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Investing Basics 2001 Getting More for your Money: The Big Advantage of Value In
by Paul A. Merriman Publisher and Editor
Let’s get something out on the table right away: This is an unpopular topic. I’m going to preach a sermon that many people won’t like – from the gospel of value investing. I’m going to tell you that you should invest in stocks that other investors don’t want, stocks whose prices may have been going down instead of up.
This goes against the grain, I know. According to the strange logic followed by so many investors, it’s apparently better to pay full price for stocks, or even pay above the full price, than to buy them when they’re on sale.
Since this is the first article in a series we will publish over the next year called Investing Basics 2001, let’s back up for a moment and define our territory.
First, I am assuming you are interested in boosting your returns in equity investing. This topic is one of the fundamental building blocks of building a buy-and-hold portfolio that will produce higher returns.
The following statement oversimplifies a complex point, but the universe of stocks can be divided into two major groups: growth companies and value companies. Growth companies are popular, "hot," the darlings of Wall Street. They exude excellence, they inspire pride and hope. They are the sort of businesses you’d be proud to own. They have rising sales, rising profits and rising prospects. Not to mention rising stock prices.
Current well-known examples among big companies are General Electric, Microsoft, America Online, Cisco Systems and Home Depot. These companies have great stories, great success, great stocks.
At the other end of the scale are value companies. These are unpopular, for whatever reasons. They may be in moribund industries. They may have stumbled badly in some way. Their sales, profits and prospects may be low or uncertain. They may have crummy management or terrific competition. For whatever reason, they have fallen from grace among investors, and their stocks show it.
A couple of current examples of companies that were once respected and now are struggling for their corporate lives: Sunbeam Corp. and CompUSA, the country’s largest computer retail chain. You’ll search in vain for an analyst who rates Sunbeam as "strong buy," but you’ll find several who rate it "hold." Translated, a rating of hold usually means "I think investors should dump this stock, but nobody at the company will speak to me again if I say that in so many words. Therefore, (wink, wink) I’ll recommend a hold, and you’ll know what I mean." CompUSA was recently rated a "strong buy" by one analyst. But another nine analysts rated it a "hold."
Now, am I saying you should rush out and buy shares of these two companies? Not at all. There are good reasons these companies are out of favor. But these stocks, and many more like them, have fallen in price. In a word, you could describe them as cheap.
When you shop, of course, you know that not everything that’s marked down is a good buy. Likewise, some bargain-priced stocks will turn out to be dogs. Some may struggle for years, only to wind up in bankruptcy court or to be bought by some other company hunting for bargains.
In a store, you can examine sale merchandise and usually figure out if it’s something you want or need. In the stock market, that’s trickier because there are so many variables and so many unknowns. Some professional analysts have had success in identifying which value stocks are worth buying and which should be left alone. But even fulltime professionals make plenty of mistakes. You’re likely to do the same if you try this on your own.
Unless you’re a professional, the best way to buy value stocks is to buy lots of them. A portfolio full of value stocks will undoubtedly contain some losers. But on average over the years, a large group of value stocks will often outperform an equally large group of popular growth stocks.
Emotionally, you’ll probably want to own some glamorous growth companies. They let you sleep well at night, knowing "your" companies have some of the best managements and some of the biggest market shares in the world. But because everyone seems to want such stocks, forget about finding them at bargain prices.
The lofty prices of growth stocks are based on the assumption that these companies will continue to produce miraculous results. When Wall Street’s prevailing mood is optimistic, these stocks are the ones that get the spotlight. But when anything goes wrong, they can drop like rocks.
If you’re looking for long-term returns above those that come from following the crowd, you may find them in value stocks, according to the best research that we know about. History bears this out, according to studies by Dr. Eugene Fama of the University of Chicago and Dr. Kenneth French of Yale. Among U.S. stocks, from 1964 through 1998, small value companies compounded at 17.6%, compared with 12.1% for small growth companies. Large value companies grew at 15.1% in the same 35 years, while large growth stocks compounded at 11.4%.
Separate studies have shown that the same effect holds true going back to 1926.
Value works in international stocks, too, though the data we have on international stocks is broken down somewhat differently.
From 1975 through 1998, an index of international value stocks gave investors a much better reward than an index of big international stocks known as EAFE:
Growth vs. value Large international growth stocks, 1975-1998
Let’s look at a few other comparisons. The time periods are different, reflecting the data that we have available on some of the important asset classes.
Growth vs. value U.S. large stocks, 1964 -1998:
Now let’s see the comparison with small U.S. stocks.
Growth vs. value U.S. small stocks, 1964 -1998:
Finally, let’s look at a more specialized asset class, emerging markets stocks.
Growth vs. value Emerging markets stocks, 1988 -1998:
The evidence seems pretty clear: There’s value in value. But just what is "value" and how do you know it when you see it?
So far, we’ve tossed around the terms "value stocks" and "growth stocks" as if they were common terms. But of course they aren’t. There are many possible ways to define value stocks, but the best correlation with the results noted above comes from what’s called the price-to-book ratio. This is the ratio of the company’s stock price divided by its book value (the total of all its assets minus all its liabilities) per share. A high price-to-book ratio indicates a growth company, a low price-to-book ratio a value company.
For instance, Microsoft has a book value of $5.37 per share. Its stock price was recently $93.50, giving it a price-to-book ratio of 17.4. By contrast, Novell a rival software company, has a book value of $4.65 and had a recent stock price of $17. That gives it a price-to-book ratio of 3.7. By the numbers, this labels Microsoft, as you would expect, a growth company and Novell a value company.
Does that mean that Novell stock will do better than Microsoft stock in the future? Not at all. These are not companies to buy one at a time, especially based on this by-the-numbers approach. But if you could identify 300 stocks like Novell and 300 like Microsoft, the chances are that over time the 300 Novells will outperform the 300 Microsofts. It’s counter-intuitive, but it works.
The best way investors can take advantage of value investing is through a mutual fund. A fund can buy shares in hundreds of value companies, avoiding the risk of being torpedoed by a few bad value stocks that deserve to be unloved and unwanted.
If you’re looking for a mutual fund that specializes in value stocks, here are some examples, taken from the Model Portfolios you can find on our Web site, www.FundAdvice.com: American Century Income & Growth, Vanguard Value Index (large stocks); Vanguard Small-Cap Value Index. And in the international arena, check out Oakmark International Small-Cap.
Source: http://www.fundadvice.com
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