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Introduction to Value Investing Thumbnail

Introduction to Value Investing

How To Invest

By: 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

Source: Morningstar Direct and Ken French Data Library in U.S. dollars. Asset Classes represented as follows: U.S. Large Value (Fama/French U.S. Large Value Research Index), U.S. Large (Fama/French U.S. Large Cap Research Index), U.S. Large Growth (Fama/French U.S. Large Growth Research Index), U.S. Small (Fama/French U.S. Small Cap. Research Index), International Value (MSCI World ex USA Value Index NR), International (MSCI World ex USA Index NR), International Growth (MSCI World ex USA Growth. Index NR), Emerging Markets Small (MSCI EM Small Cap NR Index), Emerging Markets Value (MSCI EM Value NR Index), Emerging Markets (MSCI EM NR Index), Emerging. Markets Growth (MSCI EM Growth NR Index). Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Values change frequently, and past performance may not be repeated. There is always the risk that an investor may lose money. Small company risk: Securities of small fi rms are often less liquid than those of large companies. As a result, small company stocks may fluctuate relatively more in price. Emerging markets risk: Numerous emerging countries have experienced serious, and potentially continuing, economic and political problems. Stock markets in many emerging countries are relatively small, expensive, and risky. Foreigners are often limited in their ability to invest in, and withdraw assets from, these markets. Additional restrictions may be imposed under other conditions. Foreign securities and currencies risk: Foreign securities prices may decline or fluctuate because of: (a) economic or political actions of foreign governments, and/or (b) less regulated or liquid securities markets. Investors holding these securities are also exposed to foreign currency risk(the possibility that foreign currency will fluctuate in value against the U.S. dollar). IRN-20-479. Past performance is not a guarantee of future results. Actual returns may be lower. Investing risks include loss of principal and fluctuating value. There is no guarantee an investment strategy will be successful. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.  In USD. Annual value premium is the return difference between the Fama/French US Value Research Index and the Fama/French US Growth Research Index. Source: CRSP and CompStat data calculated by Dimensional. Fama/French data provided by Fama/French. Fama/French US Value Research Index: Provided by Fama/French from CRSP securities data. Includes the lower 30% in price-to-book of NYSE securities (plus NYSE Amex equivalents since July 1962 and Nasdaq equivalents since 1973). Fama/French US Growth Research Index: Provided by Fama/French from CRSP securities data. Includes the higher 30% in price-to-book of NYSE securities (plus NYSE Amex equivalents since July 1962 and Nasdaq equivalents since 1973). Eugene Fama and Ken French are members of the Board of Directors of the general partner of, and provide consulting services to, Dimensional Fund Advisors LP. This information is intended for educational purposes and should not be considered a recommendation to buy or sell a particular security. Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.