not 100% rational. Value players owe their whole strategy to this simple truth.

Even if you ignore value shares, it is obvious that share prices in general jump around all over the place for no reason. Why is any particular share priced lower or higher than yesterday when there is no fundamental micro or general macro reason for the change? In theory it should not move, yet it does all the time. So normal is this that it would be quite a shock if share prices never moved until there is some new information requiring a change in the rational price.

So the price of shares is always irrational or perhaps more accurately, a combination of a rational price element and an irrational human element, call it the irrationality premium or discount, the latter being influenced by fashion, fear, herding and other commonplace emotional factors. Value shares are just that bit more irrational than most and occur when the rational element of price is combined with a substantial irrationality discount. Similarly in the opposite direction, overpriced shares occur when the rational price is combined with a large irrationality premium.

Value investors have no special inside knowledge of shares. We use only information that is publicly available to all. However, we act rationally towards our target shares when we believe the rest of the market is behaving somewhat irrationally. We don't get it right every time of course, no trader of any strategy can do that, but it works enough times to be profitable.

If you like we are the cure for irrationality. Our mission is to eradicate the irrationality discount on selected shares and score for ourselves whilst so doing. We are the sanest investors in the market. Everyone else is slightly nuts.

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