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Judging by their songs, Doris Day and REM might share Warren Buffett’s attitude to investing: the future is unpredictable, so don’t get hung up about it when deciding what to buy. The headlines may proclaim the end of the world as we know it but Peter Webb feels fine

I have been fortunate enough to meet and question Warren Buffett not once but on several occasions. When I knew I was due to meet the great man himself for the first time, I had to wrack my brain over what question I should ask. It had to be a question that wouldn’t embarrass me and preferably one that hadn’t been asked before. Certainly I should ask a question that served a need in terms of some education on my behalf.

I didn’t have to look far for my inspiration as, one morning when I was having breakfast, the newspaper thumped on to my doormat and gave me a prompt. The thing that struck me was just how often the headlines would be enough to choke investors on their morning cereals. Each morning it seems some sort of disaster is about to befall the market or economic system. That morning, apparently, there was plenty to worry about. My thought was: ‘How should this affect my investing outlook?’

Hindsight as foresight

It prompted me to look in my loft for old copies of magazines that I had kept to revisit in the future and benefit from some hindsight.

Digging through the archives it was difficult to find a year where I couldn’t pick out some dramatic story that seemed to put pressure on me to modify the way I thought. Whether it was a currency crisis, a trade deficit or personal or state debt, each year appeared to be defined in some way by a story that persistently nagged the market.

I sat there and pondered: had I just been lucky to avoid all these potentially catastrophic issues? My question to Buffett was defined; with all the daily headlines telling me about one potential disaster or another, just how should I account for these in my investing outlook?

The future’s not ours to see

When I came to ask Buffett, he provided a very simple answer: he doesn’t really care or take account of these headlines. ‘We only buy what makes sense today; we don’t know what will happen in the future so we don’t make decisions based upon that’.

His rationale was that, at any point in

the economic cycle, there seemed to be as many plus as minus points, and this had always been the case, whether you look for these points in the depth of a large bear market or the top of a bull market. Therefore his focus is and will always remain to buy companies at the right price. ‘I have never worried about what is going to happen, financially, ever.’

He prefers instead to adopt the philosophy of buying companies with the view that he only buys at the right price and with the outlook that there will be good and bad years but that the good should win out over time. He doesn’t attempt to judge in which order those years arrive or make decisions on that. That made a sort of sense after I thought it through, but it was a bit anecdotal, surely there were good and bad times to be a value investor?

Proving the theory

This exact question was answered in recent research by Seung-Woog Kwag, at Utah State University and Sang Whi Lee at Kyung Hee University in Seoul, Korea.

They looked at the period from July 1954 to December 2002, and examined 582 months of data. Each value and growth portfolio was risk-adjusted to ensure results were not distorted. They specially examined growth and value strategies in the context of the business cycle and more specifically the contraction and expansion phases of an economy. Value companies were defined as companies with high valuation ratios such as a low price to book, price to earnings, price to cashflow and high dividend yield value. Growth strategies were generally defined as those involving investments in companies with the same valuation ratios but in opposing directions.

During the contraction phase of an economy, they noted that value investing offered positive excess returns. However, when they examined economic expansion, the same appeared to be the case as well. Therefore they concluded that value strategies seemed to work whatever the prevailing economic wind.

They did notice, though, that the mean differences between value investing and growth investing were all greater during the contraction period than during the expansion period. This suggests that it is more beneficial for investors to move into value stocks during an economic downturn than during an upturn.

This probably makes a lot of sense as it is well known, at least by anecdote, that there appear to be more bargains at the end of a long bear market, when pessimism is at its greatest, and vice versa.

The summary of the results suggests that investors, on average, benefit from value investing regardless of economic conditions, but benefit more when they pursue a value-investing strategy during a period of economic contraction where, generally, prices and valuations are lower.

It seems Buffett was right, again.