Power of Value & Fair Price Investing

Over the last 80 years of stock market investing and tracking, value investing has always given better returns than pure growth investing over any reasonable period of time. In fact, most of the major success stories of stock market investing can be classified into two camps:

1. Value Investors — who would pay less than what the current underlying value of a company is (as measured by its balance sheet, cash flow and so forth).
2. Fair Price for a Great Company Investors — who would pay a fair price in line with underlying strength of the business, but who would do so because the type of business and the associated management was terrific.

There are very few success stories that are purely Growth Investing success stories — that is, those who would overpay (based on current fundamentals), in anticipation of even greater future successes.

The popular Efficient Market Hypothesis that holds that it is impossible to beat the market averages over time because everything that is known about a company is already priced into the market — tends to break down when dealing with either pure value investing or paying a fair price for a great company strategy. It does so because these strategies require an exceptional knowledge about the business that the vast majority of investors and traders are unlikely to gain. So inefficiency persists allowing those with the right insight to profit.

Thus great investors such as Warren Buffett, Charlie Munger, John Templeton, Phil Fisher have all made a lot of money with these philosophies.

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Power of Small Cap Investing

Smaller companies have more room to grow, period. Large behemoths such as Microsoft and Cisco have to not only maintain their market share, but have to look for the next great thing in order to show even a small improvement in their bottom line. Their stock prices reflect that.

Smaller, innovative companies on the other hand will find their market share and overall value rising quickly even with smaller ideas. Also, companies that are in industries that have suffered a long bear market also get classified as small-cap companies owing to the loss in market share, revenue and profits over the course of the bear market. Many mining companies and other commodity related companies are good examples of this.

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Small Cap Value Investing

Given the superiority of value investing and the slight edge that small-cap indexes hold over larger cap indexes, it stands to reason that small-cap value investing would give some significant advantages. It turns out to be true.

From 1926 through 2004, while large cap growth stocks had an average return of about 9.26%, small cap value stocks over the same period returned 15.9%! This 6% difference on an annual basis is astounding. Many of us would thrill at getting a 1% to 2% advantage; a long-term 6% advantage simply cannot be ignored.

This graph from the New York Times shows the rewards of investing $10,000 in small-cap value stocks in 1926 resulting in a billion dollars for you today! (Want to join the billion dollar club?).

To maximize your gains from small cap stock value investing, it is best to invest directly in stocks. However, that can be a very time-consuming affair. The good news is that investing in small cap value indexes such as the Russell 2000 Value would still generate much of the excellent returns associated with small-cap value investing. From 1995 through 2005, the Value Index has returned a value of 13.92% compared to the 9.65% for the Small Cap Index overall (a clear 4% advantage).

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Trend Shifts

In general, at the end of each recession, small cap stocks tend to take the lead during economic recoveries, followed by better returns in large cap stocks as the recovery takes a firm hold. As a small-cap value investor, it is helpful to have the wind behind your back; however, it is not necessary. But awareness of the overall cycles helps.

Future

A second reason is that value investing, in general, is boring. The stock will not move anywhere for months, sometimes years — before the market accords it a better value. This does not suit active traders, or those investors who wish to feel like they are doing something.