Does value investing work?

In an excellent book, well worth written “Buffett Beyond Value”, the author, Prem C. Jain, writes on some studies that prove the superiority of the value investing method.

“After this discussion of value investing, you might ask if there is reliable evidence in support of value investing. Academics have asked this question for a long time because they are usually not satisfied by anecdotal evidence. Buffett has addressed this issue head-on. Speaking at Columbia University in 1984, he presented the performance records of seven disciples of Benjamin Graham. He also included the performance of two pension funds for which he had helped select managers with value orientation. The results show that value investors do very well. Buffett writes: "(I)f you found any really extraordinary concentration of success, you might want to see if you could identify concentrations of unusual characteristics that might be causal factors. Scientific inquiry naturally follows such a pattern”. In this case, the main common characteristic was the value investing approach that all the Graham disciples had followed.

It is not surprising that Buffett's findings did not have any effect on the general academic opinion, at least until recently. Academics usually rely on evidence from very large data sets and are convinced only when a strategy has been shown to work over long periods. In other words, an academic study would conclude in favor of an investment strategy only if even a monkey (computer) could replicate the strategy. In my opinion, this is not necessarily a very good approach to advance our knowledge, but it is the academic standard. Nevertheless, recent academic research seems to have turned the corner in favor of value investing.

Academic Research Evidence

Academic research is based on analyzing large sets of data using extensive computer power. We should keep in mind that it is almost impossible to program a computer to identify what Benjamin Graham calls "large, prominent, and conservatively financed" companies or identify high-quality management. For example, how would a computer know that the CEO of Berkshire Hathaway is a good manager? For this reason, qualitative variables are all but ignored in most academic studies or their treatment is simplistic. In defense of academic studies, the good news is that those studies meet the highest possible standards of any studies of large data sets, and everything about the methodology is clearly laid out. Hence, they do provide us reliable statistical results to ponder.

Research has shown that even simple value investment strategies, such as investing in low P/E stocks, produce outstanding returns over a number of years. These results have been replicated by many researchers over different periods and are, thus, reliable. Therefore, it can be concluded that an investor who implements simple value investment strategies and uses other discerning qualitative variables should obtain even better returns. Graham points out that "(an) investor should start with the low-multiplier (i.e., low P/E) idea, but add other quantitative and qualitative requirements thereto in making up his portfolio.” Many apparent low P/E stocks such as Kmart and Bethlehem Steel would not have been selected by careful value investors because the companies were neither prominent nor conservatively financed. In the next section, I discuss two sets of studies. I first present a discussion of studies that compare performances of portfolios constructed by high versus low P/E stocks, and then I compare performances of portfolios constructed by high market-to-book versus low market-to-book stocks.

Performance of High versus Low P/E Stocks

The most prominent of recent studies on value investing was conducted by Professors Joseph Lakonishok from the University of Illinois and Andrei Shleifer and Robert Vishny from the University of Chicago, They formed portfolios based on P/E and several other ratios to examine annual stock returns from 1963 to 1990. In Table, I present results from a similar analysis I conducted that includes return results until 2007. The table first shows returns to 10 different portfolios of stocks formed annually on the basis of P/E ratios. Portfolio 1 is composed of 10 percent of the stocks with the highest P/E ratios, or the extreme-glamour stocks. Similarly, Portfolio 10 is composed of stocks with the lowest P/E ratios, or the extreme-value stocks.

  

Table: Evidence That Value Investing Works

The portfolios of the lowest P/E stocks beat the portfolios of the highest P/E stocks by a considerable margin. The corresponding returns are 15.9 percent versus 9.4 percent per year. Lakonishok and colleagues show that over a five-year period after formation of the portfolios, the extreme-value (lowest P/E) stocks earn a 138.8 percent return in comparison to a 71.1 percent return for the extreme-glamour (highest P/E) stocks. Thus, over a five-year period, the lowest P/E stocks outperform the highest P/E stocks by a factor of almost two to one. Even if you did not invest in only the lowest P/E portfolio, the performance is generally better for the lower P/E stocks than for the higher P/E stocks. These results support Benjamin Graham's ideas on value investing, which should encourage you to follow his approach.

Performance of High versus Low Market-to-Book Stocks

The accounting value of a company's common stock as reported on the balance sheet is known as the book value. It is based on accounting rules and procedures. On the other hand, the price per share, or the market value, receives a lot of attention and is determined by the market. Generally, if a company's earnings are expected to increase at a high rate, the market price is substantially higher than the book value. An investor should ask: "How high should the market price be in comparison to the book value in order to invest?" There is no general formula to answer this question. Therefore, an investor should examine the historical ratios of the same firm as well as the ratios of other firms in the same industry. If the market price is substantially higher than the book value, it is likely that the price is too high for a value investor to choose the stock. On the other hand, if the market price is not very high, the value investor should look favorably and possibly invest in the stock-keeping in mind Graham's view that the company should be large, prominent, and conservatively financed.

The results of a comprehensive study conducted by Eugene Fama and Kenneth French of the University of Chicago support the idea that investing in low market-to-book ratio stocks results in higher returns. Fama and French examined monthly returns for a large number of stocks from July 1963 to December 1990, a period of more than 27 years. I replicate their analysis using recent data, and those results are presented in Table. The extreme-value portfolio includes 10 percent of the lowest market-to-book stocks, whereas the extreme-glamour portfolio consists of 10 percent of the highest market-to-book stocks. The difference in returns across the two extreme decile portfolios is about 6 percent. Using the market-to-book metric, Lakonishok and colleagues also report results for a five-year strategy in which the stocks are held for five years once the portfolios are formed. They find that for a five-year holding period, the extreme-value portfolio earns 146.2 percent as opposed to only 56.0 percent for the extreme-glamour portfolio. The conclusion from these studies is that the value investment strategy works well enough that you should be able to beat most of the professional money managers who focus on short-term results.

The Power of Multiple Variables

Beyond the P/E strategy or the market-to-book strategy, researchers have examined portfolios formed on the basis of several other variables. In particular, portfolio formations based on cash-flow-to-price and growth in past sales or assets support the value investing approach. It is better to buy high cash-flow-to-price than low cash-flow-to-price stocks, and similarly, it is better to buy stocks with low past growth in sales than high past growth in sales. In addition, when two ratios are used simultaneously, the results are even stronger.

Using two variables (e.g., growth in sales and P/E), Lakonishok and colleagues form nine stock portfolios. The stocks are independently sorted, in ascending order, into three groups of bottom 30 percent, middle 40 percent, and top 30 percent based on each of the two variables. Returns presented are compounded five-year post-formation returns and assume annual rebalancing of these nine portfolios. The important conclusion from this analysis is that a value investment strategy based jointly on past performance (growth in sales) and expected future performance (P/E or market-to-book ratio) produces higher returns than strategies based exclusively on one variable, such as the P/E ratio.”