Value Investing's Fatal Flaw

Wednesday, January 28, 2009

What is value investing's fatal flaw? While I am certainly no expert on value investing nor am I an expert on momentum trading, I believe I have enough of an understanding to study these opposite approaches to the stock market. The Panic of 2008 crushed many value portfolio managers as the unthinkable happened, major financial firms went completely broke necessitating bankruptcies and takeovers.

Value investing is
"the strategy of selecting stocks that trade for less than their intrinsic values" ( The goal of the value manager is to find stocks selling at less than the intrinsic value and profit when the market realizes this discrepancy and corrects it with an appreciation in stock price. The value manager determines that he has found a discrepancy that the market does not realize yet, but will in the future. Value investors see themselves as contrarians seeking to outsmart the market. The market is wrong about a particular stock's worth and will realize it eventually, or so the thinking goes.

The fatal flaw of value investing, then, as compared with other strategies, is that it does not listen to stock price action as an indication of investment correctness. A momentum trader only listens to the stock price. If the stock price goes higher he is right, if it goes lower he is wrong. A momentum trader will exit his position as the stock moves against him because the momentum is no longer with him.

On the other hand, as the stock price moves against a value manager he is met with two diametrically opposed alternatives. Either, he is wrong about his calculation of the company's intinsic value or the market is even more incorrect. The manager should then take one of two completely opposite actions. Either he should sell the stock because he is wrong, or he should add to his position to take advantage of the even greater value offered.

The real difficultly for the value manager is understanding when he is wrong. The manager has entered the position on the belief that he is right and the market is wrong so flipping the logic as the stock moves against him is prohibitively difficult. A manager who continues to believe he is right will add to his position as it falls thus continuing to increase his exposure to a potentially failing investment. This means that the investments he is wrong about will drain greater and greater amounts of of the manager's capital.

If the manager has missed something in the fundamentals and estimated the wrong intrinsic value, there is no way for him not to lose a great deal of money on his investment. He has missed something yet sees the stock as offering a greater and greater value as it moves against him. How can he ever know he is wrong with this mentality? The manager will add and add until the company is bankrupt and he is ultimately forced to see what he missed.

This flaw is increasingly important as stock prices move more rapidly to new information than ever before. In a time of massive conglomerates with extremely complicated derivative instruments and off-balance sheet assets, the value manager can rather easily miss the cockroaches in the kitchen. The complete lack of transparency in many financial companies balance sheets fooled many value managers into believing they had found value when, in fact, they had found had found far less.

Momentum trading certainly has its flaws as well, like the often occurrence of being stopped out of long-term winning positions. So, I do not really have a concise, direct point to this writing but rather wanted to just spell out some thoughts after watching the amazing fall in 2008 and the mistakes of its victims. Perhaps someday I will rewrite this to provide some solutions to this potentially fatal flaw for value investors.


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