Value stock

A value stock is a stock that is trading below its intrinsic value or real value. Real value is calculated based on many parameters like dividends, earnings, sales, etc. Although developed in the 1920s, value investing is still a major investment strategy.

Value investing is a style of investing that looks for securities with prices that are unjustifiably lower than their intrinsic value. This approach of investing was first made famous by Professor Benjamin Graham at Columbia University and his protégé, David LeFevre Dodd, and later was successfully adopted by value investors like Buffett, William J. Ruane, Irving Kahn, Charles Brandes, John Templeton and Martin J. Whitman among others. When valuing stocks, quantifying the intrinsic value is a tricky exercise, and there is no universally accepted way to arrive at this figure. Value investors believe the intrinsic value can be approximated by deciphering a stock’s fundamentals. Like bargain hunters, value investors ferret for stocks that they believe are currently undervalued by the market and not recognised by the majority of the investment community.

Value Investing

The Conventional Definition: A value investor is one who invests in low price-book value or low price-earnings ratios stocks.

The Generic Definition: A value investor is one who pays a price which is less than the value of the assets in place of a firm.

Different Faces of Value Investing Today

Passive Screeners: Following in the Ben Graham tradition, you screen for stocks that have characteristics that you believe identify under valued stocks. Examples would include low PE ratios and low price to book ratios.

Contrarian Investors: These are investors who invest in companies that others have given up on, either because they have done badly in the past or because their future prospects look bleak.

Activist Value Investors: These are investors who invest in poorly managed and poorly run firms but then try to change the way the companies are run.

Value investing originated in the 1920s at a time when investors were guided mostly by speculation and insider information (Graham and Dodd). Its introduction represented the first rational basis for investment decisions.The underlying principle of value investing is to invest in companies trading below their true value. This can be measured using fundamentals such as book value of equity, earnings, cash flow, and dividends. Despite significant changes in the economy and securities markets during the last several decades, value investing has proved to be one of the most successful investment strategies, and its success verifies not only its validity but its competitiveness, compared with modern portfolio theory based on the efficient market hypothesis.

Several strategies for value investing exist. These include investing in companies with high valuation ratios such as book-to-market (B/P), earnings-to-price (E/P), and cash flow-to-price (C/P) ratios, and in companies with high dividend yields (DY). In contrast, growth investing strategies are generally defined as those involving investments in companies with low valuation ratios. This study examines these two strategies in the context of the business cycle—specifically, contraction and expansion of the economy. This is important to investors since business downturns (contractions) and upturns (expansions) may have different impacts on value investing than they do on demand for industrial products. For instance, demand for technological goods benefits more from upturns and suffers more from downturns than does demand for durable goods. If returns from value investing are sensitive to the business cycle, investors should pursue value investing with caution, taking into account economic conditions. Although an extensive body of previous research on value investing has documented the tendency of stocks with high valuation ratios to outperform stocks with low valuation ratios, no studies have explicitly investigated the impact of the business cycle on value investing. Given that the business cycle reflects economic risks, it is important that investors and financial planners understand the relationship between value investing and the business cycle.

Empirical evidence suggests that value investing based on high valuation ratios (that is, book-to-market ratio, earnings-to-price ratio, cash flow-to-price ratio, and dividend yield) tends to outperform growth investing based on low valuation ratios. This superior performance is robust for all economic conditions, meaning that investors will be better off investing in stocks with high valuation ratios versus stocks with low valuation ratios regardless of economic conditions. The benefits of value investing are even greater during periods of contraction than during periods of expansion.

Ben Graham’ Screens

• PE of the stock has to be less than the inverse of the yield on AAA Corporate Bonds:
• PE of the stock has to less than 40% of the average PE over the last 5 years.
• Dividend Yield > Two-thirds of the AAA Corporate Bond Yield
• Price < Two-thirds of Book Value
• Price < Two-thirds of Net Current Assets
• Debt-Equity Ratio (Book Value) has to be less than one.
• Current Assets > Twice Current Liabilities
• Debt < Twice Net Current Assets
• Historical Growth in EPS (over last 10 years) > 7%
• No more than two years of negative earnings over the previous ten years.

Value Screens

• Price to Book ratios: Buy stocks where equity trades at less than or at least a low multiple of the book value of equity.
• Price earnings ratios: Buy stocks where equity trades at a low multiple of equity earnings.
• Price to sales ratio: Buy stocks where equity trades at a low multiple of revenues.
• Dividend Yields: Buy stocks with high dividend yields.

Price/Book Value Screens

A low price book value ratio has been considered a reliable indicator of undervaluation in firms. The empirical evidence suggests that over long time periods, low price-book values stocks have outperformed high price-book value stocks and the overall market.

Price/Earnings Ratio Screens

Investors have long argued that stocks with low price earnings ratios are more likely to be undervalued and earn excess returns. For instance, this is one of Ben Graham’s primary screens.

Studies which have looked at the relationship between PE ratios and excess returns confirm these priors.

Firms in the lowest PE ratio class earned an average return substantially higher than firms in the highest PE ratio class in every sub-period.

The excess returns earned by low PE ratio stocks also persist in other international markets.

Price/Sales Ratio Screens

Senchack and Martin (1987) compared the performance of low pricesales ratio portfolios with low price-earnings ratio portfolios, and concluded that the low price-sales ratio portfolio outperformed the market but not the low price-earnings ratio portfolio.

Jacobs and Levy (1988a) concluded that low price-sales ratios, by themselves, yielded an excess return of 0.17% a month between 1978 and 1986, which was statistically significant. Even when other factors were thrown into the analysis, the price-sales ratios remained a significant factor in explaining excess returns (together with price earnings ratio and size)

Value investing comes in many stripes.

There are screens such as price-book value, price earnings and price sales ratios that seem to yield excess returns over long periods. It is not clear whether these excess returns are truly abnormal returns, rewards for having a long time horizon or just the appropriate rewards for risk that we have not adequately measured.

There are also “contrarian” value investors, who take positions in companies that have done badly in terms of stock prices and/or have acquired reputations as “bad” companies.

There are activist investors who take positions in undervalued and/or badly managed companies and by virtue of their holdings are able to force changes that unlock this value.

Warren Buffett – Value Investing

In March 2008, riding the surging price of his own company, Berkshire Hathaway, Warren Buffett became the world’s wealthiest man with an estimated fortune of $62 billion. Berkshire Hathaway posted a compound annual gain between 1965 and 2007 of 21.1 percent, more than double the gain of 10.3 percent from the S&P500 in the same period. Had an investor put $1000 in Berkshire Hathaway when it first started, he or she would have earned over $4 million by 2007. Buffet’s investment strategy is arguably the most triumphant ever, and his success is attributed to his strict adherence to value investing.