They teach you in business school that value investing is riskier than growth stock investing. The primary reason is something referred to as the value trap. A value investor tends to buy stocks when they are trading below what is perceived as intrinsic value. The most common way to determine that is the discounted cash flow analysis. The DCF analysis is an attempt to value the future stream of earnings and discount it back to todays dollar using some kinds of discount rate (the return you demand on your money). This is the method Warren Buffet is known to use in valuing the businesses and stocks he purchases.
The value trap occurs because value investors buy more stock as the price goes lower, ostensibly greater value. The value trap occurs if the investor discovers that what they perceive as a price on sale is just the results of declining business fundamentals. Buying more at a cheaper price only adds good money after bad. On the other hand, a growth stock investor that purchases a stock that goes down in value after his purchase, can wait it out and eventually the share price will recover from his unfortunate timing. No such luck with the value investor.
Yet when you ask most business school professors whether they are value or growth investors, they invariably answer they are value investors. Most insiders buy their company’s stocks when they are sold off, arguably greater value for the money. Of course some insiders buy at the top; this is usually super bullish but quite rare.
This has been a year of massive underperformance of value investing versus growth. It’s been a frustrating year for investors that believe price matters. Eventually this gap is likely to narrow.
