value stock

Understanding Value Investing

Investors continue to grapple with the concept of “value” in value investing. But for those willing to bear this risk, value stocks have ultimately provided the reward of higher returns. Here’s how to unlock the potential of value stocks.


Key Takeaways:

  • A value stock generally has a low price relative to various measures of a company’s worth, including the company’s book value, sales, earnings and cash flow.

  • Value stocks can be seen as being riskier than growth stocks in regard to both their company-level characteristics and their exposure to economic cycles.

  • For those willing to bear this risk, value stocks have ultimately provided the reward of higher returns.



Keys to unlocking the potential of value stocks. A quant perspective.

Investors continue to grapple with the concept of “value” in value investing. No single unique definition of value exists. Generally speaking, a value stock has a low price relative to various measures of a company’s worth, including the company’s book value, sales, earnings and cash flow. These company attributes tend to correlate with other measures that intuitively seem risky to investors, such as the company’s financial and operating leverage, its profit margins and variability of its financial results. Thus, looking across the cross section of companies one can invest in, value stocks are often seen to reflect concerns about a company’s profitability, stability and survivability. The different value metrics all reflect these concerns to varying degrees.

Real-world example

Consider for example two well-known stocks, Alphabet (Google) and Bank of America. The first is a growth company, with a price-to-book ratio of about 4.1 placing it so that the vast majority of stocks are cheaper. Alphabet has low debt, earnings have been growing nicely for years and there is a consensus that it is a very successful company. B of A is a value company whose price-to-book ratio of about 1.1 makes it cheaper than the vast majority of publicly traded U.S. stocks. It has a large amount of debt, and while its earnings grew nicely through 2007, they have vacillated since. B of A is widely viewed as having made several missteps during the financial crisis of the past several years.

This example illustrates the basic concepts of the risk argument. Certainly Google might be riskier by some metrics; for example, as a newer company some would consider them a greater risk. Nor will B of A necessarily outperform Google going forward. The latter has been a growth stock since inception and has continued to have strong returns. But generally the relationship between risk characteristics and value measures holds across stocks, and generally value stocks have outperformed their growth stock counterparts.

Impact of economic cycle

This value risk also manifests itself over time through exposure to the economic cycle. When times get tough, companies that have greater leverage or lower profitability will tend to suffer the most. The same holds true for smaller stocks. This can be demonstrated by considering returns of the value and size risk premiums during recessions and expansions. Returns for these premiums have been quite strong during expansions, but those returns fall dramatically during recessions. Recessions have been far fewer than expansions, and so these risks have historically paid off over time. And the risks from economic cycles are hard for investors to avoid.

Timing one’s entry and exit from the equity market can be very difficult. Recessions are often labeled as such well after the fact. Bear in mind the joke that “economists have predicted 10 out of the last 5 recessions.” And some of the highest returns to these premiums come right as or after a recession ends, so those trying to time their entry risk missing out on the strongest returns of the recovery. But for some of those willing to bear the risks, the rewards ultimately have followed.

The plot shows rolling 12-month returns to the Fama-French size factor (Small minus Big Company Returns - SMB) and value factor (High Value minus Low Value Companies - HML).

  • When these lines are above zero, small-size company returns beat large-company returns and value-company returns beat growth-company returns. These are superimposed over recessions, shown in gray. Data is from Kenneth French’s and National Bureau of Economic Research’s websites.

Capture-8-15.JPG
  • One can see that during recessions, value and smaller stocks truly show their risk characteristics and tend to lag their growth and larger counterparts. This adverse exposure to the economic cycle is another display of value’s risk characteristics.

  • Conversely, during economic good times value and small stocks recover and out-perform quite nicely. The chart below provides historical averages that offer numerical confirmation of the patterns seen in the plot.

Capture-8-15-2.JPG

Conclusion

Value investing continues to be popular, in part because it has worked well historically. There are a number of good explanations for this. We have focused on the risk explanation and have provided evidence that we find compelling. Value stocks are certainly not a sure thing, and they can disappoint at the worst times economically. But because of this risk, value stocks also can be viewed as ultimately providing the reward of higher returns for those willing to bear that risk.

Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.

 

The views, opinion, information and content provided here are solely those of the respective authors, and may not represent the views or opinions of Diversified Asset Management, Inc.  The selection of any posts or articles should not be regarded as an explicit or implicit endorsement or recommendation of any such posts or articles, or services provided or referenced and statements made by the authors of such posts or articles.  Diversified Asset Management, Inc. cannot guarantee the accuracy or currency of any such third party information or content, and does not undertake to verify or update such information or content. Any such information or other content should not be construed as investment, legal, accounting or tax advice.

Where's The Value?

July 2018

From 1928–2017 the value premium in the US had a positive annualized return of approximately 3.5%.2 In seven of the last 10 calendar years, however, the value premium in the US has been negative. This has prompted some investors to wonder if such an extended period of underperformance may be cause for concern. But are periods of underperformance in the value premium that unusual? We can look to history to help make sense of this question.

Click here to read more:

Where's The Value?

 

Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.

 

The views, opinion, information and content provided here are solely those of the respective authors, and may not represent the views or opinions of Diversified Asset Management, Inc.  The selection of any posts or articles should not be regarded as an explicit or implicit endorsement or recommendation of any such posts or articles, or services provided or referenced and statements made by the authors of such posts or articles.  Diversified Asset Management, Inc. cannot guarantee the accuracy or currency of any such third party information or content, and does not undertake to verify or update such information or content. Any such information or other content should not be construed as investment, legal, accounting or tax advice.

Growth vs. Value: Two Approaches to Stock Investing

Growth and value are two fundamental approaches, or styles, in stock and stock mutual fund investing. Growth investors seek companies that offer strong earnings growth, while value investors seek stocks that appear to be undervalued in the marketplace. Because the two styles complement each other, they can help add diversity to your portfolio when used together.

Growth and Value Defined

Growth stocks represent companies that have demonstrated better-than-average gains in earnings in recent years and that are expected to continue delivering high levels of profit growth, although there are no guarantees. "Emerging" growth companies are those that have the potential to achieve high earnings growth, but have not established a history of strong earnings growth.

The key characteristics of growth funds are as follows:

•  Higher priced than broader market. Investors are willing to pay high price-to-earnings multiples with the expectation of selling them at even higher prices as the companies continue to grow.
•  High earnings growth records. While the earnings of some companies may be depressed during period of slower economic improvement, growth companies may potentially continue to achieve high earnings growth regardless of economic conditions.
•  More volatile than broader market. The risk in buying a given growth stock is that its lofty price could fall sharply on any negative news about the company, particularly if earnings disappoint on Wall Street.

Value fund managers look for companies that have fallen out of favor but still have good fundamentals. The value group may also include stocks of new companies that have yet to be discovered by investors.

The key characteristics of value funds include:

•  Lower priced than broader market. The idea behind value investing is that stocks of good companies will bounce back in time if and when the true value is recognized by other investors.
•  Priced below similar companies in industry. Many value investors believe that a majority of value stocks are created due to investors' overreacting to recent company problems, such as disappointing earnings, negative publicity or legal problems, all of which may raise doubts about the company's long-term prospects.
•  Carry somewhat less risk than broader market. However, as they take time to turn around, value stocks may be more suited to longer-term investors and may carry more risk of price fluctuation than growth stocks.

Growth or Value... or Both?

Which strategy -- growth or value -- is likely to produce higher returns over the long term? The battle between growth and value investing has been going on for years, with each side offering statistics to support its arguments. Some studies show that value investing has outperformed growth over extended periods of time on a value-adjusted basis. Value investors argue that a short-term focus can often push stock prices to low levels, which creates great buying opportunities for value investors.

History shows us that:

•  Growth stocks, in general, have the potential to perform better when interest rates are falling and company earnings are rising. However, they may also be the first to be punished when the economy is cooling.
•  Value stocks, often stocks of cyclical industries, may do well early in an economic recovery but are, typically, more likely to lag in a sustained bull market.

When investing long term, some individuals combine growth and value stocks or funds for the potential of high returns with less risk. This approach allows investors to, in theory, gain throughout economic cycles in which the general market situations favor either the growth or value investment style, smoothing any returns over time.
 

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Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.
 


The views, opinion, information and content provided here are solely those of the respective authors, and may not represent the views or opinions of Diversified Asset Management, Inc.  The selection of any posts or articles should not be regarded as an explicit or implicit endorsement or recommendation of any such posts or articles, or services provided or referenced and statements made by the authors of such posts or articles.  Diversified Asset Management, Inc. cannot guarantee the accuracy or currency of any such third party information or content, and does not undertake to verify or update such information or content. Any such information or other content should not be construed as investment, legal, accounting or tax advice.