What Is Value Investing? What Is Its Rationale? What Are Gmo’s Main Arguments in Favor of Value Investing?

• What is value investing? What is its rationale? What are GMO’s main arguments in favor of value investing? (2 points)

Value investing is the practice centered around picking “undervalued” stocks and investing in them while their worth is at a low. The idea of value investing is to pick stocks that are underperforming or are otherwise un-favored by the market and invest in them while you can get them for low prices.  When the stocks begin to perform well they can be sold a large premium. This aggressive investing is usually only possible because of overreactive tendencies often present in the market. Negative Rumors cause panic with stockholders which causes them to uninvest.  This subsequent rise in book to market ratio has led to a strong correlation for value investors, who often invest in companies where the book to market ratio is falling.

The rationale of investing in this way stems from the idea that whatever is depressing these stocks for the time being won’t be keeping these stocks down forever and that from the rut of a terrible positions, things can only go up.  If all these assumptions are correct than the value hidden in the stocks problems can be reached under the right market conditions. One specific example of this is the concept of market inefficiency.  The market actively corrects inefficiencies so if the price is truly “lower than it should be” when compared to expected future performance of the investment, the market will correct this by raising the price.  This raise in price represents a direct value to investors, who benefit from the capital gain of value stocks.

GMO specifically based much of its investing logic on the examples of strong returns for undervalued investments like U.S. Active or the Pelican Fund during the late 80s.  GMO had a strong opinion that if a fund or security was selling below its “inherent worth” or that a security’s “inherent worth” stood to change dramatically after a significant event in the market then that security would consistently reach better than average returns relative to the market

• What are the differences between value and growth investing? What are their relative merits? (1 points)

Generally, when growth investing you are attempting to find capital appreciation over the course of many periods or a long term. Chosen investments in this style of investing are often picked for their better than average growth over a several year time period. Growth stocks are usually touted as some of the highest earning investments over these long periods since gains are generally reinvested to achieve even better growth.  Due to these factors growth stocks tend to be volatile in certain markets.

Value investors, on the other hand are basing their investments on how far below the expected price they can buy a stock. These bargain investments typically have low prices when compared to their financial indicators such as their book value, sales and EPS.  Value investors generally won’t purchase any stock with a high price, such as blue chip stocks, since the reduction in quantity can significantly harm their margins.  By buying stocks that are out of favor for political, social, or nominal reasons, investors can buy stocks at a discount.  When the price returns to the value that the market dictates, shareholders can reap large rewards.