Value is obvious: ‘buy cheap and sell expensive’ is probably the first piece of received market wisdom that any investor learns. All famous investors from Benjamin Graham to Warren Buffet have, first and foremost, been fervent advocates of value investing. Value can be assessed in very diverse ways and value investing can also suffer from some drawbacks. Here are a few pointers for understanding value and avoiding the most common misconceptions.
The underlying idea of value is very simple
Stock prices are not just quotations that move up and down on screens; stock prices should reflect what a company is worth, divided by the number of shares. Value is therefore a fundamental factor based on data from the underlying company which can be used to assess how much a company is worth. Cheap companies will trade at prices below what a company is worth. Expensive companies will be priced above that.
Assessing the value of a company is an activity as old as accounting
The balance sheet is the natural summary of how much a company is worth, as it sums up all it owns and all it owes. Therefore the price to book ratio is the most natural measure of value, although it actually takes time for the balance sheets to be published and they can involve numerous accounting treatments. This is why a share in a company can also (and better) be valued as the sum of its future flows: dividends, in a very tangible way, or earnings, in a more global view, by taking into account the share of earnings that the company keeps to invest in its growth, as this is not lost. This highlights a first link that is not always obvious to investors: high dividend investing is actually a type of value investing, since dividend is the final distributed value to investors.
At THEAM, we tend to prefer measures of value that appear ‘higher’ in accounting statements, such as cash flow-based measures, as these tend to be more difficult to manipulate, and are more directly linked to the company’s current activity. This is why, as well as earnings and sometimes dividends, we use free cash flow and net operating cash flow as measures of value. Mixing different indicators of the value of a company improves the global measure of value while retaining the natural advantages of the factor as a whole.
One danger of pure value investing is the ‘value trap’
A company that has just experienced very bad news may appear to be cheap simply because its true value is not yet reflected in its financial data while the stock price has corrected already. Once the consequences of the negative event are incorporated into financial data then an impact on all the various measures mentioned above will become apparent.
As all these measures are publicly available in companies’ financial reporting, you might wonder why the value factor should still exist, or whether it could become arbitraged or overcrowded. This comes back to doubting the persistence of value. It is true that Eugene Fama and Kenneth French have made the value factor very popular since the 1990s, and the ‘is value dead?’ question was raised during the dot-com bubble. This simple fact highlights the reason why value is highly likely to persist as an investment style: there will always be investors who prefer stories to hard facts, and although the value factor may underperform, sometimes even for years in a row, it is still a risk to ignore this obvious and intuitive factor completely.
Exhibit 1: Historical simulation of the performance (cumulated alpha) of a long-short portfolio based on the MSCI World Universe with stocks ranked by a proprietary combination of value indicators
Source: MSCI, Exshare [divider] [/divider]
This article was written by Etienne Vincent in Paris, July 2016