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How to Succeed in Value Investing

Value investing can be uncomfortable. Here's how to make it less so.

This analyst blog is part of our coverage of the 2017 Morningstar Investment Conference.

We are--once again--in a one of those stretches where it's tough to be a value investor. Over the past decade, the Russell 3000 Value Index has lagged the Russell 3000 Growth Index by 3.1 percentage points annually.

"We've all heard that stocks trading at low multiples of earnings, book value, and other fundamental measures have historically offered higher returns than their more richly valued counterparts in nearly every market studied over the very long term," Morningstar's Alex Bryan said Thursday at the 2017 Morningstar Investment Conference.

The key here, however, is "very long term"--which a decade isn't.

How can investors find the wherewithal to stick with a value strategy for very long periods?

Bryan discussed this with a trio of value specialists. Here's what they suggest.

Expect long--sometimes really long--stretches of underperformance. "It's not unusual to see a 10-year stretch of underperformance," said AQR's Ronen Israel. "I don't think its evidence of anything gone awry."

Research Affiliates' John West agreed. Research his firm has done finds that value strategies outperform in only 10% to 15% of all 10-year rolling periods. Underperformance for 10 years by no means indicates that the value premium is dead.

"As long as fear and greed exist, we will see the value premium persist," said Morningstar Investment Management's Jared Watts.

Believe the economic theory underpinning the value effect. Why value strategies work over time is rooted in economy theory that is both behavioral and risk-based.

Part of what makes value succeed, explained West, is that investors still chase performance over short time frames, such as the 1- and 3-year periods. After all, it's psychologically easier for most of us to buy stocks that are doing well rather than those that aren't doing well.

"People are uncomfortable with value," said West. "You have to viscerally believe in mean reversion to be a successful value investor."

Use more than one metric to avoid value traps. Value investors look for what's cheap, but there are plenty of ways to define "cheap," including price/earnings, price/book, and price/sales measures.

The panelists warned that using a single valuation metric in isolation when evaluating stocks--say, price/earnings or price/book--can lead investors into value traps. After all, some stocks are cheap for very good reason. Perhaps they're highly leveraged, for example.

Watts, for instance, uses a quality filter--Morningstar's Economic Moat Ratings--to avoid some of the standard value traps.

Understand unintended consequences. Israel noted that relying too heavily on simplistic valuation metrics can have an unintended consequence: sector bets. Oftentimes an entire sector can be out of favor and therefore cheap. Taking sector bets isn't bad--but it adds an additional element of risk, so be aware of whether or not you're taking them.

And if you don't want to over-rely on one or two sectors, consider changing your definition of value. One way: take a relative value rather than an absolute value approach.

"If you do a stock to stock comparison, you'll get more sector variety," said Israel.

Don't bet the farm on value alone. In the end, if your portfolio includes more than just value stocks, it's easier to ride out the cycles.

"We believe in value, but we don't think you should invest exclusively in value," admitted Israel. "It's difficult to solely be a value investor."

West agreed.

"You can diversify the value effect--but remember that the other strategies will have their uncomfortable times, too," he said.

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