Value investing sounds as logical as it gets. You buy under-priced stocks and watch as they climb in value.

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What sets the value investing approach apart is that instead of referring to stocks as vehicles of speculation, like most investors, it refers to stocks as partial ownership of a business and treats them as such. This mindset causes value investors to be less concerned with short-term price movements and more concerned with the fundamentals of the business at hand. Alternatively, speculative investors are more concerned with making a quick gain by simply finding a buyer who is willing to pay more for their asset than they did initially. Success with speculation depends on being able to predict the markets frequent fluctuations, instead of depending on sound financial analysis.

However, value investing is not without its flaws, as well. The problem with value investing lies in what it’s typically based on--rumours, hearsay and superficial analysis. Value investors believe the market overreacts to good and bad news, resulting in sharp stock price movements that don’t actually correspond with a company’s intrinsic value and long-term chances of success. Thus, giving investors an opportunity to make profit while the price is deflated.

What’s more, value investing is highly subjective. Some investors only take present assets and earnings into consideration and do not place any value on future growth. While other investors base their entire strategies only around the estimation of future growth and cash flows.

The decline of value investing

The Goldman Sach’s June 2017 report titled, “The death of value?”, recently dubbed the strategy as fading in effectiveness. They’ve even gone as far as proclaiming that implementing the value investing approach has resulted investors in a cumulative loss of 15 percent over the past decade.

Even the legendary value investor Jeremy Grantham voiced his concerns with value investing in his first quarter letter to investors for 2017. He stated, “this time seems very, very different”, and finally succumbed to the idea that the rules of value investing may no longer apply.

His reasoning? Similar to many investors, he claimed both corporate profit margins and consequently, valuations are permanently higher and that his patience has dwindled in waiting for the divergence to resolve.

Although it’s true that sound value investing has generated remarkable wealth for some (ehem... Warren Buffett), implementing value investing principles is not as easy as you might think. Or at least, that is the message that was conveyed by U-Wen Kok, Jason Ribando and Richard Sloan in their paper "Facts about Formulaic Value Investing," recently published in the "Financial Analysts Journal."

The authors take issue with strategies that scan for stocks with low price-to-earnings or price-to-book ratios, and once found, are declared as stocks that offer compelling value to investors. These strategies are becoming increasingly common, but in essence they are only finding companies with temporarily inflated accounting numbers. This is not to be confused with genuine value investing strategies that use “a comprehensive approach in determining the intrinsic value of the underlying securities."

Investors who utilize this method of buying stocks with low price-to-earnings ratios hope that the price will eventually rise and even out to the level of its peers. However, Kok, Ribando and Sloan, claim that the opposite is more likely to happen. The price-to-earnings ratio will return to a normal level, but only because the earnings in the denominator fell.

Value investing is not dead

So, which is it? Is value investing actually “dead” or is it just more challenging than it used to be?

The reason why value investing is being proclaimed as “dead” is only because those investors utilizing the approach fail to pay attention to the fine details--financial footnotes and balance sheets. If a more rigorous look at corporate profits is taken, investors will find that they are actually declining, not rising.

Even better? If you take an objective look at the historical context, you’ll see that today’s stock valuations are lower than they have been in the past 15 years, making today’s market the best for value investors. That is, the real value investors that take into account and analyze footnotes and balance sheets in addition to income statements.

If we take a closer look at the claims made by those who believe value investing is declining, we find the following errors:

Margins and Profits

The first assertion in the argument against value investing states that the average profit margin for the S&P 500 SPX, +0.12% is roughly 30% higher over the past 20 years than it was anytime prior. The fact is, the opposite holds true.

If you analyze the footnotes and balance sheets in addition to the earnings numbers from income statements, you’ll find that corporate profits have been declining in recent years.

In the figure below you can see the steady decline of economic earnings even as reported earnings are slightly up. The difference lies in the fact that economic earnings account for unusual gains and losses as well as all operating assets, including off-balance sheet assets.

Value Investing

What most investors base their conclusions off of are earnings reported under Generally Accepted Accounting Principles, or GAAP. The problem with GAAP earnings is that they contain numerous loopholes that companies can exploit to manipulate their results. And, the only way to reverse the accounting distortions is by digging through the financial footnotes and management's discussion and analysis, or MD&A. Only then can investors get an accurate picture of corporate profitability.

Valuations

Another point brought up arguing against value investing is the observation that the average P/E ratio for the S&P 500 has been approximately 70% higher over the past 20 years than for the entire preceding period.

The problem with this assertion is that if your denominator for the P/E ratio is off the mark, then it is not possible for your ratio to be accurate.

Instead of using flawed accounting numbers, using the economic earnings number calculated in Figure 1 above, the P/E ratio gives you different results:

Value Investing

On its surface, Figure 3 doesn’t look too troubling. The S&P’s P/EE has more than doubled since 2012, but is still below its pre-2008 levels. However, when you take both Figures 1 and 3 into account, the trend becomes more fascinating.

It’s clear that for several years now stock prices and accounting earnings have risen while economic earnings have declined. The overall market may not be as overvalued as once suggested and the valuations for many stocks are getting too high.

What needs to happen

Many investors are focusing solely on accounting earnings and you can’t really blame them. It’s not easy to calculate economic earnings, especially when to do so, you need to read every single 10-K and 10-Q cover to cover.

However, in order to truly practice value investing, there must be heightened awareness of fiduciary duties and more diligent habits in place. And, now more than ever is the time to do so. With trends such as interest rates no longer falling and markets no longer having the Federal Reserve to bail them out, investors need to go the extra mile to practice sound value investing.

What type of companies should you actually be looking for? The kind where economic earnings are growing faster than accounting earnings, and where P/EE ratio reveals lower growth expectations than the P/E ratio suggests.

Easy money speculative investing may have its perks, but eventually economic reality will set in and the level of diligence that comes with value investing will become increasingly necessary.

Article by Lilach Bullock

Highly regarded on the world speaker circuit, Lilach has graced Forbes and Number 10 Downing Street. She’s a hugely connected and highly influential entrepreneur. Listed in Forbes as one of the top 20 women social media power influencers and was crowned the Social Influencer of Europe by Oracle. She is listed as the number one Influencer in the UK by Career Experts and is a recipient for a Global Women Champions Award for her outstanding contribution and leadership in business.

Contact info: www.lilachbullock.com