Once you could make money in the markets by looking for value hidden away in financial statements. Thanks to the digital era and its ease of access to information, that day is now past. But there’s still a proven way to consistently earn a positive return in the market—you just have to understand why value investing once worked and why it never will again.
There’s no doubt that Benjamin Graham and David Dodd shaped the modern profession of investor more than anyone in our history. When they posited—starting in 1928 at New York City’s Columbia Business School—that investors could find companies whose stocks were mispriced by just digging through publicly available numbers, they set off a revolution.
First hundreds, then thousands, and eventually millions of investors learned the art of scrutinizing those numbers to find compelling companies trading below their “intrinsic value.†Graham and Dodd’s books—Security Analysis and The Intelligent Investor—remain staples on virtually every financial bookshelf in the library.
Prominent investors all the way up to the inimitable Warren Buffett have long espoused the wisdom of the approach. It has evolved over the years as well, moving from a focus on book value to a focus on earnings value to a combination of similar factors. In fact, there are as many variations on the theme as can be imagined—thousands of permutations on how to discover value by crunching the numbers in the right way.
However, value investing has a dirty little secret.
It’s always been based on knowing something that few other people could know. In tech speak, it’s about an asynchronous information advantage.
In other words, value investing is not that different from, say, insider trading. In the case of insider information, the opportunity lies in being able to position yourself in front of some fact that has the potential to revalue a company on the market. Maybe you know Intel is going to miss on earnings next month because your friend is on the board. Trading on that information is, of course, illegal. But it’s a crime that’s committed again and again because it works and because it can be difficult to prove.
Value investing, on the other hand, is perfectly legal because in theory it is based only on public information. The catch is that it relies on the information being hard to find or hard to make sense of.
In the 1930s, of course, gathering information on the performance of a company was difficult. Xerox photocopiers hadn’t even been invented yet. (Those didn’t come around until 1959.) Even then, gathering information on a public company was tedious, time consuming, expensive, and really a task best left to the pros.
In other words, in order to learn of a compelling value, one had to make a significant time and energy commitment. That kept competition to a minimum, and allowed those with better information and a knack for processing it faster to position themselves earlier and then benefit as the word spread (and often, they spread it themselves—no harm in talking your own book).
You profit by being ahead of the knowledge of others. Nothing more than information arbitrage.
Value investing is not alone in its dubious distinction from insider trading, however. The same thing applies to all forms of investing, including technical analysis. In fact, it is the sole basis on which it is possible to make a living investing: your ability to be right about the future value of a company’s paper before others, whether they be your fellow speculators or a corporate suitor in search of an acquisition.
