Tuesday, January 20, 2015

Why does value investing work?

We know empirically that value investing is one of the rare strategies that works over the long run and generates decent returns. But often I am asked the question why does it work?

I will attempt to answer this question with a graph.

As you can see 

  • The 1 year Index return (pink) is the most wildly fluctuating line
  • The 1 year earnings growth is also moving around a lot but not as much as the index return
  • If you notice the 5 year earnings growth and index return relative to the 1 year track each other relatively closely
The short term fluctuations in the index returns being much larger than the earnings growth fluctuations and fluctuations in the EPS growth & Index return in long run show that when the negative fluctuations occur it creates opportunities.

This same phenomenon happens to individual stock prices as well and to a larger degree as individual stock prices are not as large in market capitalization as the index itself.
This begs the question: Why does the 1 year index return fluctuate much more than the 5 year return?

The answer to this is complex and maybe I don't understand it well myself but:
  • Investment horizon of the market participants spans from milliseconds to decades. Shorter term market participants are larger in number as all open ended schemes, FIIs, retail investors and others are in a constant state of churning the portfolio. This is demonstrated by the daily volume numbers. About a third of the index market cap is traded every year and if we assume the public float to be 50% then 60% changes hands every year. So the average investment horizon can be estimated to be 1.67 Years or so.
  • Tendency of fleeting marginal capital to be highly mobile - If the market rules dictated that you had to hold a stock for at least a year maybe this difference would not be so high. There is fleeting capital moving from exchange to exchange, company to company and country to country. This capital can make exaggerating difference as well.
  • Derivative markets - Yes do I do believe the NIFTY options market drives up the volatility of the NIFTY and there the entire market. When the expected volatility (VIX) starts to rise it becomes a self fulfilling prophecy exaggerating a massive run up or down over a few months.
  • Cheaper transaction costs - make people think that the cost of trading in and out is low so lots of punts get taken.
Hopefully I have done a bit of justice to answering this question. Your comments or feedback are always appreciated.

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