Introduction to Value Investing
How To InvestBy: Clayton Johnson, CFP®
Introduction to Investing
The overarching premise of getting a return on investing in a stock in the stock market is that you get rewarded for taking the risk to invest in a company with an uncertain future. You can’t get a return without risk. That is the price of admission for being an investor.
In his groundbreaking research on the relationship between risk and return, Nobel prize winning researcher, William Sharpe, taught that, “the risk that is rewarded with higher expected return is generally risk associated with doing badly in bad times.” In other words, the higher the risk, the higher the expected return should be.
Additionally, Nobel prize winning research from professors Euguene Fama and Ken French concluded that there are three risk factor premiums that have historically rewarded investors with higher returns: stocks over bonds, small stocks over large, and value stocks over growth.
What is a ‘value’ stock?
A stock with low relative price to some balance sheet or income statement measure. In academia the price to book ratio is commonly used, while practitioners use a variety of metrics including price to book, price to earnings (P/E) ratio, and price to cash flow and often use multiple metrics in tandem.
Value company characteristics:
- Often financial distressed
- Management uncertainty or turnover
- Increased competition
Consider two companies, both of which make lightbulbs. One company is very successful and dominant, the other is struggling. Which company would you rather lend money to? The successful company is the safer choice and is going to be able to borrow at a much lower rate. Its rosy prospects are likely fully reflected in its stock price. For the struggling lightbulb company, many worries remain, and would tend to be reflected in its stock price. If it is able to overcome these hurdles, its stock price has much more upside to grow. (why we overweight small cap and value securities)
Why Value?
So, I just told you that value companies are distressed and have a more uncertain future, so why would you choose to add these kinds of stocks to your portfolio. This all goes back to the relationship between risk and reward. The higher the risk, the higher the expected return should be. Academic research finds that value companies have outperformed over the long term, as illustrated in this chart.
And when compared to growth, the average annual U.S. value premium was 4.4% per year. Meaning, over the period of almost 100 years, value stocks have outperformed growth stocks by an annual average of 4.4%.1 This does not mean that year over year you will always capture this premium. It is volatile and experiences years of underperformance relative to growth. However, for long term investors it’s very valuable.
What to expect with a value tilted portfolio
Investors who tilt toward value stocks need to be prepared for periods of significant underperformance relative to the market and relative to growth stocks.
Because everyone’s crystal ball is cloudy, no one can consistently predict what market cycle we are in or what we can expected from the stock market in the future. It’s notoriously challenging to find an indicator that consistently predicts negative value premiums.
Value stocks are expected to perform better than growth stocks every day, because lower relative price is associated with higher expected return. (Is now a good time for value?) So, regardless of value’s recent performance, investors should expect positive value premiums going forward. That’s a strong incentive for investors to maintain a disciplined stance to asset allocation, so they can capture the outperformance when value stocks deliver.
Download Staying the Course with Value Stocks PDF
