Value: Old-Fashioned Wisdom
Value stocks are not glamorous. You don’t buy them to brag at a dinner party, but over time guess who will have the last laugh?
Factor investing has gained popularity in the past few years. Factors are attributes that are likely to influence investment returns; for example, the low volatility factor may outperform by focusing on assets with lower fluctuations than others, while the momentum factor may generate potentially higher but riskier returns.
The value factor is based on the thesis that undervalued assets will outperform benchmarks over the long term. Value has a long history in investing, with its application dated as far back as 1779 when Abraham van Ketwich, a Dutchman widely regarded as the founder of the world’s first investment fund, launched a new mutual fund and stated that he would invest in “solid securities and those that based on decline in their price would merit speculation and could be purchased below their intrinsic values.”1
Perhaps the biggest champion of the value factor is Benjamin Graham, known as the the “Father of Investing”. Graham codified methods to identify undervalued stocks in his influential books, Security Analysis (1934) with David Dodd, and The Intelligent Investor (1949).
In the following decades, the value factor continued to be validated by prominent academics such as Sanjoy Basu2 in the 1970s, then Eugene Fama and Kenneth French in the 1990s. Among the contemporary disciples, the best known is Warren Buffet, a student of Benjamin Graham himself.
Why Invest In Value?
The value factor exists because investors tend to get excited about fast-growing stocks, often ignoring the companies’ weak fundamentals. The demand for these stocks pushes up their prices, creating stretched valuations. Some go on to become solid companies, but many fail to deliver on their hype – for example: Snap, Blue Apron, Pets.com and even WeWork…..the list goes on.
By comparison, investors may overlook established companies with a relatively low “price to book” or low “price to earnings” metric. These stocks are fundamentally cheap, and as their earnings grow their price will appreciate in the long run when investors become aware of their earnings power. AT&T, Intel, CVS Health and IBM are good examples of stocks with cheap valuation.
Value, by nature, is not glamourous. They are not the must-have items of the season; not that pair of fashion sneakers that has its own hashtag. Think of it more like the fine black blazer that you bought on sale - it’s discounted but timeless, high-quality and indestructible.
How Is The Value Factor Expressed?
Value can be expressed using a variety of fundamental ratios. Here are a few of the key metrics:
Equities
- Book to market
- Price to earnings
- Cyclically adjusted price earnings
- EBIT to enterprise value
- Dividends
- Buy-backs
- Total yield (dividend and buy-back yield)
- Free cash flow yield
Corporate Fixed Income
- Credit spread versus fundamentals
- Duration-hedged free cash flow yield
- Leverage
- Profitability
- Probability of default
At The Index Standard, we consider value a safe and useful factor that can enhance the stability and ballast of any portfolio. They are not high beta stocks and you won’t get quick wins; you may even have to put up with periods of underperformance. In fact, value as a factor has underperformed for the last few years. But while fashionable people keep spending money on chasing the next big thing, value stocks will have the last laugh when they gradually appreciate.
Other Factors
Visit The Index Standard Guides for information on other popular investment factors.
References
- Financial Market History. Reflections on the Past for Investors Today. CFA and Cambridge University. Chapter 12, K. Geert van Rowenhorst.
- S. Basu. (1977). Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratios: A Test of the Efficient Market Hypothesis, Journal of Finance, 12:3, 129-56