It is often said that value investing requires patience.
Unlike most investment-related generalizations, this statement is actually 100% correct. While value investing is often viewed as more of a long-term venture than "growth" investing, the fact is that any investing requires patience and discipline. Not every position works out immediately. Moreover, because nobody can time the market, some of the best-researched ideas and strategies might require time -- and patience -- to begin paying off.
Over the past decade, however, value investors -- ones who seek cheaper stocks selected on the basis of more attractive valuations -- needed a bit more patience than usual. That's because value investors have been waiting, largely in vain, for their investment style to outperform the market.
The chart below illustrates this conundrum: over the last 10 years, the value index, represented on the chart below by the iShares S&P 500 Value exchange-traded fund (NYSE: IVE), has returned significantly less than its faster-growing counterpart, iShares S&P 500 Growth ETF (NYSE: IVW): 57% vs 143%, respectively. (The S&P 500 Value and the S&P 500 Growth indices don't overlap and, combined, they comprise the better-known S&P 500.)
Wait a minute, you might say, this is not a fair comparison: value stocks (and, therefore, their value index) pay higher dividends, so the price-only chart above does not fully reflect investors' return from both indices.
And you'd be right, of course. Dividends are an extremely important part of stock-market returns, and we should always take them into account when assessing how a security performed.
But even after taking dividends into consideration, value has underperformed in the past decade. With dividends reinvested (a strategy we employ in my premium newsletter, The Daily Paycheck), total return from the growth index was 183%, while total return from value was 99%.
In other words, value -- if you simply invested in the index -- would have doubled your money. Not bad at all. However, growth, a flashier style, would have delivered more than 2.5 times the original investment.
This seems contradictory to what we know and understand about the market. After all, growth stocks -- the more expensive group, which includes non-profitable companies and companies that do not pay any dividends (the current yield of IVW is about 1.2%, compared with 2.3% for the value index IVE) -- have to be riskier, right?
This also goes against what most investors -- including Warren Buffett -- learned from the influential bestselling investment book "Security Analysis" by Benjamin Graham and Frank Dodd (Buffett wrote the foreword to one of its editions). An encyclopedia of investing and financial research, "Security Analysis" demonstrated that not overpaying for a company's business (in other words, investing in low-valuation, or value, stocks) will ultimately be rewarding.
Has the Graham and Dodd book aged so much that its methods are no longer valid? And what about the so-called "value premium," first identified by Eugene Fama and Kenneth French in 1992? Has something changed so fundamentally that many investors no longer want to have anything to do with "value"? Or does the persistent value underperformance foretell something about the future?
Why Value Stocks Have Lagged
I'm not sure anybody has good answers to these questions, but in my opinion, one of the core reasons for the recent discrepancy between growth and value lies in the fact that money has been extremely cheap.
As a direct result of near-zero interest-rate policies, there have been so many money-chasing investments that valuations have almost become irrelevant. And more money chasing a few growth stocks has inevitably resulted in the astronomical valuations for many of them. Netflix (Nasdaq: NFLX), for example, has recently become the largest entertainment company, eclipsing Disney (NYSE: DIS) and CBS (NYSE: CBS) despite trading at more than 120 times forward earnings.
And while growth is valuable -- after all, as I wrote to you before, it's the faster-growing companies that will eventually be able to deliver growing profits and dividends -- the market balance between the future promise of "growth" and the attractive valuations of "value" will eventually be restored.
Moreover, if I'm correct, higher interest rates and the changing environment should dampen some of the irrational demand for overpriced securities and may also create stronger demand for lower valuations. While this might sound counterintuitive, this also backs my opinion that the recent long underperformance of value has already incorporated at least some of these future interest-rate increases. In other words, interest rate increases are already largely priced into the value sector.
What Happens Next?
If history is any guide, underperforming investment strategies tend to come roaring back when economic conditions change.
For instance, we all remember the previous period when value underperformed -- during the tech bubble from 1994 to 2000.
Once the tide turned, however, value started to outperform. In the eight years from May 2000 to May 2008, the value index returned 40% with dividends, while growth lost 9%, even with dividends reinvested. There is light at the end of any tunnel, after all.
This does not mean that growth stocks should be forgotten and investors should immediately switch to investing in cheaper value stocks. Because timing the market is impossible, nobody can tell you when the best time for one strategy ends and when another begins.
Therefore, I must continue to stress the need to diversify -- between stocks and bonds, and between stock-investing strategies alike. For my Daily Paycheck readers, I'm telling them to not ignore our Fast Dividend Growers portfolio, which is full of securities that may not carry double-digit yields but are raising their payouts at a steady pace and tend to outperform the market over the long run.
I also must stress that stock selection and research remain paramount. You should never buy a stock just because it seems cheap to avoid putting your money into a deteriorating or, worse, dying business. But many "value" stocks are poised for a turnaround. If your research shows there is a significant chance of a business improving, and if a company's dividend is safe, then such a stock has the potential to become a strong outperformer and may be worth a second look.
Income You Can Count On
These principles are the basis of my Daily Paycheck system, designed to produce reliable, market-beating dividend income for years to come.
My team and I have created a portfolio that is both highly stable and high-yielding -- in any market environment. In fact, overall, my strategy has been 31% percent less volatile than the wider market.
Since beginning our little experiment eight years ago, at last count we've earned $132,037 in income "paychecks" from a $200,000 initial portfolio. But whether you're starting with $200,000 or $10,000... Just think of what you could you do with extra money. To learn more about how you can put our Daily Paycheck system to work for you, click here.
This article originally appeared on StreetAuthority.com.