Why value investors have the better returns

By George Athanassakos
Globe Investor Magazine Online, January 30, 2008

George Athanassakos is a professor of finance and Ben Graham Chair in Value Investing at the Richard Ivey School of Business at The University of Western Ontario

These are interesting days for value investors as volatility is what they like, and no doubt they have their hands full of it these days. While no one really knows when the market carnage will end, as markets always tend to overact on the downside as well as on the upside, investors should follow the lead of value investors – keep cool heads and be patient and disciplined.

Do you know why value strategies beat growth strategies in the long run? It is because human and institutional behaviour cause biases in stock prices that give rise to what is known as the value premium, namely that value stocks beat growth stocks. No wonder that the dean of value investing, Warren Buffett, wants his heirs to have a keen understanding of human and institutional biases.

We talk about institutions making investment decisions when in fact it is individuals working for financial institutions who make decisions. And these individuals have their own psychologies over which they have little control and their own agendas that may differ significantly from those of the organizations that employ them.

Individuals are subject to irrational behaviour. They extrapolate, they are overly optimistic, they overreact and most importantly they herd. They herd to protect their jobs – no one has lost his job from an average performance or being in the same group as their peers. If the group loses and you are in the losing group, there is the insurance that you lost as everyone else – but if you are wrong and others win while you lose, then your job and reputation are at stake.

At the same time, individuals working for institutions have their own agendas that conflict with their clients or investors. They act on these agendas to benefit themselves, rather than those who hired them. They rebalance their portfolios throughout the year to earn their Christmas bonus, they window dress to spruce up their portfolio to look better than they are to their clients and herd to protect their jobs.

All of the above behaviours create biases in the prices of financial securities, such as stocks and bonds, which in turn give rise to the behaviours that value investors exploit. This value premium will continue to exist despite the fact that we all know about it and despite the large body of academic research that has proven it to be the case.

The above-mentioned biases are exemplified in the way banks and their executives have behaved over the years. These are smart people. I suspect banks attract the best minds – and yet time and again these intelligent people make such poor decisions that one has to wonder how they can make 200 times the salaries of an average worker in Canada and around the world.

I do not want to pick on any one bank, as most of Canada’s banks are in the same club of infamy. In the early 1980s, we had excessive bank involvement in financings of oil and gas companies. In the late 1980s and early 1990s, we had excessive bank involvement in financing of real estate companies.

Of course, this doesn’t include loans to emerging countries, the Asian crisis, Enron and the bursting of the technology bubble, and finally the subprime mess of 2007-2008, which may be the biggest goof of them all.

All of the above ended with excessive amounts of writeoffs of bank assets, profit declines and stock price collapses. Did they learn their lesson? Of course not. No bank executive wanted to be left out. They know that it is fine when they all lose money together, but not if others made money and they did not. Better to lose money collectively. Besides, it’s not their money, it’s their clients’ and investors’ money. They all rushed to make the same loans and expose themselves to the same industries and to the same markets.

Together they overbid prices and then had to go after riskier investments.

Just as bank executives continue to make the same mistakes time and again lured by the fad of the day and the promises of high hanging (and yet very risky) fruit – investors also continue to believe the promises that growth stocks make, overbidding them, and giving rise to the value premium.

Special to The Globe and Mail