When an investor is deciding what approach to take to investing, they can be overwhelmed with options. Each strategy may resonate with different people depending on their temperament, goals, level of wealth, or how much spare time they have. Many short-term investment strategies offer little prospects of success and a high chance of significant loss. Value investing seeks to purchase stocks at a discount from the intrinsic value which increases the chance of above-average long-term results while minimizing the downside risk. In this article, I will cover value investing pros and cons.
Here is a table of the Pros and Cons of value investing:
| PROS | CONS |
| 1. Stocks are purchased with a margin of safety | 1. There is an element of subjectivity |
| 2. Does not follow the crowd | 2. You have to be comfortable being a minority |
| 3. May provide above-average returns in the long term | 3. May yield lower than average in the short term |
| 4. Concentrated bets can lead to significant gains | 4. Concentrated bets may lead to significant losses |
| 5. Can do it with small sums of money | 5. Requires a lot of time to research and you must be a continuous learner |
| 6. Can have an edge over large institutions | 6. Requires a lot of patience and commitment |
| 7. Uses the power of compounding | 7. Cannot automate like with dollar-cost averaging |
| 8. It can be incredibly fun | 8. It can be painful |
Let’s dive deeper into each pro and con and how they each play a role in affecting value investing
Pros
1. Stocks are purchased with a margin of safety
Value investor’s number #1 goal is to not lose money. Buying stocks at a significant discount to their underlying value, or buying a dollar for fifty cents, reduces the risk of loss of capital. By applying a conservative analysis of a company’s value, along with the patience and discipline to only buy when on discount, the investor is allowing for a certain amount of error in their analysis. This is in contrast to other mentalities of investing that are less focused on loss and only focused on the highest gains.
2. It does not follow the crowd
Value investing is a contrarian way of investing. Value is often found in beaten-up stocks, when the crowd is selling, or the market is falling beyond reason. Whereas popular stocks are rarely undervalued because they are watched so closely. As value investors are going against the herd they are often wrong in the short term as it is almost impossible to perfectly time the exact turnaround of a stock. When the stock does turn around the crowd can act in the value investors’ favor as the market will most likely recognize the company’s intrinsic value.
3. May provide above-average returns in the long term
By finding undervalued stocks, value investors can often achieve above-average returns while reducing their downside risk. If we look at the returns of the 4 investors who studied under the founder of value investing, Benjamin Graham, we can see that all of their funds have beaten the S&P 500: Warren Buffett, the most famous of these investors, from 1965 to 2021 has returned a compounded annual gain of 20.1% versus the S&P 500’s 10.5%; Walter Schloss from 1955 to 2000 had annualized returns of 15.3% versus the S&P 500’s 10%; Tweedy Browne from 1968 to 1983 returned 20% versus the S&P 500’s 7%; and Bill Ruane’s Sequoia Fund from 1970 to 2021 has returned 13.62%.
We can also look at the returns of value investors who started their funds much later and are still going today; Li Lu‘s fund has managed an annualized return of 19.4% since 1998; Seth Klarman returned a 17% annualized return over the past three decades; and Howard Marks averaged 19.9% over the past two decades.
4. Concentrated bets can lead to significant gains
Value investors seek to take large bets on great opportunities infrequently. Portfolios that reach the highest returns are not normally highly diversified. When looking at some of the greatest investors of all time, such as Warren Buffett, they all have one thing in common; they make large concentrated bets when they have very high conviction.
We can even see this statistically when looking at the whole market of portfolios. From 1999 to 2014, a 10-stock portfolio had a 35% chance of beating the S&P 500 by 1% or more on an annualized basis and beat the market by up to 22%. However, a 250-stock portfolio had just a 0.2% chance of beating the S&P500 and never beat it by more than 2% on an annualized basis. Although a 35% chance of beating the S&P 500 is not overwhelmingly high, investors have a much better chance than having a widely diversified portfolio.
5. Can do it with small sums of money
Despite what people think, you do not need large sums of capital to get started. Almost all great investors start with very small sums of money, and through the power of compounding, grew these small seeds into great wealth. By finding only a few good investment ideas that you understand and measuring everything against it (also called opportunity cost), and by betting big on them, you can produce greatly outsized returns.
6. Can have an edge over large institutions
The one benefit of having small sums of money to invest is that your investment world becomes much larger. Investors with very large sums of money are restricted to investments that equate to a significant percentage of their portfolio. It is not worth their time to search for a widely mispriced obscure mining stock in the middle of Zimbabwe when the largest bet they could make wouldn’t even equate to 0.1% of their portfolio. Smaller investors can take advantage of these opportunities that can often lead to much larger gains than what a huge investment in a very large company would make.
7. Uses the power of compounding
One of the great benefits of value investing is that it takes a long-term approach and uses the power of compounding. The effects of compounding even small sums of money over many years can be mind-boggling (see table below). Short-term-oriented investors often sell a position before the stock has had a chance to compound, stunting their potential gains.
Compounded Value of $1,000 Over Different Rates and Lengths of Time:
| Rate | 5 years | 10 years | 20 years | 30 years |
| 5% | $1,276 | $1,629 | $2,653 | $4,322 |
| 8% | $1,469 | $2,159 | $4,661 | $10,063 |
| 10% | $1,611 | $2,594 | $6,727 | $17,449 |
| 15% | $2,011 | $4,046 | $16,367 | $66,212 |
| 20% | $2,488 | $6,192 | $38,338 | $237,376 |
| 25% | $3,052 | $9,313 | $86,736 | $807,794 |
8. It can be incredibly fun
Value investing can be incredibly fun for those who love to learn, are curious about the world, and like to figure out how just about everything works. Whether business, technology, politics, or philosophy, all of these interests can help you be a better investor. Because the more you know, the better your chance of having an insight. Continuous learning is imperative to have any significant achievement in the world because the world keeps changing, and if you don’t keep up, others will pass you by.
Cons
1. There is an element of subjectivity
Value investing is often considered an art rather than rigorous science. When you are trying to calculate the intrinsic value of a company or how much margin of safety you have for an investment, there is not just one formula that can be mechanically applied. You must use many different models, such as your circle of competence, inversion, opportunity cost, and simplicity. There is also an element of prediction; what will the company’s future cash flow be? And the further out you go, the noisier the prediction gets. That is why two great investors can come up with different valuations for the same company.
2. You have to be comfortable being a minority
Humans are genetically hard-wired through evolution to follow the herd. It has kept the vast majority of humans alive during the thousands of years we have been around. Going against the crowd can be very uncomfortable, and fighting the urge not to be a contrarian requires much strength. You have to have the right mindset and great conviction through thorough research to be convinced that you are correct when most people are wrong.
3. May yield lower than average in the short term
Value investing is not for you for those looking to get rich quickly. It requires a lot of patience and trust that the market will eventually recognize the undervalued security and price it accordingly. Sometimes an undervalued stock is not recognized for multiple years, whereas other stocks that could be overvalued could continue to climb. Value investing also does not provide the wild ride or the potentially massive overnight gains that options trading does; it is a long-term strategy in which its performance is to be measured over many years.
4. Concentrated bets may lead to significant losses
As mentioned above, a particular element of subjectivity exists in value investing. Even the most experienced investors can make mistakes when calculating a company’s intrinsic value. Buying with a margin of safety is meant to mitigate the potential miscalculation. Still, it cannot mitigate such things as an unforeseen rapid change in technology that makes a product obsolete or bankruptcy due to a manager’s miscalculation of an investment. By putting such a large percentage of your available funds on a single company, you risk having a significant permanent loss of capital.
5. Requires much time to research, and you must be a continuous learner
If you do not enjoy the process of research and continuously learning new things, you will find value investing dull. It would help if you stayed engaged with the process for it to work. It also takes up much time, so for people with packed schedules, it may be tough to search for and study different companies that may be suitable investments. However, for those with full-time jobs, it is still possible with just a few hours per week to practice the principles of value investing. Here (interlink) is a guide on part-time value investing.
6. Requires a lot of patience and commitment
You have to truly be passionate about value investing in stick with it in the long term. Without this passion, you will want to give up during the tough times or periods when your portfolio is underperforming. This life-long strategy requires a commitment to the process and continuous learning. You have to be able to delay the instant gratification of short-term gains for the patience of the long-term compounding effect.
7. Cannot automate like with dollar-cost averaging
For those without the interest or the time to commit to value investing dollar-cost, averaging into index funds is a great way to invest. With value investing, there are ways to dollar-cost average into mispriced positions, but this still requires continuous observations of valuations. Value investing is not for you for those who like to set it and forget it.
8. It can be painful
Because value investing takes few concentrated bets quite often when the market is up, the value investors portfolio is up even more. When the market is down, it is often down even further. Comparing your losses to the less severe losses of the S&P 500 can make you question your investments. Even with your highest convictions when making these concentrated bets that you buy cheap, they can become even cheaper, again making you question if you had made the correct conclusions in your allocation.
