Perhaps the most overused maxim on Wall Street is “buy low and sell high.” This, in essence, is what the majority of active investors are trying to do. You hear many investors talk about stocks being “cheap.” Value Investors care about cheap stocks because they believe that cheap stocks represent a storehouse of value that the rest of the market does not seem to be aware of. The outperformance of cheap stocks to relatively expensive ones is well documented in the research literature.
We can say for sure that value is a relevant factor in asset pricing. Perhaps the most common metric for determining the value of a stock (for value investors) is the book value. A comparison of the relative value of a stock is often accomplished with a statistic known as the book to market ratio (BTM). You can think of the BTM as the number of dollars investors are willing to pay for each dollar of book value. All other things being equal, the lower BTM stocks represent greater value. Much of the academic research has determined the list of value stocks by using the lower 30% of stocks ranked by BTM. Studies differ on the precise number because of sample differences and different periods, but on average, there is about a 5% premium for holding value stocks. Investors can easily take advantage of this factor since there are value index funds that are mainly as cheap to own as broad market indices from which they are drawn.
A value trap is a stock that appears to be cheap because the stock has been trading at low valuation metrics such as P/E ratios, cash flow, or book value for a lengthy period. Such a stock attracts investors who are looking for a bargain because they seem inexpensive relative to historical valuation multiples of the stock or relative to the prevailing overall market P/E. The trap springs when investors buy into the company at low prices and the stock continues to languish or drop further.
The opposite end of the spectrum is the classification of stocks called growth stocks. Stocks classified as growth stocks will often have had a few good years, and investors have a hard time realizing that there will be a top and reversion to the mean will take place. The key issue to understand is the matter of timing; do not make the mistake of thinking that growth stocks necessarily have great growth prospects going into the future. It means that they have had great growth in the past.
Where does the value premium come from? There are various explanations some of which are behavioral based and some of which are risk-based. Since our coverage of a single factor must be brief in a general text such as this, we will only mention the risk-based explanation. Some authors have called the enhanced risk of holding value stocks a distress factor. Companies selling cheap relative to other companies usually have some problem that investors do not like, usually having to do with cash flows. The investor hopes that the company will fix the problem and get back on a path to growth, but must be compensated for taking the risk that it will not do so. If you are a single stock investor, you must take great care to understand why a stock is discounted and judge the prospects for fixing the problems.
If you are a mutual fund investor, understand that it can take a long time for the value premium to play out, depending on macroeconomic conditions. Vanguard’s Large Value, Large Blend, and Large Growth (VUVLX, VFIAX & VIGAX) funds illustrate this quite well. Since inception (2000), these funds have played out, as you would expect, according to the value thesis: Value returned 7.44%, Blend returned 5.98%, and Growth returned 5.88%.
In the boom market of the past five years, however, growth has crushed value. Value stocks are pro-cyclical and have historically performed more strongly coming off the bottom of an economic cycle. If you can buy individual securities in the type of account that you have, you would do well to consider buying Berkshire Hathaway shares. I am generally against managed funds, but Warren Buffett is a little different, and I cannot imagine a better play on the value factor.
Last Updated: 6/25/2018