Value investing, why it works!

Investors generally focus too much on recent company results and project them into the future for many years. Those projections serve as justification for their high stock prices relative to their current earnings, cash flows, and book values. Unfortunately, above average results can generally only be maintained for some more quarters until competitors catch up (mean reversion) and can only be upheld in rare cases for longer periods of time. Those glamour stocks will soon underperform their competitors.

I give you following example:
Peters and Watermann published the bestseller "In Search of Excellence: Lessons from Americas Best Run Companies". In this book the authors mined the market for successful companies and subsequently mined the data of these companies for statistically significant factors for success. Unfortunately, the above average results could not be maintained in the future and "unexcellent"companies caught up in the following years, as shown in the graph below (Haugen, The New Finance, p. 46): 

 

"In search for excellence" may be a great book for business management insights, but it is of little value for investing your money.

Underperforming companies will eventually turn around by changing their strategy and management team, or they get taken over by another company. Anyway, the probability is high that earnings and as an extension the low stock price of the underdog will recover in one or two years (mean reversion).

How quickly mean reversion takes place is made visible by the chart below (Haugen, The New Finance, p. 43):

Companies with the lowest PE will have lower earnings next year, but will recover rapidly in the coming years, surprising markets positively. Companies with the highest PE will have higher earnings next year, however their earnings will not grow rapidly in the years thereafter, and hence, surprise investors negatively.

So why do professional money managers not invest in value opportunities? 

Simple human behaviour: Undervalued stocks have a recent history of underperformance, bad results and bad press. In short, stocks that look bad in any portfolio, stocks you'd like to sell in order to get them out of sight of your client or your boss. Overvalued stocks on the other hand look great in your portfolio, so buy some for window dressing. After all, you might want to keep your clients, your job or even be promoted from fund manager to chief investment officer! Very often fund management companies do not want their manager to deviate substantially from their benchmark, as big underperformance causes bigger damage than outperformance is causing benefit. That's why funds usually exhibit a slight underperformance against the benchmark (due to fund expenses).

The critical reader might respond, Philipp, you presented a nice story, a slick theory, and even gave some anecdotal evidence so far, but that does not prove anything. Do you have some hard evidence to present as well? Or is this just another fad?

Luckily, there is tons of ignored evidence out there:

The interested reader might delve into this paper to examine the empirical evidence further.