Many people throw around the term value investing without defining what it means. Value investing has become popular, some funds will now call themselves value funds just to attract capital. Some of these “value” funds own high P/E technology stocks that Benjamin Graham would have never called a value stock. These “value” fund managers will even claim at a 50 p/e a stock could still be “undervalued”. However, with no criteria to define what is value investing one can claim that almost any stock is a value stock. So the question is what really is value investing?
I think there are two schools of thought. The first school of thought in value investing believes that there is no simple formula to investing. With thousands of analyst covering big cap stocks like Mrk (Merck) and KO (coke), you would not be getting more value by buying Merck at a P/E of eight vs Coke at a 20 P/E. This theory largely agrees with the Efficient Market theory. The Efficient Market Theory states that the market incorporates all data immediately, and therefore you cannot beat the market. Many value experts including Bruce Greenwald, Seth Klarman and many others subscribe to this notion. Seth Klarmin in Margin of Safety states ” The financial markets are far too complex to be incorporated into a formula. Moreover, if any successful investment formula be devised, it would be exploited by those who possessed it until competition eliminated the excess profits. The quest fora formula that worked would then begin anew. Investors would be much better off to redirect the time and effort committed to devising formulas into fundamental analysis of specific invest ment opportunities.” This value approach does not employ the classic low P/E, P/B, P/CF, high dividend yields etc. for security analysis.
Does that mean these investors believe in the efficient market theory? Is not value investing a contradiction to the theory? Of course these value investors do not agree completely with the theory, however I believe to an extent that they agree with this theory. These value investors believe that you cannot gain an advantage by looking at big cap stocks followed by thousands of analysts. These investors believe the best way is not to fight the crowd but to look for value situations with high margins of safety in obscure places. These include spin offs, bankruptcies, risk arbitrage and small cap stocks in general. These are situations where analysts are not covering and many institutional investors are not interested in and sometimes legally obligated to sell (eg. some funds are obligated to sell any stock that goes under $5).
The theory makes sense but does it work? The answer is a resounding yes. Benjamin Graham describes briefly some of these investments in his book The Intelligent Investor. Many of the most outstanding investors today have been beating the market for many decades using this approach. These value investors include Seth Klarman and Joel Greenblatt. Greenblatt states that spin offs on average have beat the market by a 2-1 margin. Furthermore, he states that if you look for special value situations which occur in many spins offs you can earn much higher rate of return. Greenblatt employed some of these methods returning spectacular 50% annualized returns for over ten years.
What is the other school of value investing? I would call this the contrarian investing approach made most famous by David Dreman. This approach believes that the stock market(especially in the short term) is driven by psychology. The best value is in stocks with a low P/E, P/B and P/CF. There are many other valuation metrics to measure wether a stock is over or under valued. All this information is publicly available and is true for both small cap and large cap stocks. So why doesn’t everyone just look for stocks with low P/Es and high dividend yields which can easily be found on any stock screener? The reason Dreman states why this is not so simple is because humans are emotional creatures. Investors overreact and place too high a P/E on stocks that have experienced high earnings growth in recent years. High P/Es are also placed on certain sectors that are expected to do well over the coming years such as technology. When these stocks do not match the earning estimates( or even if they match the estimates but investors are no longer willing to pay such a high premium for them since they fall out of favor), they can decline heavily in value.
Does this method also work? The answer is yes, Jason Zweig in his commentary on the Intelligent Investor by Benjamin Graham states that over the 30 year period ending in 2002 utilities outperformed technology stocks. Stocks with low P/E and P/B ratios have outperformed higher P/E and P/B stocks over long periods of time. This has been confirmed by countless other studies and data performed covering many different times periods. Value stocks have not only outperformed growth stocks in America but in virtually every stock market across the globe. The reason this is true is because people are emotional and think alike across the world. Amazon is much more excitng than Altria, which is constantly stigmatized by lawsuits and laws restricting tobacco use, yet Altria has far outperformed Amazon over the last ten years.
Both value investing approaches are legitimate and provide an investor the chance to outperform the market. Although by using the contrarian approach it is easier to find stocks that are potential investments, both require full analysis of financial statements and hard work. The first approach is harder but most times the returns are much higher. The common theme about the two different types of value investing is to always be disciplined and not driven by emotion, devote time to analysis before investing, and to invest in undervalued securities with a high margin of safety.