V ALUE INVESTING

Who is a value investor?

The Conventional Definition: A value investor is one who invests in low price-book value or low price-earnings ratios stocks.

The Generic Definition: A value investor is one who pays a price which is less than the value of the assets in place of a firm.

The Three Faces of Value Investing

1. The Passive Screener: Value Investing based upon screen or screens designed to find value stocks.

2. The Activist Intervener: Investing large in undervalued companies

3. Investing in stocks after bad news

I. The Passive Screener

This approach to value investing can be traced back to Ben Graham and his screens to find undervalued stocks. In recent years, these screens have been refined and extended. The following section summarizes the empirical evidence that backs up each of these screens.

A. Ben Graham Screens

1. PE of the stock has to be less than the inverse of the yield on AAA Corporate Bonds:

2. PE of the stock has to less than 40% of the average PE over the last 5 years.

3. Dividend Yield > Two-thirds of the AAA Corporate Bond Yield

4. Price < Two-thirds of Book Value

5. Price < Two-thirds of Net Current Assets

6. Debt-Equity Ratio (Book Value) has to be less than one.

7. Current Assets > Twice Current Liabilities

8. Debt < Twice Net Current Assets

9. Historical Growth in EPS (over last 10 years) > 7%

10. No more than two years of negative earnings over the previous ten years.

B. Price/Book Value Screens

A low price book value ratio has been considered a reliable indicator of undervaluation in firms. The empirical evidence suggests that over long time periods, low price-book values stocks have outperformed high price-book value stocks and the overall market.

Results from Other Studies

• In studies that parallel those done on price earnings ratios, the relationship between returns and price book value ratios has been studied.
• The consistent finding from these studies is that there is a negative relationship between returns and price book value ratios, i.e. low price book value ratio stocks earn higher returns than high price book value ratio stocks.

• Rosenberg, Reid and Lanstein (1985) find that the average returns on U.S. stocks are positively related to the ratio of a firm’s book value to market value. Between 1973 and 1984, the strategy of picking stocks with high book/price ratios (low price-book values) yielded an excess return of 36 basis points a month.
• Fama and French (1992), in examining the cross-section of expected stock returns between 1963 and 1990, establish that the positive relationship between book-to-price ratios and average returns persists in both the univariate and multivariate tests, and is even stronger than the size effect in explaining returns.
• When they classified firms on the basis of book-to-price ratios into twelve portfolios, firms in the lowest book-to-price (higher P/BV) class earned an average monthly return of 0.30%, while firms in the highest book-to-price (lowest P/BV) class earned an average monthly return of 1.83% for the 1963-90 period.

Evidence from International Markets

• Chan, Hamao and Lakonishok (1991) find that the book-to-market ratio has a strong role in explaining the cross-section of average returns on Japanese stocks.
• Capaul, Rowley and Sharpe (1993) extend the analysis of price-book value ratios across other international markets, and conclude that value stocks, i.e. stocks with low price-book value ratios. earned excess returns in every market that they analyzed, between 1981 and 1992. Their annualized estimates of the return differential earned by stocks with low price-book value ratios, over the market index, were as follows:

Country Added Return to low P/BV portfolio

France 3.26%

Germany 1.39%

Switzerland 1.17%

U.K 1.09%

Japan 3.43%

U.S. 1.06%

Europe 1.30%

Global 1.88%

• Fama and French point out that low price-book value ratios may operate as a measure of risk, since firms with prices well below book value are more likely to be in trouble and go out of business. Investors therefore have to evaluate for themselves whether the additional returns made by such firms justifies the additional risk taken on by investing in them.

C. Price/Earnings Ratio Screens

• Investors have long argued that stocks with low price earnings ratios are more likely to be undervalued and earn excess returns. For instance, Ben Graham, in his investment classic The Intelligent Investor, uses low price earnings ratios as a screen for finding under valued stocks.
• Studies which have looked at the relationship between PE ratios and excess returns confirm these priors. Figure 9.12 summarizes annual returns by PE ratio classes for stocks from 1967 to 1988.

• Firms in the lowest PE ratio class earned an average return of 16.26% during the period, while firms in the highest PE ratio class earned an average return of only 6.64%.
• The excess returns earned by low PE ratio stocks also persist in other international markets.

D. Price/Sales Ratio Screens

Senchack and Martin (1987) compared the performance of low price-sales ratio portfolios with low price-earnings ratio portfolios, and concluded that the low price-sales ratio portfolio outperformed the market but not the low price-earnings ratio portfolio. They also found that the low price-earnings ratio strategy earned more consistent returns than a low price-sales ratio strategy, and that a low price-sales ratio strategy was more biased towards picking smaller firms.

Jacobs and Levy (1988a) concluded that low price-sales ratios, by themselves, yielded an excess return of 0.17% a month between 1978 and 1986, which was statistically significant. Even when other factors were thrown into the analysis, the price-sales ratios remained a significant factor in explaining excess returns (together with price-earnings ratio and size).

Determinants of Success at Value Screening

1. Have a long time horizon. All the studies quoted above look at returns over time horizons of five years or greater. In fact, low price-book value stocks have underperformed high price-book value stocks over shorter time periods.

2. Choose your screens wisely. Too many screens can undercut the search for excess returns since the screens may end up eliminating just those stocks that create the positive excess returns.

3. Be diversified. The excess returns from these strategies often come from a few holdings in large portfolio. Holding a small portfolio may expose you to extraordinary risk and not deliver the same excess returns.

4. Watch out for taxes and transactions costs. Some of the screens may end up creating a portfolio of low-priced stocks, which, in turn, create larger transactions costs. (This may be partially mitigated by having a long time horizon). The excess returns reported above are also pre-tax returns. It is possible that these screens may expose the investor to high tax strategies.

II. Activist Value Investing

An activist value investor having acquired a stake in an undervalued company which might also be badly managed then pushes the management to adopt those changes which will unlock this value. For instance,

If the value of the firm is less than its component parts: push for break up of the firm, spin offs, split offs etc.

If the firm is being too conservative in its use of debt: push for higher leverage and recapitalization

If the firm is accumulating too much cash: push for higher dividends, stock repurchases.

If the firm is being badly managed: push for a change in management or to be acquired

If there are gains from a merger or acquisition push for the merger or acquisition, even if it is hostile

A. Effects of Spin offs, Split offs, Divestitures on Value

The overall empirical evidence is that spin offs, split offs and divestitures all have a positive effect on value.

• Linn and Rozeff (1984) examined the price reaction to announcements of divestitures by firms and reported an average excess return of 1.45% for 77 divestitures between 1977 and 1982.
• Markets view firms that are evasive about reasons for and proceeds from divestitures with skepticism.

Market Reaction to Divestiture Announcements