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Value Is Cheap, but Is It Worth Buying?

It has never been a better time to be a value investor, or that's what the data tells us anyway. In theory, value investors now have more opportunity than they have at any other point since the bursting of the dot-com bubble in the early 2000s.

This is based on the valuation gap between the MSCI World Value index and MSCI World Growth index. At the time of writing, the MSCI World Value index is trading at its lowest level relative to the MSCI World Growth index since the peak of the dot-com bubble, according to research conducted by Justina Lee on Bloomberg.

Time to buy value?

Historically, when the valuation gap has hit this level, value stocks have then gone on to beat their growth peers by 50% over the next 12 months. Will the same pattern emerge this time? It is difficult to tell. There are really only two examples of value stocks outperforming growth stocks by an average of 50% after reaching this level in the past. They did so in the early 1980s and again in the early 2000s.

However, we are in unprecedented times. Central banks around the world are printing money at an ever-increasing rate, and the global stock of negative-yielding debt is at a record high.

Meanwhile, economic growth is slowing around the world, and recession fears are starting to gain traction. History tells us that value stocks tend to outperform the market immediately after a significant market pullback, but this didn't happen in 2008. If we have to wait for another pullback before value outperforms, it could be several years before this happens -- if central banks let the market decline.

Trying to predict what the future holds for stock markets is usually a fool's errand. So, it doesn't make much sense to try to forecast if value will outperform growth after reaching this unusual technical level.

But there are so many good businesses now dealing at relatively attractive valuations. Some of the most substantial holdings in the MSCI Value index also feature as top holdings in Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B)'s portfolio. These companies look cheap, but that doesn't mean they will be bad investments individually.

That's not to say that there are not businesses in the value index that do not deserve to have a low valuation. The market has become much better at determining between good businesses and bad businesses over the past decade, and because value and quality has tended to outperform value over the long term, investors have skewed toward this style. That's one of the reasons value stocks have underperformed so dramatically over the past decade.

Investors are no longer willing to give companies the benefit of the doubt just because they are cheap.

Value still exists

Nevertheless, there are still opportunities to exploit in the market. It just requires much patience and research. The market is more driven by flows than ever before, and indiscriminate selling swamps unpopular sectors. Taking advantage of the opportunities offered by these dislocations is one avenue left to value investors today.

Value investing still has its benefits -- paying a low price for a good company is never going to be a bad investment decision -- but investors today have to be much more selective in the companies they choose to add to their portfolios. It is no longer acceptable just to buy the market's cheapest stocks, put them in a portfolio and hope for the best, in the same way Benjamin Graham did.

Buying good companies at low valuations is a sensible investment strategy. Buying stocks just because they are cheap is not. It might be best to keep that in mind when trying to exploit the current discrepancy between the valuations of value and growth stocks.

Disclosure: The author owns shares in Berkshire Hathaway.

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This article first appeared on GuruFocus.