VALUEX: a value approach to domestic equities
All financial decisions are dictated by two main parameters: quality and valuations. Whether an investor is buying a house, a small business or even just a pair of shoes, it is the intertwined relationship of what price is being required to acquire a certain level of quality that defines the transaction.
Often investors dealing with stocks forget this straightforward relationship and let emotional biases drive their analysis. This behavioral vacuum, along with other structural issues, recurrently create dislocations in markets that could otherwise be mostly efficient.
The value anomaly, or stocks selling at a discount to their intrinsic fair value, has been the subject of much research over the years starting with Benjamin Graham and David Dodd, the fathers of value investing. Most research indicates that over the long term (often defined as at least five years), a portfolio of good businesses purchased at lower valuations usually outperforms growth and glamour.
The reason for such outperformance resides in the inherently mean reverting nature of growth. Most investors have a tendency to extrapolate rates of super growth into time frames that are usually too long. Spurts of innovation, superior productivity or large profits margins are rarely maintained for long stretches of time. In this case, most investors tend to pay multiples that do not justify the real future growth of the business.
Identifying value generally depends on relative analysis of different ratios and multiples that can allow an investor to rank different companies. Graham’s preferred method was to buy businesses at deep discount to their book value even though this approach relied on infrequent opportunities. Other ratios, over time, became popular tools of value screening such as Return on Equity and Return on Capital Invested. More recent studies by Wesley Gray and Tobias Carlisle showed how a price metric like Earnings Before Interest and Taxes (EBIT) over Total Enterprise Value seems to produce the best screening results. This would seem intuitive as EBIT/TEV captures quite efficiently that relationship between earnings power and enterprise value which we mentioned earlier.
Other useful metrics for value investors are dividend yield, in its absolute and historical dimension, and financial strength.
The Value Process
The process of finding good or fair businesses at enticing valuations can be decomposed into four phases as the research of Doctor Gray has indicated:
- Avoid weak or opaque balance sheets
- Screen for quality measured by profitability and margins
- Screen for Relative Value by using current and historical pricing ratios
- Check for supporting catalysts or at least signs of potential turning events:
- Insider buying
- Institutional interest
- Short interest
These four phases are modeled into a framework that provides high quality candidates for our value portfolio. A qualitative additional layer of analysis helps define the ultimate portfolio composition.
Our VALUEX portfolio is comprised of US stocks only, with a minimum market cap of $1.4 billion; our screening framework also excludes ADRs, Mortgage REITS, ETFs and ETNs, CEFs, SPACs. We equally weight our portfolios and rebalance yearly.
It is not often that markets offer real discounts and attractive bargains but when such dislocations occur the astute investor should have a ready framework to successfully arbitrage such opportunities.
As mentioned above, Benjamin Graham and David Dodd were the original bargain hunters in the investing universe and wrote the, still today, most relevant book on the subject, Security Analysis, in 1934 delivering a value framework for picking securities.
Their approach was then successfully implemented by the likes of Warren Buffet – an apprentice of Graham -, Sir John Templeton, Seth Klarman and many others. Many studies were done to test if indeed value was a better approach than other strategies such as growth investing or passive indexing and the evidence seems to confirm a long term hedge of the value approach.
In recent times, finance “enfant terrible” James Montier has written extensively on the subject highlighting how this approach tends to work across international borders and across different sectors. In his 2008 article, Going Global: Value Investing without Boundaries, he quotes an outperformance of value over glamour of approximately 9% per annum across a group of developed markets. This outperformance increases when looking at emerging markets, where the performance delta between the cheapest 20% of all stocks and the most expensive reaches a significant 15%.
Montier also tested across different time frames and his results seem to indicate that a longer time horizon is often required to allow markets to arbitrage such value discrepancies. While value outperformance can be realized as quickly as in one year periods, a five year investment horizon seems to help magnify the value/growth delta to a significant 40%.
Similar results occur also in the work of Fama and French who compiled the benchmark value series in academic finance labeled VMG (Value-minus-Growth). The two researchers compiled a portfolio of US equities long low Price to Book companies and short stocks with high P/B multiple. The portfolio was rebalanced yearly and tested back to 1926 resulting in a consistent outperformance of value stocks.