Why value investing works – in a single chart
Investors unfamiliar with our philosophy may, reasonably enough, be wondering why they should adopt a value approach to investing and, greeted by an initial response of, say, ‘Because over the longer term it works’, might then equally reasonably enquire: ‘So why does it work?’ At which point, we would direct their attention to the following chart, which is, in essence, the North Star of value investing.
10 year annualised return by starting cyclically adjusted P/E (CAPE)
Past performance is not a guide to future performance and may not be repeated.
*Source: Stock market data used in "Irrational Exuberance" Princeton University Press, 2017, updated. Robert J. Shiller. Based on US Equity market – since 1871
Using data going back to the late 1800s, this shows the 10-year annualised returns of US equities, grouped by valuation, and as such is the visual embodiment of the basic principle of value investing – that if you buy cheap companies then, on average and over the longer term, you will make money and, if you buy expensive companies then, on average and over the longer term, you will not.
The thing that is so enduring and powerful about this chart is that it talks about nothing other than the price you pay – no macroeconomics, thematics, politics, profits or anything else.
That is an important lesson but one that so many people manage to look past – possibly because the more problematic aspect of the chart is that, while it makes it very clear where you ought to invest, that is far, far easier said than done.
In fact, humans are pretty much hardwired to do the opposite of what the chart advises because the companies that live on the right-hand side seem exciting and attractive while those on the left look dull and scary.
In Lord of the Rings terms, it is akin to choosing between staying in The Shire or taking a trip to Mordor – most would pick The Shire but, of course, if Frodo had stayed home, the story could have had an unhappy ending.
Ultimately, here in the value team at Schroders, the way we make money is not by looking to forecast any of the factors that matter so much to other investors – those macroeconomics, thematics, politics, profits and so on.
No, it is by counting on the one thing we believe will not change over time – the only aspect of investing that we can see has remained consistent over the last 150 or so years.
And that is human behaviour.
We may like to think we are more sophisticated than we were 150 years ago but the evidence would suggest otherwise – that, in effect, in the short term, we learn a lot; in the medium term we learn a bit; and, in the long term, we learn almost nothing.
Yes, that is pretty depressing but it also contains a hugely important lesson that can help us make money for our investors.
The reality is that most investors behave in a very consistent pattern – a predictable cycle of emotional responses, any of which we are likely to witness on an almost daily basis (a full cycle of emotions can be found on our blog).
While this cycle may sound depressing, it is also something value investors can trade off.
Amid all the change of the last century and more, one thing has stayed the same. Us. Human beings are the constant – markets are cheap when we are fearful; and they are expensive when we are greedy.
We are what is underpinning value’s ‘North Star’ chart and we are systematically exploitable.
And value investing is the system.
Important Information: For professional investors and advisers only. The material is not suitable for retail clients. We define ‘Professional investors’ as those who have the appropriate expertise and knowledge e.g. asset managers, distributors and financial intermediaries. Past performance is not a guide to future performance and may not be repeated. Schroders Investment Management Ltd is an authorised financial services provider FSP No: 48998, registration number: 01893220
