Value Investing

Value investing is an investment strategy that focuses on buying companies that are cheaply priced. While this seems an intuitively straightforward path to investment success and history supports that argument, taking the right 'value' approach is important.

Benjamin Graham, the father of Value Investing, believed undervalued companies have the capability to perform well in the long run. He believed that you should always invest with a ‘margin of safety’.

‘Margin of safety’ is the principle of buying a security at a significant discount to its intrinsic value. The ‘margin of safety’ concept is deeply embedded in Benjamin Graham’s Value investing philosophy.

Value investing, as Graham advocated, is not concerned with short-term trends in the market or daily movements of stocks, rather it is a long-term investment approach.

The observation that cheaply priced stocks outperform pricier stocks in the long term is the foundation of value investing. Cheaply priced stocks are those that are trading lower than their ‘intrinsic’ or book ‘value’. Value investing, therefore, is like bargain hunting, it is about buying companies that appear to be cheaper than they are worth. This often means buying companies that are out of favour with investors. In some cases, these companies may have been oversold and investors can benefit when they return to their intrinsic value.

It’s worthwhile understanding how the value of a company is measured. Common valuation metrics, such as earnings or price-to-book value ratios have traditionally been used to measure value. Those with low metrics are considered value.

Value investing has been around since before the Great Depression. Over that time it has faced criticism, been finessed and different value investors have employed different ways to calculate value.

One of the criticisms of value investing is that over certain time periods, it has underperformed.

According to a paper written by MSCI in 2015, a big part of the value underperformance is the mis-definition of value by relying on price-to-book in a world where intangibles are increasingly important.

To overcome this many value managers now place greater emphasis on enterprise value, a measure of the company’s total value (typically based on debt plus equity market cap less cash). It also serves as the basis for many financial ratios that measure the performance of a company. Firms with high enterprise multiples have high expected cash flows relative to operating income, implying high growth opportunities and a relatively lower discount rate than firms with low multiples.

MSCI’s analysis also found that forward earnings have helped protect against ‘value traps’, and that whole-firm valuation measures, such as enterprise value, have reduced concentration in highly leveraged companies, meaning those that have borrowed heavily. Therefore, MSCI developed its Enhanced Value Indices, which apply three valuation ratio descriptors on a sector-relative basis:

• price-to-book value - Ratio of the price to the company’s book value or what is on the balance sheet. The lower the price to book, the cheaper the company;
• price-to-forward earnings - A version of the ratio of price-to-earnings (P/E) that uses forecasted earnings for the P/E calculation. The forward earnings are the weighted average of the consensus of analysts’ predicted earnings. The lower the Forward P/E the cheaper the company.; and
• enterprise value-to-cash flow from operations - The ratio of the entire economic value of a company to the cash it produces. When you divide EV by CFO, you're essentially calculating the number of years it would take to buy the entire business if you were able to use all the company's operating cash flow to buy all the outstanding stock and pay off all the outstanding debt. The lower the ratio faster a company can pay back the cost of its acquisition or generate cash to reinvest in its business.

Compared to a traditional value approach, MSCI’s Enhanced Value overcomes many of the criticisms of value investing because it puts less weight on price-to-book as a metric and removes backward-looking dividend yield. It uses a whole-firm valuation measure in enterprise value that could reduce concentration in leveraged companies. An analysis of historical performance supports MSCI’s Enhanced Value approach.

Read more about MSCI’s approach to value here.

1920s – Value investing defined

Economists Benjamin Graham and David Dodd formally developed the concept of value in the 1920s. Their book, Security Analysis (1934) and Graham’s later work, The Intelligent Investor (1949) introduced investors to methods that could be used to identify value.

Graham and Dodd believed that the true value of a stock could be determined based on its assets, future earnings, dividends and prospects. The lower the price of the security, relative to this intrinsic value, the higher the ‘margin of safety’. Behind this concept of value investing is the belief that ‘cheaply’ valued assets tend to outperform more expensive stocks over the long term.

This has proven to be true. One of the world’s most successful investors, Warren E. Buffett, who got an A+ from Graham at Columbia in 1951, has made his fortune using the principles of Graham and Dodd as the CEO in Berkshire Hathaway Inc.

1970s - Further research

Academics too have studied value. Early research done by Basu (1977), Stattman (1980), and Rosenberg, Reid, and Lanstein (1985) shows that valuation ratios such as price-to-book and price-to-earnings are indicative of future returns, and that low value stocks tend to outperform high value stocks over a long time horizon. This led to Fama and French developing the Three-Factor Model as an extension of the Capital Asset Pricing Model (CAPM) to account for size and value factors. Fama and French’s Three-Factor (later Five-Factor) Model changed the way investors considered and measured risks and returns. It paved the way for research into the persistent and identifiable drivers of stock returns, resulting in the rise of ‘factors’. According to index provider MSCI, there are six main investment factors: quality, size, value, momentum, dividend yield and volatility.

1970s to beyond the GFC

It was during the 70’s, 80’s and 90’s that value investing flourished. According to the commentary of the 2003 edition of Graham’s The Intelligent Investor, at the time, prominent value advocate and active manager Peter Lynch had the best 20-year return of any mutual fund ever.

Key to his success was identifying real value stocks and avoiding the cheap and nasty. A low price alone does not indicate good value, and those who pursue low price alone can easily fall into ‘value traps’. This has been one of the criticisms of value. The danger is that sometimes the market’s pessimism toward a company is justified due to poor financial prospects or poor management. The possibility of these value traps means investors have to consider value beyond traditional metrics.

The use of forward earnings estimates can help mitigate the potential for investing in those companies whose valuation might appear favourable, but where earnings growth is low or even negative, causing book value to stagnate. This is what MSCI’s Enhanced Value approach aims to do. Compared to a traditional value approach, MSCI’s enhanced value overcomes many of the criticisms of value because it puts less weight on price-to-book as a metric and moves away from backward-looking dividend yield altogether. It uses a whole-firm valuation measure in enterprise value that could reduce concentration in leveraged companies. It also employs a sector neutral approach that MSCI found mitigates some of the drawdown inherent with the value investing style.